Курсовая: Европейская денежная система

European Monetary System and European Currency

Based on selected papers kindly provided by the European Central Bank

Compiled by Dm. Evstafiev

for the students of the School of Political Science

at St. Petersburg State University

St. Petersburg

1999

Developments in the Financial Sector in Europe

following the Introduction of the Euro

Speech by Dr. Willem F. Duisenberg,

President of the European Central Bank,

to be delivered at the Third European Financial Markets Convention

Milan, 3 June 1999

1. Introduction

The period of the five months following the introduction of the euro has been

very rich in new events, with significant developments taking place both in

the continental securities markets and in the financial system as a whole.

Although experience has been gathered over a relatively short period of time,

I am tempted to make two observations of a fundamental nature.

The first observation is that developments following the introduction of the

euro do not imply that the euro area is set to become a financial fortress

whose financial markets and institutions would be cut off from the rest of

the world. In fact, market participants residing outside the euro area seem

to be taking a keen interest in the financial markets of the euro area. "Core

Europe", so to speak, has become more interesting to outsiders as the breadth

and liquidity of its financial markets has increased.

The second observation is that the euro can be expected to have a significant

influence on the structure of the financial system by bringing about more

securitisation. A traditional feature of the financial system of continental

Europe has been a marked dependency on the funds intermediated by banks. This

feature contrasts with the financial system of the United States which is

much more securitised. For instance, corporate bonds have not been very

widely issued in the euro area, and stock market capitalisation - relative to

the size of the economy - is much lower in the euro area than in the United

States. There are good reasons to believe that a process of securitisation

will gather pace in the euro area now that the single currency is in use.

This view seems to be shared by many observers and I shall, in the course of

my remarks, provide some arguments in its favour.

In my remarks today, I should like to discuss the structural changes in the

financial sector, in particular those that have occurred as a result of the

launch of new product types and the changing nature of public and private

institutions. I shall address developments in the money markets, the bond

markets and the equity markets as well as the process of adaptation of

banking institutions to their new environment.

2. Money markets

The money markets of the euro area became rapidly integrated after the

introduction of the euro despite the fact that their structures had

previously been quite different at the national level. Transaction volumes

and measures of bid-ask spreads on the various money market instruments both

indicate that the markets reached a very high level of liquidity very rapidly

in the course of January 1999 and have subsequently retained it.

The high degree of integration of the euro area money markets is, first of

all, a result of the single monetary policy, which is conducted through the

harmonised operational framework of the Eurosystem. This integration has also

been made possible by the significant and increasing integration of payment

systems. Cross-border payments processed by TARGET accounted for more than

37% of the value of all real-time payments (domestic and cross-border)

effected by credit institutions in March and April 1999. Moreover, the

continuously high use which our counterparties make of the correspondent

central banking model (or CCBM) for the cross-border transfer of collateral

in monetary policy operations is an important indication of area-wide

integration. This is evidenced by the fact that cross-border collateral

currently represents around 25% of the total amount of collateral in custody

in the context of the Eurosystem's monetary policy operations.

Taking a closer look at the various instruments traded in the money markets,

a feature that is worthy of note is that market participants in the 11

countries of the euro area have shown an increasing tendency to demonstrate a

similar reliance on each instrument type. For example, what we call

"overnight indexed swaps", which are swaps indexed on the overnight reference

interest rate EONIA, have become an important derivative instrument in the

money markets of the euro area. This can be seen from the low level of quoted

bid-ask spreads and the high turnover relative to other major international

markets. Both indicators show a high level of liquidity in this instrument.

Another type of instrument of interest in the money market (but also at the

fringe of the bond market) is that of the repurchase agreement. The

development of more integrated repo markets in the euro area will obviously

accompany the development of area-wide securities trading, settlement and

custody systems. This will reduce transaction costs and improve efficiency

for the cross-border transfer of securities through repurchase operations.

Looking ahead, other developments in the money markets are expected in the

coming months. There are aims to establish new area-wide standards for the

repo markets, with a view to overcoming the separation between different

models in the national markets. These new standards could obviously co-exist

with other standards and broader conventions for international transactions.

In fact, over the last few months the European Central Bank (ECB) has been

examining whether this co-existence could affect the integration of money

markets. We have come to the conclusion that, in particular owing to the

efforts of the sponsors of the different standards, this should not be

considered a threat.

Finally, it should also be noted that national and international central

securities depositories are currently developing links with one another,

which will enable participants in one country to make direct use of

securities deposited in other countries. Twenty-six of these links

(concerning mainly Belgium, Germany, France, Luxembourg, the Netherlands,

Austria and Finland) may be used by the Eurosystem.

3. Bond markets

I should now like to turn to bond markets and first to comment on the

position of euro area bond markets in the global market. Some data sources on

international securities issuance available so far show a pattern of

increased reliance on euro-denominated bonds at the beginning of 1999, in

particular as opposed to US dollar-denominated bonds. While it remains

difficult to draw firm conclusions on the determinants of bond denomination

choices without considering information on the nature of bond holdings and

trading patterns, recent bond issuance volumes indicate that the euro has the

potential to become an important currency for international bond issuance.

The importance of the euro area bond market is also apparent in measures of

secondary market activity, i.e. turnover or trading volumes. In particular,

trading volumes on exchange-traded bond futures are indicative of the overall

degree of market activity. Volumes traded in euro-denominated bond futures

were low shortly before the changeover to the euro, when the bond markets in

the euro area were exceptionally quiet. Since then, volumes have increased

markedly and they currently stand at consistently high levels, which

indicates a continuously high degree of turnover in euro-denominated bond

markets in general.

Turning to the internal structure of the bond markets of the euro area, I

should like to make an initial observation related to the recent marked

increase in euro-denominated corporate bond issuance, which was accompanied

by an increase in the average size of issues. This tendency is likely to

continue in the future, in particular to the extent that bonds may be used by

firms to finance increasing mergers and acquisitions activity in the euro

area. The underlying reasons for increased bond issuance by euro area firms

are clear, both on the supply and on the demand side. On the supply side,

large firms with good credit ratings will find opportunities in the increased

depth and liquidity of the euro area bond market. On the demand side, the

respect by governments of the parameters of the Stability and Growth Pact

over the medium term should leave more room for the private sector to issue

debt securities. In addition, the euro area must be in a position to save in

order to be able to take care of its future pension payments, and a part of

these savings is likely to be invested in corporate debt securities. An

increase in global demand for euro-denominated debt securities is also

expected as the euro becomes a major reserve currency. Moreover, the demand

for higher risk euro-denominated debt securities is likely to increase,

particularly as the current low level of sovereign yields increases

incentives to search for higher yields.

With regard to the government bond markets, an issue of importance for the

euro area that I should like to stress is the fact that governments now find

themselves in a rather new position as issuers. This reflects a number of

developments, two of which I should particularly like to mention. First, the

major public issuers have attempted to position themselves as providers of

benchmarks for euro-denominated bond markets. Second, certain issues of

government bonds have effectively gained larger portions of secondary

markets, in particular in relation to developments that have occurred on bond

futures markets.

Market participants have responded to these developments in the bond markets

with a range of concurring or competing initiatives and alliances. In the

derivatives industry, market participants have established new alliances. On

the trading side, electronic cross-border platforms for bonds have been

created or are in the process of being developed. On the clearing side,

integrated platforms for different markets have been launched or are being

finalised, while, finally, on the securities settlement side, initiatives

have also been launched. It is important to note that while some of these

developments are internal to the euro area, others aim at creating links with

financial markets outside the euro area. One may reasonably expect that all

of these new circuits, as well as others, may in the future be enlarged to

encompass a growing number of market participants.

4. Equity markets

Turning to equity markets, structural developments of most interest relate to

the infrastructure of stock exchanges on the one hand and equity derivative

exchanges on the other. First, within the euro area, equity investment and

trading activities appear to be less and less influenced by country-specific

factors and increasingly subject to area-wide considerations. Consistent with

this development, area-wide equity indices have been developing. Market

participants are showing considerable interest in these area-wide indices, in

particular as they are also now adopting investment positions on area-wide

industrial sectors, using the sub-indices made available for that purpose. An

indication of the degree of interest raised by area-wide indices is the

relatively fierce competition for benchmark status that has developed between

the various proponents of area-wide indices.

Second, market developments in relation to stock index futures and options

will reflect the rise of area-wide indices. This may in turn lead to either

consolidation or product specialisation of equity derivative exchanges. For

my part, I consider the development of fair competition between exchanges to

be a positive factor in terms of the improvement of the range of products and

services available to the financial industry.

Third, in the equity market the euro has also provided a powerful incentive

for the creation of new - and possibly competing - alliances among exchanges.

Before the launch of the single currency, circuits had been created for the

launch of integrated "new markets" within and beyond the euro area,

encompassing the shares of small and medium-sized companies with a high

potential for growth. The development in the integration of exchanges has

also continued more recently, and, as you know, it has not been limited to

the euro area.

5. Banking

In the field of banking, the securitisation trend appears to demand strategic

and organisational adjustment on the part of banks. The relative importance

of the more traditional types of banking activity can be seen to be

decreasing, even though it should be mentioned that traditional banking

activities have nonetheless continued to grow at a rate exceeding that of

growth of nominal GDP. In the euro area, growth in recent years has been much

more rapid in assets under the management of mutual funds and other

institutional investors than in the assets of banks. This reflects a tendency

towards decreasing the relative weight of bank deposits compared with

securities in financial wealth.

The euro area banking industry has reacted to this development already by

diversifying into the asset management area. Banking groups have been able to

"internalise" a significant part of the securitisation tendency as they

control a large majority of the mutual funds. As a result of the

securitisation trend, there has been an increase in the share of security

holdings among bank assets, and an increase in the share of capital gains -

although those are quite cyclically sensitive - as well as in fee income

stemming from asset management services. Meanwhile, the relative importance

of interest income has declined correspondingly. At the bank level, dividend

income from equity participations has generally become much more important,

indicating an increase in the importance of the profit generated by non-bank

subsidiaries.

Beside the establishment of non-bank subsidiaries, there have been other

strategic and organisational changes that have resulted in banks

strengthening their securities-related activities. In particular, significant

motives behind the recent merger trend seem to include the desire to increase

bank size and hence to be able to operate efficiently in wholesale securities

markets as well as to be able to cater for the needs of large international

corporations for investment banking services.

The trend towards securitisation can be regarded as one of the reasons for

the structural changes in the banking system that appears to have accelerated

recently. There have naturally also been other reasons why banks have sought

to merge, predominantly the need to cut capacity and to reduce costs. These

cost-driven mergers have taken place primarily among smaller banks.

6. Conclusion

In my remarks today, I have referred to a number of changes and market

initiatives in the euro area financial landscape. These developments point to

the increasing importance of the fixed income and equity markets that many

expected in Stage Three of Economic and Monetary Union (EMU), providing new

opportunities for borrowers and investors and causing pressure to adjust for

financial institutions. In this respect, I should like to mention the

importance of removing the remaining regulatory barriers to the further

development of the securities markets. To this end, the European Commission

has recently published an Action Plan of regulatory changes to improve the

single market for financial services that would certainly - when implemented

- boost the integration and market-driven development of the European

securities markets.

Finally, I should like to conclude with some remarks about the role of the

Eurosystem (the term that we use to mean the ECB and the 11 national central

banks of the Member States participating in Stage Three of EMU) in the

developments in the financial sector in Europe. First of all, the Eurosystem

contributes to developments in the financial sector by providing it with a

stable and credible monetary policy. With a strong and credible commitment to

its primary objective, price stability, the Eurosystem has created a

situation in which the financial sector can concentrate on those issues that

are of the greatest relevance to its activities.

The Eurosystem does not play a direct role in structural developments in the

financial sector. With its single monetary policy framework and TARGET in

particular, the Eurosystem has created an infrastructure that has proved to

be useful for the establishment of an integrated money market in the euro

area.

In addition, the Eurosystem carefully monitors structural developments in the

financial sector to the extent that they might have an impact on the conduct

of monetary policy. To make a final point, in observing developments in the

financial sector, the Eurosystem constantly takes account of the fact that

one of its tasks, laid down in the Treaty establishing the European

Community, is to "contribute to the smooth conduct of policies pursued by the

competent authorities relating to (.) the stability of the financial system"

[(Article 105 (5))]. Analysis of the common developments in the European

financial system represents such a contribution.

***

Economic and Monetary Union in Europe - the challenges ahead

Speech by Professor Dr. L.H. Hoogduin,

on behalf of Dr. Willem F. Duisenberg,

President of the European Central Bank,

at the symposium sponsored by the Federal Reserve Bank of Kansas

City

on "New challenges for monetary policy"

on 27 August 1999 in Jackson Hole, Wyoming

From the European perspective, the title of this year's Jackson Hole

symposium - "new challenges for monetary policy" - is particularly

appropriate. Economic and Monetary Union (EMU) in Europe is a unique project

and its consummation with the introduction of the single monetary policy on 1

January 1999 took place less than eight months ago. Today, given the time

available, I will not endeavour to review all the challenges which are raised

by EMU comprehensively. I shall have to be selective, largely focusing on the

primary objective of the Eurosystem, which is to maintain price stability in

the euro area. In this context, let me briefly explain our terminology, which

may perhaps not be known to everybody as yet. The "Eurosystem" is the name we

gave to the European Central Bank (ECB) and the currently eleven national

central banks of those countries which have introduced the euro. The "euro

area" comprises these eleven countries.

I should like to start with some observations on the objective and

limitations of monetary policy in the euro area. Owing to the successful

process of disinflation and convergence within Europe over the past decade,

the launch of the euro last January took place in an environment of price

stability that few observers would have predicted only a few years ago.

Consumers and firms are already reaping the benefits of this environment. The

relative price signals on which the efficiency of the market mechanism relies

are not obscured by volatility in the general level of prices. By avoiding

the costs and distortions inflation would impose on the economy, price

stability is contributing to the growth and employment potential of the euro

area.

This contribution is substantial. Unfortunately, it is all too easily taken

for granted. Memories of the still recent past relating to the consequences

of high and unstable inflation tend to fade rapidly. We are sometimes already

hearing the argument that, given that price stability has been achieved,

monetary policy should now be re-oriented away from its primary objective of

price stability towards other goals. One of the challenges facing the

Eurosystem is to maintain the support of the broad public constituency

necessary to resist these calls, which - as I hardly need to point out to

such a distinguished audience of central bankers and monetary economists -

are misguided and ultimately counter-productive. However, it can be said that

the situation is the same as that in the world of sports; winning a

championship and reaching the top is difficult, but staying there is even

harder.

The institutional framework for European monetary policy, as created by the

Maastricht Treaty (i.e. the Treaty on European Union, which has become part

of the Treaty establishing the European Community, or the EC Treaty, in

short) is well suited to meeting this challenge. Most importantly, the single

monetary policy has been clearly assigned the primary objective of

maintaining price stability in the euro area. To facilitate the achievement

of this goal, the ECB and the national central banks have been accorded a

high degree of institutional independence so as to protect monetary policy

decisions from undue external interference.

The Treaty imposes several duties and tasks on the ECB. However, there is no

doubt that the objective of price stability is over-riding. For example, the

Treaty stipulates - if I may quote - that the Eurosystem "without prejudice

to the objective of price stability, . shall support the general economic

policies in the Community, with a view to contributing to the achievement of

the objectives of the Community", which include "sustainable and non-

inflationary growth" and "a high level of employment".

Given the clear priority attached to the primary objective of price

stability, how does the ECB address these other Treaty obligations? Let me

make three points in this regard.

First, among economists and central bankers, there is overwhelming agreement

that there is no long-run trade-off between real activity and inflation.

Attempting to use monetary policy to raise real economic activity above its

sustainable level will, in the end, simply lead to ever higher inflation, but

not to faster economic growth. I am convinced that the best contribution

monetary policy can make to sustainable growth and employment in the euro

area is to maintain price stability in a credible and lasting manner,

allowing the considerable benefits of price stability to be reaped over the

medium term. This is the economic rationale underlying the EC Treaty and the

Eurosystem's monetary policy strategy.

Second, it is generally acknowledged that monetary policy does affect real

activity in the short run. Although the focus must always be on price

stability, in many cases the policy action required to maintain price

stability will also help sustain short-run economic and employment prospects.

The reduction of the Eurosystem's main refinancing rate on 8 April was a case

in point. Following the Asian and Russian financial crises last year, global

demand weakened. Weaker external demand led to a shift in the balance of

risks to price stability in the euro area towards the downside, as demand

pressures abated. As monetary indicators did not signal inflationary risks at

that time, the Governing Council of the ECB concluded that a cut of 50 basis

points in the main refinancing rate best served the maintenance of price

stability. This lower level of interest rates may also be supportive of real

activity and employment in the short-run. Our eyes must always be firmly

focused on the goal, on our goal, to maintain price stability in the medium

term. Our monetary policy does not explicitly aim at influencing the business

cycle. However, as said in many cases, the necessary monetary policy measures

to achieve our goal also tend, almost automatically, to work in the right

direction from a cyclical point of view.

This leads me to my third point. In situations where monetary policy might

face a short-term trade-off between adverse developments in real activity and

deviations from price stability, the over-riding priority accorded to

countering the latter must be made absolutely clear. Any ambiguity on this

point will simply endanger the credibility, and therefore the effectiveness,

of the monetary policy response. This does not mean that the policy action

must be draconian. The medium-term orientation of the Eurosystem's monetary

policy strategy permits a gradualist and measured response to previously

unforeseen threats to price stability, should this be regarded as

appropriate, depending on the nature of the threat. Such gradualism may help

to avoid the introduction of unnecessary uncertainty into the real economy.

Recognition and an understanding of these three central points are essential

for the implementation of a successful monetary policy. Communicating both

the objective and the limitations of monetary policy to the public is a vital

issue to which I will return later in my remarks. But it would be remiss at

this point if I did not address what is surely the greatest economic

challenge facing the euro area at present, namely the unacceptably high level

of unemployment. There is a broad consensus that unemployment in the euro

area is overwhelmingly structural in nature. Monetary policy cannot solve

this problem. National governments bear the main responsibility for

structural economic reforms. In particular, further reforms of the tax and

welfare systems are required in many EU countries in order to increase the

incentives to create new jobs and to accept them. Wage moderation can also

have a significant beneficial impact. Monetary policy makes its best

supportive contribution by providing the environment of price stability in

which structural reforms can work most effectively.

It should be recognised that the implementation of EMU has made it even more

urgent to improve the flexibility of labour and goods markets. In this

context, it would very likely be the wrong answer if governments were to try

to create a "social union", harmonising social security systems and standards

at a very high level. The ECB will continue to cajole governments into

implementing necessary and long overdue reforms, but the final hard decisions

- and I acknowledge that they are hard decisions, since the considerable

benefits of structural reform often only become apparent with time - lie with

the national authorities. In those countries where appropriate structural

reforms have been implemented and wage growth has been moderate, unemployment

is either low by euro area standards or is falling more rapidly. These

experiences offer important lessons for other countries in the euro area.

Fortunately, a broader awareness of the necessity of structural reforms

recently seems to be emerging in Europe. Of course, ultimately only sustained

action will count. The cyclical recovery that is underway is no substitute

for such action.

Thus far, I have largely discussed the goal of the single monetary policy.

How is this goal to be achieved? At the heart of the answer to this question

is the Eurosystem's monetary policy strategy. The strategy has two closely

related aspects. First, the strategy must structure the monetary policy-

making process in such a way that the Governing Council of the ECB is

presented with the information and analysis required to take appropriate

monetary policy decisions. Second, the strategy must ensure that policy

decisions, including the economic rationale on which they are based, can be

presented in a clear and coherent way to the public. The communication policy

as part of the strategy obviously has to be consistent with the structure of

the internal decision-making process.

In designing the Eurosystem's strategy, the Governing Council of the ECB

recognised the new circumstances faced by monetary policy in the euro area.

Where there were previously eleven open, generally small economies, there is

now one large, relatively closed single currency area. The challenges implied

by this transformation in the landscape of monetary policy are profound.

Relatively little is known as yet about the transmission mechanism of

monetary policy in the euro area after the transition to Monetary Union. One

important challenge for the Eurosystem is to obtain a better knowledge of the

structure and functioning of the euro area economy and the transmission

mechanism of monetary policy within it, so that policy actions can be

implemented accordingly. Together with experts in the national central banks,

the ECB has embarked on an intensive programme of analysis and research into

these issues.

One obvious problem related to the fact that the euro area did not exist as a

single currency area in the past regards the availability of statistical

data. Compared with national central banks, we do not have the same amount of

long historical time series of monetary and economic indicators, based on

harmonised statistical concepts, at our disposal. However, we have already

developed quite reliable estimates for a number of these historical series,

and the quality and availability of current statistics on the euro area has

increased significantly over the last few quarters, for example in the areas

of money and banking and balance of payments statistics, but also across a

wide range of economic statistics. This process of improving the quality and

the availability of statistical data covering the euro area will continue.

It would have clearly been unwise for the ECB to develop a strategy which

relies mechanically on the signals offered by a single indicator or forecast

in order to take monetary policy decisions. Indeed, such a simplistic

approach to monetary policy-making is unwise in all circumstances. Our

knowledge of the structure of the euro area economy and the indicator

properties of specific variables - although improving rapidly - is simply too

limited.

The primary objective of monetary policy has been quantified with the

publication of a definition of price stability, against which the Eurosystem

can be held accountable. This definition illustrates our aversion to both

inflation and deflation, since it defines price stability as annual increases

of below 2% in the Harmonised Index of Consumer Prices (HICP) for the euro

area. To maintain price stability according to this definition, monetary

developments are closely monitored against a quantitative reference value for

the broad benchmark aggregate, M3. In parallel, a broadly based assessment of

the outlook for price developments in the euro area is undertaken. This

assessment encompasses a wide range of indicator variables, including

inflation projections produced both inside and outside the Eurosystem. Using

all this information, the Governing Council comes to a decision on the level

of short-term interest rates that best serves the maintenance of price

stability over the medium term.

On the basis of this strategy, I am confident that the Governing Council has

taken - and will continue to take - appropriate monetary policy decisions.

The effectiveness of these policy decisions will depend, in large part, on

the credibility of the single monetary policy. Transparent and accountable

policy-making can help to build up a reputation and, hence credibility.

Transparency and accountability, in turn, rely on clear and effective

communications between the Eurosystem and the public.

In this regard, the Eurosystem faces an especially formidable task. As

mentioned earlier, the euro area currently consists of eleven different

sovereign nations, each with its own distinct monetary history and heritage.

With each policy announcement or Monthly Bulletin, the Eurosystem must thus

communicate with the public of eleven different countries and must speak in

all eleven different official languages of the European Union. Such a

situation is unprecedented. This diversity of language, history and culture

across the euro area raises further challenges for the ECB.

Over the years, each national central bank had developed its own strategy

and, linked to this, its own "monetary policy language" for communicating

with the public in the nation it served. This language reflected the unique

circumstances of the country in question. The process by which the public

learnt this monetary language from the statements and behaviour of the

national central bank was largely subconscious. Over time, the strategies and

the related language and conventions of monetary policy came to be so well

understood as to be almost second nature. In these circumstances, private

economic behaviour was shaped by the monetary policy environment.

Many of us have experienced the problem of trying to learn a second language

in adult life. This rarely comes as easily as learning your native tongue as

a child. It is certainly not a subconscious process, but rather one that

requires effort and perseverance. It is often difficult to overcome the

habits and conventions of one's first language, which are inevitably somewhat

at odds with those of a foreign tongue. Of course, it is easier to learn a

language that shares common roots with one's own. Nevertheless, to obtain any

degree of fluency, there is no alternative to long hours practising

pronunciation, studying grammar and learning vocabulary. Even then, the

idioms and slang of the new language are sometimes hard to follow. There are

no easy short cuts.

With the adoption of the euro last January, the public, financial markets and

policy-makers in the euro area have all had to get used to a new monetary

policy environment and have, thus, had to learn a new "monetary policy

language". The Eurosystem's monetary policy strategy has been designed, in

part, to make this learning process as straightforward as possible.

Continuity with the successful strategies of the national central banks prior

to Monetary Union was one of the guiding principles governing the selection

of the monetary policy strategy. Nevertheless, given the changed environment

for monetary policy, a new strategy with a new vocabulary had to be

developed, reflecting the unique and novel circumstances facing the

Eurosystem.

Some commentators have suggested that the Eurosystem simply adopt the

strategy used by another central bank or by a national central bank in the

past. Tellingly, such observers often suggest the strategy they know best:

Americans suggest using the Federal Reserve as a model; Britons, the Bank of

England; Germans, the Bundesbank. However, the Eurosystem cannot simply adopt

a strategy designed by another central bank for a different currency area

under different economic circumstances. A strategy that might have been

suitable in one situation may be quite inappropriate for the unique and novel

circumstances facing the Eurosystem, given the very different economic

structure and environment confronting it.

A key feature of the ECB's communication policy is the monthly press

conference given by the ECB's Vice-President and myself, usually immediately

following the first Governing Council meeting of each month. During these

press conferences, I make an introductory statement summarising the Council's

discussions and conclusions before answering questions from journalists. As

the statement is agreed, in substance, with all the Council members

beforehand it is similar to what others call minutes. The press conference

provides prompt information in an even-handed way, and it offers the

opportunity for immediate two-way communication. As far as I am aware, no

other central bank communicates with the public in such a prompt manner

immediately after its monetary policy meetings.

These press conferences are a tangible expression of the Eurosystem's

commitment to be open, transparent and accountable in its conduct of monetary

policy. In my view, our commitment to openness should not be in doubt.

However, ensuring that this openness translates into effective communications

continues to be a challenge. Journalists, financial markets and the public

are still learning the new strategy and language of monetary policy in the

euro area.

By its nature, the challenge of improving communications between the

Eurosystem and the public is two-sided. On the one hand, the ECB must use a

clear and transparent language consistent with the strategy it has adopted.

It must help the public understand the changes of emphasis and communication

necessitated by the new monetary policy environment in Europe. We have made

important progress in this regard over the last eight months, but I

acknowledge that we still have some way to go. The ECB must do its utmost to

be understood by its counterparts in the media that act as important

intermediaries to the public at large. By learning from one another, we can

improve the transparency, democratic accountability and effectiveness of the

single monetary policy.

Before concluding, I should like to add a brief comment on the likely future

enlargement of the European Union (EU) and, prospectively, the euro area.

Currently, the EU negotiates the accession of six countries to the EU. Once

the accession of new Member States is decided, these countries have to fulfil

the so-called convergence criteria, if they want to join the euro area. The

euro area can finally only be enlarged if the European Council, following an

assessment by the ECB and the European Commission, decides that further

Member States of the EU are ready to adopt the single currency. New countries

joining the euro area will be a challenge for us. For example, we will have

to integrate the respective economy fully in our area-wide analysis of

monetary, financial and other economic developments in the euro area.

Enlargement is a challenge we clearly welcome. I have no doubts that we can

master it, not least as the EC Treaty outlines a clear and transparent

procedure for countries wishing to join the euro area. In simple terms, this

can be viewed as involving three phases. First, a candidate country must join

the European Union, for which certain requirements must be met. Second, the

candidate is expected to join the new exchange rate mechanism, ERM II. Third,

as mentioned earlier, the country must fulfil the convergence criteria. In

addition to fiscal discipline and inflation control, these criteria include a

relatively low level of long-term interest rates and stable exchange rates.

Let me conclude. Monetary policy cannot solve all of the economic challenges

facing the euro area, in particular those concerning the urgent need to

reduce the high level of structural unemployment. National governments are

responsible for carrying out the required structural reforms. The Eurosystem

makes its best contribution to area-wide growth and employment prospects by

credibly focusing on the maintenance of price stability in the euro area.

I am confident that the monetary policy strategy adopted by the Governing

Council of the ECB last October has been successful - and the monetary policy

decisions that have been based on it over the last eight months - serve the

fulfilment of this objective. Nevertheless, we will not become complacent; on

the contrary, we will have to continue to invest substantially in analysing

the structure of the euro area economy, and in understanding the monetary

policy transmission mechanism and the information content of the various

monetary and economic indicators.

Monetary policy is most effective when it is credible. Transparent and

accountable policy-making can help to build up a reputation and credibility.

Effective direct communications with the public, including the financial

markets, other policy makers and the media requires that we speak with one

voice in an even-handed way with our diverse counterparties and audience.

Successfully refining our area-wide communications, aimed at making our

strategy, and the monetary policy based on it, transparent so that it can be

well understood by the large and varied population we serve, is one of the

challenges faced by the Eurosystem and, by implication, one of our

priorities.

***

EMU AND BANKING SUPERVISION

Lecture by Tommaso Padoa-Schioppa

Member of the Executive Board of the European Central Bank

at the London School of Economics, Financial Markets Group

on 24 February 1999

TABLE OF CONTENTS

I. Introduction

II. Institutional framework

III. Industry scenario

IV. Current supervision

V. Crisis management

VI. Conclusion

Tables

I. INTRODUCTION

1. I am speaking here, at the London School of Economics, only a few weeks

after one of the most remarkable events in the history of monetary systems:

the establishment of a single currency and a single central banking

competence for a group of countries which retain their sovereignty in many of

the key fields where the State exerts its power. To mint or print the

currency, to manage it and to provide the ultimate foundation of the public's

confidence in it has been, from the earliest times, a key prerogative of the

sovereign. "Sovereign" is indeed the name that was given in the past to one

currency. And a British Prime Minister not so long ago explained her

opposition to the idea of the single currency with the desire to preserve the

image of the Queen on the banknotes.

2. For centuries money has had two anchors: a commodity, usually gold; and

the sovereign, i.e. the political power. Less than 30 years after the last

bond to gold was severed (August 1971), the second anchor has also now been

abandoned. Although I personally think that political union in Europe is

desirable, I am aware that the present situation, in which the area of the

single currency is not a politically united one, is likely to persist for a

number of years. This means that we have given rise to an entirely new type

of monetary order. For the people, the success of this move will ultimately

depend on the ability of governments and political forces to build a

political union. For the central banker and for the users of the new

currency, the success will be measured by the quality of the currency itself,

and such quality will be measured in the first place in terms of price

stability. This is not only a requirement explicitly set by the Treaty of

Maastricht, it is also, in the opinion of most, the "new anchor" that purely

fiduciary currencies need after the gold anchor is abandoned.

3. My remarks, however, will focus on another, less fundamental but still

important novelty of the monetary constitution that has just come into

existence. It is the novelty of the abandonment of the coincidence between

the area of jurisdiction of monetary policy and the area of jurisdiction of

banking supervision. The former embraces the 11 countries that have adopted

the euro, while the latter remains national. Just as we have no precedent of

any comparable size of money disconnected from states, we have no precedent

for a lack of coincidence between the two public functions of managing the

currency and controlling the banks.

In the run-up to the euro this feature of the system was explored, and some

expressed doubts about its effectiveness. I will tonight examine the problems

of banking supervision in the euro area. The plan of my remarks is the

following. I will first review the existing institutional framework for the

prudential control of banks in EMU. I will then examine the likely scenario

for the European banking industry in the coming years. Against this

institutional and industry background, I shall then discuss the functioning

of, and the challenges for, banking supervision and central banking in the

euro area, both in normal circumstances and when a crisis occurs.

II. INSTITUTIONAL FRAMEWORK

4. The origin and developments of modern central banks are closely linked to

key changes undergone by monetary systems over the past two centuries. Such

changes could, very sketchily, be summarised as follows. First, paper

currency established itself as a more convenient means of payment than

commodity currencies. Second, commercial bank money (bank deposits) spread as

a convenient substitute for banknotes and coins. Third, the quantity of money

was disconnected from the quantity of gold. Thus, a double revolution in the

technology of the payment system, the advent of banknotes and that of cheques

or giros, has shaped the functions that most central banks performed over

this century: monetary policy and prudential supervision. Man-made money made

monetary policy possible. The fact that a large, now a predominant, component

of the money stock was in the form of commercial bank money made banking

supervision necessary.

Ensuring confidence in the paper currency and, later, in the stability of the

relationship, one could say the exchange rate, between central bank and

commercial bank money, were twin public functions, and, in general, they were

entrusted to the same institution. Just as money has three well-known

economic functions - means of payment, unit of account and store of value -

so there are three public functions related to each of them. Operating and

supervising the payment system refers to money as a means of payment;

ensuring price stability relates to money as a unit of account and a store of

value; and pursuing the stability of banks relates to money as a means of

payment and a store of value. In each of the three functions commercial banks

have played, and still largely play, a crucial role.

