Speech before the Los Angeles World Affairs Council on October
2, 2002:
ERNST
WELTEKE
President Deutsche Bundesbank
Ladies and gentlemen. German-American relations have traditionally been strong, and I regard my speaking to the World Affairs Council today as a good opportunity to reaffirm our ties. I would like to thank you for your kind invitation, which gives me an opportunity to discuss the European Monetary Union with such a distinguished audience.
First, I would like to reflect on the workings of the European Monetary Union (EMU). Then I will present the current situation of the euro-area and its outlook, including the upcoming enlargement. I will round off my remarks with some impressions from post-election Germany.
All too often the project of a European Monetary Union had been declared dead-on-arrival—and I have often thought the same about the American interpretation of the European Monetary Union: that it would not come and it's a stupid idea. I thought so too five years ago, but now it's working. No question about that. We launched the euro on time, the EMU is working smoothly, and the cash changeover in January went without a hitch. I don't know if any of you have had a euro note, in your hand but I can show you one if you like. The doomsayers have been proven wrong.
The single currency is helping to deepen European integration. A "European identity" is emerging. People from way up north in Finland and other areas purchase their espressos when they are on holiday in Sicily, or in Greece, with their home currency, the euro.
The single currency has brought about a degree of monetary stability unprecedented in many of the 12 euro-area member states. This is a major achievement – not only in terms of prosperity.
The monetary policy is the first policy area in Europe to be designed on a truly European scale. Monetary policy decisions in the ECB Governing Council are taken to fit the aggregate European data: national interests are set aside when it comes to the making of monetary policy. This is not only theory; it is practice.
The Eurosystem, composed of the European Central Bank and the national central banks of the euro-area countries, forms the institutional framework of euro-area monetary policy. Since independent central banks—like the U.S. Federal Reserve or pre-Monetary Union Bundesbank—are more successful in pursuing this objective than non independent central banks, all central banks of the European System of Central Banks are free from political interference.
As regards the goals of monetary policy, the Eurosystem and the Federal Reserve differ to some extent. The Employment Act of 1946 and the Humphrey-Hawkins Act of 1978 require the Federal Reserve System to pursue several objectives at the same time; economic growth in line with potential output growth, stable prices, full employment and moderate long-term interest rates. The Eurosystem has a slightly different and unmistakably clear mandate. The primary objective of the European System of Central Banks is to maintain price stability. This reflects the conviction that keeping the general price level in check is the best a central bank can do to foster economic growth and employment. The difference in their mandates explains to a certain extent why the Fed and the Eurosystem sometimes take different routes in similar situations. In the Eurosystem you have the definition that price stability is when the consumer price index does not increase more than two percent in a medium time on an annual basis, and to reach this definition, this objective, we have the so-called two-pillar strategy, built in the European System of Central Banks. One pillar is related to money supply and the other is related to all indicators that might influence the prospect of inflation.
The second stability-ensuring institutional feature of the EMU is the Stability and Growth Pact. It spells out how member states are supposed to ensure sound public finances, as the Maastricht Treaty obliges them to avoid excessive deficits. Why is that beneficial? As long as national budgets are in order, there is no incentive for member states to press for an overly lax monetary policy, with an eye to reducing the interest burden on their budgets.
However, some perceive the Stability and Growth Pact, with its three percent deficit threshold, as imposing an excessively tight fiscal policy on E.U. member states. This kind of criticism reflects a misperception of the Pact. The Pact is based on the notion of the "breathing budget." A budget that is fundamentally balanced can allow automatic stabilizers to fully work their magic during a downturn. Unlike in the U.S., automatic stabilizers—for example, unemployment benefits—are rather large in Europe. Countries that now have an issue with the three percent limit neglected fiscal consolidation during the late nineties' economic expansion, and these are the bigger countries in the EMU like Italy, France and Germany. The Pact itself should not be blamed for misplaced fiscal largesse. In an aging society, which Europe is, sound public finances are becoming even more important. In this respect, the fiscal discipline imposed by the Stability and Growth Pact is of help.
The success of the common currency depends not least on the convergence of the euro-area economies. In the run-up to the introduction of the euro, convergence was the main challenge for the member countries. A lot has been achieved in terms of integration, but further efforts have to be made.
The euro has been a catalyst for financial integration in the monetary union. Integration of major parts of the European financial markets has improved the allocation of assets, has stabilized financial developments and has smoothed the monetary transmission process.
The wholesale market for interbank liquidity is now a single European money market. The same holds true for the bond market. The increased size of average issues and the enhanced activity of private issuers indicate that capital is being allocated more efficiently throughout the euro area. Those parts of the financial markets that are crucial to the transmission of the Eurosystem's monetary policy are already working to our satisfaction.
