Европейская денежная система

БОЛЬШАЯ ЛЕНИНГРАДСКАЯ БИБЛИОТЕКА - РЕФЕРАТЫ - Европейская денежная система

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 ‚[pic]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 DX

:>48@>2:0 ?;5=:8T- -#"+ !-+ 1999\DXCODE.HTof 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

-#"+ !-+ 1999\DRAFT SYLLABUS FOR THE CLASummary 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

1999\GERMAN COFFEE COMPANY ORGANIZES THE PROMOTION CAMPAIGN IN

ST.DOCЦюй±%€ѕ[pic]

А- -#"+ !-+ 1999\GERMhonorary 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

#"+ !-+ 1999\EVALUATION DER BEITRAEGE AUS JUNI99.DOC¤АјXї[pic][pic]?- -#"+

!-+ 1999\EVALUATION DER Bйtat 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 ri"+ !-+ 1999\MAYOR99.DOC†[?]р?p-

-#"+ !-+ 1999\INDUSTRIAL MARKETING.DOC?[?]р?x- -#"+ !-se 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. In 1999\SCHD-MAY.DOCf[pic]1 T-

-#"+ !-+ 1999\PROT10.DOCfter-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 Z- -#"+ !-+

1999\SEATSCASE.DOCh[?]€б@[?]Rreference 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 MESTER PROGRAM OF

MARKETING WEEK AT.DOCl[pic][?]\- -#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 PROGRAM

99.DOC[pic][pic]&Microsoft Word 8.0

аto 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

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