In an increasing number of countries the original triadic task entrusted to

the central bank has now been abandoned in favour of a "separation approach",

according to which banking supervision has been assigned to a separate

institution. Following the recent adoption by the United Kingdom and

Luxembourg of the separation approach, only two of the 12 countries

represented in the Basle Committee on Banking Supervision (Italy and the

Netherlands) have the central bank as the only authority responsible for

banking supervision. In all systems, however, whether or not it has the task

of supervising the banks, the central bank is deeply involved with the

banking system precisely because the banks are primary creators of money,

providers of payment services, managers of the stock of savings and

counterparties of central bank operations. No central bank can ignore the

need to have a concrete and direct knowledge of "its" banking system, i.e.

the banking system that operates in the area of its monetary jurisdiction.

Personally, I have an intellectual attachment to, as well as a professional

inclination for, the central bank approach to banking supervision, due partly

to the fact that I spent most of my professional life in a central bank which

is also to this day the banking supervisor. Yet I can see, I think, the

arguments that have led a growing number of industrialised countries to

prefer the separation approach. Such arguments basically point to the

potential conflict between controlling money creation for the purpose of

price stability and for the purpose of bank stability. On the whole, I do not

think that one model is right and the other wrong. Both can function, and do

function, effectively; if inappropriately managed, both may fail to satisfy

the public interest for which banks are supervised.

5. Against this background, let me now describe the institutional framework

currently adopted by the Treaty. As my description will refer to the area in

which both the single market and the single currency are established, it will

not specially focus on the problems of the so-called "pre-in" countries,

including the United Kingdom.

The current institutional framework of EMU (i.e. the single market plus the

single currency) is a construct composed of two building blocks: national

competence and co-operation. Let me first briefly review the main aspects of

these two building blocks and then see how the Eurosystem relates to them.

First, national competence. In a market based on the minimum harmonisation

and the mutual recognition of national regulatory standards and practices,

the principle of "home country control" applies. According to this principle

every bank has the right to do business in the whole area using a single

licence, under the supervision, and following the rules, of the authority

that has issued the licence. The full supervisory responsibility thus belongs

to the "home country". This allows, inter alia, the certain identification of

the supervisor responsible for each institution acting as a counterparty to

the monetary policy operations of the Eurosystem. The only exception to this

principle - the "host country" competence for the supervision of liquidity of

foreign branches - is no longer justified now that the euro is in place;

hence it should soon be removed.

Second, co-operation. In a highly regulated industry such as banking, a

single market that retains a plurality of "local" (national) supervisors

requires close co-operation among supervisors to safeguard the public good:

namely, openness, competition, safety and soundness of the banking industry.

EU directives (the 1st and 2nd Banking Directives and the so-called BCCI

Directive) lay the foundations for such co-operation, but they do not contain

specific provisions or institutional arrangements to this end. They limit

themselves to stating the principle of co-operation among national

authorities and to removing obstacles to the exchange of information among

them.

6. How does the Eurosystem relate to this construction? Essentially in two

ways. First, the Treaty assigns to the Eurosystem the task to "contribute to

the smooth conduct of policies pursued by competent authorities relating to

the prudential supervision of credit institutions and the stability of the

financial system" (Article 105 (5)). Given the separation between monetary

and supervisory jurisdictions, this provision is clearly intended to ensure a

smooth interplay between the two. Second, the Treaty gives the Eurosystem a

twofold (consultative and advisory) role in the rule-making process.

According to Article 105 (4), the ECB must be consulted on any draft

Community and national legislation in the fields of banking supervision and

financial stability; and, according to Article 25 (1) of its Statute, the ECB

can provide, on its own initiative, advice on the scope and implementation of

the Community legislation in these fields. It should be borne in mind that

central banks are normally involved in the process of drawing up legislation

relating to, for example, regulatory standards, safety net arrangements and

supervision since this legislation contributes crucially to the attainment of

financial stability.

7. Two observations should be made about the institutional framework just

described. First, such an arrangement establishes a double separation between

central banking and banking supervision: not only a geographical, but also a

functional one. This is the case because for the euro area as a whole banking

supervision is now entrusted to institutions that have no independent

monetary policy functions. The separation approach that was chosen for EMU

has effectively been applied not only to the euro area as a whole, but to its

components as well. Indeed, even in countries where the competent authority

for banking supervision is the central bank, by definition this authority is,

functionally speaking, no longer a central bank, as it lacks the key central

banking task of autonomously controlling money creation.

The second observation is that the Treaty itself establishes (in Article 105

(6)) a simplified procedure that makes it possible, without amending the

Treaty, to entrust specific supervisory tasks to the ECB. If such a provision

were to be activated, both the geographical and the functional separation

would be abandoned at once. The fact that the Maastricht Treaty allows the

present institutional framework to be reconsidered without recourse to the

very heavy amendment procedure (remember that such procedure requires an

intergovernmental conference, ratification by national parliaments, sometimes

even a national referendum) is a highly significant indication that the

drafters of the Treaty clearly understood the anomaly of the double

separation and saw the potential difficulties arising from it. The simplified

procedure they established could be interpreted as a "last resort clause",

which might become necessary if the interaction between the Eurosystem and

national supervisory authorities turned out not to work effectively.

III. INDUSTRY SCENARIO

8. When evaluating the functioning of, and the challenges to, banking

supervision in the current institutional framework, two aspects should be

borne in mind. First, the advent of the euro increases the likelihood of the

propagation of financial stability problems across national borders. For this

reason a co-ordinated supervisory response is important at an early stage.

Second, the sources of banks' risks and stability problems depend on ongoing

trends that are not necessarily caused by the euro, but may be significantly

accelerated by it. On the whole, we are interested not so much in the effects

of EMU or the euro per se, as in the foreseeable developments due to all

factors influencing banking in the years to come.

9. It should be noted at the outset that most banking activity, particularly

in retail banking, remains confined to national markets. In many Member

States the number, and the market share, of banks that operate in a truly

nationwide fashion is rather small. Although banks' international operations

have increased, credit risks are still predominantly related to domestic

clients, and the repercussions of bank failures would be predominantly felt

by domestic borrowers and depositors.

10. Assessing the internationalisation of euro area banks is a complex task

because internationalisation can take a number of forms. One is via cross-

border branches and subsidiaries. Although large-scale entry into foreign

banking markets in Europe is still scarce, reflecting persisting legal,

cultural and conduct-of-business barriers (less than 10% on average in terms

of banking assets in the euro area; Table 1), there are significant

exceptions. The assets of the foreign branches and subsidiaries of German and

French banks account for roughly a third of the assets of their respective

domestic banking systems (Table 2). The Dutch banking system is also strongly

diversified internationally.

Another way to spread banking activity beyond national borders is

consolidation. Cross-border mergers or acquisitions still seem to be the

exception, although things have started to change. The recent wave of

"offensive" and "defensive" banking consolidation has mainly developed within

national industries, thus significantly increasing concentration,

particularly in the smaller countries (Table 3); it may be related not so

much to the direct impact of EMU as to globally intensified competition and

the need to increase efficiency.

In the coming years internationalisation is likely to increase, because, with

the euro, foreign entrants can now fund lending from their domestic retail

deposit base or from euro-denominated money and capital markets. The

relatively large number of foreign branches and subsidiaries already

established could be a sufficient base for an expansion of international

banking activity (Table 4) since a single branch, or a small number of

branches, may be sufficient to attract customers, especially when they are

served through direct banking techniques, such as telephone and Internet

banking. Also, the cross-border supply of services on a remote basis is

likely to spread as direct banking techniques develop. As to cross-border

mergers and acquisitions aimed either at achieving a "critical mass" for

wholesale financial markets, or at rapidly acquiring local expertise and

customers in the retail sector, they may remain scarce because the cost

savings from eliminating overlaps in the retail network are likely to be

limited and the managerial costs of integrating different structures and

corporate cultures are substantial.

11. However, banks' internationalisation does not provide the full picture of

the interconnections of banking systems. As "multi-product" firms, banks

operate simultaneously in many markets which have different dimensions:

local, national, continental (or European) and global. The advent of the euro

is likely to enlarge the market for many banking products and services to the

continental dimension; this will "internationalise" even those banks that

remain "national" in their branch networks and organisation.

The formation of the single money market in the euro area has largely taken

place already. The dispersion in the euro overnight rate across countries, as

reported by 57 so-called EONIA banks, fell in January from around 15 to 5

basis points. The variation between banks has been significantly greater than

between countries. The TARGET system has rapidly reached the dimension of

Fedwire, with a daily average value of payments of E1,000 billion, of which

between E300 and E400 are cross-border. The ever stronger interbank and

payment system links clearly increase the possibility of financial

instability spreading from one country to another. Through these links the

failure of a major bank could affect the standing of its counterparties in

the entire euro area. On the other hand, the deeper money market could absorb

any specific problem more easily than before.

As regards the capital markets, the effects of the euro will take more time

to manifest themselves, but are likely to be substantial. The single currency

offers substantial opportunities for both debt and equity issuers and

investors. The increase in the number of market participants operating in the

same currency increases the liquidity of the capital markets and reduces the

cost of capital. The low level of inflation and nominal interest rates and

diminishing public sector deficits are additional supporting factors of

capital market activity, especially private bond market activity which has so

far been relatively limited (Table 5). Banks will thus operate in

increasingly integrated capital markets and will be exposed to shocks

originating beyond their national borders.

As to corporations, they may concentrate their operations (treasury, capital

market and payment management) in a single or few "euro banks", while the

disappearance of national currencies may break links between firms and their

home country "house bank". This dissociation would make the domestic economy

indirectly sensitive to foreign banks' soundness, thus creating another

propagation channel of banking problems across countries.

12. When considering the industry scenario for the coming years, the

viewpoint has to be broadened beyond the impact of the euro. Rather than the

exclusive, or even primary, force for change, the euro is expected to be a

catalyst for pre-existing trends driven by other forces. The recent ECB

report prepared by the Banking Supervision Committee on "Possible effects of

EMU on the EU banking systems in the medium to long term" gives a

comprehensive analysis of such trends, which can be summarised as follows.

First, regulation: the industry has yet to feel the full impact of such

fundamental, but relatively recent, regulatory changes as those related to

the single market legislation. Second, disintermediation: other financial

intermediaries and institutional investors will grow relative to banks,

pushed by demographic and social changes, as well as by the increasing depth

and liquidity of the emerging euro area-wide capital market.

Disintermediation is expected to take the form of increasing recourse to

capital market instruments relative to bank loans by firms, and diminishing

investment in deposits by households relative to mutual funds and related

products. Third, information technology: bank products, operations and

processes are changing rapidly, while technology offers increasing

possibilities for dissociating the supply of a large number of services from

branches and face-to-face contact with customers. The current tendency in the

EU banking systems to reduce over-branching and over-staffing will grow

stronger.

These factors will increase competition, exert pressure on profitability and

oblige banks to reconsider their strategies. Such effects are already visible

throughout the EU. They produce changes in organisation, new products and

services, mergers, strategic alliances, co-operation agreements, etc. They

also involve strategic risks, because the pressure for profitability and some

losses of revenue due to the euro, for example from foreign exchange, may

push some banks to seek more revenue from unfamiliar business or highly risky

geographical areas. Inadequate implementation of new technologies or failure

to reduce excess capacity may also affect banks' long-term viability. In the

short term, the structural adaptation process could be made more difficult by

the combination of factors like the protracted financial difficulties of Asia

and Russia, or the preparations for the year 2000.

IV. CURRENT SUPERVISION

13. Against the background of the institutional framework and the industry

scenario I have outlined, let me now turn to the functioning of banking

supervision in the euro area. Two preliminary observations. First, the

objective of financial stability pursued by banking supervisors is only one

in a range of public interests, which also includes competition policy and

depositor and investor protection policy. Second, current supervision and

crisis management involve different situations and procedures and will

therefore be examined in sequence.

14. Starting with current supervision, let me consider banking regulation

first. As observed earlier, the regulatory platform for the euro area banking

industry combines harmonised rules with country-specific (non-harmonised, but

mutually recognised and hence potentially competing) rules.

The harmonised part of the platform includes most of the key prudential

provisions that have been developed in national systems over the years. More

than 20 years ago (1977), the 1st Banking Co-ordination Directive adopted a

definition of a credit institution and prescribed objective criteria for the

granting of a banking licence. In 1983 the first Directive on carrying out

supervision on a consolidated basis was approved, and in 1986 the rules

relating to the preparation of the annual accounts and the consolidated

accounts of banks were harmonised. In 1989 the 2nd Banking Co-ordination

Directive (which became effective on 1 January 1993) marked the transition

from piecemeal to comprehensive legislation, introducing, inter alia, the

principle of "home country control". A number of other specific directives

have subsequently addressed the main aspects of the regulatory framework -

notably, own funds, solvency ratios and large exposures. A Directive imposing

deposit guarantee schemes supplemented the legislation in support of

financial stability. All in all, the European Union, including the euro area,

now has a rather comprehensive "banking law" consistent with the Basle

Committee's rules and with the 1997 Core Principles of Banking Supervision.

The country-specific, non-harmonised, part of the platform is also quite

relevant and very diversified. It includes, among other things, the different

organisational arrangements for the conduct of banking supervision (central

bank, separate agency or a mixed arrangement); the tools used by banking

supervisors (e.g. supervisory reporting, on-site inspections); provisions for

the liquidation and restructuring of banks; and the definition and legal

protection of financial instruments and contracts. Even the key notion of a

regulated market is harmonised only to a very limited extent.

15. Such "neutrality" and "incompleteness" on the part of the EU legislator

with respect to key aspects that are normally incorporated in the regulatory

framework is a unique feature of EU banking regulations and is likely to

trigger a deregulatory process, pushed by competition among the national

systems and the different financial centres in the euro area, and beyond that

in the EU. Against the background of the increasing competition and other

changes in the banking industry, one can expect that the regulatory platform

will evolve in the years to come. Additional EU legislation may prove

necessary to complete and strengthen the harmonised part. One important part

of common legislation, namely the draft Directive on liquidation and re-

organisation measures for credit institutions, has not yet been adopted and,

indeed, has been stalled for years. This Directive is needed to bring legal

certainty to the framework for banking crisis management. In this regard, it

would be useful for the Eurosystem, if necessary, to be able to exclude

counterparties from the single monetary policy on prudential grounds. Also,

the non-harmonised part of the platform will come under pressure to converge,

as I have just mentioned, through the process of "regulatory competition".

Like any other rapidly changing industry, the banking sector will require

careful attention by regulators. As indicated earlier, the ECB will have the

possibility of contributing to the rule-making process through its advisory

tasks under Article 105 (4) of the Treaty and Article 25.1 of the Statute of

the ESCB.

16. On the whole, and taking a euro area perspective, the legislative-cum-

regulatory platform of the banking industry, although rather unusual and very

diversified in comparison with those of most currency jurisdictions, does not

seem to present loopholes or inconsistencies that may hamper the pursuit of

systemic stability. Seen from the point of view of the regulatory burden, it

is a light system. It will become even more so if competition among national

banking systems and financial centres encourages national regulators to free

their banks from regulatory burdens that are not required by the EU

Directives. Conversely, seen from the point of view of its flexibility, i.e.

how quickly it can adapt to new situations, it is, on the contrary, a heavy

system. This is the case both because the EU legislative process is slow

(three years or even longer may be needed to pass Directives) and, perhaps

more importantly, because many provisions are embodied in the Community

primary legislation (i.e. Directives) rather than in Community secondary

legislation (amendable through simpler comitology procedures).

The establishment of EMU does not seem to determine a need for revising the

pillars of the current legal framework. What seems to be necessary, however,

is a more flexible legislative procedure which allows for a faster and more

effective revision of Community legislation, whenever needed in relation to

market developments.

17. Let me now turn to the execution of banking supervision. It should

immediately be recalled that supervision, contrary to regulation, is a

national task, exercised by what the jargon of the Directives calls the

"competent authority". Since the euro area has adopted a separation approach

between supervisory and central banking functions, it is natural to examine

first the functioning of the "euro area supervisor" (i.e. the co-operative

system of national supervisors) and then turn to the tasks and needs of the

"euro area central banker" (i.e. the Eurosystem).

18. The euro area supervisor can be regarded as a rather peculiar entity

composed of national agencies working in three modes: stand-alone, bilateral

and multilateral. Let us briefly examine each of them.

The stand-alone mode is the one in which the supervisor exclusively operates

in the national (or even local) context. Today it is by far the most

predominant mode. In most cases, this approach is sufficient to achieve the

objectives of banking supervision because most banks in Europe are operating

in a context that does not even reach the nationwide market of the country of

origin. Such a decentralised model is even more effective because it allows

the efficient use of information that may not be available far from the

market in which the bank operates. That is why it is actually applied even

within countries. In Italy, for example, over 600 of the 900 licensed credit

institutions at end-1998 were entirely supervised by the Banca d'Italia

branch of the town in which the bank is licensed.

The bilateral mode involves co-operation between two supervisory agencies. It

is used for cross-border supervision of the same type of financial

institutions, such as credit institutions, or the supervision of different

types of financial institutions operating in the same market, such as credit

institutions and securities firms. The instrument that has been devised to

organise bilateral co-operation between banking supervisors is the Memorandum

of Understanding (MoU). With the implementation of the 2nd Banking Co-

ordination Directive, the Member States began to negotiate extensively MoUs

in order to establish the necessary co-operation between "home" and "host

country" authorities to supervise efficiently institutions that have cross-

border activities or foreign country establishments.

By the end of 1997, 78 bilateral MoUs had been signed between the EEA banking

supervisory authorities. The key aims of MoUs are to establish a regular

exchange of information between national supervisory authorities. While the

"gateways" for the exchange of information have been laid down in Community

legislation, MoUs provide a practical framework for communication to be

carried out between supervisors. Moreover, MoUs define procedures and

reciprocal commitments between pairs of EU supervisors related to the various

parts of the supervisory process, such as establishment procedures and on-

site examinations.

Finally, the multilateral mode is the one in which a group of supervisors

works collectively as, say, a single consolidated supervisor. Such a mode is

required when the problems involved are area-wide. They may be area-wide for

a number of reasons with regard to the institutions, or groups, involved:

their dimension; their linkages with a number of different markets in various

countries; the role they play in the payment system or in other "systemic"

components of the market, etc. Multilateral co-operation can also enhance the

quality of supervision by examining common macroeconomic influences on the

banking system and common trends in the financial system that may not be

revealed from the national perspective only.

Today, the Banking Supervision Committee is the key forum for multilateral

co-operation. It is composed of representatives of the banking supervisory

authorities of the EU countries, either forming part of the respective NCB or

separate bodies. The Banking Supervision Committee's main functions are the

promotion of a smooth exchange of information between the Eurosystem and

national supervisory authorities and co-operation among EU supervisory

authorities. Another forum for dealing with the requirements of the

multilateral mode is the Groupe de Contact, a group of EU banking supervisory

authorities which, for many years, has discussed individual banking cases in

a multilateral way, but at a lower organisational level than the high-level

Banking Supervision Committee.

19. So far, the need to develop the multilateral mode has been relatively

limited, as the emergence of a single banking market in the European Union

has been slow and the euro was not yet in place. Thus, the fact that the

multilateral mode has not gone, for the moment, beyond periodic discussions

among supervisors and occasional industry-wide analyses should not be a cause

for concern.

I am convinced, however, that in the future the needs will change and the

multilateral mode will have to deepen substantially. Over time such a mode

will have to be structured to the point of providing the banking industry

with a true and effective collective euro area supervisor. It will have to be

enhanced to the full extent required for banking supervision in the euro area

to be as prompt and effective as it is within a single nation.

There are no legal impediments to that. The existing legislation, whether

Community or national, permits all the necessary steps to be made.

Information can be pooled; reporting requirements and examination practices

can be developed and standardised; common databases can be created; joint

teams can be formed; and analyses of developments across the whole banking

system can be conducted. The Community legislation providing for the

unconstrained exchange of confidential information between supervisors does

not distinguish between bilateral and multilateral co-operation, but the

common interpretation is that it covers both modes. It will be the task of

the Banking Supervision Committee, for its part, to develop the multilateral

mode among EU banking supervisors.

20. If the above concerns primarily the euro area supervisor, what about the

euro area central banker, i.e. the Eurosystem? The euro area central banker

has neither direct responsibility for supervising banks nor for bank

stability. It is, however, no stranger in this land. It has a vital interest

in a stable and efficient banking industry; it is, therefore, keen to see its

action complemented with an effective conduct of the supervisory functions by

the competent authorities; it needs a clear and precise knowledge of the

state of the euro area's banking industry as a whole and of its major

individual players; and it may have a role to play, as we shall see, in the

management of crises.

For the Eurosystem, natural reference models are provided by the central

banks of countries that apply the separation approach, for example: Germany

before the euro; the United Kingdom after the creation of the Financial

Services Authority; or Japan. In all these cases the central bank has a well-

developed expertise in the micro and macro-prudential field; each

distinctively plays a role in the macro-prudential field by addressing

threats to the stability of the banking system and analysing the soundness of

the structural features of the system. For their own purposes, these central

banks also have precise and comprehensive information about the banks in

their respective country. This is obtained either from performing practical

supervisory duties, as in the case of the Bank of Japan or the Bundesbank; or

from the national supervisory authority; or through direct contacts with the

banking industry, as in the case of the Bank of England.

The Banking Supervision Committee is in a good position to co-operate with

the Eurosystem in the collection of information. Indeed, the so-called BCCI

Directive has removed the legal obstacles to the transmission of confidential

information from competent supervisory authorities to "central banks and

other bodies with a similar function in their capacity as monetary

authorities". This includes national central banks and the ECB. Of course,

the provision of supervisory information is voluntary and its development

will have to be based on an agreed view of the central banking requirements

the Eurosystem will have in this field.

V. CRISIS MANAGEMENT

21. In normal circumstances central banking and prudential supervision have

an arm's length distance between them. In crisis situations, however, they

need to act closely together, often in co-operation with other authorities as

well. Charles Goodhart and Dirk Schoenmaker have made here at the London

School of Economics a valuable contribution to analysing the handling of

major banking problems in the history of industrial countries. One of their

conclusions is that, in most instances, central banks have indeed been

involved. Banking problems are so close to monetary stability, payment system

integrity and liquidity management that this finding hardly comes as a

surprise. The advent of the euro will not, by itself, change this state of

affairs.

22. When discussing crisis management, it should not be forgotten that, while

central banks have a direct and unique role to play when the creation of

central bank money is involved, this represents just one category of

emergency action. Another category refers to the injection - by politically

liable Finance Ministries - of taxpayers' money into ailing or insolvent

credit institutions. There is also a third, market-based, category,

consisting of the injection of private money by banks or other market

participants. These three typologies of emergency action all require the

involvement of policy-makers, but they must not be mixed up when evaluating

the existing arrangements. Therefore, before discussing the much debated

question of the lender-of-last-resort, let me briefly comment on the two,

probably less controversial cases where central bankers are not the providers

of extra funds.

23. First, the "private money solution". This market-based approach is

clearly the preferable option, not just to save public funds and avoid

imbalances in public finances, but also to reduce the moral hazard problem

generated by public assistance to ailing institutions. Indeed, policy-makers

are increasingly aware that the expectations of a helping hand can increase

financial institutions' risk appetite in the first place. However, even when

a market-based solution is possible, on the grounds of private interest,

private parties may not be able to reach a solution for lack of information

or co-ordination. Public authorities have therefore an active role to play

for the market solution to materialise. The recent rescue package co-

ordinated by the Federal Reserve Bank of New York to prevent the LTCM hedge

fund from collapsing is a good example of public intervention being used to

achieve a private solution.

Acting as a "midwife" in brokering a private sector deal is not the only

example of managing crises without injecting public funds. Banking

supervisors have at their disposal a number of tools to intervene at the

national level to limit losses and prevent insolvency when a bank faces

difficulties. These tools include special audits, business restrictions and

various reorganisation measures.

In the euro area, national supervisors and central banks will continue to be

the key actors in the pursuit of market-based solutions to crises. The

Eurosystem, or the Banking Supervision Committee, would become naturally

involved whenever the relevance of the crisis required it.

24. Second, the "taxpayers' money solution". Taxpayers have been forced to

shoulder banks' losses in the past, when public authorities felt that otherwise

the failure of a large portion of a country's banking system or of a single

significant institution would have disrupted financial stability and caused

negative macroeconomic consequences. In such instances banks have been taken

over by the state, or their bad assets have been transferred to a separate

public entity to attract new private investment in the sound part of the

otherwise failed banks. The US savings & loans crisis of the 1980s, the

banking crises in Scandinavia in the early 1990s and the current banking crises

in Japan and some East-Asian countries are examples of system-wide insolvency

problems that have triggered taxpayers' support. Crйdit Lyonnais and Banco di

Napoli are recent examples of public support to individual insolvency problems.

The introduction of the euro leaves crisis management actions involving

taxpayers' money practically unaffected. The option of injecting equity or

other funds remains available for the Member States, since these operations

are not forbidden by the Treaty. Nevertheless, the European Commission will

be directly involved in scrutinising and authorising such actions, since any

state aid must be compatible with the Community's competition legislation.

This happened, for example, in the cases of Banco di Napoli and Crйdit

Lyonnais.

The handling of solvency crises is not within the competence of the national

central banks nor that of the ECB, although national central banks are likely

to be consulted, as they have been in the past.

25. Third, the "central bank money solution". This is the lender-of-last-

resort issue that has brought the Eurosystem under vigorous criticism by

distinguished academics and the IMF's Capital Markets Division of the

Research Department. The criticism has been that the alleged absence of a

clear and transparent mechanism to act in an emergency raises doubts in the

markets about the ability of the Eurosystem to handle crisis situations. It

is said that the uncertainty generated by the present arrangements would

entail new risks, including the possibility of investors requiring an

additional risk premium at times of financial market volatility and,

ultimately, of the credibility of EMU being damaged. Two examples of these

concerns deserve an explicit mention. The IMF "Report on Capital Markets",

September 1998, stated that "it is unclear how a bank crisis would be handled

under the current institutional framework .which is not likely to be

sustainable". Similarly, the first report of the CEPR (Centre for Economic

Policy Research) on monitoring the ECB entitled "The ECB: Safe at Any Speed?"

expressly suggested that the Eurosystem lacks crisis management capacity and

is too rigid to pass the A-Class test to keep the vehicle on the road at the

first steep turn in financial market conditions in Europe.

26. My response to this criticism is threefold. To my mind, the criticism

reflects a notion of lender-of-last-resort operations that is largely

outdated; it underestimates the Eurosystem's capacity to act; and, finally,

it represents too mechanistic a view of how a crisis is, and should be,

managed in practice.

27. The notion of a central bank's lender-of-last-resort function dates back

more than 120 years, to the time of Bagehot. This notion refers to emergency

lending to institutions that, although solvent, suffer a rapid liquidity

outflow due to a sudden collapse in depositors' confidence, i.e. a classic

bank run. A bank could be exposed to depositors' panic even if solvent

because of the limited amount of bank liquidity and an information asymmetry

between the depositors and the bank concerning the quality of bank's assets

that do not have a secondary market value.

Nowadays and in our industrial economies, runs may occur mainly in textbooks.

They have little relevance in reality because, since Bagehot, many antidotes

have been adopted: deposit insurance, the regulation of capital adequacy and

large exposures, improved licensing and supervisory standards all contribute

to the preservation of depositors' confidence and minimise the threat of a

contagion from insolvent to solvent institutions.

A less unlikely case is a rapid outflow of uninsured interbank liabilities.

However, since interbank counterparties are much better informed than

depositors, this event would typically require the market to have a strong

suspicion that the bank is actually insolvent. If such a suspicion were to be

unfounded and not generalised, the width and depth of today's interbank

market is such that other institutions would probably replace (possibly with

the encouragement of the public authorities as described above) those which

withdraw their funds. It should be noted, in this respect, that the emergence

of the single euro money market lowers banks' liquidity risk, because the

number of possible sources of funds is now considerably larger than in the

past.

Given all of these contingencies, the probability that a modern bank is

solvent, but illiquid, and at the same time lacks sufficient collateral to

obtain regular central bank funding, is, in my view, quite small. The

textbook case for emergency liquidity assistance to individual solvent

institutions has, as a matter of fact, been a most rare event in industrial

countries over the past decades.

28. What if this rare event were nevertheless to occur and cause a systemic

threat? The clear answer is that the euro area authorities would have the

necessary capacity to act. This is not only my judgement, but also that of

the Eurosystem, whose decision-making bodies have, as you can imagine,

carefully discussed the matter. I am not saying that we are, or shall be,

infallible; no one can claim such a divine quality. I am saying that there

are neither legal-cum-institutional, nor organisational, nor intellectual

impediments to acting when needed. In stating this, I am aware that central

banks may be the only source of immediate and adequate funds when a crisis

requires swift action, while solvency remains an issue and failure to act

could threaten the stability of the financial system.

In these circumstances the various national arrangements would continue to

apply, including those concerning the access of central banks to supervisors'

confidential information. As is well known, such arrangements differ somewhat

from country to country.

29. The criticism I have referred to also underestimates the Eurosystem's

capacity to act. To the extent that there would be an overall liquidity

effect that is relevant for monetary policy or a financial stability

implication for the euro area, the Eurosystem itself would be actively

involved.

The Eurosystem is, of course, well equipped for its two collective decision-

making bodies (the Board and the Council) to take decisions quickly whenever

needed, whether for financial stability or for other reasons. This readiness

is needed for a variety of typical central bank decisions, such as the

execution of concerted interventions or the handling of payment system

problems. Indeed, it has already been put to work during the changeover

weekend and in the first few weeks of this year.

A clear reassurance about the capacity to act when really needed should be

sufficient for the markets. Indeed, it may even be advisable not to spell out

beforehand the procedural and practical details of emergency actions. As

Gerry Corrigan once put it, maintaining "constructive ambiguity" in these

matters may help to reduce the moral hazard associated with a safety net. I

know of no central bank law within which the lender-of-last-resort function

is explicitly defined.

The question of who acts within the Eurosystem should also be irrelevant for

the markets, given that any supervised institution has an unambiguously

identified supervisor and national central bank. As to the access to

supervisory information, the lack of direct access by the Eurosystem should

not be regarded as a specific flaw of the euro area's institutional

framework, as has been frequently argued, since this situation also exists at

the national level wherever a central bank does not carry out day-to-day

supervision.

30. Finally, the criticism reflects an overly mechanistic view of how a

crisis is, and should be, managed in practice. Arguing in favour of fully

disclosed, rule-based policies in order to manage crises successfully and,

hence, maintain market confidence, is almost self-contradictory. Emergency

situations always contain unforeseen events and novel features, and

emergency, by its very nature, is something that allows and even requires a

departure from the rules and procedures adopted for normal times or even in

the previous crisis. Who cares so much about the red light when there is two

metres of snow on the road? As for transparency and accountability, these two

sacrosanct requirements should not be pushed to the point of being

detrimental to the very objective for which a policy instrument is created.

Full explanations of the actions taken and procedures followed may be

appropriate ex post, but unnecessary and undesirable ex ante.

31. So far, I have focused on the provision of emergency liquidity to a bank.

This is not the only case, however, in which central bank money may have to

be created to avoid a systemic crisis. A general liquidity "dry-up" may

reflect, for example, a gridlock in the payment system or a sudden drop in

stock market prices. The actions of the Federal Reserve in response to the

stock market crash of 1987 is an often cited example of a successful central

bank operation used to prevent a dangerous market-wide liquidity shortfall.

This kind of action is close to the monetary policy function and has been

called the "market operations approach" to lending of last resort. In such

cases, liquidity shortfalls could be covered through collateralised intraday

or overnight credit, or auctioning extra liquidity to the market. The

Eurosystem is prepared to handle this kind of market disturbance.

VI. CONCLUSION

32. In my remarks this evening, I have looked at the euro area as one that

has a central bank which does not carry out banking supervision. This would

be normal, because in many countries banking supervision is not a task of the

central bank. What is unique is that the areas of jurisdiction of monetary

policy and of banking supervision do not coincide. This situation requires,

first of all, the establishment of smooth co-operation between the Eurosystem

and the national banking supervisors, as is the case at the national level

where the two functions are separated. The most prominent reason for this is,

of course, the scenario where the provision of liquidity from the central

bank has to be made in a situation that is generated by problems of interest

to the supervisor. But beyond that, I do not know any country in which the

central bank is not very closely interested in the state of health of the

banking system, irrespective of its supervisory responsibilities.

33. In my view, we should move as rapidly as possible to a model in which the

present division of the geographical and functional jurisdiction between

monetary policy and banking supervision plays no significant role. I do not

mean necessarily a single authority or a single set of prudential rules.