However, some segments of the financial markets still have some way to go before they can be regarded as fully integrated. Nonetheless, the process of translating European legislation into national law, of making securities-market legislation compatible among the members of the E.U., is progressing. The E.U. Commission has drafted an ambitious program, the "Financial Services Action Plan." This plan intends to create a fully integrated financial market in Europe by 2005.
The recent equity downturn arrived in the midst of an increasing capital market orientation on the part of financial investors and the corporate sector. Disintermediation is a trend unbroken, as may be seen in corporate bond issuance, which has held up fairly well and is picking up again. I am pretty sure that the recent turmoil in international financial markets would have entailed major disruptions within Europe, if it were not for the single currency.
The financial market turmoil has been the dominant theme for the euro economy during this summer. In this respect, the euro economy is no different from the U.S. economy. Confidence in the financial markets has been severely shaken. Let me first put the turbulences in the financial markets into perspective. In high volatility, the Dow Jones Euro Stoxx 50 and the German Dax 30 have both more than halved since reaching their all-time highs. The U.S. Standard and Poor's 500 Index has shed about 40 percent, while the tech-heavy Nasdaq Composite Index has shrunk to almost one-quarter of its peak value.
Remember, in an environment of then-healthy corporate profits, soaring asset prices took price-earnings ratios up to heights rarely seen. Equity markets looked overvalued, but the "New Economy" paradigm enticed investors into not regarding them as overvalued. With the wisdom of hindsight, we can identify the bubble as such.
Financial disturbances affect the real economy, irrespective of what generated the turbulence in the first place. Transmission to the real economy works via three main channels. First, there is the wealth effect. As their portfolios shrink in line with stock valuations, consumers tend to cut their expenditures. Second, as business financing costs rise in line with decreasing stock prices, investment expenditure is cut back. The third channel through which adverse financial developments may impinge on the real economy can be described as "negative sentiment." A certain sense of crisis will tend to weaken confidence in general. Also, the accounting problems have done something to this confidence in the financial markets.
Financial markets and the real economy are both post-bubble blues. Businesses and consumers are short on confidence and long on worries. Financial, economic and political uncertainty have risen in parallel. After the "golden nineties," the pendulum is swinging back. It may even swing back too far and overshoot like exchange rates tend to do. Unfortunately, there is no medicine to alleviate post-bubble blues.
The situation, however, is better than the somber mood suggests, although admittedly not as good as we had hoped for. Economic growth in the euro-area economy is subdued this year. Expectations were running far ahead of the economic recovery. The downward revision of upbeat expectations has narrowed the unusually large gap between runaway expectations and the assessment of the current situation.
The business and consumer climates now suggest a slower start to a less vigorous recovery. The process of unwinding bubble-era imbalances is taking longer than was expected in the rather optimistic assessments early this year.
In actual fact, the moderate pace of economic expansion in the euro-area is set to continue. Leading indicators do not point to another economic downturn. We now expect the euro-area economy to be back to potential growth next summer, not least because macroeconomic policy is supportive. The monetary policy is expansionary. Liquidity is ample. Real interest rates, both long and short-term, are below average and are not hampering investment.
Recent price developments are bolstering consumption. The euro-area inflation rate, at 2.2 percent as of the last month, is almost back in the range the ECB Council regards as price stability.
The world economy is set to stay on its—admittedly not very steep—path of growth. Both investors and consumers will soon have to make up for the investment and consumption spending that was put off during the downturn.
Euro-area monetary policy has been confronted with conflicting signals during the summer: monetary growth continues to be strong. Its high growth rate owes much to low opportunity costs and ongoing portfolio reallocation. Given weak financial demand, the risk of ample liquidity being channeled into inflationary pressure is regarded as quite low.
However, a serious risk to price stability is posed by the price of crude oil, which has begun to rise on the heels of increasing political tension in the Middle East. Bearing these facts in mind, the Governing Council of the ECB believes the risks to price stability are balanced. Therefore, we decided to stay on hold when we last assessed the monetary policy stance in mid-September.
The European Union is on the eve of major enlargement. Twelve countries, including ten transition countries, are anxious to join the club. This week, the European Commission is due to make a detailed proposal on how to progress with enlargement.
In its latest annual progress report on the accession process, the European Commission confirms the prospect of ten countries joining the E.U. as early as 2004: the three Baltic nations of Estonia, Latvia and Lithuania; five central and eastern European countries; Poland, Hungary, the Czech Republic, the Slovak Republic and Slovenia; and the two Mediterranean islands of Cyprus and Malta.
The process of accession is organized in three stages. We are currently in the pre-accession stage. The next step will be that of accession to the E.U., and the final stage might be full participation in the European Monetary Union.