Rather I mean that the system of national supervisors needs to operate as

effectively as a single authority when needed. While the causes of banking

problems are often local or national, the propagation of problems may be

area-wide. The banking industry is much more of a system than other financial

institutions.

34. I am clearly aware that we are far from having a common supervisory

system. But since the euro has just been launched and will last, we have to

look in prospective terms at what needs to be set in place. There is no

expectation, at least to my mind, that the division of responsibility in the

euro area between the central bank and the banking supervisory functions

should be abandoned. Although the Treaty has a provision that permits the

assignment of supervisory tasks to the ECB, I personally do not rely on the

assumption that this clause will be activated. What I perceive as absolutely

necessary, however, is that co-operation among banking supervisors, which is

largely voluntary but which finds no obstacles in the existing Directives or

in the Treaty, will allow a sort of euro area collective supervisor to emerge

that can act as effectively as if there were a single supervisor. This is

desirable in the first instance to render the supervisory action more

effective against the background of current and future challenges and,

second, to assist the Eurosystem in the performance of its basic tasks.

TABLES

Table 1. Market share of branches and subsidiaries of foreign

credit institutions as % of total domestic assets, 1997

From EEA countries From third countries TOTAL

Branches Subsidiaries Branches Subsidiaries

AT 0.7 1.6 0.1 1.0 3.4

BE 9.0 19.2 6.9 1.2 36.3

DE 0.9 1.4 0.7 1.2 4.2

ES 4.8 3.4 1.6 1.9 11.7

FI 7.1 0 0 0 7.1

FR 2.5 NA 2.7 NA 9.8

IR 17.7 27.8 1.2 6.9 53.6

IT 3.6 1.7 1.4 0.1 6.8

NL 2.3 3.0 0.5 1.9 7.7

SE 1.3 0.1 0.1 0.2 1.7

UK 22.5 1.0 23.0 5.6 52.1

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 2. Assets of branches and subsidiaries of domestic credit

institutions in foreign countries

as % of total domestic assets, 1997

In EEA countries In third countries TOTAL

Branches Subsidiaries Branches Subsidiaries

AT 2.6 NA 3.7 NA NA

DE 12.0 7.3 7.8 0.9 27.9

ES 5.5 1.4 2.1 5.9 14.9

FI 5.9 0.3 6.6 0.3 13.1

FR 9.1 6.9 9.4 3.8 29.2

IR 8.3 14.9 1.3 10.1 34.6

IT 7.2 2.7 3.8 1.5 15.2

SE 7.2 NA 5.4 NA NA

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 3. Concentration: Assets of the five biggest credit

institutions as % of total assets

1985 1990 1997

AT 35.8 34.6 48.3

BE 48.0 48.0 57.0

DE NA 13.9 16.7

ES 38.1 34.9 43.6

FI 51.7 53.5 77.8

FR 46.0 42.5 40.3

IE 47.5 44.2 40.7

IT 20.9 19.1 24.6

NL 69.3 73.4 79.4

SE 60.2 70.02 89.7

UK NA NA 28.0

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 4. Number of branches and subsidiaries of foreign credit

institutions, 1997

From EEA countries From third countries TOTAL

Branches Subsidiaries Branches Subsidiaries

AT 6 20 2 11 39

BE 25 16 15 15 71

DE 46 31 31 45 153

ES 33 21 20 6 80

FI 9 0 0 0 9

FR 46 118 43 98 305

IR 18 21 3 7 49

IT 36 4 17 4 61

NL 11 8 11 19 49

SE 14 0 3 1 18

UK 106 18 149 114 387

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Table 5. Private non-financial enterprises' bonds, credit

institutions' bonds and government bonds outstanding as % of GDP,

1997

Private Credit Government

non-financial institutions' bonds

bonds bonds

AT 2.7 31.1 30.6

BE 10.0 38.3 111.0

DE 0.1 54.6 37.6

ES 2.6 4.5 52.9

FI 3.7 7.1 35.5

IE 0.01 1.6 32.2

IT 1.6 19.4 100.4

NL NA 43.1 53.4

SE 3.6 38.6 46.5

Source: ECB report "Possible effects of EMU on the EU banking

systems in the medium to long term" (February 1999).

Euro and European integration

Speech delivered by Eugenio Domingo Solans,

Member of the Governing Council and the Executive Board of the

European Central Bank,

at the "Euro and Denmark" exhibition in Aalborg, Denmark,

on 10 September 1999

INTRODUCTION

It is a real pleasure for me to participate in the "Euro and Denmark"

exhibition in Aalborg. It is the first time since my appointment as a member

of the Executive Board of the European Central Bank (ECB) in May 1998 that I

have had the opportunity to speak in Denmark. Thank you for your invitation

and for asking me to share my views on the euro and on European integration

with investors and experts of this "pre-in" country.

I should like to refer to two main topics. First, and more extensively, allow

me to explain the ECB's view and my own view on the role of the euro as an

international currency. After this I intend to make some brief comments on

the key role that the euro and the Eurosystem are playing in the process of

European economic integration.

Before I begin, I should like to add that it goes without saying that the

institutional position of the ECB - and therefore my own official position -

concerning Denmark's entry to the euro area is one of strict neutrality. This

is an issue which has to be decided by the Danish people, whenever and in

whatever way they deem appropriate.

THE EURO AS AN INTERNATIONAL CURRENCY

The three basic functions of the euro

Every currency fulfils three functions: store of value, medium of exchange

and unit of account. Concerning the first function (store of value), the euro

is used and will increasingly be used as an investment and financing currency

by market players, and as a reserve currency by public authorities. Regarding

the second function of money (medium of exchange), the euro is used and will

increasingly be used as a payment or vehicle currency for the exchange of

goods and services and for currency exchange itself. It will also have an

official use as an intervention currency. Finally, as regards the third

function of any currency (unit of account), the euro is used and will

increasingly be used by economic agents as a pricing or quotation currency

and as a pegging currency by the authorities responsible for exchange rate

issues.

Let me give you some information about the present use of the euro in each of

these areas. I shall first refer to the private use of the euro, after which

I shall consider its official public usage.

The euro as a store of value

The available information seems to confirm that the euro already plays a

significant role as an investment and financing currency in international

financial markets. Without going into precise details (1), regarding the

international debt securities market (money market instruments, bills and

bonds), it can be said that in the first two quarters of 1999 net

international issues denominated in euro amounted to EUR 83.9 billion,

compared with EUR 74 billion for the US dollar and EUR 50.9 billion for

former euro area national currencies and ECUs during the same period of 1998.

In other words, in the first two quarters of 1999 net international issues of

debt securities denominated in euro were 13.4% higher than those denominated

in US dollars, and 64.8% higher than those denominated in former euro area

national currencies and ECUs issued during the same period of last year.

With regard to equity markets, the weight of euro area stock exchanges in

terms of capitalisation ranks a clear second, far behind the United States.

As to the banking sector, the latest data show that, at the end of March

1999, above 40% of deposits and loans vis-а-vis non-residents were

denominated in euro, with the share of the US dollar almost as high.

The euro as a medium of exchange

As for the second function of money (medium of exchange), the euro needs more

time to develop as a payment currency for goods and services in international

trade and as a vehicle currency in the foreign exchange markets. Although no

precise data are available at this stage, the value of world exports

denominated in euro is not likely to differ significantly from that of euro

area exports. By contrast, the value of world exports settled in US dollars

is nearly four times as high as that of US exports. This difference can

easily be explained by the combined and reinforcing effects of network

externalities and economies of scale in the use of a predominant

international currency, as is the case with the US dollar.

The euro as a unit of account

The use of the euro as a unit of account (its third general function) is

closely linked to its use for the other two main functions. The use of a

currency as a unit of account is, in a way, the basis for its use as a store

of value or as a medium of exchange. The value stored in euro, or the

payments made in euro, will tend to be recorded in euro. Therefore, we can

conclude that the euro is playing an ever larger role as a unit of account

for all the financial assets linked to the use of the euro as an investment

and financing currency, and has a much less relevant role as a standard for

pricing goods and services, owing to the widespread use of the US dollar as a

payment and vehicle currency in international trade. The convenience of using

a single standard for pricing commodities in the international markets,

allowing traders to make direct comparisons between prices, makes it

difficult for the euro to acquire a significant role in this respect. We can

conclude that the development of the euro as a unit of account will follow

the pace at which the issuers or suppliers of assets, goods or services

priced or quoted in euro obtain a predominant position in the international

markets.

The official use of the euro

The euro also has official uses as reserve, intervention and pegging

currency, all three functions being strongly interrelated in most cases.

With regard to its official use, the euro is currently the second most

international currency after the US dollar, this being a legacy of the former

euro area national currencies.

Compared with the former euro area national currencies, there has been a

technical decline in the share of the euro as a reserve (and, therefore, as

an intervention) currency, mainly owing to the fact that such former national

currencies became domestic assets within the euro area. However, there are

good reasons to expect an increase in international public use of the euro as

a reserve and intervention currency, inasmuch as the public authorities

understand that it is worthwhile to allocate their foreign reserves among the

main international currencies and to give the euro a relevant share in

accordance with its internal and external stability and the economic and

financial importance of the euro area.

In connection with the use of the euro as a pegging currency, approximately

30 countries outside the euro area currently have exchange rate regimes

involving the euro to a greater or lesser extent. These exchange rate regimes

are: currency boards (Bosnia-Herzegovina, Bulgaria, Estonia); currencies

pegged to the euro (Cyprus, FYROM [the Former Yugoslav Republic of Macedonia]

and 14 African countries in which the CFA franc is the legal tender);

currencies pegged to a basket of currencies including the euro, in some cases

with a fluctuation band (Hungary, Iceland, Poland, Turkey, etc.); systems of

managed floating in which the euro is used informally as the reference

currency (Czech Republic, Slovak Republic and Slovenia); and, last but not

least, European Union currencies pegged to the euro through a co-operative

arrangement, namely ERM II. As you well know, Denmark and Greece joined ERM

II on 1 January 1999 with a ±2.25% fluctuation band for the Danish krone and

a ±15% fluctuation band for the Greek drachma. Although the euro remains in

second position after the US dollar in terms of its official use, the role of

the euro will increase in the future, without a doubt.

The position of the Eurosystem concerning the international role of the euro

As a general conclusion stemming from the previous analysis of the use of the

euro in the world economy, we can affirm that the euro is the second most

widely used currency, behind the US dollar and ahead of the Japanese yen. The

private use of the euro as an investment and financing currency and its

official use as a reserve, intervention and pegging currency are increasing

rapidly, while it is developing at a slower pace as a payment currency in the

exchange of goods and services. The use of the euro as a unit of account is

linked to its use as store of value and a medium of exchange.

Taking the current situation as a starting point, the Eurosystem's position

concerning the future international role of the euro is crystal clear: we

shall not adopt a belligerent stance in order to force the use of the euro

upon the world economy. We are convinced that the use of the euro as an

international currency will come about anyway. It will happen spontaneously,

slowly but inexorably, without any impulses other than those based on free

will and the decisions of market participants, without any logic other than

that of the market. In other words, the internationalisation of the euro is

not a policy objective of the Eurosystem; it will neither be fostered nor

hindered by us. The development of the euro as an international currency will

be a market-driven process, a free process, which will take place, without a

doubt.

Factors determining the importance of the euro in the world economy

We understand that the euro fulfils the necessary conditions to become a

leading international currency with the US dollar and not against it. There

is enough room for both currencies in the world economy.

The necessary conditions for a currency to become an international currency

are based on two broad factors: low risk and large size. The low risk factor

is related to the confidence inspired by the currency and its central bank,

which in turn mainly depends on the internal and external stability of the

currency. The low risk factor tends to lead to diversification among

international currencies, since diversification is a means to reduce the

overall risk; it acts, so to speak, as a centrifugal force. By contrast, the

large size factor relates to the relative demographic economic and financial

importance of the area which supports the currency; in other words, the

"habitat" of the currency. The large size factor generally tends to lead to

centralisation around one or several key international currencies. It can be

seen as a centripetal force, as a virtuous circle, which will tend to lead to

an increasing use of the euro as an international currency. Let us consider

these two factors in more detail.

The stability of the currency and the credibility of the ECB

The first factor concerns low risk, credibility and stability. The stability

of the euro is a priority for the ECB. Compared with the idea of stability,

the strength of the euro is of lesser importance. This does not mean that the

exchange rate of the euro does not constitute an element to be considered in

the monetary policy strategy of the ECB. However, the basic factor that will

determine the importance of the euro as a widely used currency in the world

economy, in addition to the demographic, economic and financial dimensions of

the euro area, is, without a doubt, the stability of the new currency,

understood as a means to maintain the purchasing power of savings.

In the global economy the transmission of financial crises by means of

different mechanisms (devaluations of weak currencies, subsequent increases

in interest rates, etc.) is frequently mentioned. Less is said about the

spillover or transmission of positive economic circumstances, such as

stability. The Eurosystem will "export" stability to the rest of the world

economy, and not only in the case of those countries which decide to tie

their currencies, formally or otherwise, to the euro (through the ERM II or

other arrangements). In a global economy the euro area cannot be an island of

stability, but it can transmit its stability to the rest of the world economy

as the links between regions increase.

Stability is the basic requirement for a good currency. It is what we at the

ECB want for the euro. We want a stable euro, not necessarily a strong euro.

In the long term the euro will derive strength from its stability.

The stability of the euro is the basis for the confidence in and the

credibility of the ECB, without which a large international role for the euro

would be unthinkable. Stability is the proof of the effectiveness of the

institution. Yet in order to be credible it is not sufficient for the ECB to

maintain stability. Other parameters of its action must be considered:

accountability, transparency and communication, a Europe-wide perspective.

The conditions for the credibility of the euro are certainly demanding.

However, the achievement of these conditions is the aim of all those of us

who have responsibilities in relation to the operation of the Eurosystem.

The "habitat" of the euro

The second factor, which we have called the large size factor or the habitat

of the euro, is important because without a certain critical mass, a currency

cannot have international relevance, however high its degree of stability. In

addition to quality, quantity is required, as suggested by the example of the

reduced degree of international use of the Swiss franc in relation to other

stable currencies, such as the US dollar or the Deutsche

Mark until 1998.

The figures relating to the population and the GDP of the euro area

illustrate this. With 292 million inhabitants, its population exceeds that of

the United States (270 million) and that of Japan (127 million). The GDP of

the euro area is, on the other hand, equal to 76% of the GDP of the United

States (EUR 5,774 billion compared with EUR 7,592 billion), though it is

higher than that of Japan (EUR 3,327 billion). The source of this

information, which refers to 1998, is Eurostat.

However, even more important than the current figures is the potential for

the future development of the euro area, in terms of population and GDP, if

and when the so-called "pre-ins" (Denmark, Greece, Sweden and the United

Kingdom) join the Eurosystem.

The entry of these countries would result in a monetary area of 376 million

inhabitants, 39% larger than the United States and almost triple the size of

Japan, with a GDP of EUR 7,495 billion, only slightly less than that of the

United States and 125% higher than that of Japan.

All these facts and figures which demonstrate the demographic and economic

importance of the European Union would be further strengthened by enlargement

to Eastern Europe. Our continent has a historical, cultural and geographical

identity - from the Iberian Peninsula to the Urals, with certain additional

external territories - which, in the future, may also come to form an

economic unit. However that is, for the moment, a distant prospect.

The degree of openness of an economic area is also a relevant factor as

regards the international role of its currency. In this respect the euro area

is more open than the United States or Japan, with a percentage of external

trade of around 25.8% of GDP, compared with 19.6% for the United States and

17.9% in the case of Japan (data from Eurostat for 1997). However, a euro

area consisting of the 15 countries of the European Union would be more

closed, by the mere arithmetic fact that the transactions with the present

pre-ins would become domestic transactions, resulting in a coefficient of

openness of 19.4%, similar to that of the United States. Clearly, the size

and the degree of openness are parameters that move in opposite directions:

the larger the euro area, the smaller its degree of openness to other

countries.

The financial dimension of the euro

The size or habitat of an economy does not only depend on demographic or

economic factors; it also has to do with the financial base or dimension of

the area. In considering the financial dimension of the euro area, the first

relevant feature to observe is the low level of capitalisation of the stock

markets in comparison with the United States and Japan. Compared with a stock

market capitalisation of EUR 3,655 billion in the euro area in 1998, the

United States presents a figure almost four times this amount (EUR 13,025

billion). Japan ranks third, with EUR 2,091 billion. There would be a marked

difference if one were to include all 15 countries of the European Union,

since the stock exchange capitalisation would increase to EUR 6,081 billion.

Although these figures could give the impression that the euro area has a

relatively small financial dimension relative to its economic dimension, this

is not the case. The lower degree of development of the capital markets is

offset by a higher degree of banking assets. This means that the financial

base of real economic activity in Europe is founded on bank intermediation,

which is also a feature of the Japanese economy. For example, private

domestic credit in the euro area amounts to 92.4% of GDP, while in the United

States it is only 68.9%. Conversely, fixed domestic income represents 34.2%

of GDP in the euro area compared with 66.1% of GDP in the United States

(statistics from the International Monetary Fund and the Bank for

International Settlements as at the end of 1997, taken from the Monthly

Bulletin of the European Central Bank). We therefore have two distinct models

of private financing which clearly have to be taken into account when

assessing Europe's financial dimension compared with the United States or

Japan.

THE ROLE OF THE EURO AND THE EUROSYSTEM IN THE PROCESS OF

EUROPEAN INTEGRATION

The euro as a catalyst for European integration

The euro, the Eurosystem's monetary policy and, in general, the activity of

the ECB and the Eurosystem will play a key role in the integration of

European financial markets and all markets in general. We can say that the

euro will act as a catalyst for European economic integration.

Monetary and financial integration

The integration of the European money markets relies, of course, on the

existence of a single system for refinancing the banks in the euro area, that

is to say on the common monetary policy. However, it also relies technically

on a system of instantaneous data transfer and on the new common payment

system, TARGET, enabling real-time gross settlement. Thanks to the smooth

operation of the information, communication and payment systems, a common

monetary policy is realistic and the integration of the markets can take

place. Such integration will, in turn, involve greater liquidity and further

development of the financial markets.

A specific channel through which the monetary policy of the ECB and the

TARGET system can have a direct impact on the development of the financial

markets of the euro area is the requirement to have guarantees or collateral

for operations with the ECB. This requirement for adequate collateral can

stimulate the process of loan securitisation, especially in the case of the

banking institutions of certain financial systems. The underlying assets can

be used across borders, which means that a banking institution in a country

belonging to the European System of Central Banks (ESCB) can receive funds

from its national central bank by pledging assets located in other countries,

which is also relevant from the perspective of the integration of the

financial markets of the area.

The trend towards further integration of the European financial markets,

accompanied by increased use of the euro as a vehicle for international

investment, should logically follow a process which would start in the short-

term money market, subsequently be expanded into the longer-term money market

and finally extend to the public and private bond and equity markets. In the

short term there must be a tendency for the differentials in money market

interest rates to be eliminated, as the functioning of the market improves,

while in the long-term securities markets - both public and private, of

course - interest rates will always include a risk premium linked to the

degree of solvency of the country (deficit and public debt, commitments on

pensions), or to the credit risk of the private issuer, and to the liquidity

of the securities.

Economic integration Monetary and financial integration stemming from the

euro and the activity of the Eurosystem will affect the operation of the

European single market in a positive way. The European market, with a single

currency, will tend to be more transparent, more competitive, more efficient

and will function more smoothly. This is the reason why joining the European

Union, as a general rule, leads to joining the euro area, once certain

economic conditions (the so-called convergence criteria) are fulfilled.

The case of Denmark, as you will know better than I, constitutes an accepted

exception to the general rule, formalised in Protocol No. 8 on Denmark of the

Treaty on European Union signed in Maastricht on 7 February 1992, and in the

so-called "Decision concerning certain problems raised by Denmark on the

Treaty on European Union" of 11 and 12 December 1992, which contains the

notification from Denmark that it would not participate in the third stage of

the European Economic and Monetary Union.

However, the Danish krone was in fact pegged to the Deutsche Mark from 1982

until the end of 1998. Furthermore, since 1 January 1999 it has been

participating in ERM II with a rather narrow fluctuation band of ±2.25%, and

effectively has had an almost fixed exchange rate vis-а-vis the euro.

Therefore, the Danish monetary policy, through this exchange rate strategy,

is the monetary policy of the Eurosystem. In other words, Denmark follows

"the rules of the game" almost entirely, or as the Governor of Danmarks

Nationalbank, Ms Bodil Nyboe Andersen, often says, "The Danish krone shadows

the euro".

In this connection, and before the question and answer session begins, let me

conclude by addressing the following key questions to you, on the

understanding that this is a rhetorical way to express my ideas and that I do

not necessarily expect any of you to answer them.

If Denmark already is following "the rules of the game", why, then, should

you not make use of the advantages of belonging to the Eurosystem? Why, then,

should you not participate in the decisions concerning the monetary policy

which, in actual fact, applies to Denmark?

______________________

(1) For a more detailed analysis, see the article entitled "The international

role of the euro", in the August 1999 edition of the ECB's Monthly Bulletin,

pp. 31-35.

***

European Economic and Monetary Union - principles and

perspectives

Summary of a presentation by Ms Sirkka Hдmдlдinen,

Member of the Executive Board of the European Central Bank,

The Tore Browaldh lecture 1999,

School of Economics and Commercial Law, Gцteborg University,

Gothenburg, 25 February 1999

The European integration process started shortly after the Second World War

and was, at the time, strongly motivated by political factors. The aim was to

eliminate the risk that wars and crises would once more plague the continent.

The first concrete result was the establishment, in 1952, of the European

Coal and Steel Community between six countries (Belgium, France, Germany,

Italy, Luxembourg and the Netherlands). This was followed by the adoption of

the Treaty of Rome in 1957, laying the foundations for the European Economic

Community.

The first concrete proposal for a Monetary Union was presented in the so-

called Werner Report in 1970. The Report was intended to pave the way for the

establishment of a Monetary Union in the early 1980s. However, the proposals

of the Werner Report were never implemented - being overtaken by world

events. After the break-up of the Bretton Woods system and the shock of the

first oil crisis in 1973, most western European economies were contaminated

by the economic sickness popularly labelled "Eurosclerosis", characterised by

high inflation and persisting unemployment. At that time, the European

economies were protected by regulations and financial markets were still

poorly developed. In this environment, it was concluded that a Monetary Union

would not be possible and the project was postponed.

The idea of establishing Monetary Union was revived only in 1988 and a

detailed proposal was presented the following year in the Delors Report,

after the launch (in 1985) of the Single Market programme on the free

movement of goods, services, capital and labour. Because of the single

market, the Report could be more explicit and credible with regard to how

best to achieve closer economic ties between the EU economies before the

introduction of a single currency. Moreover, the Report was supported by a

detailed description of an institutional set-up geared towards ensuring

stability-oriented economic policies.

Notwithstanding the thorough work invested in the Delors Report, almost 10

years of convergence and technical preparations were required in order to

ensure the successful implementation of the euro on 1 January 1999. And the

project is still not over: the euro coins and banknotes will be introduced

only in 2002 - 13 years after the presentation of the Delors Report and 32

years after the presentation of the Werner Report.

Achieving a credible currency

Today, almost two months after the introduction of the euro, we can say that

the technical changeover to the euro was successful. Now, the Eurosystem

(i.e. the ECB and the 11 national central banks of the participating Member

States) must focus on ensuring the long-term success of the new currency. The

credibility of a currency is built up by several factors, the basis of which

is the central bank's commitment to price stability. Here, the Eurosystem is

in the fortunate position of being assigned, through the Maastricht Treaty,

the unambiguous primary objective of maintaining price stability in the euro

area. Another fundamental building block of credibility is ensuring that

monetary policy decisions are independent of political pressures. This

building block was also laid down in the Maastricht Treaty, which ensures

that the ECB and the participating national central banks enjoy a very high

degree of independence, possibly more than any other central bank in the

world.

The credibility of a currency also relies on the preparedness of governments

to pursue stability-oriented policies of fiscal discipline and to undertake

necessary structural reforms. On this point, the Stability and Growth Pact

adopted by the EU countries provides a basic framework for fiscal discipline

and should enhance the governments' incentive to proceed with structural

reforms.

In order to enhance credibility, it is also important that the central bank's

strategy for achieving the primary objective is clear and that the link

between the strategy and the central bank's policy actions is easily

understood by the public. By following a transparent approach, the central

bank can directly improve the efficiency of monetary policy. This contributes

to achieving stable prices with the lowest possible interest rates.

Striving towards increased transparency led the Governing Council of the ECB

(composed of the Governors of the 11 national central banks and the six

members of the ECB's Executive Board) to establish a precise definition of

price stability in order to bring about absolute clarity as regards the

primary objective; price stability was defined as a year-on-year increase of

the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

This is a medium-term objective. In the short run, many factors beyond the

scope of monetary policy also affect the price movements.

The adoption of the Eurosystem's monetary policy strategy also aimed at

enhancing transparency in the implementation of monetary policy. The strategy

is based on two key elements: First, money has been assigned a prominent role

in the form of a reference value for the growth of the euro area wide

monetary aggregate M3. Second, the Eurosystem carries out a broadly based

assessment of the outlook for price developments and the risks to price

stability in the euro area on the basis of a wide range of economic and

financial indicators.

In order to explain to the public the Eurosystem's policy actions against the

background of the adopted monetary policy strategy, the Eurosystem uses

several channels: the ECB's Monthly Bulletin; the issuance of a detailed

press release after each Governing Council meeting, in which the decisions

are explained; the organisation of a monthly press conference at the ECB; the

appearances of the President at the European Parliament; and, finally, the

numerous speeches and articles by the members of the Governing Council. Taken

as a whole, the Eurosystem is probably among the more active central banks

when it comes to explaining its policies to the public.

A further important building block in order to establish credibility is the

promotion of an efficient implementation of the monetary policy decisions.

The Eurosystem has aimed to set up an operational framework which is

consistent with market principles and which ensures equal treatment of

counterparties and financial systems across the euro area. The Eurosystem's

operational framework is based on the principle of decentralisation in order

to take advantage of the established links between the national central banks

and their counterparties. The monetary policy operations will therefore be

conducted by the national central banks, while decisions are taken centrally

in the ECB's decision-making bodies.

The consequences of a single currency: perspectives for the future

The most important effects of the single currency relate to the possibility

of improving macroeconomic stability and credibility for the policies

pursued; these effects are particularly important for the smaller European

economies. Moreover, important benefits can be derived from microeconomic

factors, such as lower transaction costs, wider and deeper financial markets,

improved price transparency and increased competition.

Starting with the macroeconomic factors, Monetary Union makes it possible for

the participating countries to combine their credibility. In this way, small

countries can, to a certain extent, "borrow" credibility from some of the

large countries which have pursued stability-oriented policies for a long

time. Under credible conditions, the financial markets are no longer under

pressure from speculative attacks by large institutional investors. Price and

interest rate developments are stabilised, and the investment climate for

companies is secured. In the microeconomic field, the most obvious

consequences relate to lower transaction costs and increased price

transparency across national borders. These factors are likely to contribute

to increased competition and downward price pressure on many products.

One very important consequence is that the use of a single currency will give

rise to larger and more competitive financial markets in the euro area. In

most European countries, the financial markets have, by tradition, been

rather shallow, with few participants and a rather narrow set of financial

instruments on offer. A high degree of segmentation and a lack of cross-

border competition have implied relatively low trading volumes, high

transaction costs and a reluctance to implement innovative financial

instruments.

On the introduction of the euro, the foreign exchange risk of trading in the

different national markets in the euro area fully disappeared. This has

triggered increasing cross-border competition and has provided an incentive

for the harmonisation of market practices. In fact, the trading of money

market paper and euro area government bonds can already be considered to be

largely integrated. The markets for private bonds are still segmented owing

to the differing institutional and regulatory conditions across Member

States, but they, too, will gradually integrate and provide an incentive for

increasing the issuance volumes of private bonds. This will contribute to

reducing the financing costs for private companies, and it will provide

improved opportunities for investors.

Monetary Union provides much needed assurance of exchange rate stability for

exporters, importers and investors. This is particularly important for small

and open economies. In fact, most countries in Europe are to be considered

small in the current global perspective. The active use of the exchange rate

as a tool of economic policy could be an alternative for a large reserve-

currency country. For a small country, experience has shown that large

changes in the exchange rate tend to give rise to higher costs rather than

benefits, due to the harmful effects on expectations and higher interest

rates.

Some of the economic effects of the Monetary Union may partially benefit also

the countries remaining outside Monetary Union. Nevertheless, it is important

for the "out" countries, to assess whether they find that the benefits of

maintaining a national monetary policy "autonomy" - if there is any such

autonomy in an integrated and globalised market situation - outweigh the

possible drawbacks of not being able to fully draw on the credibility of the

euro area, the integration of the euro area financial markets, lower

transaction costs, improved price transparency and increased competition.

The euro and the Nordic countries

The Nordic countries have chosen to organise their monetary policy ties to

the euro area in very different ways: Finland is the only Nordic country

taking part in Monetary Union as from the start of Stage Three; Denmark

negotiated an opt-out from Monetary Union but follows a fixed exchange rate

policy vis-а-vis the euro within the new Exchange Rate Mechanism (ERM II);

Sweden decided not to participate in Monetary Union from the start of Stage

Three, without having a formal opt-out and the Swedish krona still floats

freely against the euro; and Norway and Iceland remain outside the EU

altogether.

The divergent approaches taken by the Nordic countries as regards one of the

most important economic and political projects in Europe in modern times are

somewhat strange in view of their traditionally close cultural, historical,

political and economic ties. Nordic co-operation has always been very

important and close. I note with satisfaction that the public opinions in

Denmark and Sweden now seem to be swinging in a more favourable direction

with regard to future membership. Maybe the successful implementation of the

euro has made the public understand that Monetary Union is aimed at ensuring

long-term stability in Europe. In this context, the recent signals from the

Government of the United Kingdom in favour of membership in the Monetary

Union are also very encouraging.

Personally, I think that it would be beneficial to all Nordic countries - and

the United Kingdom - to join Monetary Union within the not too distant

future. I hope that Sweden and Denmark can become members already before the

introduction of the euro banknotes and coins in 2002.

It is important for these countries to also assess the political aspects of

remaining outside Monetary Union. Experience has shown that EU Member States

which have taken initiatives and worked constructively towards European

integration have been generally more successful in gaining influence than

those less committed to the project. In this respect, it should be noted that

the aim of the Maastricht Treaty is clearly to establish a Monetary Union

comprising all EU Member States.

Personally, I also think that the Nordic countries could provide a fruitful

joint contribution to the long-term success of Monetary Union. There is no

need to overemphasise the role of small countries in this process, but it is

clear that co-ordinated views by a group of small countries would have a

larger influence than the views of individual countries. One of the benefits

of the Nordic countries - and small countries in general - is that they are

seldom bound to their old traditional system. In contrast, they typically

fight for efficient solutions which would be in the interest of the whole of

the euro area.

Concluding remarks

The project to establish European Economic and Monetary Union was carefully

prepared and based on very strong political commitment. It has contributed to

the co-ordination of economic policies - even in a wider sense - in an

environment of deregulated financial markets and the free flow of capital.

The stability arguments behind the introduction of the euro have been so well

accepted that we are already seeing serious and visible efforts aimed at the

next step towards a global "single currency" through the establishment of

exchange rate co-ordination between the euro, the US dollar and the Japanese

yen. In order for any such world-wide currency co-ordination to become

successful, there would be a need for political commitment to globally

harmonising fiscal, monetary and structural policies. In this context, I

would advise realism, caution and a gradual approach in spite of the longer-

term ideal goal of global stability. There are still many challenges and

adjustments ahead within the euro area before any world-wide steps should be

considered. Our first priority is to ensure long-term stability in the euro

area economies under the single monetary policy and on the hope that the euro

area will soon cover all EU countries.

***

Eurosystem: new challenges for old missions

Inaugural Lecture by Tommaso Padoa-Schioppa,

Member of the Executive Board of the European Central Bank,

on the occasion of his appointment as

honorary Professor of Johann Wolfgang Goethe-Universitдt,

Frankfurt am Main, 15 April 1999

Table of contents

1. Introduction

2. Policy missions

3. New challenges

4. Making the eurosystem a central bank

5. Dealing with the European unemployment

6. Managing financial transformations

7. Coping with a lack of political union

8. Conclusion

1. INTRODUCTION

I participate in this Dies Academicus, at the University that carries the

name of Goethe, in the town of Frankfurt, in the first year of the euro, with

thoughts and emotions that are hard to conceal.

In my early youth, at the time of the decisions that determine one's life,

the dearest of my Gymnasium teachers told me: "You have to resolve, in order

to decide your future, the dilemma of what interests you most: whether to

understand or to change the world." My choice has been Economics. And, the

subject of economics being human action, I early discounted that the call for

action would prevail, in my motivations, over the enquiring spirit. I did not

expect how strongly that dilemma would continue to accompany my life. More

importantly, I did not understand, at the time, how much acting and enquiring

are complementary ways of being in the world and searching for truth, as

Goethe's work and life so profoundly witness. Science changes reality;

practical activity not supported by reflection and analysis is ineffective

and even harmful.

If I now live in Frankfurt and am here today it is because most of my

professional life was spent in an institution - the Banca d'Italia - where

eminent persons like Guido Carli, Paolo Baffi and Carlo Azeglio Ciampi

allowed the dilemma of my early years being kept somewhat unresolved and

favoured independent analysis as a complement of practical activity. They

also shared and encouraged the combination of enquiry and action that helped

the euro to become a reality. To them I therefore dedicate this lecture.

Academia is the place where teaching and enquiring reinforce each other by

going hand in hand. It originates from Socrates' precept that "the wisest

recognises that he is in truth of no account in respect to wisdom". Teaching

is assertive, enquiring interrogative. One is based on the presumption that

we have answers to transmit; the other is based on the modesty imposed by

unresolved questions.

The mode of the following remarks will be the interrogative, rather than the

assertive one. Not only because presumption is certainly not my йtat d'esprit

today, but, more importantly, because the theme of this lecture - the new

challenges posed by the advent of the euro - has a distinctly intellectual

dimension, not only a practical one. The success of EMU will largely depend

on the ability to identify new problems at an early stage and to analyse them

without prejudice. While the mission entrusted to central bankers is not new,

the challenges in the years to come may indeed differ from those of the last

few decades. They may be "new" either because they have not been experienced

before, or because they have acquired a new dimension.

In reviewing what I consider to be, for the Eurosystem, the most important of

such challenges, I shall use the academic privilege of taking a free and

forward-looking perspective. My point of view will, therefore, not

necessarily coincide with that of my institution. Moreover, I shall not be

objective, because I shall mainly draw on the intellectual and practical

experiences that have constituted my professional life.

2. POLICY MISSIONS

Policy missions have not been altered by the start of the euro. They

correspond to aspects of the public interest that were not redefined, and did

not need a redefinition, because of the euro.

In the field of central banking the public interest is to provide economic

activity with a medium of exchange that preserves its value over time. In the

broader field of economic policy - of which monetary policy is part - the

public interest is, to use words from the Maastricht Treaty that can be

similarly found in most national constitutions and legislation, "to promote

economic and social progress which is balanced and sustainable" (Article B).

In the field of European integration, the mission is that of "creating an

ever closer union among the people of Europe, in which decisions are taken as

closely as possible to the citizen" (Article A). Finally, in the field of

international relations the public interest is to "maintain international

peace and security" (UN Charter Article 1.1) as well as to "contribute to the

promotion and maintenance of high level of employment and real income"

(Articles of Agreement of the IMF, Article 1.ii).

The formulation of these policy missions has taken shape over the course of

this century, or even earlier, on the basis of experience, scholarly

investigation, political debate and action. There would be no consensus about

the primary mission of the central bank if countries had not experienced

first hyperinflation and then successful monetary management by a stability-

oriented and independent central bank. Social progress and economic growth

would not be on the agenda of governments without the labour movement and the

Great Depression. We would not have the EU Treaties and the Charter of the UN

without the tragedy of two World Wars.

Economists have explored the scope for economic policy action, and the limits

thereof, in the monetary, fiscal and regulatory fields. Without thirty years

of academic debate about the role of monetary policy, the EMU Treaty and the

Statute of the ESCB/ECB would not have been written the way they were. The

subordination of economic policies to the principle of "an open market

economy with free competition" would not have been explicitly inserted in the

Maastricht Treaty (Article 3A) had those principles not gained recognition in

the community of scholars.

Central bankers (most notably in the Delors Committee) have prepared the

blueprint for the single currency. International and constitutional lawyers

have elaborated the legal concepts and studied the procedures to carry out

the policy missions. They have built that legal monument that is the

Rome/Maastricht Treaty. Citizens and politicians have discussed, promoted and

implemented the whole process.

Different policies carry different degrees of compulsion and effectiveness.

In general, instruments are more strongly framed when they are entrusted to

institutions whose area of jurisdiction coincides with that of the nation

state. Strongly framed instruments, however, do not necessarily produce

strong results. Tough regulation against air pollution adopted only by a

small country is less effective, for that same country, than softer

regulation adopted by a larger group of countries. The economic literature

about externalities, or that about optimal currency areas, are seminal

examples of the contribution economic research can make in this respect.

In the following I shall focus on the mission of the central banker, because

this is the function assigned to me. I am convinced, however, that the

missions I mentioned are fundamentally complementary. Different assignments

are part of an orderly division of labour. In a democratic and market-

oriented environment not only citizens, but also officials, can consider the

aims of the various policy bodies and charters - national and international -

to which they refer as forming a consistent configuration. I regard this as a

special privilege of the time and space in which I have lived so far.

3. NEW CHALLENGES

In the last thirty years central bankers have fought for two objectives: the

recognition of the primacy of price stability for monetary policy, and the

independence of the central bank. This has been the period in which the

combination of political democracy and fiduciary currency made the governance

of money particularly difficult in many countries.

The intellectual recognition, then the political acceptance and finally the

actual implementation of a monetary constitution based on price stability and

central bank independence have required a long process. The academic

profession has contributed to it in a powerful way, from Irving Fisher to Don

Patinkin to Robert Lucas. Even those who have denied the need of having a

central bank, like Milton Friedman and Friedrich A. von Hayek, have in the

end contributed to clarify its role and function. No less persuasive have

been the arguments of experience. In a positive sense, the economic success

of the country - Germany - where the two elements had been introduced at an

early stage. In a negative sense, the social evil of high and prolonged

inflation suffered by many other countries, including my own.

In legal and institutional terms, the result of this long fight has been

engraved in the Treaty of Maastricht. The Treaty represents the strongest

monetary constitution ever written, not only because of its substance, but

also because the procedure to amend it is more difficult than that required

for the charter of any existing central bank. Largely induced by Maastricht

and EMU is also the independent status of national central banks in the

European Union. We should indeed not forget that, until recently, key

decisions in the field of monetary policy were still in the hands of the

Treasury in such countries as the United Kingdom, France, Italy and Spain.

The Maastricht process has been the catalyst for monetary reforms central

bankers had advocated for years.

Partly, but not exclusively, because of this process, the conditions under

which the single currency has come to life differ from those prevailing in

the past years.

Prices have for some time now shown the highest degree of stability seen for

more than thirty years. Most countries have made significant progress towards

fiscal consolidation. The consensus on sound principles of budgetary and

monetary management is broader and stronger, among both politicians and

ordinary people, than in any other period the present generation can

remember. Few dispute in an open way the now widely used expression "culture

of stability".

However, when in 1981 it was decided to save the last specimen of the

smallpox virus in a laboratory for the sake of documentation, health had not

ceased to be in danger. Similarly, none of these achievements can be

considered as permanent and central bankers should primarily strive to

preserve them. To this end, detecting new challenges at an early stage is

essential. The question is: where do the problems come from? What are the

circumstances under which the "old mission" will have to be accomplished in

the coming years? What threatens our health besides smallpox?

4. MAKING THE EUROSYSTEM A CENTRAL BANK

The first challenge consists in making the Eurosystem a central bank. It may

seem simple, but is not. Let me start my explanation from the two key words

of this proposition.

Eurosystem is the word chosen by the ECB to indicate the "ECB+11

participating national central banks", i.e. the central bank of the euro. The

Treaty has no name for this key entity, while it refers extensively to the

ESCB (European System of Central Banks) formed by the ECB and the 15 European

national central banks). However, as long as there are "out" countries, the

ESCB in its full composition will remain a scarcely relevant entity because

it neither refers to a single currency area nor has any policy competence.

Instead, the word Eurosystem indicates clearly the articulated entity which

is for the euro what the Federal Reserve System is for the dollar.

Central bank is the institution in charge of the public interests associated

with the currency. It originates from fundamental changes in the technology

of payments: the adoption of banknotes, cheques and giros, and their final

disconnection from gold. These changes have shaped the two other functions

that most central banks have derived from the original payment system

function: monetary policy and banking supervision. Man-made money made

monetary policy possible. Commercial bank money made banking supervision

necessary.

These three functions have most often been entrusted to the same institution

because they are inextricably linked. Just as money has the interrelated

roles of means of payment, unit of account and store of value, so central

banking has a triadic function that refers to the three roles of money.

Operating and supervising the payment system refers to money as a means of

payment; ensuring price stability refers to money as a unit of account and a

store of value; pursuing the stability of banks refers to money as a means of

payment and a store of value. The function remains triadic (albeit, in my

view, in a less satisfactory way) even where prudential control is entrusted

to a separate agency. I am referring to the special "supervision" any central

bank has over its banking community, necessitated by the fact that banks are

the primary creators of money, providers of payment services, managers of the

stock of savings and counterparties of central bank operations.

In performing its triadic function the central bank exerts operational and

regulatory powers, interacts with other public authorities and the financial

community, entertains relations with other central banks, participates in

international debates and negotiations about monetary and financial matters.

In all these activities it pursues and represents the public interest of a

sound currency; all are instrumental to that interest. From the point of view

of the perceptions of people and markets all such activities refer to that

same public good that we call confidence.

For the Eurosystem the challenge is to rise to a full central banking role as

just defined. It is necessary because of the links that bind the various

functions of money. The Eurosystem would find it hard to play effectively its

most delicate role - the pursuit of a stable currency or, as the German

Constitution puts it, "die Wдhrung zu sichern" - if it appeared as an

inexplicable exception to the classic paradigm of a central bank. The public,

the markets, the international institutions and fora would not understand.

But it is also difficult, because the steps to take are multiple and complex

from both a conceptual and a practical point of view. Moreover, they cannot

all be taken at once. Let me briefly explain.

In the articulation of any federal constitution (Bund, Land and local, to use

the German terminology) the central bank undoubtedly belongs to the level of

the "federation", or Bund. The fact that important activities are conducted

by "local" components of the system (Landeszentralbanken, or Federal Reserve

District Banks) is an organisational feature that does not impinge upon the

constitutional position of the central bank. The same happens within Monetary

Union. The Eurosystem is the central bank of the euro area, even though

operations are carried out - to the extent possible and appropriate - through

its component parts, the NCBs. Indeed, the constitutional and the

organisational profile of the institution are not in contradiction.

Although a federal and decentralised central bank is not a novelty, the

Eurosystem is a special case. It is the central bank of an economy that has a

much deeper national segmentation than any other currency area. Its

components have for many generations (and until few weeks ago) performed the

full range of central banking functions under their own responsibility and in

a national context. They have been accountable to, and sometimes dependent

on, national institutions. Public opinion has perceived, and still perceives,

them as national entities. The notion of the public interest they were

referring to was the notion of a national interest. Significant differences

existed, and partly remain, in their tasks, organisations, statutes and

cultures.

In this situation, making the Eurosystem a central bank requires drawing the

appropriate distinction between being national in the organisational sense

and being euro area-wide in the definition of the public interest pursued.

This is a difficult distinction to draw in conceptual terms, not only in

practical terms or from the point of view of personal attitudes.

In the preparatory discussions and negotiations that led to the Maastricht

Treaty, central banks took the view that monetary functions are indivisible

and that, contrary to the fiscal field, subsidiarity cannot apply to the

monetary field. Their traditional and strongly held position has been that

the public interest assigned to central bank is a whole which cannot easily

be decomposed. Indeed, while there is a fairly well developed theory of

fiscal federalism, there is no equivalent for the monetary field.

As I said, I do think that the functions of a central bank constitute a whole

that cannot be split. This does not exclude that the Eurosystem should avoid

seeking more uniformity than necessary and that some diversity is a positive

factor and has always been valued as an aspect of the richness of Europe.

Perhaps even a limited degree of internal competition may be used as an

incentive to good performance. But can the Eurosystem depart from the two

historical models of the Federal Reserve System and the Bundesbank? What are,

in conceptual terms, the criteria of what I just called the "appropriate

distinction"? What should be the touchstone?

It would be an illusion, I think, to expect or pretend to have a full and

satisfactory answer solely from legal interpretation. And it would be

unfortunate if the Eurosystem were to fall into the trap of the narrowly

legalistic approach that paralyses international organisations. The

Eurosystem is not an international organisation, its model is not the

Articles of Agreement of the IMF. Of course, the answer will have to comply

with the Treaty, which provides useful guidance. However, the system is

entrusted to decision-making bodies that are composed not of lawyers, but of

central bankers. They carry the primary responsibility to manage the euro and

are accountable for that responsibility. They have known for years what a

central bank is and how vague the wordings of central bank statutes have

historically been. Their touchstone can only be, in the end, the

effectiveness in the accomplishment of the basic mission embodied in the

triadic paradigm of central banking functions.

5. DEALING WITH EUROPEAN UNEMPLOYMENT

The second challenge comes from the high level of unemployment in Europe.

Every economist, observer or policy-maker would probably agree that the most

serious problem for the European economy, today and in the years to come, is

high unemployment. In large parts of continental Europe the economic system

just seems to have lost the ability to create new jobs.

Also on the nature and causes of European unemployment there is a large

degree of agreement, as there was agreement on the nature and causes of

European inflation well before price stability was finally restored in the

1990s. The key words describing such agreement are structural factors and

flexibility. There is agreement that perverse incentives, direct and indirect

taxation of labour, unsustainable pension schemes, overly tight employment

rules and rigidities throughout the economy are the main obstacles to the

creation of new jobs. There is agreement that the typically European welfare

state system should be profoundly corrected, but not suppressed. Many also

think that rather than following a "Thatcherian" policy of cracking down on

the trade unions, it would be preferable to work with, rather than against,

the labour organisations, although reform entails occasional confrontations.

As with inflation in the 1970s and 1980s, so unemployment in the 1990s -

while being a European disease - is quite diversified across European

countries and regions, due to differences in both policies and economic

situations. It is over or around 20 per cent in the Mezzogiorno and Sachsen-

Anhalt, but below 7 per cent in Lombardy and Baden-Wьrttemberg; over 18 per

cent in Spain, but less than 4 in the Netherlands.

Notwithstanding the intergovernmental debates at a European level and the

stated intention to undertake common initiatives, the instruments of

employment policy remain in national hands, although only partly in the hands

of governments. I regard this as appropriate because competition should not

be suppressed from the labour market.

Adopting the appropriate policies of structural reform has proved extremely

difficult in many key European countries, including my own and this one.

Other countries, such as the Netherlands and the United Kingdom, have been

more successful. Even the most successful experiences, however, have shown

that reducing unemployment is a long and gradual process. Although some

countries started labour market reforms in the early 1980s, they only reaped

the benefits in the 1990s.

Unemployment will thus remain with us in the years to come and I am convinced

that it should be regarded as the greatest policy challenge not only by

governments and labour organisations, but by the Eurosystem as well. Let me

explain why.

An economy in which unemployment drags above 10 per cent for years is a sick

economy, just like one in which public finances or inflation are chronically

destroying savings. To operate in a sick economy is always a risk for the

central bank and for the successful fulfilment of its primary mission. In the

case of prolonged unemployment, the risk arises both on a functional and an

institutional ground.

On a functional ground, i.e. from the point of view of the relationship

between economic variables that models usually consider, a chronically weak

economy is one in which expectations deteriorate, investments stagnate,

consumption declines. Structural unemployment may increase the risk of a

deflationary spiral because a longer expected duration of unemployment may

imply that households respond more conservatively (in terms of increasing

savings) in the face of a deflationary shock. Today, we see no signs of

deflation. Markets and observers who pay attention to communications by the

Eurosystem know that the monetary policy strategy of the euro area is

symmetrical, equally attentive to inflation and deflation. Thus, they know

that if that risk became reality, the Eurosystem would have to act, and would

act. But we know that monetary policy is much less effective in countering

deflation than it is in countering inflation.

A more insidious threat, however, may arise on the institutional ground. It

comes from a chain of causation involving social attitudes, economic theory

and policy, actual economic developments and institutional arrangements.

Attitudes of society respond to economic situations and policies, which in

turn depend on the state of development of economics. Institutions, on their

part, are influenced by attitudes of society. Both the course of economic

thought and the practice of policy were lastingly altered by the Great

Depression. The epitome of this historical event was the Keynesian

revolution. In many countries the strong consensus about the primacy of price

stability and the independence of the central bank was the outcome of the

prolonged inflation suffered in the 1970s and 1980s. Here in Germany, it is

rooted in the experience of hyperinflation. Would such a consensus survive if

high unemployment remained a chronic feature of key European economies for

many more years? And how would the position of the central bank change if

that consensus faltered?

As central bankers primarily concerned with price stability, what can we do

to cope with this challenge and to reduce the risks? My answer may seem

disappointingly partial, as I do not think there is a miraculous medicine

that monetary policy can provide. I would phrase it as follows.

Firstly, the central banker should be aware of the danger. He should know

that in the future his principal objective may not receive, from the public,

governments and parliaments the same strong support which has been the

outcome of the two decades of high inflation. Since unemployment is what

concerns the voters and the youngsters most, it may be increasingly necessary

for him to play an educational role in explaining the benefits of a stable

currency to those who have not directly experienced the costs of inflation.

This is very much like the case of the post-war generations in Europe which,

being fortunate enough not to experience the horror of World War II, need now

to be reminded about the human costs of that terrible conflict.

Secondly, the central banker should avoid mistakes. It may seem obvious, but

he should never forget that independence does not mean infallibility and that

the likely new environment will offer no forgiveness for mistakes. A mistake

would be the attempt to provide a substitute for the lack of structural

policies by providing unnecessary monetary stimulus: it is not because the

right medicine is neither supplied by the pharmacist nor demanded by the

patient that the wrong medicine becomes effective. Another mistake would be

to give the impression that the central bank has a ceiling in mind for

growth, rather than for inflation. On the contrary, the central bank should

make it clear that any rate of non-inflationary growth is welcomed and would

be accommodated, the higher the better.

Technically, this will not be an easy task. The analytical uncertainty

surrounding estimates of potential output and its growth rate might lead the

central banker to respond quite cautiously to evidence of shifts in the rate

of non-inflationary growth. While such caution is certainly optimal from an

inflation stabilisation point of view, it might be wrongly interpreted as a

systematic deflationary bias by the public and the politicians. This is a

clear case in which any progress made by scholars in refining the analytical

tools of the economic profession will greatly help the central banker to

achieve his goals without imposing unnecessary costs on society at large.

On the whole, however, it is part of the central banker's role to make the

day-by-day decisions that, in the end, constitute monetary policy. This

responsibility can be neither transferred to, nor challenged by, policy

makers responsible for other areas. Last week, the Eurosystem has made, for

the first time in its life, an affirmative monetary policy decision by

lowering its official rates. In this way, the Eurosystem has acted in line

with its monetary policy strategy and made a significant contribution towards

an economic environment in which the considerable growth potential of the

euro area can be exploited in full. It is now the responsibility of other

sectors of economic policy making to do their part by strictly adhering to

the Stability and Growth Pact and implementing decisive structural reforms.

6. MANAGING FINANCIAL TRANSFORMATIONS

The third challenge consists in accompanying and surveying the rapid changes

the European financial institutions and markets are undergoing, and will

continue to undergo over the coming years, partly - but not exclusively - as

a consequence of the euro.

It is sufficient to observe the US Federal Reserve System to understand the

role the Eurosystem should play in the coming years: attention in monitoring

changes in the financial system, active participation in the policy debate

caused by such change, intense dialogue with both the Administration and

Congress, influence exerted on opinions and decisions.

To a large extent the factors of change are technology determined, hence

independent of the euro and even not specifically European. Technology is the

driving force of the transformation in banking and finance that modifies the

traditional deposit loan structure of banks. Technology also reshapes

dramatically the back office and the communication with customers, thus

producing massive over-branching and over-staffing in traditional banks. Also

the globalisation of finance comes primarily from the combination of data

processing and telecommunications.

Other changes are specifically European. Since universal banking has

historically prevailed in continental Europe, the change from an institution-

based to a market-based financial system is particularly significant in this

part of the world. Similarly, the development of financial conglomerates is

more pronounced in Europe than in the United States or Japan. Typical of

continental Europe are also the labour market rigidities that make the

restructuring of banks so difficult and slow.

Finally, there are changes induced by the euro. The removal of currency

specificity as a cause of national segmentation of the financial industry is

causing a convulsive shake-up of both institutions and markets. Since the

beginning of this year, about ten banks ranking near the top of their

respective national lists have concluded or started merger operations in

France, Spain, Italy, the Netherlands, Belgium and Norway. In most European

countries stock exchanges and other organised markets, which were legally and

structurally organised as providers of a public service, have been

transformed into profit-driven private institutions and are now in a process

of rapid concentration. In the coming two or three years the number of banks

will shrink, the largest banks will become much larger, few financial centres

and market networks will replace the present one-country one-centre

configuration.

In any national system the central bank would actively monitor and even guide

the course of such a transformation. It would do so along with the various

agencies responsible for financial supervision and competition policy, and

with an involvement of the executive power itself. Although largely

determined by business decisions, these developments indeed involve the

public interest in various ways.

Surveying and accompanying a profound transformation of the financial

industry would be a difficult task for any central bank. For the Eurosystem

it will represent a daunting challenge because it will put to the test an

unprecedented articulation of the policy functions that are called for. Let

me briefly explain this assertion.

The institutional setting of the euro area establishes a double separation

between central banking and other public functions. Firstly, a functional

separation, whereby banking supervision is now assigned to institutions that

- even when they are national central banks - no longer exert independent

monetary policy functions. Of this separation we have many previous examples

(Germany, Japan, Sweden, now the UK, etc.). Much newer is a second,

geographical, separation, whereby - with only the partial exception of

competition policy - the area of jurisdiction of central banking does not

coincide with the area of jurisdiction of the other public functions involved

(banking supervision, regulation of the securities market, etc.).

Experts, including academic people, have so far focused attention on lender-

of-last-resort functions and suggested that the new setting would not be able

to act effectively in a crisis. I have argued elsewhere why this criticism

seems unjustified. Here, I would like to suggest that the real challenge

could come, in my opinion, from tensions between the national and the euro

area interest in the process of financial transformation.

The process of industry transformation will inevitably involve aspects that

have traditionally been considered as sensitive by public authorities:

suppression of jobs, location of facilities and headquarters. Financial

transformation will also produce a hardening of competition and competition

will be, to a considerable extent, one between national financial centers and

industries, not only between individual banks or institutions. The propensity

to defend national champions may prevail over the pursuit of efficiency. The

risk for the Eurosystem to fall in the trap of an improper interplay between

the EU and the national dimension of the public interest may become high.

Like any central bank, the Eurosystem should be both active and neutral in

the great transformation of "its" financial industry. The word "system" that

is part of its own name refers, and should apply in practice, to the whole

euro area.

7. COPING WITH A LACK OF POLITICAL UNION

The fourth challenge consists in coping with the lack of a political union.

The relationship between monetary and political union and whether the latter

should be a precondition for the former has been a central issue in the

European debate well before the establishment of the Delors Committee in

1988. While I do think that there is a lack of political union and that this

lack constitutes a serious challenge for the Eurosystem, I also think that

the expression "lack of political union" is often used in an unclear way that

blurs the issue. Let me thus first consider two meanings of this expression

with which I do not concur.

First, I do not concur with the idea that there is no political union in

Europe today. It is not because the content and the competence of the

European Union are mainly economic, that its nature and historical role are

not political. Even before the single currency, EU competence extended over

virtually the whole Corpus Iuris of economic activity, from the establishment

of "the free movement of goods, persons, services and capital" (the four

freedoms proclaimed by Article 3 of the Treaty) to external economic

relationships. To understand how very political these issues are, it should

suffice to think about the place they take in the US political debate today,

or have taken in the politics of our countries before the creation of the

European Community. Moreover, the institutional architecture of the European

Union is entirely that of a political system, not that of an international

organisation based on intergovernmental co-operation: a legislative capacity

that prevails over that of Member States, a judicial power, a directly

elected Parliament.

Second, I do not concur with the idea that Monetary Union has developed

outside the political process. Quite the contrary is true. The establishment

of a single currency in the European Union has been achieved because of the

strong political determination of elected governments over a full decade,

from June 1988 to May 1998. It is significant that during that long period

continuity has not been broken by repeated changes of political majority in

virtually all countries except Germany. Technocrats, i.e. central bankers,

have "only" played their role, crucial as it may be. They have provided

expertise, from the drafting of the blueprint to the preparatory work for the

actual start of the system. And, no less important, they have loyally

accepted the limits of their role and recognised that the ultimate decisions

have belonged to elected politicians. This is the meaning of the two

statements of July 1988 and March 1998 with which the Bundesbank has defined

its position at the beginning and the end of the crucial decade. "In der

Beschrдnkung zeigt sich der Meister".

The establishment of a single currency is a strongly political event in its

genesis and a profound social and cultural change in its nature. As

economists and central bankers we pay limited attention to notes and coins

because they are a minor and endogenous component of the money stock. For

many politicians, however, Monetary Union meant little else than a common

banknote. They saw, better than us, that for the people money has to do with

the perception of the society to which they belong and, ultimately, with

their culture. As such, money goes well beyond the economic sphere of human

action. Indeed, the act whereby we accept to provide goods or services to an

unknown person in exchange for pieces of paper that have no intrinsic value

is perhaps the most significant and widespread testimony of the social

contract that binds people. This is why coinage and money printing have

always been a prerogative of the State.

Yet, for two main reasons it remains true that Europe has a lack of political

union. First, the European Union is still not the ultimate provider of

internal and external security, the two key functions that constitute the

raison d'кtre of the modern State. Second, EU institutions still fail to

comply with the key constitutional principles that constitute the heritage of

western democracies: foundation of the legislative and executive functions on

the popular vote, majority principle, equilibrium of powers.

Why does the lack of political union constitute a challenge for the

Eurosystem? I would answer as follows.

In a period of less than thirty years money has abandoned both the anchors it

has had since the earliest times: metal and the sovereign. It is true that

central banks have struggled for years to free the printing press from the

influence of the modern sovereign, as they struggled in the past to free it

from the influence of private interests. It is equally true that the present

status of the Eurosystem in the constellation of public powers is

exceptionally favourable. However, only a superficial thinker could confuse

independence with solitude and take the view that the lack of political union

strengthens the position of the central bank and makes it freer to fulfil its

mission.

The security on which a sound currency assesses its role cannot be provided

exclusively by the central bank. It derives from a number of elements that

only the State or, more broadly, a political union as previously defined, can

provide. When we say that a currency is a "safe haven" we refer not only to

the quality and credibility of its central bank, but to the solidity of the

whole social, political and economic structure to which it belongs. And

historical experience shows that when that structure appears to weaken, the

currency weakens, irrespective of the actions of the central bank. A strong

currency requires a strong economy and a strong polity, not only a competent

central bank. The central bank is, and should remain, an institution with too

limited a mission to replace the lack of a political union.

The problems posed by the coexistence of a single currency with a still

unachieved political union will influence both practical and intellectual

activity in the coming years. They will have implications for the central

banker, the politician and, more generally, the citizen. For the politician

the implication is that his political decision to move ahead with Monetary

Union in advance of political union contains an implicit commitment to work

for the completion of political union. The central banker should be aware of

the special difficulties and responsibilities deriving from this anomalous

condition. On the one hand he will have to cope with this situation and adapt

his attitudes to a composite - EU and national - institutional architecture,

one that lacks the simplicity he was used to and in which the Eurosystem now

represents the most advanced supranational component. On the other he should

be prepared for the further evolution of that same architecture. Finally,

from the citizens that we all are, it will require a deeper reflection about

the multiple "social contracts" he is part of, and the loyalties they entail.

8. CONCLUSION

I have been fortunate to operate in an environment in which no conflict has

arisen between the central banking profession I have exercised for more than

thirty years and the European conviction that, like many persons of my

generation, I matured in my youth. Since the early '80s I have also been

convinced that monetary union, i.e. a confluence of the two motives, was

desirable and possible. At the same time, the challenges for the Eurosystem

originate precisely from that confluence.

The challenges are not solely economic in their nature, nor can their

features be captured by the functional relationships economists are most

familiar with. Although partly related to economic factors, their features

are in fact tied to the special institutional environment to which the

Eurosystem now belongs. They derive from the tension between the completion

of the union in the monetary field and the incompleteness of the overall

construction. It is a tension because in that environment the notion of the

public interest is no longer as simply and statically defined as it was when

the Nation-State was an all-pervasive reality and the jurisdiction of the

central bank coincided with its jurisdiction. Inevitably, this tension runs

through the institutions of the European Union, the Eurosystem itself, and

even our minds.

A challenge is a call to a difficult task; it entails the two notions of

necessity and difficulty. The problems I have tried to describe are a

challenge not only for practitioners, but also for the academic profession,

because their solutions can hardly be found in a textbook and will only be

invented if the creativity of practitioners will be supplemented with that of

scholars.

***

Monetary policy in EMU

Prof. Otmar Issing

Member of the executive board of the European Central Bank

Washington, D.C.

6 October 1998

1. Introduction

On 1 January 1999, the curtain will rise on a world premiиre. For the first

time in history, sovereign states will abandon their own currencies in favour

of a common currency, and transfer their monetary policy sovereignty to a

newly created supranational institution. This process is all the more unusual

from a historical perspective because the national currencies involved are

not being abolished because of their weakness. On the contrary, proof of a

large measure of monetary stability is demanded as a precondition for

participation.

The decision has been taken. The Euro will start on time. It must not - and

it will not - fail. The European System of Central Banks (ESCB) will devote

its best endeavours to making European Monetary Union (EMU) a success.

The French president recently called this unique project a "great collective

adventure". As a central banker I am generally not in favour of "adventures"

- but who would deny that there are risks and uncertainties in this

enterprise? You should be reassured that at the European Central Bank (ECB),

we have the necessary independence, instruments and tools to deal with these

risks and uncertainties in a successful way. I will discuss some of these in

a moment.

Moreover, when considering the uncertainties implied by the transition to

Stage Three of EMU, we should not forget that Monetary Union will also

reduce, or even eliminate, a number of risks. This has already been

demonstrated, even before the actual introduction of the euro. Recent turmoil

in international financial markets did not cause any significant disruption

to exchange rates among currencies of the designated participants in Stage

Three. This is a clear demonstration of the success of the EMU process.

Today, I will address the role of monetary policy in EMU.

First, I will make reference to the final goal of monetary policy - the

maintenance of price stability.

Second, I will discuss some important issues relating to the design and

implementation of the monetary policy strategy at the outset of Stage Three

of Monetary Union; and

Finally, I will describe some features of the operational framework of the

ESCB that have recently been finalised.

Let me begin by discussing the over-riding priority we attach to the

maintenance of price stability.

2. The priority of price stability

The Treaty on European Union - the Maastricht Treaty - stipulates that the

"primary objective of the ESCB shall be to maintain price stability". It was

left to the ESCB to provide a quantitative definition of this primary

objective. At the ECB's precursor, the European Monetary Institute (EMI), it

was agreed that, in the interests of transparency and accountability, the

ESCB's chosen operational definition of price stability should be announced

publicly. This announcement would form an important element of the overall

monetary policy strategy. Simply defining price stability leaves open the

question of why price stability is desirable. As a central banker, the

benefits of price stability appear self-evident. Any single argument in

favour of price stability cannot comprehensively describe the benefits that

it brings.

For instance, concerning the United States, Martin Feldstein has recently

shown that, in combination with taxes and social contributions, even quite

modest rates of inflation can cause considerable real economic losses.

Research at the Bundesbank has produced similar results for Germany.

But elimination of the losses caused by this channel is only one illustrative

example among the many benefits of price stability. The greatest contribution

that the ESCB can make to the euro area's output and employment performance

is to achieve and maintain the stability of prices. Stable prices are at the

core of the 'stability culture' we are trying to create in Europe, a culture

that is the foundation of sustainable and strong growth in the standard of

living for Europe's citizens.

At the same time, the ESCB does not operate in a vacuum. Monetary policy

needs to be supported by an appropriate fiscal policy and necessary

structural reforms implemented at the national level if this 'stability

culture' is to be built on solid and sustainable foundations. The private

sector also has its part to play, notably by exercising wage moderation,

given the high levels of structural unemployment in the euro area. Progress

on all these dimensions is not only desirable, but also absolutely necessary.