Accession to the European Union is conditional upon the fulfillment of the "Copenhagen criteria." These comprise the following: (1) the "stability of institutions guaranteeing democracy, the rule of law, human rights, and respect for, and the protection of, minorities." This political criterion is already met by all ten countries. (2) The "existence of a functioning market economy as well as the capacity to cope with competitive pressures and market forces within the E.U." All of the countries envisaging accession in 2004 are functioning market economies. The E.U. Commission, in its recent report, also expects them to be able to cope with competitive pressures and market forces within the E.U. in the short term; and (3) the "ability to accept the obligations of membership, including adherence to the aims of political unification, as well as Economic and Monetary Union. The E.U. Commission recognizes substantial progress in candidate countries towards the adoption, implementation and enforcement of the "acquis communautaire" – the Community's legislation. The Copenhagen criteria define the common ground for the future European Union.
Accession to the European Monetary Union is conditional on a "high degree of sustainable convergence" as specified in the Maastricht criteria. It stipulates nominal convergence of inflation rates, sound public finances, long-term interest rates and exchange rate stability. Candidates may join the EMU two years after E.U. accession at the earliest, since they have to spend at least two years in the European Exchange Rate Mechanism prior to entering the euro area.
Discrepancies between the candidate countries and the present E.U. member states are more pronounced than they were in the previous three rounds of enlargement. The wealth gap between the current member states and the accession candidates is large. The per capita GDP is only 44 percent of the E.U. average. Furthermore, even across the candidate countries themselves, the gulf in per capita GDP is wide.
Before the E.U. can add the eastern region, a lot of political work needs to be done, not only by the candidate countries, but also by the E.U and EMU countries. It has to reshape its institutions to be able to cope with the membership which, in less than two years' time, could number 25 countries.
The accession countries already participate in the "European Convention." The European Convention is composed of delegates from national parliaments and governments, from the European Commission and from the European Parliament. Since February the delegates have been working to revamp the soon-to-be-enlarged E.U. 50 years after its foundation. The E.U.'s structure and institutions will be adapted to make it function more smoothly and to streamline its decision-making process. Even the establishment of a truly European constitution is now under consideration.
Integration and enlargement were the grand themes in Europe at the turn of the century. Germany has long been a proponent of both. Our own history has taught us how valuable a free Europe, united in peace and prosperity, truly is. This achievement came not least with the help of the U.S. right after WWII, and again when the window of opportunity for reunification opened in 1989.
Recently, Germany is increasingly being portrayed as compromising prosperity by its unwillingness to reform. However, more and more people are aware that there is no dodging reforms in Germany any longer. Our new government is basically our old government. I believe that it has learned some lessons from recent experience. That means we can be confident that we will see a new stretch of reforms soon. The "to do" list is well known. I would like the new government to focus on three areas:
The number one task is to overcome remaining resistance to reform. Germans tend to be fascinated with the downside. The government must make it clear that reforms are an opportunity rather than an inevitable evil.
Then there is the fiscal plight. We need to reduce public spending, taxes, and the public sector financial deficit at the same time. Only then will our children be in a position to cope with the costs of our aging society.
The third task is to reform the labor market. For starters, there is the proposal put forward by a committee chaired by Peter Hartz, human resources manager at the Volkswagen Group. Its aim is to make the employment agencies more efficient. The proposal is already being put into practice. Furthermore, the education system should be overhauled so that the qualification mismatch between labor supply and labor demand can be reduced. The success of any labor market reform hinges crucially on making the labor market a true market again, where supply and demand are balanced by the price mechanism.
Strengthening competition and making the macro economy more flexible will help to generate economic growth, which in turn will help to ease the strains on the budget and on the labor market.
True, Germany is now a bit of a laggard in Europe—but remember reunification. Today's Germany is the economic powerhouse formerly known as "West Germany" plus a transformation country formerly known as "East Germany" If you adjust the German figures for the difficulties of the transformation process in the eastern part of Germany, we are par for the course in Europe. Par for the course is not enough, but once transformation approaches the finish line and reforms are undertaken, Germany will be returned to the top of the European league.
Ladies and gentlemen, the world economy is in the grip of post-bubble economic blues. Political uncertainty has grown worldwide in the wake of September 11. The pace of change in the world has accelerated. Change may be both an opportunity and a danger. A certain degree of stability is crucial in this respect—stability in the world economy and its financial markets, but also stability in transatlantic relations. Good transatlantic relations are invaluable in a changing world.
The ups and downs of politics have recently put some strains on transatlantic relations. Fortunately, the good relationship between Americans and Germans can withstand these strains. Businesses on both sides of the Atlantic have established close trade and financial relations—to our mutual benefit. These strong personal ties made the horror of last year's attack on America only more concrete. Transatlantic relations are so resilient because we share common values. These shared values are the strongest possible foundation for a lasting friendship.
Thank you very much.