Monetary policy alone cannot ensure strong, non-inflationary growth and

improved employment prospects throughout the euro area. However, only a

monetary policy focussed closely on the achievement of price stability can

lay the basis for these conditions.

Of course, that is not to say that the ESCB can, or should, ignore broader

macroeconomic considerations. For instance, the threats posed by deflation in

combination with nominal rigidities to the real economy have to be taken into

account. In order to prevent any misunderstanding, let me be very clear: my

discussion of deflation has to be seen in the context of the formulation of

an optimal definition of price stability for the ESCB that takes into account

deflationary dangers. These dangers certainly cannot be ruled out and our

definition of price stability should reflect them. However, simply recalling

the current rate of inflation in the euro area - 1.2% - shows that deflation

is not an immediate concern for policy-makers.

While periodic and transitory falls in the price level may be normal, and

should not give rise to major concerns, a prolonged deflation is clearly

inconsistent with any meaningful definition of price stability. Moreover,

since nominal interest rates cannot fall below zero, a prolonged deflation

may render the interest rate policy of the central bank rather ineffective.

What remains is out-right purchases of assets - both foreign and domestic.

Similarly, the ESCB cannot ignore the implications of nominal rigidities in

wages and prices for the transmission mechanism of monetary policy. If we

were to live long enough under a regime of stable prices, I would not exclude

the possibility that wage and price setting behaviour would adapt, and

nominal rigidities would finally disappear. This would reduce some of the

potential output costs of fighting inflation, and thus increase the net long-

run benefits of price stability. However, for the time being we may have to

live with these rigidities and take their effects into account when deciding

on our monetary policy strategy.

In this respect, the present situation is not easy for the ESCB. Unemployment

in the euro area is currently very high.

However, in contrast to these persistently high levels of unemployment -

which are largely structural in origin - the prospects for maintaining price

stability are currently very encouraging. Inflation expectations and long-

term interest rates in the euro area are at close to historical lows. Actual

area-wide inflation is also very subdued.

The current low 'headline' rate of inflation has been moderated somewhat by

recent falls in oil and commodity prices, themselves stemming, in part, from

the economic and financial crises in Asia and, more recently, in Russia.

However, this effect on inflation has been largely off-set by the impact of

indirect tax rises in a number of participating countries, which have raised

consumer prices for certain goods. All in all, the changed external

environment contributes to an overall outlook of very subdued inflationary

pressures.

In defining price stability, one might ideally refer to a conceptual measure

of 'core' inflation that tries to isolate monetary effects on the price level

- for which the ESCB is properly responsible - from such terms of trade or

indirect tax shocks, over which it has little immediate control.

In our month-to-month communication with the public, 'core' measures of

inflation may prove useful. But, in its preparatory work for Monetary Union,

the EMI recognised that any sensible definition of price stability for the

euro area would have to be based on a comprehensive and harmonised price

measure. 'Core' measures of inflation typically exclude some items. They are

unlikely to be comprehensive enough to satisfy the requirements of an index

suitable for a sensible public definition. These considerations point to

using the 'headline' measure of the harmonised index of consumer prices (or

HICP) for the euro area in the definition of price stability.

Finally, the ESCB needs to build on the success of its constituent national

central banks (NCBs) in reducing inflation and achieving price stability

during the convergence process in Stage Two of EMU. Given the current

generally benign inflation outlook in the euro area that is the product of

these accomplishments, there is an understandable desire to 'lock-in' the

current success in achieving price stability as well as the apparent

credibility of monetary policy, and ensure continuity with existing central

bank practice.

3. The importance of the monetary strategy for a successful start of European

monetary policy

When price stability is defined using the principles just outlined, how

should the ESCB proceed to maintain it? In achieving and maintaining price

stability - the primary objective of the Treaty - the choice of monetary

policy strategy is vital.

Within the ECB, a considerable amount of work on the monetary policy strategy

has already been completed, building to a large extent on the substantial

earlier preparatory work of the EMI. A high degree of consensus has been

reached among the NCBs and within the ECB about the main outlines of the

strategy - I will address some of these areas of agreement in a moment. The

final decision has not yet been made. But you should be reassured that

progress is being made at a good pace. I have no doubt that we will be in a

position to announce the details of the ESCB's monetary policy strategy in

good time, prior to the start of Stage Three.

Being a new institution, the European Central bank must be prepared to come

under intense scrutiny right from the start. In particular, the international

financial markets will monitor its every decision like hawks. Facing this

environment in the run-up to Monetary Union, the ESCB must ensure that

everything possible is done to make the launch of Stage Three as tension-free

as is possible. Choosing and announcing an appropriate monetary strategy is

crucial.

The monetary policy strategy is, in the first place, important for the

internal decision-making process of the ESCB - how the Governing Council will

decide on the appropriate monetary policy stance, given the economic

environment. Above all, the ESCB strategy must lead to good - that is to say,

timely and forward-looking - monetary policy decisions.

But the strategy is also of the utmost significance in communicating with

audiences outside the ESCB. It should stabilise inflation expectations. The

more the strategy helps to promote credibility and confidence in the ESCB's

monetary policy at the outset of EMU, the more effective that policy will be

- and the easier the ESCB's task of maintaining price stability will become.

In deciding upon the appropriate monetary policy strategy, the following

aspects must be seen as essential requirements. The strategy must:

* reinforce the ESCB's commitment to price stability, the

primary and over-riding task stipulated by the Treaty;

* it must clearly signal the anti-inflationary objectives of

the ESCB, and serve as a consistent benchmark for the

monetary policy stance; and,

* it must be transparent and explained clearly to the general

public - only then can the strategy serve as a basis for the

ESCB's accountability to the public at large.

The realisation that achievement of an optimal, non-inflationary

macroeconomic outcome may founder on the private sector's distrust has been

central to the monetary policy debate of the nineteen-eighties and 'nineties.

The search for answers to the questions raised by this debate has spawned an

enormous economic literature. The keywords "time inconsistency" and

"credibility" draw forth an almost unmanageable flood of publications that

have appeared in the wake of the pioneering contributions of Kydland /

Prescott and Barro / Gordon.

The need to establish a credible and consistent monetary strategy in the face

of the well-known time inconsistency problem faced by policy makers - the

dilemma highlighted by this economic literature - is especially important for

the ESCB at the outset of Monetary Union. As a brand new institution, the

ESCB will have no track record of its own.

Building its reputation, and the associated credibility of monetary policy,

is vital. But the process of doing so is complicated by the relatively high

level of uncertainty surrounding the transition to Monetary Union itself. The

transition to Stage Three is a unique event, and will create unique

opportunities for many - but it will also create some unique problems for

monetary policy makers. At the ECB, we are addressing these problems and are

confident that the risks can be managed successfully. Many of the

difficulties we face will be overcome through our own efforts over the coming

months.

Among these problems are the difficulties involved in creating a

comprehensive and accurate database of euro area-wide statistics. Running a

single monetary policy for the euro area requires timely, reliable and

accurate euro area data. In some cases, the euro area statistics simply did

not exist until quite recently. In others, the statistics are based on new

concepts, and the properties of the data series are not yet well known. The

long runs of high quality back-data required for empirical economic analysis

may be unavailable. Those that do exist are likely to have been constructed

using some degree of estimation and judgement, possibly rendering the

econometric results produced with them questionable.

Furthermore, the regime shift associated with the adoption of the single

monetary policy may change the way expectations are formed in the euro area,

and thereby alter forward-looking economic behaviour. Monetary policy's

effects on consumption, investment, and wage bargaining - and therefore the

whole transmission mechanism of monetary policy to developments in the price

level - would be among the important economic relationships to be affected in

this way.

This may be no bad thing. Indeed, using the regime shift implied by the

transition to Stage Three to change both public and private sector behaviour

in favourable directions may be one of the largest gains that the euro area

can extract from Monetary Union. Nevertheless, these changes are likely to

complicate the implementation of certain important elements of a monetary

strategy, at least in the short term, as past relationships between

macroeconomic variables may break down. What is good for the euro area

economy as a whole may create some practical problems for the ESCB.

One example of this so-called 'Lucas critique' phenomenon is the impact of

current, very low rates of inflation on private behaviour. For many countries

participating in Monetary Union, there is simply no - or only very recent -

experience of how the private sector will behave in an environment of

sustained and credible low inflation. Instability in past relationships may

result, should behaviour change in this new, low inflation environment. I

have already argued that these structural changes will benefit Europe's

citizens - price stability will allow markets to work more efficiently,

thereby raising growth, and improving employment prospects. But these changes

may also complicate the ESCB's assessment of economic and financial

conditions.

These uncertainties - arising directly from the transition to Stage Three

itself - are both compounded by, and inter-related with, the broader economic

context in which Monetary Union will be established. The increasing

internationalisation of the global economy, and the current rapid pace of

technological change, have affected all sectors of the economy, and the

banking and financial systems in particular. For example, at present there

are many, inter-related innovations in the payments system, such as:

* the introduction of TARGET (directly related to EMU itself);

* greater technological sophistication of payments mechanisms,

as use of computers and information technology becomes more

widespread and advanced;

* the additional incentive for cash-less payments that may

arise from the fact that for some time to come -

approximately three years - the new euro-denominated notes

and coin will not come into circulation. In particular,

narrow monetary aggregates might be affected by this

development; and,

* increased competition among banks and settlements systems,

arising from globalisation and the breakdown of barriers

between previously segmented national markets, which may

drive down the margins and fees charged to customers.

At the ESCB we will need to keep abreast of these developments, both for

their immediate impact on one of our "basic tasks" - promoting the smooth

operation of the payments system - and because of their broader implications

for the euro area economy. Reducing transactions costs in the way I just

described will benefit European consumers and producers - but it may also

change the indicator properties of monetary, financial and economic variables

that national central banks have looked to as guides for monetary policy in

the past.

Finally, in Monetary Union there will be some heterogeneity across countries

within the euro area. Europe's diversity is one of its greatest assets. But

this diversity is greater than is typically the case between different

regions in the same country using a single currency. Nevertheless, the ECB

Governing Council will have to concentrate on monetary and economic

developments in the euro area as a whole when discussing and taking monetary

policy decisions.

How should a monetary policy strategy be selected in this - for monetary

policy makers, at least - potentially difficult environment? The EMI outlined

a number of 'guiding principles' for the selection of a monetary strategy by

the ESCB. Foremost amongst these was the principle of 'effectiveness'. The

best monetary policy strategy for the ESCB is the one which best signals a

credible and realistic commitment to, and ensures achievement of, the primary

objective of price stability.

For many commentators, this criterion points unambiguously in the direction

of so-called 'direct inflation targeting'. If monetary strategies are to be

judged according to how well they achieve price stability, defined as a low

rate of measured inflation, then advocates of inflation targets argue an

optimal strategy would surely target this low inflation rate directly. These

commentators would place explicit quantitative targets for inflation itself

at the centre of the ESCB's monetary policy strategy. Their approach has been

strongly endorsed in some academic and central banking circles.

But, in the current circumstances, a pure 'direct inflation targeting'

strategy is too simplistic for the ESCB, and possibly even mis-conceived. The

ESCB well understands the primacy of price developments and price stability

for monetary policy making. Indeed, the Treaty's mandate is unambiguous in

this respect. We will signal our intentions on this dimension very clearly by

making a transparent public announcement of our definition of price

stability. The current low level of long-term nominal interest rates in the

euro area suggests that the financial markets, at least, understand and

believe the over-riding priority that we attach to achieving price stability.

Regarding strategy, our choice therefore need not be governed solely by a

desire to signal our intent to maintain price stability. This has already

been well-established - by the Treaty, and by the success of the convergence

process in reducing inflation in Europe to its current low level. Rather than

signalling our intent, the strategy must constitute a practical guide that

ensures monetary policy is effective in achieving the goal we have been set.

In this respect, there are considerable problems with using inflation itself

as the direct target within the ESCB's overall strategy. Because of the well-

known lags in the transmission mechanism of monetary policy to the economy in

general, and the price level in particular, it is impossible for a central

bank to control inflation directly. Therefore, 'inflation targeting' in

practice means 'inflation forecast targeting' where central banks set

monetary policy to keep their best forecast of inflation at the target level

deemed consistent with price stability.

But recognition of this need for forecasts in an inflation targeting strategy

immediately raises practical difficulties. In the uncertain environment

likely to exist at the outset of Monetary Union, forecasting inflation will

be very difficult, not least for the conceptual, empirical and practical

reasons I outlined a moment ago. Forecasting models estimated using historic

data may not offer a reliable guide to the behaviour of the euro area economy

under Monetary Union. Forecast uncertainty is likely to be relatively large,

possibly rendering the whole inflation targeting strategy ineffective.

To address these uncertainties, a large element of judgement would have to be

introduced into the forecasting process, in order to allow for the regime

shifts and structural and institutional changes that are a seemingly

inevitable consequence of EMU. Simply relying on historic relationships to

forecast future developments is unlikely to prove accurate or effective.

While introducing judgmental adjustments into forecasts in these

circumstances would be both appropriate and necessary, such adjustments are

likely to compromise the transparency of the inflation forecasts and, thus,

of any inflation targeting strategy. Using judgement may prevent outside

observers from readily assessing the reliability and robustness of the

inflation forecasting procedures used by the ESCB.

I see a distinct bias in the academic discussion of the comparative

advantages of inflation targeting and monetary targeting. With good reason,

many arguments are presented against the ESCB adopting a monetary target. But

proponents of inflation targeting seem to forget that, in the current

context, most of these arguments could also be used against inflation

targeting. Above all, I have not seen any attempt thus far - even if only a

tentative one - to explain how the ESCB should deal with the specific

difficulties involved in making an inflation forecast at the outset of

Monetary Union that could be used as the centrepiece of an inflation

targeting strategy.

In many respects, a strategy giving a prominent role to monetary aggregates

has considerable advantages over direct inflation targeting. Monetary

aggregates are published. They are clearly not subject to various kinds of

'judgmental manipulation' by policy makers or central bank staff that might

be possible with inflation forecasts. To the extent that policy makers wish

to depart from the signals offered by monetary growth because of 'special

factors' or 'distortions' to the data - including those distortions arising

from the transition to Monetary Union itself - they will have to do so in a

public, clear and transparent manner.

Moreover, a strategy that assigns a prominent role to the monetary aggregates

emphasises the responsibility of the ESCB for the monetary impulses to

inflation, which a central bank can control more readily than inflation

itself. These monetary impulses are the most important determinants of

inflation in the medium term, while various other factors, such as terms of

trade or indirect tax shocks, may influence the price level over shorter

horizons.

In the light of these considerations, it was agreed at the EMI that,

regardless of the final choice of the monetary policy strategy, monetary

aggregates would be accorded a prominent role in the overall monetary

framework adopted by the ESCB.

However, the EMI also noted that certain technical pre-conditions would have

to be met before this 'prominent role' could be translated into an explicit,

publicly announced monetary target, guideline, benchmark or monitoring range.

Specifically, such targets or ranges would only be meaningful guides to

monetary policy if the relationship between money and prices - as

encapsulated in a 'demand for money' equation - was expected to remain

sufficiently stable.

In this regard, several existing empirical studies point towards the

stability of the demand for euro area-wide monetary aggregates. However,

these studies are necessarily only preliminary. The reliability of these

results in the face of the uncertainties raised by the transition to Stage

Three is unknown. Future shifts in the velocity of money are certainly

possible - perhaps even likely. They cannot be predicted with certainty.

Moreover, it is not clear whether those aggregates that have the best results

in terms of stability are sufficiently controllable in the short-term with

the policy instruments available to the ESCB. In these circumstances, relying

on a pure strategy of strict monetary targeting is simply too risky.

Against this background, the ESCB will have to design a monetary policy

strategy of its own. The chosen strategy will show as much as possible

continuity with the successful strategies that participating NCBs conducted

in the Stage Two. At the same time the ESCB's strategy will take into account

to the extent needed the unique situation created by the introduction of the

euro.

4. The new monetary policy instruments and procedures for the euro area

Having a well-designed monetary strategy is vital. But we must also be able

to implement it successfully at an operational level. What instruments are

available to implement this strategy?

The ECB will have a complete set of monetary policy instruments at its

disposal. These instruments have been selected on the basis of their

efficiency for transmitting monetary policy and their neutrality across

market participants.

Three types of instruments are available to the ESCB: open market operations,

standing facilities and a minimum reserve system. I will briefly present

these instruments in the remainder of my speech.

4.1 Open market operations

Open market operations include, first, a weekly main refinancing operation,

which will take the form of a reverse repurchase transaction with a maturity

of two weeks. The main refinancing operation will be based on a tender

procedure. The tender may be a fixed rate tender, with counterparties bidding

amounts, or a floating rate tender, where counterparties propose bids

including both amounts and interest rates.

Second, there is the monthly longer term refinancing operation, which has a

maturity of three months and will always take the form of an interest rate

tender. This is because the ECB will avoid signalling its monetary policy

stance through these particular operations.

The ECB will also conduct fine-tuning operations, through the national

central banks of the euro area or, in exceptional circumstances, on its own

account. Fine tuning operations will be conducted whenever liquidity or money

market conditions warrant. Fine tuning operations may take the form of

reverse repurchase transactions (that is, the same type of transaction as

that used in the main refinancing and the longer term refinancing operations,

but with no pre-set start date nor a pre-set maturity), foreign exchange

swaps or the taking of fixed-term deposits. Fine tuning operations in the

form of reverse repurchase operations may be executed either through quick

tenders or bilaterally. In both cases, these operations will involve a

limited set of eligible counterparties that have an appropriate track record

of activity in the money market. The other types of fine tuning operations

will also be executed with a limited number of eligible counterparties, which

will be selected ex ante by the ECB. In some countries, there will be a

rotation scheme, which will aim at giving the opportunity to all eligible

fine tuning counterparties to participate in fine tuning operations.

Finally, open market operations may also be conducted whenever structural

reasons, such as the longer-term evolution of liquidity profiles, warrant it.

These so-called structural operations may take the form of outright purchases

or sales of securities or the issuance of debt certificates by the ECB.

4.2 Standing facilities

The ECB will operate two overnight standing facilities, which will be

available to all credit institutions at national central banks of the euro

area, provided that, when using the marginal lending facility, they have

sufficient collateral. The rate of the marginal lending facility will

constitute the upper bound of collateralised overnight money market rates.

The deposit facility will be remunerated at a rate that will constitute the

lower bound of overnight money market rates.

When using the marginal lending facility, or, for that matter, when entering

in liquidity-providing open market operations in the form of reverse

transactions, counterparties have to post assets with their national central

bank (or the ECB in the exceptional case when the ECB conducts fine tuning

operations on its own account). These assets are meant to act as guarantees

for credits received from the European System of Central Banks. A list of

eligible assets has been drawn up for this purpose. The list comprises a wide

variety of assets and has two sub-sets. First, the so-called tier one assets,

which are selected by the ECB according to uniform criteria relating to their

credit standing in the whole euro area. Second, the so-called tier two

assets, which have been selected by the ECB because they are of particular

importance for certain national banking systems of the euro area, in order to

promote a certain degree of continuity at the start of the Stage Three of

EMU. Two principles of equal treatment are applied, however. First, the

credit standing of tier two assets is as high as that of tier one assets.

Second, both tier one and tier two assets may be used by any credit

institution in the euro area, irrespective of its location.

In addition, a set of risk control measures has been elaborated to ensure

that, for any counterparty, the amount of assets provided is always

sufficient. Risk control measures cover the assets' price and credit risks,

taking account of the asset type, its characteristics and the maturity of the

transaction. The ECB's risk control measures have been elaborated with

careful attention to the best market practices in this area. They include the

deduction of haircuts from the assets and the imposition of initial margins

to the credit amount. Another feature of the risk control framework is the

regular revaluations of the assets, which will, in most cases, take place

daily and may trigger margin calls, most often to be settled through delivery

of additional assets.

4.3 Minimum reserve system

The ECB will also apply a minimum reserve system to credit institutions of

the euro area. Two main monetary policy objectives have been assigned to the

minimum reserve system. The first objective is to stabilise money market

interest rates through the averaging mechanism, whereby the fulfilment of

minimum reserve requirements is based on average reserve holdings over

monthly periods of time. During the maintenance period, this allows the

banking system to absorb liquidity shocks. The reduced volatility of money

market rates will reduce the need for frequent fine tuning operations, which

will mean that markets are less distorted by central bank interventions than

they would otherwise be. The second objective of the minimum reserve system

is to enlarge the demand for central bank money, so as to enlarge the

liquidity deficit of the banking system vis-а-vis the ESCB. This will

safeguard the role of the European System of Central Banks as a provider of

liquidity to the banking system.

Reserve requirements will be calculated by applying a reserve ratio of 1.5%

to 2.5% to the deposits, debt securities and money market paper issued by

credit institutions, except for residual maturities above two years. Although

repurchase agreements are included in the reserve base, they will be subject

to a zero reserve ratio. Inter-bank liabilities and liabilities vis-а-vis the

ESCB will not be subject to reserve requirements. An allowance of the order

of E 100,000 will be deducted from reserve requirements, so that credit

institutions with a small reserve base will not have to hold minimum

reserves.

Reserve holdings will be remunerated up to the required reserve level, at the

rate of the main refinancing operation (as averaged over a month). It may be

argued that a less than full remuneration of minimum reserves would increase

the interest rate elasticity of central bank money demand. This

notwithstanding, the ECB has decided in favour of a full remuneration of

minimum reserves in view of the distortion to efficient markets that a less

than full remuneration would have implied. As a result of the full

remuneration of minimum reserves, the European Central Bank has also decided

not to exempt any credit institution from the minimum reserve system.

4.4 Procedures

The ECB will have many counterparties and be subject to close public

scrutiny. It has therefore set up procedures for informing its counterparties

and the public about its monetary policy instruments in a robust and

transparent manner.

The ECB will inform its counterparties and the public through a document

detailing its monetary policy instruments and procedures and through the

regular publication of various materials on its Internet site.

General Documentation

The ECB has produced a document describing its monetary policy instruments

and procedures in detail. This is called "General Documentation on ESCB

Monetary Policy Instruments and Procedures". A revised version of this

document was published recently. This revised version includes all the newly

specified elements of the monetary policy framework of the ECB, including for

instance the minimum reserve system. This document also includes a calendar

for the standard tender operations in 1999 (both main refinancing and longer

term refinancing operations). Calendars of standard tender operations will be

published by the ECB every year.

Publications on the ECB's Internet site

The list of assets that are eligible as guarantees for liquidity providing

operations will be made public on the Internet site of the ECB. The list will

be updated on a weekly basis and users will be able to subscribe to an e-

mailing facility for receiving certain designated parts of the list on a

regular basis. Users will also be able to query the list, which will contain

a large number of assets.

The list of institutions subject to minimum reserves, that is, credit

institutions established in the euro area, will also be available on the

Internet site of the ECB, together with the list of all monetary and

financial institutions in the European Union.

5. Concluding remarks

We are less than three months away from the moment when monetary policy

sovereignty is transferred from the NCBs to the ESCB. The bulk of the

preparatory work has already been completed, but major decisions - above all,

the choice of a monetary policy strategy - still have to be made. The public

can be certain that we will always inform them, regularly and

comprehensively, about our considerations and deliberations. We will make all

our decisions transparent. I have no doubt that we will be well prepared for

the moment at which we take over responsibility for monetary policy in the

euro area.

The euro as an international currency

Speech delivered by Eugenio Domingo Solans,

Member of the Governing Council and the Executive Board of the

European Central Bank,

at The Athens Summit '99,

in Athens on 18 September 1999

Thank you for inviting me to the Athens Summit '99 and for giving me the

opportunity to speak to you at this important event.

I should like to share with you my views, and the ECB's views, on the

importance of the euro as an international currency. I understand that

this issue may be of interest to experts from Greece, a "pre-in" country

which intends to join the euro area, and to many participants from

countries outside the euro area and the European Union, some of which

currently have exchange rate regimes related to the euro.

Nowadays the euro is the second most widely used currency in the world

economy, behind the US dollar and ahead of the Japanese yen. As we all

know, any currency fulfils three basic functions: it is a store of

value, a medium of exchange and a unit of account. As a store of value

the use of the euro as an investment and financing currency is rapidly

increasing, as investors understand the advisability of diversifying

their portfolio currencies among those which are more stable and more

internationally used. The euro is developing at a slower pace as a

medium of exchange or payment currency in the international exchange of

goods and services. This fact can easily be explained by the combined

and reinforcing effects of network externalities and economies of scale

in the use of a predominant international currency as a medium of

exchange, as is the case with the US dollar. The use of the euro as a

unit of account is linked to its use as a store of value and a medium of

exchange. The value stored in euro or the payments made in euro will

tend to be counted in euro.

There are good reasons to expect an increase in international public use

of the euro as a reserve, intervention and pegging currency, inasmuch as

the public authorities understand that it is worthwhile to allocate

their foreign reserves among the main international currencies and to

give the euro a relevant share in accordance with its internal and

external stability and the economic and financial importance of the euro

area.

In connection with the use of the euro as a pegging currency,

approximately 30 countries outside the euro area currently have exchange

rate regimes involving the euro to a greater or lesser extent. These

exchange rate regimes are currency boards (Bosnia-Herzegovina, Bulgaria,

Estonia); currencies pegged to the euro (Cyprus, the Former Yugoslav

Republic of Macedonia and 14 African countries in which the CFA franc is

the legal tender); currencies pegged to a basket of currencies including

the euro, in some cases with a fluctuation band (Hungary, Iceland,

Poland, Turkey, etc.); systems of managed floating in which the euro is

used informally as the reference currency (Czech Republic, Slovak

Republic and Slovenia); and, last but not least, European Union

currencies pegged to the euro through a co-operative arrangement, namely

ERM II. As you well know, Denmark and Greece joined ERM II on 1 January

1999 with a ±2.25% fluctuation band for the Danish krone and a ±15%

fluctuation band for the Greek drachma. Although the euro remains in

second position after the US dollar in terms of its official use, the

role of the euro will increase in the future, without a doubt,

especially after the year 2002 when the euro banknotes and coins will

begin to circulate.

Taking the current situation as a starting point, the Eurosystem's

position concerning the future international role of the euro is crystal

clear: we shall not adopt a belligerent stance in order to force the use

of the euro upon the world economy. We are convinced that the use of the

euro as an international currency will come about anyway. It will happen

spontaneously, slowly but inexorably, without any impulses other than

those based on free will and the decisions of market participants,

without any logic other than that of the market. In other words, the

internationalisation of the euro is not a policy objective of the

Eurosystem; it will neither be fostered nor hindered by us. The

development of the euro as an international currency will be a market-

driven process, a free process.

The euro fulfils the necessary conditions to be a leading international

currency with the US dollar and not against it. There is enough room for

both currencies in the world economy. The necessary conditions for a

currency to become an international currency are based on two broad

factors: low risk and large size. The low risk factor is related to the

confidence inspired by the currency and its central bank, which in turn

mainly depends on the internal and external stability of the currency.

The low risk factor tends to lead to diversification among international

currencies, since diversification is a means to reduce the overall risk;

it acts, so to speak, as a centrifugal force. By contrast, the large

size factor relates to the relative demographic economic and financial

importance of the area which supports the currency; in other words, the

"habitat" of the currency. The large size factor, which concerns the

demographic, economic and financial dimension, generally tends to lead

to centralisation around one or a few key international currencies. It

can be seen as a centripetal force, as a virtuous circle, which will

tend to lead to an increasing use of the euro as an international

currency. Let us consider these two factors in more detail.

The first factor concerns low risk, credibility and stability. The

stability of the euro is a priority for the ECB. Compared with the idea

of stability, the strength of the euro is of lesser importance. This

does not mean that the exchange rate of the euro does not constitute an

element to be considered in the second pillar of the monetary policy

strategy of the ECB, which consists of a broadly based assessment of the

outlook for price developments and risks to stability obtained from a

wide range of economic indicators, the euro exchange rate being one of

them. However, the basic factor that will determine the importance of

the euro as a widely used currency in the world economy, in addition to

the demographic, economic and financial dimensions of the euro area, is,

without a doubt, the stability of the new currency, understood as a

means to maintain the purchasing power of savings.

Stability is the basic requirement for a good currency. It is what we at

the ECB want for the euro. We want a stable euro and we are convinced

that, in the long term, the euro will derive strength from its

stability.

The stability of the euro is the basis for the confidence in and the

credibility of the ECB, without which a large international role for the

euro would be unthinkable. Stability is the proof of the effectiveness

of the institution. Yet in order to be credible it is not sufficient for

the ECB to maintain stability. Other parameters of its action must be

considered: accountability, transparency and communication, a Europe-

wide perspective, etc.

These parameters or conditions for the credibility of the euro are

certainly demanding. However, the achievement of these conditions is the

aim of all those of us who have responsibilities with regard to the

functioning of the Eurosystem.

The second factor, which we have called the large size factor or the

habitat of the euro, is important because without a certain critical

mass, a currency cannot have international relevance, however high its

degree of stability.

The figures relating to the population and the GDP of the euro area

illustrate this. With 292 million inhabitants, its population exceeds

that of the United States (270 million) and that of Japan (127 million).

The GDP of the euro area is, on the other hand, equal to 76% of the GDP

of the United States (EUR 5,774 billion compared with EUR 7,592

billion), though it is higher than that of Japan (EUR 3,327 billion).

The source of this information, which refers to 1998, is Eurostat.

However, even more important than the current figures is the potential

for the future development of the euro area, in terms of population and

GDP, if and when the so-called "pre-ins" (Denmark, Greece, Sweden and

the United Kingdom) join the Eurosystem.

The entry of these countries would result in a monetary area of 376

million inhabitants, 39% larger than the United States and almost triple

the size of Japan, with a GDP of EUR 7,495 billion, only slightly less

than that of the United States and 125% higher than that of Japan.

All these facts and figures which demonstrate the demographic and

economic importance of the European Union would be further strengthened

by enlargement to eastern Europe. Our continent has a historical,

cultural and geographical identity - from the Iberian peninsula to the

Urals, with certain additional external territories - which, in the

future, may also come to form an economic unit. However that is, for the

moment, a distant prospect.

The size or habitat of an economy does not only depend on demographic or

economic factors; it also has to do with the financial base or dimension

of the area. In considering the financial dimension of the euro area,

the first relevant feature to observe is the low level of capitalisation

of the stock markets in comparison with the United States and Japan.

Although this feature could give the impression that the euro area has a

relatively small financial dimension relative to its economic dimension,

this is not the case. The lower degree of development of the capital

markets is offset by a higher degree of banking assets. This means that

the financial base of real economic activity in Europe is founded on

bank intermediation, which is also a feature of the Japanese economy.

For example, private domestic credit in the euro area amounts to 92.4%

of GDP, while in the United States it is only 68.9%. Conversely, fixed

domestic income represents 34.2% of GDP in the euro area compared with

66.1% of GDP in the United States (statistics from the International

Monetary Fund and the Bank for International Settlements as at the end

of 1997, taken from the Monthly Bulletin of the European Central Bank).

We, therefore, have two distinct models of private financing which

clearly have to be taken into account when assessing Europe's financial

dimension compared with the United States or Japan.

The euro, the Eurosystem's monetary policy and, in general, the activity

of the ECB and the Eurosystem play a key role in the integration of

European financial markets and all markets in general. The euro is

acting as a catalyst for European economic integration. And more

integration will lead to a greater economic and financial dimension.

Monetary and financial integration stemming from the euro and the

activity of the Eurosystem will affect the operation of the single

European market in a positive way. The European market, with a single

currency, will tend to be more transparent, more competitive, more

efficient and will function more smoothly. This is the reason why

joining the European Union, as a general rule, will lead to joining the

euro area, once certain economic conditions (the so-called convergence

criteria) have been fulfilled.

Monetary union is always a political operation, irrespective of its

technical and economic implications. Currency is one of the most genuine

expressions of sovereignty, because the power to issue money is one of

the greatest powers in existence. The Treaty on European Union led,

first, to the depoliticisation of monetary power in Europe, by means of

granting independence to the central banks and prohibiting the

monetising of public deficits, and afterwards to denationalisation or

supranationalisation (via the creation of the Eurosystem). The

Eurosystem was not only created for the purpose of improving the

operation of the Single Market, but also in order to make progress on

the building of the European political structure.

The euro should not only be seen as a catalyst for European economic

integration, it should also be seen as a main beam necessary to

construct the European political structure. The relationship between

political power and monetary power is an interesting subject which is

open to investigation and discussion, but that would certainly go beyond

the scope of this speech. I merely wish to point out that, in the case

of Europe, it is clear that following the achievement of a single

currency, the door remains open to political union, which would

represent a crucial step in the process of integration. In conclusion,

it would seem clear that the implications of the euro go "beyond

supply and demand" (to use the title of the work of Wilhelm Rцpke). We

are now fully immersed in "meta-economy", which means it is time to end

my speech.

Keynote address to be delivered by

Dr. Willem F. Duisenberg

President of the European Central Bank

on

The European System of Central Banks

Current position and future prospects

At a Conference organised by the Royal Institute of International

Affairs on

European economic and Monetary Union

Markets and Politics under the Euro

London 27 november 1998

1. Introduction

Ladies and Gentlemen, I should like to express my appreciation at being

invited to deliver a speech at this conference organised by the Royal

Institute of International Affairs. It is a great pleasure for me to be here,

in London, today.

The topic I am going to address relates to the current position and the

future prospects of the European System of Central Banks. I feel that this

topic provides me with an opportunity to deal with the objective of the ESCB

and its contribution to the other policies in the Community. I will also

briefly touch upon the decision-making in the ESCB, recall the main features

of our monetary policy strategy and talk about our regard for openness and

transparency. The final part of my talk will cover the views of the ESCB on

recent economic developments and the future outlook for price stability in

the euro area.

2. Independence, transparency and accountability

In the Maastricht Treaty the ESCB has been given an independent status. The

reason is that politicians all over the world have come round to the view

that monetary policy decisions taken with too close a political involvement

tend to take too short a time horizon into consideration. The consequence is

that in the longer term such decisions do not support sustainable gains in

employment and income, but only lead to higher inflation. This view is

confirmed by a host of economic research.

Independence, however, requires a clear mandate. The ESCB has such a mandate.

Its primary objective is to maintain price stability. Without prejudice to

the objective of price stability the ESCB shall support the general economic

policies in the Community. Price stability is not an end in itself: it

creates the conditions in which other, higher-order, objectives can be

reached. In particular, I share the deep concerns about the unacceptably high

level of unemployment in Europe. The ESCB will do what it can to contribute

to the solution of this problem. By maintaining price stability inflation

expectations and interest rates can be kept at a low level. This creates a

stability-oriented environment which fosters sustainable growth, a high level

of employment, a fair society and better living standards. Moreover, in

specific circumstances, if production, inflation and employment all move in

the same direction, monetary policy can play some role in stabilising output

and employment growth without endangering price stability. However, the

contribution from monetary policy can generally be only limited. Given the

structural nature of the unemployment problems the solution is to be found,

above all, in structural reforms aimed at well-functioning labour and product

markets.

An independent central bank does not only need a clear mandate. It has also

to be an open and transparent institution, for at least three reasons. First,

transparency enhances the effectiveness of monetary policy by creating the

correct expectations on the part of economic agents. A predictable monetary

policy contributes to achieving stable prices without significant adjustment

costs and with the lowest interest rate possible. The second reason is that

in a democratic society the central bank has to account for its policies.

Finally, transparency towards the outside world can also structure and

discipline the internal debate inside the central bank.

Let me now turn to the ways and means of achieving transparency. As a first

element the ESCB has defined a quantitative objective for price stability. It

reads as follows: price stability is a year-on-year increase in the

Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%.

Although I do not consider deflation to be likely in the current environment,

I may add that a situation of falling prices would not be consistent with

price stability.

The Governing Council has made it clear that "Price stability is to be

maintained over the medium term". The ESCB cannot be held accountable for

short-run deviations from price stability, for example due to shocks in

import prices or specific fiscal measures. A monetary policy reaction to

short-run fluctuations in the price level would provide the wrong signals to

the market and cause unnecessary interest rate volatility. In summary, the

ESCB will react in an appropriate, measured and, when necessary, gradualist

manner to economic disturbances that threaten price stability in the medium

term, rather than in an abrupt way, in order to avoid unnecessary disruptions

of the process of economic growth. That said, the ESCB will, whenever

necessary, openly discuss and explain the sources of possible deviations from

the quantitative definition of price stability.

In addition, let me remind you that by focusing on the HICP for the euro

area, the ESCB makes it clear that it will base its decisions on monetary,

economic and financial developments in the euro area as a whole. The single

monetary policy has to take a euro area-wide perspective: it will not react

to specific regional or national developments.

The institutional implication is that the ESCB should develop into a strong

unity, with a strong centre and strong national central banks. It should

become a truly European institution, with a truly European outlook. Of

course, it may take some time to arrive where we ultimately want to be. We

have to get used to thinking in euro area-wide terms. In the ECB Governing

Council we are already "practising" that approach and are making progress. I

am confident that the ESCB will indeed act as a unity.

Transparency and openness will be apparent from the way in which the ESCB

communicates with the public. The ESCB will regularly present its assessment

of the monetary, economic and financial situation in the euro area and

provide information about each specific monetary policy decision, be it a

move in interest rates or an absence of change. This will notably be done by

way of press releases, press conferences, publications and speeches. Press

releases are made available immediately after the fortnightly meetings of the

Governing Council and, as you may know, they always include a precise list of

the decisions taken together with background information.

There will be a monthly press conference. Such a press conference will start

with a detailed introductory statement, as has been the case so far, and

these introductory statements will also be published immediately, without

delay. In this statement the Vice-President and I will present the Governing

Council's view of the economic situation and the underlying arguments for its

monetary policy decisions, followed by a question and answer session.

The publications of the ESCB will include, in particular, an ECB Bulletin

each month as well as an Annual Report. As from 1999, a detailed analysis of

the economic situation in the euro area will be presented in the monthly

Bulletin. Thematic articles in this Bulletin will include in-depth analyses

by the ECB on matters regarding the monetary policy of the ESCB and the

economy of the euro area. Further, you may also recall that, as required by

its Statute, the ESCB will publish its consolidated balance sheet on a weekly

basis.

My colleagues on the Executive Board of the ECB and I intend to be very

active in giving speeches dealing with all issues of relevance for the

conduct of monetary policy. I am convinced that the Governors of the national

central banks will also play their role in this respect.

Since I am talking about the communication and external relations of the

ESCB, I would like to underline that I am prepared to accept invitations to

appear before the European Parliament at least four times a year to present

the activities of the ESCB and the ECB's Annual Report. Finally, it should be

noted that the ESCB will have a regular exchange of information and views

with the ECOFIN. Representatives of the ECB will be invited to ECOFIN

meetings whenever issues of concern to monetary policy are discussed. A

similar relationship will naturally also exist with the EURO-11, whose

meetings will generally be attended by the President of the ECB, whenever

matters relevant to the ESCB are on the agenda.

3. Monetary policy strategy of the ESCB

We are now approaching the start of the Third Stage of EMU. The decision-

making bodies of the ECB have made a certain number of important decisions

since the ESCB was established. As part of these decisions, the monetary

policy strategy of the ESCB was recently announced and explained to the

public. The selected stability-oriented strategy promotes as much continuity

as possible with the existing strategies of national central banks in the EU.

At the same time, its design is adapted to the unique situation of

introducing a single currency in eleven countries, which may to a certain

extent change economic behaviour. Therefore as much continuity as possible

and as much change as required is the thrust of our strategy.

Our strategy consists of two pillars. The first is an important role for

money and the second is a broad-based assessment of the outlook for price

developments in the euro area. The main reason for assigning a prominent role

to money is the empirically well-founded view that inflation, at least in the

long run, is a monetary phenomenon. This simple and obvious observation led

the Governing Council to announce a quantitative reference value for the

growth of a broad measure of money. This choice will create a "nominal

anchor" for monetary policy and therefore help stabilise private inflation

expectations at longer horizons. The reference value will be derived in a

manner that is clearly consistent with - and serves the achievement of -

price stability. It will be constructed such that, in the absence of special

factors or other distortions, deviations of monetary growth from the

reference value will signal risks to price stability.

However, it has to be clear that the reference value is different from an

intermediate monetary target, as the ESCB has not made any commitment to

correct deviations of actual monetary growth from the reference value over

the short term. In particular, it has been realistically recognised that the

move to a single currency and ongoing financial innovations may generate

fluctuations in the selected monetary aggregate which are not necessarily

associated with inflationary or deflationary pressures. For this reason, it

is important to continuously monitor the relevance of temporary factors or

even structural changes in order to avoid a mechanistic policy reaction to

deviations of the chosen monetary aggregate from the reference value. The

results of this analysis and its impact on the ESCB's monetary policy

decisions will be explained to the public.

Let me turn now to the second key element of the monetary policy strategy,

the broad-based assessment of the risks to price stability. The information

contained in monetary aggregates, while of the utmost importance, will by no

means constitute the whole of the "information set" in the hands of the ESCB.

In parallel with the analysis of money growth, a wide range of economic and

financial variables will be used to formulate an assessment of the outlook

for price developments. The envisaged strategy will enable the ESCB to

perform a cross-check between the information coming from the evolution of

monetary aggregates and those from other economic and financial indicators.

4. Recent economic developments and prospects

Let me turn to the current economic situation. The euro area experienced a

strengthening of economic growth in 1997, to 2.5%, and a further acceleration

has been anticipated for this year. The global environment has, of course,

deteriorated in the meantime, but this has not so far had an observable

impact on growth which has, in any event, been increasingly led by domestic

demand. Inflation has remained subdued and even fallen somewhat over the past

year, partly as a result of the impact of weaker global demand on oil and

commodity prices. However, the favourable pattern of inflation has also been

supported by domestic factors, such as a very moderate development in unit

labour costs and industrial producer prices.

Concerning recent price developments, HICP inflation for the euro area fell

to 1.0% in September, due to a strong impact from food prices, but I would

not want to read too much into this latest decline as some price components

can be relatively volatile over short periods. More significantly,

preliminary data suggest that various broad monetary aggregates for the euro

area are increasing at between 3 and 5%, and thus do not appear to signal any

strong incipient inflationary or deflationary pressures. We are in line with

the consensus view that inflation in the euro area will rise moderately in

1999, but remain below 2%. I do not consider deflation to be a serious risk

for price stability at present.

So far, despite the worsening of the global environment, euro area-wide

activity has continued to expand at a fairly stable rate. At around 3%,

annual real GDP growth was broadly unchanged in the first half of 1998 from

the solid growth seen in the second half of 1997. Industrial production

growth has slowed somewhat since the spring. More recent evidence,

particularly that of the area-wide survey data, may also suggest a moderation

in the pace of growth and further developments in these indicators will

continue to be monitored closely. Area-wide growth should, however, be

supported by a number of domestic factors. One factor supporting continued

growth, particularly in private consumption, is the gradual improvement in

labour market conditions. Moreover, the lowest short-term interest rates in

the euro area currently stand at 3.3%, and several countries have cut

interest rates towards this level recently as part of the process towards

interest rate convergence. The process of convergence towards this level has

been gradual, but should imply a reduction in the average short-term interest

rate in the euro area of about 0.5 percentage point since July. Long-term

rates also stand at low levels. And, there has been a marked degree of

exchange rate stability among countries participating in the euro. This is

undoubtedly a welcome development from the standpoint of encouraging trade

and investment. Thus, our assessment is similar to that of other

international organisations, that - unless the international environment

deteriorates further, which is not currently expected - growth will be

somewhat weaker in 1999. Growth should, however, remain high enough to

support continued employment creation and, assuming a recovery in the

international environment, there should be a pick-up in growth in the year

2000. At the meetings in December the ECB Governing Council will again assess

the outlook for economic and price developments.

Although the economic outlook may be less favourable than expected - let us

say - half a year ago, I believe that the conditions for a successful launch

of the euro are in place. You can be sure that the ESCB will do its utmost to

make the euro a stable currency.

The euro: pushing the boundaries

Presentation by Ms Sirkka Hдmдlдinen,

Member of the Executive Board of the European Central Bank,

at the symposium arranged by the European Private Equity and

Venture Capital Association

on 11 June 1999 in Prague

It is a great honour for me to be invited here today to this symposium

arranged by the European Private Equity and Venture Capital Association to

speak about the new European currency - the euro. Indeed, the theme of this

symposium - "Pushing the boundaries" - is very appropriate when speaking

about the euro. To my mind, the establishment of Economic and Monetary Union

can be characterised as pushing the boundaries in several ways, such as:

* pushing the boundaries in the process of European

integration;

* pushing the boundaries of stability-oriented policies in

Europe; and

* pushing the boundaries of market integration in Europe.

In today's presentation, I shall give an overview of these three aspects of

Economic and Monetary Union. Thereafter, I shall discuss more thoroughly the

implications of the single currency for the development of the European

financial markets, focusing on the capital markets. Finally, I shall reflect

briefly on the importance of equity prices, and other asset prices, in the

formulation of monetary policy.

1. Pushing the boundaries of the process of European integration

I shall start with a few comments on the role of the euro in the overall

European integration process: I think there is little doubt that in future

books on European history the start of the third stage of European Economic

and Monetary Union on 1 January 1999 will be marked as a significant and

unique event in the long process of European integration. On that day, the

national currencies of 11 EU countries became denominations of the euro. At

the same time, the "Eurosystem" (which is composed of the European Central

Bank (ECB) and the 11 national central banks (NCBs) of the participating

Member States) assumed responsibility for the monetary policy of the euro

area.

In order to put this event into a historical context, I should like to note

that the establishment of an Economic and Monetary Union in Europe was, in

fact, originally motivated more by general political arguments than by

economic arguments. In the current debate, these overall political arguments

have almost disappeared. Instead, the media and economic analysts are

increasingly focusing their assessment of the new currency on the recent

short-term economic and financial developments in the euro area.

The process of European integration started shortly after the end of the

Second World War and gained momentum in the 1950s. At the time, the striving

for integration was mainly driven by the aim of eliminating the risk that

wars and crises would once more plague the continent. Through the

establishment of common institutions, political conflicts could be avoided or

at least resolved through discussion and compromise.

The idea of establishing a monetary union and a common monetary policy was

raised at an early stage of this process. It was argued that the full

economic effects from integration in Europe could only be gained if the

transaction costs of exchanging different currencies were eliminated. Other

benefits of a monetary union in Europe were emphasised less in the early

stages of the discussion, partly due to the fact that at that time the

Bretton Woods system was already providing a high degree of exchange rate

stability.

The first concrete proposal for an economic and monetary union in Europe was

presented in 1970 in the so-called Werner Report, named after the then Prime

Minister of Luxembourg, Pierre Werner. However, this proposal was never

implemented. In the aftermath of the break-up of the Bretton Woods system and

the shock of the first oil crisis in 1973, the European economies entered a

period of stagnation with high inflation, persisting unemployment and

instability in exchange rates and interest rates. The European countries

applied very different policy responses to the unfavourable economic

developments, and policy co-ordination deteriorated. In this environment, it

was not realistic to establish a monetary union.

The experience of this volatile period showed that large exchange rate

fluctuations between the European currencies led to a disruption of trade

flows and an unfavourable investment climate, thereby hampering the aims of

achieving growth, employment, economic stability and enhanced integration.

Therefore, the benefits of eliminating intra-EU exchange rate volatility

became an increasingly powerful argument when the issue of establishing an

economic and monetary union was revisited in the so-called Delors Report in

1989.

The Delors Report contained a detailed plan for the establishment of Economic

and Monetary Union and eventually became the basis for the drafting of the

Maastricht Treaty. This time, the time schedule for establishing the Economic

and Monetary Union took into account the need to first achieve a high degree

of nominal convergence for the participating countries.

The fact that the plan for the introduction of the single currency was then

pursued and implemented in such a determined and consistent manner implied,

in itself, a boost for the overall process of integration. The momentum of

the process of integration is no longer crucially dependent on political

decisions. By contrast, the integration of the European economies has become

an irreversible and self-sustained process, which is proceeding automatically

in all areas of political, economic, social and cultural life. The euro can

thus be seen as a catalyst for further co-ordination and integration in other

policy areas. This is one way in which the introduction of the euro has

definitely helped to push the boundaries in the process of European

integration.

Another way to push the boundaries in the European integration process

relates to the geographical extent of the euro area and the European Union.

Here, I sincerely hope that the four EU countries which have not yet adopted

the euro will soon be able to join the Monetary Union. At the same time, I

hope the process to enlarge the European Union with the applicant countries

will progress successfully. An enlargement of the euro area and of the

European Union would further strengthen the role of Europe in a global

perspective and should be for the benefit of all participating countries.

However, it is clear that countries aiming to join the Economic Monetary

Union would have to fulfil the same degree of nominal convergence as was

required from the participating countries when the Economic and Monetary

Union was established. This is essential in order to avoid tensions to emerge

in the euro area, which could eventually compromise macro-economic stability.

2. Pushing the boundaries of stability-oriented economic policies

Economic and Monetary Union in Europe also provides an opportunity to push

the boundaries in areas of economic policy. The convergence process prior to

the establishment of Economic and Monetary Union was helpful in order to

achieve a broad consensus among policy makers on the virtues of stability-

oriented policies, i.e. policies directed towards price stability, fiscal

discipline and structural reform geared at promoting growth and employment.

The convergence process also helped policy makers to focus their efforts on

the formulation of stability-oriented economic policies in the participating

countries and it also facilitated the acceptance of these policies among the

general public.

In the new environment of Economic and Monetary Union, monetary policy can no

longer be applied as a means of accommodating economic developments in an

individual Member State. Such nation-specific developments would have to be

countered by fiscal and structural policies, while the best way in which the

single monetary policy can contribute to improved conditions for growth and

employment is by ensuring price stability in the euro area as a whole. In

this respect, the formulation of the Maastricht Treaty is instrumental, since

it guarantees the Eurosystem's firm commitment to price stability; it clearly

specifies that price stability is the primary objective of the single

monetary policy.

The Eurosystem has put a lot of effort into establishing a monetary policy

framework that will ensure that it can fulfil its primary objective of price

stability as efficiently as possible. There are several aspects to this

framework.

First, the Eurosystem has adopted a quantitative definition of the primary

objective - the Governing Council of the ECB has defined price stability as a

year-on-year increase of the Harmonised Index of Consumer Prices (HICP) for

the euro area of below 2%. This is a medium-term objective. In the short run,

many factors beyond the scope of monetary policy also affect price movements.

Second, the Eurosystem has made public the strategy to be used for the

implementation of the single monetary policy. This strategy is based on two

key elements, whereby money has been assigned a prominent role, as signalled

by the announcement of a reference rate of 4Ѕ% for the 12-month growth of the

euro area monetary aggregate M3. The other element consists of a broadly

based assessment of the outlook for price developments and the risks to price

stability in the euro area on the basis of a wide range of economic and

financial indicators.

Third, the Eurosystem puts significant emphasis on the need to carefully

explain its policy actions in terms of its monetary policy strategy.

Therefore, the Eurosystem has established various channels for the

communication with market participants and the general public. The most

important communication channels are the ECB's Monthly Bulletin, its press

releases and the press conferences following the meetings of the Governing

Council, the President's appearances in the European Parliament and the

speeches given by the members of the Governing Council.

Fourth, the Eurosystem's monetary policy is implemented in a marketed-

oriented manner. The Eurosystem's key policy instrument is its weekly tender

for two-week repo operations, the so-called main refinancing operations. The

features of the monetary policy operations are decided by the decision-making

bodies of the ECB, but the operations are conducted in a decentralised manner

by the NCBs.

The experience gained from the first five months of operations has shown that

the Eurosystem's procedures for decision-making and operational

implementation works very well. There are therefore no operational reasons to

call into question the ability of the Eurosystem to fulfil its mandate to

ensure price stability in the euro area. However, stable macroeconomic

policies cannot be achieved by monetary policy alone. It is also necessary

for governments to pursue fiscal and structural policies consistent with such

macroeconomic stability.

In order to ensure fiscal discipline in the participating countries, the EU

Council agreed in June 1997 to establish the so-called Stability and Growth

Pact. This Pact sets an upper limit of 3% of GDP for the fiscal deficits of

the countries participating in the euro area. Furthermore, the Pact specifies

as an objective that Member States are to bring government budgets close to

balance or even into surplus in the medium term. Only if this objective is

met will sufficient room for manoeuvre be created to enable fiscal policy to

react to cyclical developments without risking a loss of credibility.

As regards structural policies, the policy framework is, so far, less well

developed. This is worrying given that the need for structural reform is

urgent in many areas in order to be able to effectively promote greater

growth potential and higher employment. I appreciate that these problems are

generally acknowledged, and some action has been taken in recent years. For

example, it is encouraging that the European Employment Pact adopted at the

EU Summit in Cologne last weekend explicitly recognises the need to pursue

comprehensive structural labour market reform.

Nevertheless, experience from several countries shows that it usually takes a

long time for the full effects of structural reforms to be seen. Therefore,

it is worrisome that structural reforms, in particular as regards labour

markets as well as those to limit expenditure on social security and pension

systems, are long overdue in several Member States.

Clearly, the establishment of Economic and Monetary Union does not mean that

the efforts undertaken during the convergence process can be relaxed. On the

contrary, the need for policy co-ordination among the participating countries

is now even more pressing. We have already seen examples of negative market

reactions to any perceived slippage in fiscal discipline or postponement of

structural reform. Personally, I think that these swift market reactions,

although sometimes exaggerated, may be helpful in promoting a continued

stability-oriented policy thinking in Europe. Any move towards less

responsible policies would come up against intense peer pressure from other

countries.

In this context, I would once more like to underline how important it is that

a consensus has emerged among European policy-makers on the virtues of price

stability, fiscal discipline and market-oriented structural reform. In this

way, we have already pushed the boundary significantly towards a

macroeconomic environment conducive to growth and employment, although much

still needs to be done in the years to come.

4. Pushing the boundaries in the development of financial markets

However, the success of the euro is not only in the hands of central bankers

and policy-makers. An important area in which the private sector has an

instrumental role in meeting the challenge of pushing the boundaries is in

the development of the European financial markets. In order for the euro to

be a success, it is important for the euro area financial markets to become

wider, deeper and more diversified. The introduction of the euro has provided

further input into this process; the elimination of exchange rate risks has

removed one of the main barriers to financial market integration in Europe.

In most European countries, the financial markets have, traditionally, been

rather shallow, with few participants and a narrow range of financial

instruments on offer. A high degree of segmentation and a lack of cross-

border competition have implied relatively low trading volumes, high

transaction costs and a reluctance to implement innovative financial

instruments. This segmentation has been a function of exchange rate borders,

tradition, differing practices and, of course, national regulations and tax

regimes.

Following the elimination of the barriers implied by different currencies, it

is now up to the European Commission and the relevant national authorities to

further the integration process in the areas of regulation and taxation.

Meanwhile, it is up to market participants to take advantage of the business

opportunities implied by the increased scope for market integration.

The introduction of the euro brought about an almost immediate integration of

the national money markets into a euro area-wide money market. This was made

possible thanks to the establishment of pan-European payment systems, such as

the TARGET system set up by the Eurosystem, which enables banks to access

liquidity throughout the euro area in real time.

The cross-border integration of bond markets in the euro area is progressing

at a slower pace, as is also true of equities and derivatives markets. This

notwithstanding, we are also experiencing important developments in these

segments of the financial markets. These developments are partly due to the

general trends towards globalisation and technological refinement and partly

related to the introduction of the euro. As a result of the introduction of

the euro, market participants increasingly perceive similar instruments

traded in the different national markets to be close substitutes. This holds

true, in particular, for bonds issued by the euro area governments, where the

establishment of common benchmarks, the narrowing of yield spreads and

increased market liquidity seem to indicate that a high degree of cross-

border substitutability has already been achieved.

The fact that euro area financial instruments are increasingly considered to

be close substitutes increases the competitive pressures on national markets

to attract issuers and investors wishing to benefit from increased cross-

border competition and lower transaction costs. In this context, we have

recently experienced several initiatives aimed at creating capital markets

across national borders, such as the plans to establish common trading

platforms linking the European stock exchanges. Similar initiatives have also

been taken to establish links between national securities settlement systems,

which would facilitate the cross-border mobilisation of securities. In the

longer run, such developments will make it possible for investors to manage

their investment portfolios more efficiently.

The Eurosystem welcomes such initiatives aimed at improving the cross-border

integration of financial markets in the euro area, and globally, since they

may result in a wider range of financial instruments on offer, and at a lower

cost, than is currently the case in the national markets. This could lead to

a virtuous circle in which the increased issuance of instruments denominated

in euro will draw the attention of international investors to the euro area

capital markets, in turn making the euro an increasingly attractive currency

for private as well as public issuers.

In fact, the experience of the first few months of the life of the euro seems

to indicate that such a positive development may already be under way. In the

first quarter of 1999, bonds denominated in euro accounted for around 50% of

the bonds issued internationally. This share is considerably higher than the

traditional aggregate share for bonds denominated in the constituent

currencies, which had been in the range of 20% to 30% in recent years. We

have also seen a considerable increase in the average size of bond issues

denominated in euro, as compared with those of bonds denominated in the

former currencies, which may indicate that the trade in euro-denominated

issues is likely to become increasingly liquid.

Despite the recent developments in the euro area capital markets, euro area

companies are still mainly dependent on financing through the banking system.

Hence, there is still plenty of scope for further development in the area of

corporate financing. For example, the amount of private bonds traded in the

euro area is still very low compared with the United States. The market

capitalisation of equities is considerably lower in most euro area countries

as compared with the United States and the United Kingdom. Likewise, the

venture capital business in the euro area is still in its infancy compared

with the relatively mature venture capital markets in the United States and

the United Kingdom. Personally, I am convinced that the introduction of the

euro will also be helpful to the development of these segments of the

financial markets.

In this context, I should like to say a few words on how the introduction of

the euro may underpin the reshaping of the European banking sector. The

increased scope for securitisation will put pressure on the European banking

sector to move away from traditional retail banking activities in favour of

more advanced financial services. The European banking industry is still

segmented into relatively small national markets. The introduction of the

euro is likely to add momentum to cross-border integration in the European

banking sector. Although a considerable consolidation of the European banking

sector has taken place over the last decade, this consolidation has so far

been almost exclusively based on mergers and acquisitions within national

borders. It is only recently that we have also started to see such deals

taking place across national borders.

I welcome this trend towards an expansion beyond national borders with open

arms, since the establishment of truly pan-European - and global - banking

groups will be instrumental in efforts to enhance competition in the

provision of financial services.

5. The Eurosystem and the equity markets

I should like to conclude my presentation today by briefly discussing about

the euro area equity markets as seen from the perspective of the Eurosystem.

It is clear that the Eurosystem has no direct control or influence over the

development of equity markets. However, the Eurosystem acknowledges the

importance of well-functioning and efficient equity markets for the economy

as a means of mobilising savings into productive investment. Hence, efficient

equity markets with transparent price formation, high market liquidity and

low transaction costs are of great value in the capital formation process.

The existence of efficient equity markets should also reduce the risk of the

emergence of asset price bubbles, which is desirable from a monetary policy

perspective. Prior to the emergence of asset price bubbles in some

industrialised countries in the early 1990s, few central banks paid much

attention to the development of prices of equities or other assets in their

monetary policy formulation.

However, the effects of the bubble economies in the early 1990s, notably in

Japan, the United Kingdom and Scandinavia, led to an intense debate among

economists on how monetary policy could have responded better to the

situation. Some research was carried out in order to establish price indexes

that would incorporate asset prices and which could be used as target

variables or indicators within the monetary policy framework. However, no

central bank is explicitly making use of such asset price-weighted indexes in

monetary policy formulation. Nevertheless, this development in the early

1990s made most central banks aware of the fact that large swings in asset

prices can have important effects the price formation in the economy through

its implications on real economic developments and, in particular, financial

market stability.

However, in practice it is not easy to let monetary policy actions respond to

asset price developments. Central banks have only one tool for the

implementation of monetary policy - the short-term interest rate. They can

therefore not effectively try to achieve several objectives at the same time.

It is also difficult to judge how developments in asset prices actually feed

into consumer prices, thereby making it tricky to assess the need for the

appropriate monetary policy response to their changes. This difficulty is

exacerbated by the rather high volatility of certain asset prices, such as

equities, which could result in frequent changes in policy interest rates if

the central bank were to incorporate them mechanistically into its reaction

function.

In this respect, the present situation in the United States, as well as in

several European countries, is interesting: equity prices have risen rapidly

for an extended period but consumer prices remain very subdued and there are,

so far, no signs that there is going to be a spill-over from asset price

developments into consumer price inflation.

Against the background of the rather unclear relationship between asset price

developments and consumer price inflation, the development of equity prices

does not have a prominent role in the formulation of the Eurosystem's

monetary policy. This notwithstanding, the Eurosystem closely monitors the

prices of equities and other assets within its broadly based assessment of

economic developments in the euro area, which forms the second pillar of its

monetary policy strategy. The Eurosystem will therefore remain vigilant in

order to detect any influence from asset prices, through their impact on real

economic developments and financial market stability, on the formation of

consumer prices.

***

THE MONETARY POLICY OF THE EUROPEAN CENTRAL BANK

Speech by Eugenio Domingo Solans

Member of the Executive Board of the European Central Bank

during the "Working Breakfast" at the Permanent Seminar

on 4 December 1998 in Madrid

Introduction

It was with immense pleasure that I accepted the invitation to take part in

this event, organised by Euroforum. In view of the prestigious nature of

Euroforum, the professional standing of its President, Eduardo Bueno,

Professor at the Universidad Autуnoma de Madrid and consultant to the Banco

de Espaсa (there is a great deal of similarity between our respective

professional histories) and, above all, the value I have attached to his

friendship over the past thirty years, there was no question as to whether to

agree to join you for this working breakfast.

I have been asked to keep my presentation brief in order to allow as much

time as possible for discussion. Therefore I will try to put forward a few

ideas on the monetary policy of the European Central Bank (ECB) which I can

develop during subsequent discussions. During the discussion period please

feel free to raise any questions on other aspects of the ECB's operations.

The three fundamental principles underlying the monetary policy

As in the case of any other central bank, the ECB's monetary policy is based

on three fundamental principles: setting the objectives to be achieved,

establishing the most appropriate strategy for accomplishing these objectives

and, finally, selecting the best instruments for implementing its chosen

strategy.

While the Governing Council of the ECB is responsible for formulating its

monetary policy, both the Executive Board of the ECB and the national central

banks are involved in its application and therefore this constitutes one of

the tasks allotted to the European System of Central Banks (ESCB) as a whole.

Objectives, strategies and instruments therefore form the three main elements

which enable us to establish the precise point within the range of monetary

policy possibilities which should constitute the ECB's policy: its precise

altitude, longitude and depth.

The ECB's monetary policy objectives

We did not have to think long and hard to define the ECB's monetary policy

objectives and, generally speaking, those of the ESCB. This had been done for

us by the Treaty on European Union in which, under Article 105, it is stated

that "the primary objective of the ESCB shall be to maintain price stability"

which, on a more practical level, the ECB has defined as a year-on-year

increase in the harmonised index of consumer prices (HICP) for the euro area

of below 2%, which it seeks to maintain in the medium term. "Without

prejudice to the objective of price stability", continues the aforementioned

Article 105 of the Treaty, "the ESCB shall support the general economic

policies in the Community with a view to contributing to the achievement of

the objectives of the Community as laid down in Article 2".

If you refer to the aforementioned Article 2 of the so-called Treaty of

Maastricht, you will find that sustainable and non-inflationary growth,

together with a high level of employment and social protection, are among its

aims.

The ECB, then, must prioritise those of its activities which promote the

objective of stability and, without prejudice to this approach, it will

contribute, indirectly and to the extent possible, to economic growth and

increased employment.

Is this approach in any way contradictory? Absolutely not. The best

contribution the ECB can make to promoting investment and thus to generating

economic growth and increased employment is precisely by providing a

framework for price stabilisation. The worst path that the ECB could follow

would be to implement a lax economic policy which claimed to be directly

creating jobs.

In fact, in the medium term price stability will encourage efficient

investment, sustainable growth and employment. This is because stability

prevents price distortions, that is to say any distortion of the mechanism

which guides decision-makers in the markets, and thus favours an improved

allocation of resources. When stability is achieved, prices are more

transparent, which promotes competition and therefore efficiency.

Moreover, if economic agents have positive expectations with regard to

stability, the risk premium element of long-term of interest rates will fall,

promoting investment and lasting consumption. In this respect, it should be

remembered that one of the clearest inflation forecast indicators is an

increasingly steep maturity-related asset yield curve.

Finally, stability promotes growth and employment insofar as it allows

resources to be channelled into productive activity. Inflation, on the other

hand, merely encourages speculative investment with the aim of safeguarding

funds against monetary deterioration.

As we saw earlier, the aims set out in Article 2 of the Maastricht Treaty

also include social safeguards. In this context, therefore, it can be said

that inflation is the most unjust of all taxes, because it attacks personal

income and assets while distorting certain public redistribution mechanisms

such as, for instance, progressive taxation scales.

In other words, stability is not just important for economic efficiency but

also for social justice, since it provides economic conditions which benefit

the weakest and most vulnerable members of society.

An appropriate ECB monetary policy is a necessary condition but will not, in

itself, enable us to achieve stability. National taxation policies geared to

satisfying the objectives of the Stability and Growth Pact, together with

several supply-side policies leaning towards liberalisation and flexibility,

are also necessary to enable us to avoid the persistent need for measures to

combat inflation.

We must avoid the temptation to reinterpret the Stability and Growth Pact by

introducing "golden rules" of dubious legality, based on the false

theoretical foundations of the so-called "ultra-rationality hypothesis"

which, in the past, claimed to justify increased taxation pressure and which

now calls for increased public spending in terms of investment. Let's not

beat about the bush: taxation policy has only one golden rule, which consists

in maintaining a long-term budgetary balance on the economic horizon.

In connection with the ECB's objectives, it should also be noted that it is

difficult or even impossible to meet two separate targets simultaneously

using only a single monetary policy. This applies when dealing with the

concept of fixing fluctuation bands for the rate of exchange between the euro

and the US dollar. In this case, the exchange rate objective could conflict

with the price stability concept and the ECB would then fail in its primary

objective. We must not forget, with regard to this issue, that combining

linked exchange rates, the free circulation of capital and monetary autonomy

is not, to be quite blunt, sustainable. It is precisely this which is the

raison d'кtre of the ECB as the single monetary authority in an economic area

which has irrevocably fixed exchange rates (a single currency) and freely

circulating capital (a single market).

To conclude this section, let me stress that it is essential for the ECB to

make it absolutely clear that its main objective is stability. If, as some

would suggest (for instance in the Modigliani manifesto), the ECB were to

directly target employment, this would adversely affect the credibility of

its monetary policy and thus have an impact not only on inflation but also,

paradoxically, on employment. The direct targeting of employment objectives

by a central bank is counterproductive.

The ECB's monetary policy strategy

A strategy is a combination of criteria and procedures which allow decisions

to be taken in order to achieve a monetary policy objective. This decision-

making process can be based on inflation forecasts which depend on the

behaviour of a relevant monetary variable or, more simply, on the "pegging"

of exchange rates to a stable currency. This last strategy is ideal for more

open economies, encompassed by a specific monetary zone, such as, for

instance, the Netherlands and Germany. However, this would not be suitable

for a much larger but relatively closed economic space such as the euro area.

I believe that it is a mistake to try to exaggerate the polarity of the

inflation strategy and the monetary strategy. These are quite clearly

separate strategies but they are not in any way opposed, incompatible or

irreconcilable. Certainly, some aspects of each of these strategies should be

combined, resulting in another, completely separate and valid strategy. This

is what the ECB has done and it now needs to give the end product a name

which does not merely describe the desired objective ("the stability-

orientated monetary policy strategy").

There are two components to the ECB's monetary policy strategy. The first,

more practical and visible component consists in a quantitative reference to

the growth of the money supply as defined by the broad M3 aggregate. Taking

into account the quantitative definition of stability, economic growth and

realistic hypotheses on money circulation rates, this monetary reference has

initially been set at 4 1/2%.

The second component of the ECB's monetary strategy, a more general and

enveloping one, is the estimation of inflation forecasts and risks for price

stability in view of changes in a group of significant variables, all of

which are related to the euro area as a whole. Some examples of these

significant variables are credit, long-term interest rates, prices of raw

materials, import prices, wages and public spending deficits.

Inflation is a monetary phenomenon. When the rate at which the money supply

grows is greater than the nominal potential rate of growth of an economy, in

the medium term this will generate inflation. In other words, the medium-term

inflation rate is indicative of excessive monetary expansion in relation to

economic growth. Growth in the money supply therefore provides the best early

warning of inflation and monetary control is the best monetary policy

strategy. The virtues of the first component of the ECB monetary strategy

are, when all is said and done, well known. If it worked, this alone would be

sufficient.

In practice, however, things are never so simple. Inflation forecasting and

control cannot rely solely on a monetary aggregate because of doubts as to

whether or not this monetary aggregate can be controlled and is stable and

meaningful. If a narrow definition of money, such as M1, is adopted,

controllability can be achieved in that, through the monetary policy

instrument, it is possible to have a greater impact on its evolution, but

this is offset by the loss of stability and significance. If it is decided to

opt for a broad monetary aggregate, such as M3 or M4, the money demand

function becomes more stable and clearly more significant, in that a greater

correlation can be achieved between exchange rates, providing a better

explanation of changes in nominal costs and inflation, in return for some

loss of control. Despite this, doubts persist. In practice, these will, of

course, increase when national currencies are replaced with the euro; then

the need for the second part of the monetary policy strategy will become

obvious.

The ESCB monetary policy tool

The wide range of instruments available to the ESCB for the implementation of

the euro area monetary policy has been established with reference to two

fundamental criteria: efficiency and neutrality. These instruments can be

separated into three categories, related to open market operations, standing

facilities and minimum reserves.

The ESCB's instruments and procedures do not differ significantly from those

traditionally used by the Banco de Espaсa and with which you are all

familiar. This means that I only need to highlight a few differences. In

addition, I should add that over recent weeks the Banco de Espaсa has

introduced changes aimed at facilitating a smooth transition.

With regard to open market operations, the frequency and maturity of the main

re-financing operation has become that of a weekly auction of loans with a

maturity of two weeks, and an interest rate which is either announced in

advance (fixed rate auction) or announced later as the result of offers

received (variable rate auction). There will also be monthly auctions for

three-month loans which will always be of the variable rate type in order to

avoid sending signals to the market. Fine-tuning will be carried out in

exceptional circumstances between two regular auctions and, finally, the

structural liquidity demand can be influenced by means of open market

transactions which consist in the direct purchase and sale of securities or

the issuance of debt certificates.

Standing credit and deposit facilities will supply or absorb overnight

liquidity, without the imposition of any other restrictions on their use by

institutions other than the provision of guarantees or collateral. Both types

of interest on standing facilities constitute a strip or corridor which will

contain short-term market interest rate swings and provide a structure for

monetary policy trends. This means that they will play an important role in

terms of providing signals, a role also fulfilled by the Banco de Espaсa but

in a less predetermined and formalised manner.

As far as guarantees for all these transactions are concerned, it should be

stated that acceptable collateral may take the form of either a public

instrument or a private instrument, provided that these are of a suitable

nature, according to the neutrality principle applied to the public sector

and to the private sector.

The minimum reserves will be equal to 2% of book liabilities calculated on

the basis of a monthly average, will be subject to a minimum exempt level of

EUR 100,000 and - this being the most important point underlining the main

difference compared with the current position in Spain - will be remunerated

in line with market rates. The averaging provision will allow us to absorb

liquidity shocks without recourse to standing facilities. Such a minimum

reserves will constitute a useful tool for restricting the volatile nature of

monetary market interests rates, for reducing the need for fine-tuning and

for tightening up the system's liquidity, thereby enhancing the effectiveness

of the monetary policy. Its remuneration in line with the market will not

only reduce money demand elasticity with regard to interest rates but also

offer neutrality to euro area banks as compared with those in other countries

which do not use such a tool.

Conclusion

Although inevitably in a simplified form, I hope that this statement on the

aims, strategy and instruments of the euro area monetary policy has provided

some basic information on the central core of the ECB's operations and that

it can be used as a starting-point for our discussions.

Thank you for listening; during the discussion period, I shall be pleased to

elaborate on the issues raised or examine any others which you think may be

of interest.

The monetary policy of the Eurosystem

Main remarks of the speech delivered by Eugenio Domingo Solans

Member of the Governing Council and the Executive Board of the

European Central Bank

at the SOCIETAT CATALANA D'ECONOMIA

(Institut d'Estudis Catalans)

Barcelona, 2 July 1999

The text will be available in Catalan at a later stage.

* The primary objective of the Eurosystem and, therefore, the touchstone to

measure its success is the achievement of price stability. In the medium term

the best contribution that the Eurosystem can make in favour of sustained

growth is, precisely, to create an environment of stability. There is clearly

no greater fertiliser for economic growth than price stability, and nothing

is more refractory to economic growth than inflation. Provided that stability

is achieved and that there is no risk for stability in the future, the

Eurosystem has to create the best monetary conditions for exploiting the

considerable growth potential of the euro area. This should be done in a

passive way, without any activism: like the air we breathe, not like the air

from an oxygen tank.

* The 5.2% increase in the three-month moving average of the 12-month growth

rates of M3 covering the period from March to May 1999 is in line with the 4

Ѕ reference value for money growth, which is the basis of the first pillar of

the ECB's monetary policy. Neither the slight increase in the moving average

compared to its value last month (5.1%) nor the non-substantial and almost

constant difference from the reference value signal a risk for price

stability.

* The results of the broadly based assessment of the outlook for price

developments, which constitutes the second pillar of the ECB's strategy,

confirm that there is no risk to price stability in the euro area.

* The second pillar of the ECB's monetary policy strategy includes, among

other indicators, the exchange rate developments of the euro. The ECB's

assessment on the evolution of the exchange rate of the euro should,

therefore, be linked to the risk for price stability of a depreciation of the

euro. Taking into account that the euro area economy is a rather closed one,

no significant inflationary impact should be expected from the recent

exchange rate developments of the euro.

* One main feature of the instruments and procedures of the Eurosystem's

monetary policy is their high level of flexibility, in the sense that without

discretionary changes the instruments can accommodate a wide range of

different market situations. On the other hand, there is flexibility in the

sense that the Eurosystem has at its disposal a wide set of monetary policy

instruments and has, therefore, the possibility to move from one to the other

if and when it is deemed appropriate, taking into account their advantages

and disadvantages. In the first stage of the ECB's monetary policy, the fixed

rate tender with a discretionary allotment is the best choice for the main

refinancing operation owing to its advantages in terms of signalling effects

and controlling both the liquidity allotted and the volatility of overnight

rates. On the contrary, in the case of longer-term refinancing operations,

the Eurosystem as a rule does not intend to send signals to the market and

the effects on the liquidity and on the overnight rates are weaker.

Therefore, for longer-term refinancing operations, the market-oriented

variable rate tender has a clear advantage.

* The activities and the monetary policy decisions of the ECB should be

interpreted from a euro area perspective as a whole. To interpret them from a

national standpoint would be a mistake.

***

THE ROLE OF THE CENTRAL BANK IN THE UNITED EUROPE

Speech by Dr. Willem F. Duisenberg,

President of the European Central Bank,

National Bank of Poland,

Warsaw, Poland on 4 May 1999

1. Introduction

First and foremost, I should like to congratulate the National Bank of Poland

(the NBP) on its 75th anniversary. The age of the NBP already suggests that

as the President of the European Central Bank (ECB), an institution that is

even less than one year old and has only been conducting monetary policy

since January this year, I should be modest. I am aware that the role of the

NBP has not been constant over these 75 years and that in the past decade, in

particular, the NBP has gone through a remarkable restructuring process. My

previous central bank, de Nederlandsche Bank, has, together with the

International Monetary Fund and many national central banks, been involved in

assisting the NBP in its efforts to adapt to the role of a central bank in a

market economy. Of course, the real work had to be done by you yourselves and

I believe you can be proud of what has been achieved over the past decade.

Today in my speech I should like to focus on the role of the ECB, as a truly

European institution. First of all, I shall explain the background against

which the introduction of the euro and the establishment of the ECB should be

considered. Thereafter, I shall discuss the main features of the

institutional structure that determines monetary policy-making. I shall then

turn to our monetary policy strategy and the role of accountability and

transparency in this strategy. I shall conclude by briefly addressing the

issue of EU enlargement.

2. The process of European integration

On 1 January of this year the euro was introduced in 11 countries with a

combined population of almost 300 million. The ECB started to conduct a

single monetary policy for the so-called euro area. Former national

currencies, such as the French franc and the German Mark are no longer

autonomous currencies, but subdivisions of the euro. Euro banknotes and coins

will only be introduced in 2002.

The voluntary transfer of monetary sovereignty from the national to the

European level is unique in history. However, it should not be seen as a

single, isolated event. The introduction of the euro is part of the process

of European integration. This process started shortly after the second World

War and has now been under way for more than half a century. The aims of

European integration are not only, or even primarily, economic. Indeed, this

process has been driven and continues to be driven by the political

conviction that an integrated Europe will be safer, more stable and more

prosperous than a fragmented Europe. It is true that economic integration has

been the main engine of this process and that, although it has had its ups

and downs, integration has delivered important economic benefits. On balance

it has been successful.

The introduction of the euro and the establishment of the ECB are important

new steps in this process of European integration. They are not the

completion of this process, for at least two reasons. First, the launch of

the euro can be compared to the launch of a rocket. A good launch is crucial,

but only the beginning of the mission. The euro has been launched

successfully. The challenge now is to make it a success. This will not happen

automatically, but will require effort on the part of many authorities,

institutions and people. Second, four EU Member States have not (yet)

introduced the euro. I hope that this will happen in the future. Moreover, as

you are aware, the EU itself is likely to increase its membership over time,

also to include Poland. Ultimately, this is bound to extend the euro area.

This process, too, is already requiring and will continue to require great

efforts: no pain, no gain, as is often the case.

3. The institutional framework of the single monetary policy

Let me now turn to the institutional framework for the conduct of the single

monetary policy. This was laid down in the Treaty establishing the European

Community, the so-called Maastricht Treaty, and the Statute of the ESCB,

which is an integral part of this Treaty. According to the Treaty the ECB has

the primary objective of maintaining price stability. Without prejudice to

this objective, it is to support the general economic policies in the

Community, with objectives such as economic growth and high employment.

Decisions on monetary policy are made by the Governing Council of the ECB.

This body comprises the six executive directors of the ECB and the 11

governors of the national central banks (NCBs) of the Member States which

have introduced the euro. These 17 people meet every fortnight at the ECB, in

Frankfurt am Main. Decision-making on monetary policy is fully centralised.

All members of the Governing Council have one vote, whether they come from

Germany or Luxembourg. This is because of an important principle. They are

not representing their country, but are obliged to take decisions on the

basis of euro area-wide considerations. Regional or national monetary policy

does not and cannot exist in the euro area. There is only one, single

monetary policy for the euro area as a whole. Therefore, the ECB should

develop into a truly European institution. This is a process that will

inevitably take some time, but my feeling is that we are already making good

progress.

The execution of monetary policy is to a great extent decentralised. It is in

large part carried out by the NCBs. The ECB and the 11 NCBs together are

referred to as the Eurosystem. If we refer to the ECB and the 15 NCBs of all

EU Member States, we speak of the European System of Central Banks (ESCB).

The General Council of the ECB meets quarterly and comprises the President

and Vice-President of the ECB and the 15 governors of the NCBs of all the EU

Member States. This body does not make decisions on monetary policy, but

discusses issues concerning the relationship between the "ins" and the

countries I prefer to call "pre-ins", such as exchange rate issues. The third

decision-making body of the ECB is the Executive Board of the ECB, comprising

the six executive directors of the ECB. The Executive Board is responsible

for current business and the implementation of monetary policy as decided by

the Governing Council. The staff of the ECB will, in the course of this year,

reach a level of between 750 and 800 and is likely to grow further in the

years ahead.

The ECB is one of the most, if not the most, independent central bank in the

world. Its independence and that of the participating national central banks

are firmly enshrined in the Maastricht Treaty. Members of the Governing

Council are not allowed to take or seek instructions from anybody,

politicians included. Politicians are not allowed to give such instructions.

Members of the Governing Council have a term of office of at least five

years. The ECB is financially independent.

The independent status of the ECB fits into the recent world-wide trend of

granting independence to central banks. This tendency is evidenced by both

practical experience and academic research. By shielding monetary policy

decisions from political interference, price stability can be maintained

without having to give up economic growth. Indeed, in that sense having an

independent central bank is a good thing for all concerned. The reason for

central bank independence is that monetary policy-making under the influence

of politicians tends to focus too much on short-term considerations. This can

easily lead to temporary, non-sustainable increases in growth, but inevitably

results in lasting increases in inflation with no lasting gains in growth and

employment at all. Politicians all over the world have come to realise this

and have decided to remove the temptation to pursue short-term gains and to

make their central bank independent. It should be underlined that granting

this independence is, as it should be, a political decision. An independent

central bank needs a clear legal mandate.

4. The monetary policy strategy

The ECB has, as I mentioned earlier, such a mandate. However, the Treaty does

not specify how the ECB should pursue its primary objective of maintaining

price stability; in other words: it is silent on what is called the monetary

policy strategy. The ECB therefore formulated its strategy in the second half

of last year. That was no easy task. The introduction of the euro constitutes

a structural break, which may change the behaviour of firms and individuals

and make it less predictable. To a certain extent it is comparable to what

Poland experienced when it embarked on its reform process. The rules of the

game change and this makes policy-making more complicated. Our monetary

policy strategy has taken these specific circumstances into account. It is

tailored to this unique period of the introduction of the euro, although it

has elements of both monetary targeting and inflation targeting.

In the context of this strategy the ECB has provided a quantitative

definition of price stability. Price stability is defined as a year-on-year

increase in the harmonised index of consumer prices (HICP) of below 2% for

the euro area as a whole. Price stability is to be maintained in the medium

term.

The strategy consists of two pillars. The first pillar is a prominent role

for money. Ultimately, inflation is a monetary phenomenon. It is in the end

result of too much money chasing too few goods. Therefore, we have formulated

a reference value for the growth of a broad monetary aggregate, M3, of 4 Ѕ%

on an annual basis. Growth of the money stock at this pace would provide the

economy with sufficient liquidity for growth in activity in line with trend

growth, without inflation. At the end of this year this figure will be

reviewed. It should be emphasised that we did not define a target for money

growth. The reason for this is the structural break that the introduction of

the euro creates. By calling this a reference value, it is made clear that

money is one variable which we look at very carefully in order to examine

whether inflationary or deflationary pressures are tending to emerge. We do

not, however, react mechanistically to changes in money growth.

The formulation of the second pillar is also prompted by the potential

changes in economic behaviour on account of the introduction of the euro. It

is a broadly based assessment of the outlook for price developments on the

basis of an analysis of monetary, financial and economic developments. In

this context interest rates, the yield curve, wage developments, public

finance, the output gap, surveys of economic sentiment and many other

indicators are analysed. Use is also made of forecasts produced by other

bodies and internally for inflation and other economic variables.

This brings me to the role of the exchange rate of the euro in our strategy.

Since our primary objective is price stability and since the euro area as a

whole is a relatively closed economy with an export share of 14% of gross

domestic product, we do not have a target for the exchange rate of the euro,

for example, against the US dollar. This does not mean, and it is good to

underline this once more, that the ECB is indifferent to the external value

of the euro or even neglects it. The external value of the euro is one of the

indicators we look at in the broadly based assessment of the outlook for

price developments. Within that framework, we constantly monitor exchange

rate developments, analyse them and shall act on them, if and when this

becomes necessary. However, such action will never be mechanistic, nor will

it be isolated. The external value of the euro and its development are

analysed and considered in the context of other indicators of future price

developments. The ECB also tries to assess international confidence in the

still very young euro. Of course, the level of international confidence in

the euro is not the only factor determining its external value, nor is the

exchange rate the only indicator of confidence in the euro. It is, for

instance, encouraging to see how the euro has been received on the

international money and capital markets. I am sure that an internally stable

euro will also strongly underpin international confidence in this currency,

as it has for other currencies in the past.

As the currency of a very large area, the issue of the international role of

the euro naturally arises. The ECB takes a neutral stance regarding this

role. It will neither be stimulated, nor hindered. On the one hand, an

international currency has advantages for citizens in the euro area, on the

other, it may sometimes complicate the conduct of monetary policy when a

large amount of euro is circulating outside the euro area. We shall leave the

development of the international role of the euro to market participants and

market forces. If history is a guide as to what will happen, there will be a

gradual process whereby the euro will have an increasingly international

role. Such a gradual development would also be a welcome development, if only

to prevent the euro from becoming too strong externally at some point in

time. It is likely and understandable that interest in the euro is already

considerable in those countries aspiring to join the EU, including Poland. I

shall elaborate on this issue at the end of my speech.

Coming back to our monetary policy strategy, I should like to point out that

it is important to make clear what monetary policy can and cannot do.

Monetary policy can maintain price stability, but only in the medium term. In

the short term prices are also influenced by non-monetary developments.

Moreover, monetary policy measures only have an impact on prices with long,

variable and not entirely predictable time-lags of between 1.5 and 2 years.

Therefore, monetary policy-making should have a forward-looking character.

Today's inflation is the result of past policy measures, and current policy

measures only affect future inflation. The uncertainty of the economic

process in a market economy is another reason for policy-makers to be modest.

The ECB does not pursue an activist policy. Precise steering of the business

cycle or a cyclically-oriented monetary policy are not feasible and are

likely to destabilise rather than stabilise the economy. Some commentators

have interpreted our recent interest rate reduction as a change to a more

cyclically-oriented monetary policy strategy. This is not true. Our strategy

was, is and shall remain medium term-oriented and firmly focused on

maintaining the price stability which currently prevails in the euro area.

Monetary policy should be supported by sound budgetary policies and wage

developments in line with productivity growth and taking into account the

objective of price stability. Otherwise, price stability can only be

maintained at a high cost in terms of lost output and employment. This also

explains why independence should not mean isolation. It is important to have

a regular exchange of information and views with other policy-makers. The

Maastricht Treaty stipulates that the President of the ECB is invited to

meetings of the EU Council meeting in the composition of the Ministers of

Economy and Finance whenever there are issues on the agenda which are

relevant to the ECB's tasks. The President of the Council of Ministers and a

member of the European Commission may attend meetings of the Governing

Council, although they do not have the right to vote. The President of the

Council of Ministers may submit motions for deliberation. Apart from these

formal contacts, there are many informal contacts, for example in the context

of the so-called Euro-11 group of finance ministers from the euro area

countries. I regularly attend meetings of this group.

Monetary policy cannot be used to solve structural problems, such as the

unacceptably high level of unemployment in the euro area. Structural problems

call for structural solutions, in this case measures targeted at making

labour and product markets work more flexibly. The best contribution the

ECB's monetary policy can make in this context is to maintain price

stability. In this way one of the conditions for sustainable growth in

incomes and employment is created. As important as this is, it should be

realised that jobs are created by firms which are confident about the future

and not by central banks.

5. Accountability and transparency

Accountability for policies is the logical complement to independence in a

democratic society. The Maastricht Treaty includes a number of provisions in

this respect. First, there is the mandate to pursue price stability. This

provides a qualitative measure against which the ECB's performance can be

measured. As I have already mentioned, we have decided to enhance this by

providing a quantitative definition of price stability. One of the aims of

publishing our monetary policy strategy is to make our policy decisions

transparent.

The ECB has to publish an annual report in which, inter alia, the monetary

policy of the previous and current year are discussed. I present this Annual

Report to the EU Council and to the European Parliament, which may hold a

general debate on the basis of it. The President and other members of the

Executive Board of the ECB may be heard by the competent committees of the

European Parliament. I have agreed to appear before the European Parliament

at least four times a year. The ECB has to report on its activities at least

quarterly. It has been decided to go beyond this requirement and to publish a

monthly bulletin.

It is my view that the main way to achieve accountability is through being

transparent and open. In passing, I should like to note that transparency

also enhances the effectiveness of a central bank. The better it is

understood, the more successful a central bank is. Apart from the activities

I have already mentioned, transparency is achieved in several ways. Every

month, after the first meeting of the Governing Council, the Vice-President

and I give a press conference. I start the conference with a comprehensive

introductory statement, in which I explain the decisions taken by the

Governing Council and the underlying analysis and arguments for and against.

This introductory statement is published immediately on the ECB's Internet

Web site. This is followed by a question and answer session attended by

several hundred journalists. The questions and answers are also published on

the Internet shortly afterwards. All the members of the Governing Council

frequently make speeches, give interviews and contribute to journals and

books. Thousands of people visit the ECB and the national central banks each

year and, for our part, we and our staff attend many conferences and other

public events.

6. EU enlargement

The European integration process continues. The euro should be made a

success. I have already explained how we have started the process of doing

that. Some observers have criticised the EU for its "obsession with its own

internal dynamics", in particular in the context of European Economic and

Monetary Union (EMU). With all energies focused on meeting the convergence

criteria and the preparation for the launch of the euro, Europeans outside

the EU have wondered whether EMU and enlargement are not mutually exclusive

objectives.

Let me briefly comment on this issue. After the historic decision to complete

the European Single Market in the 1980s, it was felt that economic

integration should not stop at that point. To fully reap the rewards of

economic integration within the Community, a single currency was felt

necessary; a logic pointedly encapsulated in the title of one report: "One

market, one money".

Hence, the underlying idea of EMU was to advance European integration and to

ensure that full use would be made of the economic potential of the Single

Market. This idea continues to be the focus of European policy-makers, as

evidenced by the association agreements and the ongoing accession

negotiations with a number of European countries, Poland among them. Good and

mutually beneficial economic relations with third countries in Europe and

further afield are a pillar of EU policy orientation. Recognising this, the

principles of an open market economy with free competition are enshrined in

the Treaty on European Union. EMU will not weaken this commitment, but rather

reinforce it. Closer co-operation in Europe and the respect of common

principles in the political, economic and social fields are likely to form

the basis for further integration. The ECB shall contribute to this process

within the scope of its responsibility.

Countries wishing to deepen their monetary co-operation to the ultimate

extent possible by forming a monetary union will have to adapt their economic

and legal systems to the standards required by the Treaty and aim at a

sufficient degree of economic convergence. In the absence of these

conditions, adjustment costs for both current and new participants could be

high. Any premature decision on the adoption of the euro could have severe

repercussions on a country's competitiveness and trigger painful economic

adjustments. Therefore, implementation of the necessary institutional reforms

and of a sufficient degree of convergence should not be considered as an

obstacle preventing further integration in Europe, but rather as an essential

means of ensuring the lasting success of EMU, for existing and new

participants alike. Looking at the impressive progress made in a relatively

short time in this country, there is no reason to be pessimistic about

Poland's chances of meeting these standards and convergence criteria. I shall

not venture, however, to predict when this will be the case.

Even at the current juncture, though, EMU in one part of Europe is already

having an impact on the whole region. Let me briefly mention two aspects:

* If the euro emerges, as I believe it will, as a strong and

stable currency, it will provide the countries in the region

with an important reference currency, an anchor towards

which, should the intention arise, monetary policy could

credibly be oriented.

* Furthermore, EMU is set to bring about the development of a

truly unified European financial market, close to that of

the United States in depth and sophistication. The

competitive pressures of this euro area financial market

will create more favourable financing conditions for

borrowers. A number of central and eastern European

countries have already successfully tapped this market.

In view of these effects, it is altogether natural that the ECB has started

to follow with great interest economic and financial developments in the

wider Europe, particularly in those countries which have applied for EU

membership. Moreover, the ECB monitors closely the exchange rate developments

with those countries which have established some form of exchange rate link

to the euro.

The euro has the potential to become more than just a new currency for almost

300 million people in 11 countries. It may also become a unifying symbol,

standing for all that the peoples of Europe have in common. Consequently, the

public perception of the euro could endow the single currency with a role in

the European integration process reaching beyond monetary policy in the

strict sense. May the euro contribute to the establishment of what the

preamble to the Treaty Establishing the European Community calls: "an ever

closer union among the peoples of Europe".

***

The single European monetary policy

Speech by Willem F. Duisenberg

President of the European Central Bank

at the University of Hohenheim

on 9 February 1999, in Hohenheim, Germany

Ladies and gentlemen, The single European monetary policy has been a reality

for a little more than five weeks. After years of intensive preparatory work

and successful economic convergence, monetary policy is now jointly

determined for a large part of Europe by the Governing Council of the

European Central Bank. The monetary policy is implemented by the Eurosystem,

the name given to the ECB and the 11 central banks of the EU Member States

participating in Monetary Union.

The single currency is quoted on the international financial markets and is

used in non-cash payments. However, the euro will not appear as yet in

tangible form as banknotes and coins. Nonetheless there is no doubt that this

currency, which was only brought into existence on 1 January 1999, will play

an important role both within the euro area and beyond.

There is good reason for this confidence, ladies and gentlemen. Overall the

first few weeks went smoothly for the single currency and the monetary policy

of the Eurosystem. The start did not pass by entirely without a hitch - which

was not to be expected in any case, given the significance and scale of this

project - but there were no major complications.

Monetary Union is a unique and outstanding achievement. It provides the great

opportunity to achieve the goal of lasting price stability throughout Europe.

Price stability is the best contribution that monetary policy can make to

lasting economic and employment growth in Europe. The national governments

and all those involved in collective wage bargaining are being called on to

remove the structural causes of the excessively high unemployment. We can

only hope that the introduction of the euro will spur the implementation of

structural reforms.

The stability-oriented monetary policy strategy of the Eurosystem

The Treaty establishing the European Community assigns the European System of

Central Banks (ESCB) - and thereby the Eurosystem - the primary objective of

maintaining price stability. The Governing Council will do its utmost to

fulfil this task and to explain its monetary policy so as to be

comprehensible to the general public. For this reason we have developed a

stability-oriented monetary policy which essentially consists of three main

elements.

The Governing Council has published a quantitative definition of its primary

objective, price stability. This gives clear guidance for expectations in

relation to future price developments. Price stability is defined as an

increase in the Harmonised Index of Consumer Prices of the euro area of less

than 2% compared with the previous year. The publication of this definition

provides the public and the European Parliament with a clear benchmark

against which to measure the success of the single monetary policy, and

thereby provides for the transparency and accountability of the Eurosystem

and its policy.

The wording "less than 2%" clearly defines the upper limit for the measured

inflation rate which is compatible with price stability. I do not think I

need emphasise that deflation - or a sustained fall in prices - would be

incompatible with price stability. The latest available data for the annual

rate of inflation according to the Harmonised Index of Consumer Prices for

the euro area as a whole fall within the definition of price stability. This

outcome is clearly the result, above all, of the successful monetary policy

of the national central banks in the years before the start of Monetary

Union.

The ECB has only been responsible for monetary policy for a little more than

one month. It will only be possible to judge the success of its current

policy in one to two years'time. This reflects the fact that the transmission

of monetary policy impulses is subject to relatively long and variable time

lags. The Governing Council has therefore emphasised that price stability

must be maintained in the medium term. This statement underlines not only the

need for a forward-looking approach to monetary policy, but also takes into

consideration the short-term volatility of prices in response to non-monetary

shocks which are beyond the control of monetary policy.

In order to achieve the goal of price stability, our strategy rests, in

particular, on two "pillars". Before I explain this in more detail, I should

like to emphasise that traditional and previously established macroeconomic

relationships could change as a consequence of the introduction of the euro.

This was one key reason why neither a monetary targeting nor a direct

inflation targeting strategy could be applied. Our strategy is also more than

just a simple combination of these two approaches. Rather, it is precisely

tailored to the needs of the ECB.

The first pillar of the monetary policy strategy is a prominent role for

money. Since inflation is ultimately a monetary phenomenon in the medium

term, the money supply provides a natural "nominal anchor" for a monetary

policy geared to safe-guarding price stability. To emphasise this prominent

role, the Governing Council has published a quantitative reference value for

growth in the money supply. The first reference value decided upon by the

Governing Council for growth in M3 was 4.5% per annum and was published on 1

December. This value is based on the above-mentioned definition of price

stability and assumes a trend growth in real gross domestic product of 2-2.5%

per annum, as well as a medium-term reduction in the velocity of circulation

of M3 of around 0.5-1% per annum.

We shall not, however, respond mechanistically to deviations from the

reference value for money supply growth, but shall first analyse them

carefully for signals relating to future price developments. Larger or

sustained deviations normally signal risks to price stability.

The second pillar of the monetary policy strategy consists in a broadly based

assessment of the outlook for price developments in the entire euro area.

This assessment will be based on a broad range of monetary policy indicators.

In particular, those variables which could contain information on future

price developments will be analysed in depth. This analysis should not only

provide information on the risks for price development, but should also help

to identify the causes of unexpected changes in important economic variables.

Some commentators reduced this comprehensive analysis to an inflation

forecast. At the same time, there were demands for the ECB to have to publish

these forecasts in order to satisfy the need for transparency and

accountability. Therefore allow me to make this clear: our strategy includes

a comprehensive analysis of numerous indicators and several forecasts. To

focus on a single official inflation forecast of the Eurosystem for a

specific point in time would in no way accurately reflect our internal

analytical and decision-making process. It would impinge upon the

transparency and clarity of the explanation of our policy. The publication of

an official inflation forecast would also be inappropriate with regard to the

accountability of the ECB, all the more so if this forecast were based on the

assumption of no change in the monetary policy. The success of the monetary

policy of the ECB should primarily be measured in terms of the maintenance of

price stability, not the accuracy of its conditional forecasts.

The stability-oriented monetary policy strategy of the Eurosystem, which I

have just outlined, constitutes a new and clear strategy. It emphasises the

primacy of the goal of price stability. It takes into account the inevitable

uncertainties concerning economic relationships inherent in the transition to

Monetary Union and the associated systemic changes and guarantees a high

degree of transparency.

Ladies and gentlemen, allow me to comment on certain suggestions on the

orientation of monetary policy which have recently appeared in the press.

Some of these ideas give the impression that monetary policy should

concentrate upon objectives other than price stability, since stable prices

have already been achieved. Inter alia, it has been suggested that the ECB

should react more or less mechanistically to exchange rate developments or

other variables such as, for instance, unit labour costs. Furthermore, there

were calls for monetary policy, by means of reductions in interest rates, to

be used to combat unemployment. Against this background there is a need to

set out clearly the possibilities and limitations of monetary policy.

Both the reasoning in the Maastricht Treaty and many economic analyses show

that the best contribution the single monetary policy can make to employment

growth is to concentrate on price stability. Without such a clear approach

there is a danger that the public may question the commitment of the

Eurosystem to the goal of maintaining price stability. Inflation

expectations, risk premia and thus long-term rates would rise. This would

increase the cost of the investment which is necessary for a sustained and

lasting rise in the standard of living.

Even under the best possible circumstances, though - i.e. if it proves to be

possible to assure lasting price stability - monetary policy alone cannot

solve the major economic problems of unemployment and future problems in

social security systems.

The Governing Council regards the current high level of unemployment in the

euro area as a matter of great concern. This problem is, however,

predominantly a structural one. It is mainly the result of the rigidities in

the labour and goods markets in the euro area which have arisen partly

through an excessive and disproportionate degree of regulation. Structural

economic reforms, which target the reduction of rigidities, are the

appropriate solution. In those euro area countries in which such reforms have

been implemented unemployment figures have declined markedly. In addition, I

should like to emphasise that moderate wage developments and a reduction in

the burden of tax and social security contributions would generally help to

reduce unemployment. This would be the case even if the country concerned did

not trade heavily with its neighbouring countries. The positive influence of

low taxes and wages on employment clearly has overall benefits from an

international perspective. Such a policy should not be denounced as "wage

dumping".

Turning to the role of exchange rates between the euro and other important

currencies outside the EU, in particular the US dollar, the Eurosystem has,

in formulating its monetary policy strategy, made an unambiguous choice. This

strategy clearly rules out explicit or implicit objectives or target zones

for the euro exchange rate. The pursuit of an exchange rate objective could

easily jeopardise the maintenance of the objective of price stability and

could thereby also be detrimental to real economic development. Target zones

for exchange rates could, for example, lead to the ECB having to raise

interest rates in a recession, despite increasing downward pressure on

prices. I am sure you will agree that such a mechanistic response to a change

in the euro exchange rate would not be optimal. Furthermore, it is important

to remember that we are living in a world with high capital mobility.

Exchange rate agreements, which might have been possible to implement until

recently, are no longer feasible.

The lack of an exchange rate target does not mean that the ECB is totally

indifferent to or takes no account of the euro exchange rate. On the

contrary, the exchange rate will be observed and analysed as a potentially

important monetary policy indicator in the context of the broadly based

assessment of the outlook for price developments. A stability-oriented

monetary and fiscal policy, as stipulated by the Maastricht Treaty and the

Stability and Growth Pact, is an essential pre-condition for a stable euro

exchange rate. Of course, there is no guarantee of lasting exchange rate

stability, not even in a fixed exchange rate regime. Exchange rate

fluctuations are often caused by structural or fiscal policy, asymmetric real

shocks or conjunctural differences. Monetary policy would clearly be

overburdened if it had to prevent such movements in the exchange rate.

We cannot and shall not gear our monetary policy towards a single variable,

whether a money supply aggregate, an index, the exchange rate or an inflation

forecast for a particular point in time. Nor can we be involved in any ex

ante co-ordination which would entail an obligation to react to particular

commitments or plans. The ECB will always carefully analyse all relevant

indicators. In this context, it is particularly important that the economic

causes of potential risks to price stability in the euro area are understood

as fully as possible. Appropriate monetary policy decisions also depend upon

the causes of unexpected changes in important economic variables. The

Governing Council must, for example, take a view on whether changes in

important indicators are of a temporary or permanent nature, and whether a

demand or supply shock is involved. In our deliberations we also attempt to

take into account how the financial markets, consumers and firms are expected

to react to monetary policy decisions. I believe few would contest that such

a complex analysis cannot meaningfully be reduced to a more or less

mechanistic reaction to a few variables or a single official forecast.

In addition, concern was often expressed that the Eurosystem would not act

transparently enough. In this context, it was said that a transparent

monetary policy also necessitated the publication of the minutes of the

meetings of the Governing Council and disclosure of the voting behaviour of

the individual members of the Council.

For sound reasons the Governing Council decided not to adopt this approach.

The publication of individual positions could easily lead to national

influence being exerted over the individual Council members. The members of

the Governing Council must not, however, be seen as national representatives.

They decide together on the monetary policy for the euro area as a whole. The

Governing Council has committed itself to go beyond the reporting and

explanatory requirements laid down in the Treaty, which are among the most

comprehensive requirements by international standards.

On the basis of our strategy, after every first meeting in the month I

deliver to the press a detailed explanation of our assessment of the overall

economic situation and, in particular, the outlook for price stability. The

content of this so-called "introductory statement" is very close to what

other central banks refer to as minutes. In this way, the public receives

comprehensive information immediately following the meetings of the Governing

Council. In addition, each month we shall publish a detailed report on the

economic situation and monetary policy throughout the euro area in our

Bulletin. Such rapid information on the results of the meetings of the

Governing Council and the current economic analysis of the ECB without doubt

demonstrates a high degree of openness and transparency.

The most recent monetary policy decisions and operations

Co-operation between the European central banks was always very close. In the

last few months of 1998 the countries participating in the third stage of

Monetary Union co-operated more and more closely. The co-ordinated reduction

in leading rates at the beginning of December 1998 clearly showed that the

currency union had begun de facto before the start of Stage Three. This co-

ordinated measure contributed substantially - as we now know - to the

stabilisation of market expectations.

For more than five weeks the ECB has been conducting monetary policy

operations, mainly in the form of reverse open market operations. The main

operation will be carried out at a weekly frequency with a maturity of two

weeks. So far, five such operations have been conducted successfully, at a

fixed interest rate of 3%.

Besides the reverse transactions which constitute the main instrument for

liquidity control and targeting interest rates, the Eurosystem offers two

"standing" facilities: the marginal lending facility and the deposit

facility. These can be accessed by credit institutions via the national

central banks. The marginal lending facility is primarily a safety valve for

short-term liquidity shortages in the banking system and thereby limits

upward movements in money market rates. To some extent, its counterpart is

the short-term deposit facility, which is used to absorb short-term liquidity

surpluses. This forms the lower limit for money market rates. For the start

of Monetary Union the interest rate on the deposit facility was set at 2% and

the rate on the marginal lending facility was set at 4.5%.

As a transitional measure, the Governing Council decided to establish a

narrow corridor of 2.75-3.25% between the rates on the marginal lending

facility and the deposit facility from 4 to 21 January 1999. The intention

was to facilitate the necessary adjustment to the new institutional

environment brought about by the transition to Stage Three. As already

announced, on 21 January 1999 it was decided to return to the rates on the

two "standing" facilities that were set for the start of the single monetary

policy. Since 22 January 1999, therefore, the rate on the deposit facility

has been 2% and the rate on the marginal lending facility has been 4.5%.

A critical factor in this decision was the behaviour of the money market for

the euro area as a whole since the beginning of the year. The Governing

Council established that over time there had been a marked reduction in the

difficulties experienced by some market participants with the introduction of

the integrated money market and, in particular, with cross-border liquidity

flows. All in all, the integration of the money market in the euro area

reached a satisfactory stage only three weeks after its implementation. In

analysing the money market it should be noted that, inter alia, there can be

a marked difference between ECB interest rates and short-term market rates.

On the one hand, market rates may include credit risk premia, and on the

other, expectations may lead to differences between the two rates.

At its meeting last Thursday the Governing Council confirmed its earlier

assessment of the outlook for price stability. Therefore it was decided to

leave the conditions for the next main refinancing operations, on 10 and 17

February 1999, unchanged. They will be carried out as volume tenders at a

fixed rate of 3%, the same conditions as the last such monetary policy

operations.

In addition, in recent weeks the first longer-term open market operations

were also conducted, in the form of reverse transactions. These were carried

out on 14 January 1999 in three parallel tender procedures with maturities of

one, two and three months. The fixed rate tender procedure was used. By

contrast with the regular main refinancing operations, the Eurosystem does

not use these longer-term operations to send signals to the market and

therefore usually acts as a price-taker. The ECB thus gives advance

indication of the planned allocation. The interest rates which arise from

these monetary policy operations should therefore be seen as indicators of

prevailing market conditions.

Regular assessment of the monetary, financial and economic situation

To conclude, I should like briefly to report on the Governing Council’s

current assessment of the monetary, financial and economic situation. On the

basis of these assessments the Governing Council decided last Tuesday to

leave interest rates unchanged.

Taking into account the latest monetary data for December 1998, the three-

month moving average of the 12-month growth rate of the monetary aggregate M3

(for the period from October to December 1998) remained more or less stable

at 4.7%. This value is very close to the reference value set by the Governing

Council. According to our analysis, the evolution of the money supply shows

no risks to price stability. Credit to the private sector also grew strongly

in December last year. Although at present we do not perceive any

inflationary signals, further developments will be very carefully monitored.

With regard to the broadly based assessment of the outlook for price

developments and the risks to price stability in the euro area, monetary and

financial developments can be seen to indicate a favourable assessment of the

latest monetary policy decisions of the Eurosystem. They indicate that market

participants expect a continuation of the environment of price stability.

Long-term rates fell to new historical lows at the beginning of 1999 and

there was an overall downward shift in the yield curve. Therefore, financing

conditions for investment are currently exceptionally favourable.

At present the growth prospects for the euro area are, however, still marked

by the uncertainties relating to the development of the world economy in

1999. These uncertainties have had a negative impact on indicators of the

economic climate in the euro area. There are widespread expectations of an

economic slowdown in the near future. This deterioration in the external

economic environment can be linked, above all, to the financial crises in

Asia, Russia and Latin America. However, there is a mixed picture. While the

growth rate for industrial production fell up to November 1998, retail sales

figures and consumer confidence have recently shown positive trends.

Furthermore, growth in real gross domestic product in the euro area was

relatively robust in the third quarter of 1998. In the United States real

growth in the fourth quarter actually turned out higher than expected.

Measured against the Harmonised Index of Consumer Prices, the HICP, consumer

prices in the euro area rose by 0.8% in December 1998. This is a tenth of a

percentage point lower than in November. This development is in line with

earlier trends. It can be linked, in particular, to a further decline in

energy prices and a weakening in price increases in industrial goods.

All in all, the above-mentioned economic development and the available

forecasts for 1999 do not indicate any noticeable upward or downward pressure

on prices. Potential upward risks could arise from a change in the external

global economic situation and any associated effects on the euro area, via

import and producer prices. These developments must be carefully monitored.

There is concern that inflationary pressure might develop in the event of a

strong increase in wage prices and an easing of fiscal policy. Developments

in the exchange rate will also be closely monitored in view of their

significance for price developments.

Finally, let me emphasise that the current level of real interest rates is

exceptionally low. If real interest rates are taken simply as the difference

between nominal rates and the current increase in consumer prices (HICP),

short-term real interest rates in January 1999 stood at 2.3%, i.e. around 80

basis points lower than one year ago. Long-term real rates have fallen even

more, by 110 basis points, and stood at 3% in January. These levels are very

low, both compared with other countries and with historical data. In line

with the safe-guarding of price stability, the current monetary and financial

conditions thus clearly support future economic growth. Monetary policy can

do no more than this without jeopardising the great overall economic

advantages of price stability and its own credibility.

Real structural reforms which increase the flexibility of the labour markets,

as well as a continuation of the moderate increase in wage prices, would not

only ease the burden on monetary policy but would also support employment

growth. This will be all the more true if the deterioration in the economic

situation this year is worse than expected owing to the negative aspects of

the external economic environment.

The statistical requirements of the ESCB

Speech delivered by Eugenio Domingo Solans,

Member of the Executive Board of the European Central Bank

on the occasion of a visit to the Banque Centrale du Luxembourg

Luxembourg, 25 March 1999

The booklet introducing statistical requirements for Stage Three, which the

EMI published in July 1996, began with the bold statement: "Nothing is more

important for the conduct of monetary policy than good statistics." These

challenging words show the importance which the EMI attached to this area of

preparations for Monetary Union, and I must say this has been fully justified

by our experience in the first few weeks of the life of the euro.

The statement of requirements

But let me start back in 1996. Because of the time it takes to implement

statistical changes in reporting institutions and central banks, a statement

of prospective statistical requirements could be delayed no longer. But that

statement had to be made with very imperfect knowledge. Nobody knew at that

stage (for example) what definitions of monetary aggregates would be chosen

for the single currency area, or what their role would be. Given the

differences in financial structures in our countries, it was not clear how to

identify the financial institutions from whose liabilities the money stock

would be compiled. It was decided to define them in functional terms, and in

such a way that money-market funds as well as banks of the traditional type

would be included. It was not clear at that stage whether minimum reserves

would be applied, and, if they were, what form they would take - although it

had been decided that the banking statistics data would provide the basis for

any such system. Implementation had to start quickly for the statistics to be

ready in time for a Monetary Union starting in 1999, but no one knew which

Member States would adopt the single currency - though it was clear that the

distinction between business inside and outside the euro area, would be of

critical importance for monetary and balance of payments statistics, and

would have to be planned for in statistical systems.

In mentioning monetary and balance of payments statistics, I do not want to

suggest that the statistical requirements set out in 1996 were confined to

these areas. On the contrary, they covered a wide range of financial and

economic data, including financial accounts, prices and costs - relating

directly to the ESCB's main responsibility under the Treaty, namely to

maintain price stability - government finance data, national accounts, labour

market statistics, production and trade data and other conjunctural

statistics, and more besides. These areas are, or course, under Eurostat's

responsibility.

The focus on the euro area as a whole

In formulating and implementing statistical requirements, it was important to

realise that the ESCB's attention would have to focus on the euro area as a

whole. Monetary policy cannot discriminate among different areas of the

Monetary Union - although in practice it may have different effects because

of different national economic and financial structures. Focus on the area as

a whole has important implications. The data must be sufficiently comparable

for sensible aggregation; they must also be available to a comparable

timeliness and to the same frequency. In some cases (monetary and balance of

payments statistics) they had to be available in a form permitting

appropriate consolidation. In short, with a few exceptions, it was realised

that adding together existing national data would not be adequate. Important

initiatives were already under way, such as the adoption of a new European

System of Accounts [ESA95] and the implementation at national level of a new

IMF Balance of Payments Manual. However, wide-ranging statistical

preparations would be necessary for the ECB to have the sort of statistical

information that the national central banks have traditionally used in

conducting monetary policy.

How far the provision meets the current need

I arrived at the ECB about 2 years after these requirements had been released

and 7 months before the start of Monetary Union. I must confess that I

doubted many times in those early weeks whether statistics could be ready in

time to sustain monetary policy decisions. There were anxious moments too in

the late stages of finalising the monetary policy strategy: would the

requirements set out in 1996 correspond to the need perceived in autumn 1998?

I am now sure that the decisions made in 1996 were correct. In practice, one

choice in autumn 1998 was almost automatic: thanks to the work of Eurostat

and the national statistical offices in the context of the convergence

criteria (with active involvement of the EMI), there was no plausible rival

to the Harmonised Index of Consumer Prices (HICP) for the purpose of defining

price stability. I am aware that national consumer price indices are

sometimes criticised for overstating inflation, because they take

insufficient account of quality improvements and use outdated weights. While

further development of the HICP is to come, and at present there is no

satisfactory treatment of expenditure on housing, I believe that every effort

has been made to apply the lessons from experience with national consumer

price measures. The other choices for statistical elements in the strategy

were less obvious. In fact the banking statistics reporting structure

announced in 1996 proved able to provide the monetary aggregates and the

counterpart analysis required, and - with a little fine-tuning - to meet the

needs of a statistical basis for reserve requirements, details of which were

also finalised in the autumn. We were thus able to begin publishing monetary

statistics only a few days after the final decisions were taken (at the

Council meeting on 1 December), and were able to publish with some estimation

last month back data on the three monetary aggregates monthly to 1980, and a

note urging caution on users of the earlier data.

However, the monetary strategy avoids putting too much weight on one area or

type of information. This is only partly for statistical reasons. The

formation of the euro area is a substantial structural change, which may in

time affect monetary and financial relationships. So the ECB also examines a

range of economic data for the light they shed on the assessment of the

economic situation and, in particular, prospects for inflation. The editorial

and economic developments sections of the Monetary Bulletin show the way the

ECB draws on this information; the statistical information itself is set out

in tables in the statistical section. Thus, in addition to money and credit

and the HICP, the editorial typically touches on GDP, industrial output,

capacity utilisation, orders, the labour market, business and consumer

confidence, costs and prices other than the HICP, earnings and wage

settlements, fiscal positions - naturally placing the emphasis on what are

judged to be the most important developments at the time. All these areas

were covered by the statement of requirements made in 1996.

I do not need to say that, at present, an accurate assessment of the economic

situation in the euro area is of vital importance. The editorial section of

the March Bulletin concludes that the overall outlook for price stability

remains favourable, with no major risk that HICP inflation will exceed 2% in

the near future, but there is nevertheless a balance of conflicting

influences. To reach this judgement, the Bulletin assesses the latest GDP

data (slower growth in the provisional Eurostat figures for GDP in the 4th

quarter of 1998; declining manufacturing output), the labour market

(unemployment falling slightly; some signs of rising pay settlements), and

confidence indicated by opinion surveys (business confidence weak; the

consumer mood rather optimistic). The economic developments section supports

the overall conclusion, and analyses in more detail price and cost

developments and of output, demand and the labour market. It concludes with

analysis of the fiscal position in the euro area in 1998, and a preview based

on fiscal plans for 1999. I am drawing your attention to this to show the

variety of material supporting the ECB's assessment of the economic and

financial position and prospects. Although we pay particular attention to

certain items - the monetary statistics, with an emphasis this time on

influences contributing to recent faster growth, and to the rather rapid

growth of credit, and the HICP - we draw on a wide range of information in a

continuous monitoring exercise. The establishment of an institution

responsible for monetary policy in the euro area has caused a fundamental

change in the use of macroeconomic statistics at European level, very much as

anticipated by the Implementation Package nearly 3 years ago.

Priorities for further improvement of statistics

I would like to take this opportunity to thank Eurostat for their efforts to

improve the quality and comparability of economic statistics relating to the

euro area, and to deliver them to the ECB on a timely manner. They have given

this high priority and much progress has been made in the last year or so.

Further improvement will come with the introduction of the new European

System of Accounts [ESA95] starting next month (although we must expect some

temporary confusion following the introduction of a new system). Experience

suggests that substantial statistical changes initially bring classification

problems. Although, of course, provision has been made for back data to be

available on the closest possible approximation to the new basis, we must

also expect some discontinuity in important series. Implementation of last

year's short-term Statistics Regulation will bring improvements across a wide

range of conjunctural statistics not covered by ESA95. There are also

initiatives to improve labour market statistics. With Eurostat, who are

responsible for all these areas of statistics at European level, we do our

best in the ECB to promote better data. Perhaps I should underline our

support here for the priorities established last year by a working group of

the Monetary Committee (the current Economic and Financial Committee), in

which Yves Franchet and two of my ECB colleagues participated (Peter Bull and

Gert Jan Hogeweg): in addition to quarterly GDP and short-term conjunctural

statistics, these were government finance statistics, data relating to the

labour market (including labour costs), and the balance of payments. At

present the lack of comparable national statistics during the course of the

year makes it difficult to monitor the fiscal stance in the area as a whole,

and so to assess the balance of fiscal and monetary policy. Better labour

market statistics are important, not only for the ECB's assessment of

possible inflationary pressure, but also to improve understanding of the

structure of labour markets in our countries, and the rigidities which impede

the achievement of fuller employment. Balance of payments statistics - a

shared responsibility of the ECB and Eurostat at European level - require a

new approach in compiling data for the euro area as a whole. We intend to

publish the first monthly data for the euro area following the new

methodology next month, and to begin joint publication of a quarterly euro-

area balance of payments with Eurostat in the summer. But there are deeper

questions about future needs for balance of payments statistics in the new

circumstances which are currently being addressed. Principally, the question

arises of the usefulness for policy purposes of national balance of payments

statistics for Member States participating in Monetary Union. There is no

question, of course, that certain data in this area are needed within the

ESA95 framework of national and financial accounts.

The organisational, legal and technical infrastructure

I have talked mainly about statistical requirements and their provision, but

this is only part of the story. The Treaty (specifically in Article 5 of the

Statute of the ESCB and the ECB) clearly envisaged that the ECB would perform

statistical functions, assisted by and in co-operation with national central

banks, other national authorities, the Commission (meaning in this context in

particular Eurostat), and international organisations. A large part of the

preparatory work carried out by the EMI consisted of sorting out who would do

what, avoiding so far as possible duplication, wasted effort and conflicting

data, and keeping the whole development consistent with international

statistical conventions. Much of this had to be framed in legal instruments,

which would complete the statutory framework provided by the Treaty and the

ESCB/ECB Statute. Although work on an EU Council Regulation concerning ECB

statistics began as early as 1996, the Regulation could not be finalised

until last autumn and the ECB could not adopt legal instruments on statistics

in advance of that event - much work in this area therefore had to be done at

the last minute.

Information Technology is another of my responsibilities at the ECB. I am

glad to say that essential elements of our data transfer and statistical

processing systems were in place when I arrived, or brought into operation

soon afterwards. But here, too, there is room for further improvement - the

EMI and the ECB in these early months have had so much to do in relation to

the resources available that, broadly speaking, only the essentials have been

provided so far.

Conclusion

"Nothing is more important for monetary policy than good statistics." The

formation of Monetary Union has shifted the focus of interest on to data

covering the euro area as a whole. This has required substantial changes to

statistics, which need time to settle down and are some way short of

completion. At the same time, the adoption of the single currency is itself a

massive structural change. This will surely affect economic and financial

relationships and make any data harder to interpret, although these deeper

effects may occur over a period and take some time to become apparent. What

is clear, however, is that the ECB must take policy decisions and explain

them publicly in terms of the data available relating to its policy

responsibility. What we continue to strive to do, through our own efforts and

with the help of Eurostat, is to improve the quality of the data underlying

policy decisions, which are so important in gaining public understanding and

acceptance for them.

***

The tasks and limitations of monetary policy

Speech delivered by Christian Noyer

Vice-President of the European Central Bank,

at the Volkswirtschaftliche Tagung of the Oesterreichische

Nationalbank,

on 10 June 1999 in Vienna

Ladies and Gentlemen,

It is a pleasure for me to be here in Vienna today and I should like to start

by thanking the conference organisers for giving me the opportunity to

elaborate on the tasks and limitations of monetary policy.

This topic is extremely important. Looking back over the history of economic

thought, it is clear that the perception of what monetary policy can do and

what it cannot or should not do has changed. This has clearly shaped the role

of monetary policy in economic policy. In the 1960s economic theories

suggested a long-run trade-off between inflation and output. These theories

provided the intellectual basis for policy-makers to pursue monetary policies

biased towards higher inflation. The high inflation experience of the 1970s

together with new theoretical findings, especially on the role of

expectations, led policy-makers to move towards lowering and stabilising

inflation.

Theoretical considerations as well as empirical evidence over several decades

suggest that high rates of inflation are clearly unhelpful - indeed

detrimental - to growth and employment in the long term. A large number of

economic arguments point to the benefits of price stability for economic

growth and employment prospects. Stable prices eliminate economic costs such

as those arising from unnecessary uncertainty about the outcome of investment

decisions, the distortionary effects on the tax system, rising risk premia in

long-term interest rates and the reduced allocative effectiveness of the

price and market systems. To quote Alan Greenspan, chairman of the United

States Federal Reserve, "Price stability is achieved when the public no

longer takes account of actual or prospective inflation in its decision-

making." Monetary policy must take into account the fact that the horizon for

decisions by economic agents is rather long-term in nature. By guaranteeing

price stability, monetary policy supports the efficient functioning of the

price mechanism, which is conducive to the allocation of scarce resources.

Price stability is a means of promoting sustainable economic growth and

employment creation and of improving productivity levels and living

standards.

Against this background, the predominant view has emerged that the best and

most lasting contribution that monetary policy can make to long-term economic

welfare in the broader sense is that of safeguarding price stability. Central

banks throughout the world have been moving towards adopting long-term price

stability as their primary goal.

In order to achieve this goal most successfully, independence from political

interference and a clear legal mandate for price stability are of the utmost

importance. A lack of central bank independence and an ambiguous mandate can

easily force central banks to focus on the short term and, thus, fail to

adopt the forward-looking, medium-term orientation that is crucial for a

successful monetary strategy.

All these issues were taken into consideration by policy-makers when drafting

the Treaty establishing the European Community and designing the blueprint

for the European Central Bank. Both central bank independence and an

unequivocal commitment to price stability are therefore tenets of the

monetary policy framework enshrined in the Treaty. There can be no doubt that

the European Central Bank (ECB) is determined and well-equipped to tackle its

main task, namely, that of maintaining price stability in the euro area over

the medium term. It will thereby make a significant contribution to the

achievement of other Community objectives such as high employment and

sustainable non-inflationary growth. In this connection, the pursuit of sound

macroeconomic policies by the EU Member States would considerably facilitate

the task of the ECB. The room for manoeuvre in monetary policy and the degree

of success in terms of maintaining price stability are crucially dependent on

the support of sound fiscal policies and responsible wage settlements in the

euro area.

The Treaty establishing the European Community states that the primary

objective of the European System of Central Banks (ESCB) is to maintain price

stability. Without prejudice to this objective, the ESCB shall support the

general economic policies in the European Community. It shall operate in a

manner that is consistent with the establishment of free and competitive

markets. The Treaty states explicitly how the ESCB shall set its priorities.

Price stability is the first goal of the monetary policy of the Eurosystem,

and a contribution to the achievement of the other objectives of the European

Community can only be made if this primary objective is not compromised.

However, there is ultimately no incompatibility between maintaining price

stability and pursuing these other objectives. By maintaining price

stability, the ECB will also contribute to the achievement of other Community

objectives.

Of course, the ECB is concerned about the intolerably high level of

unemployment in Europe, but we should realise that the role of monetary

policy in reducing unemployment in Europe can only be very limited. Many

empirical studies show that the high unemployment rate is mostly the

consequence of structural rigidities within the European labour and product

markets. The European unemployment rate has, indeed, been high and stable

over the business cycles in the past decade. Only structural reforms,

preferably of a comprehensive nature, can therefore tackle the underlying

impediments to employment growth.

The monetary policy of the Eurosystem is geared towards the euro area as a

whole and, thus, cannot take into account purely national and regional

developments. The cyclical positions of participating countries have not yet

completely converged, although, with the single currency in place, some

national differences may disappear over time. This requires national policies

and labour and goods markets to be increasingly flexible in order to be able

to respond effectively to economic shocks. Well-functioning labour and

product markets are therefore needed to allow adjustments to wages and prices

to be made if local economic conditions change.

Budgetary policies play a major role in conditioning monetary policy.

National fiscal authorities have to demonstrate their commitment to the

maintenance of price stability in the euro area over the medium term. In this

context, the Stability and Growth Pact is a crucial element. Its aim is to

encourage the pursuit of disciplined and sustainable fiscal policies by the

participating EU Member States and the prospective members. Sound public

finances, with lower public debt and tax burdens, contribute to a lowering of

long-term interest rates, reduce uncertainty and increase private capital

formation. They not only facilitate the task of monetary policy with regard

to the maintenance of price stability, but also strengthen the conditions for

sustainable growth conducive to employment creation. Conversely, unsound

fiscal policies tend to increase inflation expectations and force monetary

policy to keep short-term rates higher than would otherwise be necessary.

The single monetary policy has to be conducted independently of the short-

term political considerations of national governments. In this context, the

ECB cannot commit itself to move its interest rates in a certain way in

response to specific actions or plans of other policy-makers. Monetary policy

has to take into account the overall economic situation to assess the risks

to price stability. Direct ex ante co-ordination with fiscal authorities

might endanger meeting the primary objective and would set the wrong

incentives for the conduct of sound macroeconomic policies. This does not, of

course, exclude a constructive dialogue between the Eurosystem and government

authorities which clearly respects the independence of the ECB.

When dealing with one of the major world currencies and with the currency of

one of the two main world economies, it is inconceivable that price stability

might be maintained by setting an exchange rate target as an intermediate

objective. However, external developments including the exchange rate are

taken into account in accordance with our strategy, as they may have an

impact on domestic economic developments and thereby on price stability.

Referring to recent exchange rate developments in this context, it is

appropriate for me to quote the President of the ECB, Dr. W. F. Duisenberg,

who recently said that "the euro is a currency firmly based on internal price

stability, and therefore has a clear potential for a stronger external

value".

The absence of exchange rate targets for the euro vis-а-vis other major

currencies should not be misunderstood. For smaller, very open economies,

fixed exchange rates may be a very reasonable choice. The Austrian example is

one of the most prominent in this respect. By pegging the Austrian schilling

to the Deutsche mark for over twenty years, it proved possible to import

credibility and price stability. The increasingly close pegging of the

Austrian currency to the currency of its main trading partner was, among

other features of the Austrian policy mix, the driving force behind the

economic convergence process in the run-up to Stage Three of Economic and

Monetary Union (EMU). The credibility of the Austrian exchange rate target

was also underpinned by an income policy aiming at relatively high real wage

flexibility and a fiscal policy geared towards consolidation. All in all, the

Austrian model, which set out to guarantee stability in nominal and real

terms, has turned out to be very successful.

The example given by past Austrian experience is, I believe, very valuable.

It shows that the achievement of sustainable convergence with the euro area

can be assisted by means of an exchange rate target. The new Exchange Rate

Mechanism of the European Union, ERM II, may play a similar role for those

current and prospective EU Member States which have not yet joined Stage

Three of EMU.

The achievement of price stability is also of high importance for the

stability of the financial system. The financial system of the euro area

showed a high degree of stability during last year's period of financial

turbulence as well as during the rather dramatic structural shift connected

to the changeover to the euro. At the ECB, we play our part in the evolution

of the euro area financial system by providing it with stable monetary

conditions. By creating an environment of price stability, we allow private

sector agents to focus their attention on the questions that are most

relevant to their activities and to take advantage of benefits of this stable

environment, such as the lengthening of their planning horizons. There is a

lot of empirical evidence that safeguarding price stability is the optimal

contribution that a central bank can make to the maintenance of financial

stability and that those two goals are actually complementary.

I should like to conclude by saying that the main contribution of the single

monetary policy to the welfare of the people in the euro area will be the

maintenance of price stability in the medium term. The ECB is determined to

tackle this task and is well-equipped to do so. Our conviction is that the

economic performance of the euro area will benefit significantly from price

stability. This will ultimately facilitate the achievement of those

objectives, which underlie the general economic policies of the European

Community and the individual governments at the national level. However, the

economic problems in the euro area cannot be tackled by monetary policy

alone. We have to be realistic about the goals which can be achieved by

monetary policy. Neglecting the limitations of monetary policy and promising

too much could, in the long term, be detrimental to the establishment of a

stability culture in Europe, and could also lead to delays in implementing

the economic reforms that are crucial to achieving high growth and

employment.

***

European Central Bank

Press Division

Kaiserstrasse 29, D-60311 Frankfurt am Main

Tel.: 0049 69 1344 7455, Fax: 0049 69 1344 7404

Internet: http://www.ecb.int

Reproduction is permitted provided that the source is

acknowledged