SPEECH/06/529

Joaquín Almunia

European Commissioner for Economic and Monetary Affairs

Monetary and Economic Integration –

the EU Experience

Singapore Management University

Singapore, 18 September 2006

Good afternoon
It is a great pleasure to have the opportunity to address such a young and diverse
audience here at the Singapore Management University. What I would like to do
today with you is to talk about monetary and economic integration in the European
Union.
The East Asia region is currently undergoing rapid change with the fast emergence
of China as a manufacturing hub and the increasing trade integration among
countries in the region. History has shown that increasing trade integration leads
sooner or later to calls for exchange rate coordination to avoid competitive
depreciations, and the resulting distortions in competitiveness, disruption of trade
and disruption of production. This is why monetary cooperation has been so
intensively debated during the Annual Meetings of the IMF and of the World Bank,
and why it is likely to be on the agenda of future policy-makers. So I am pleased to
share Europe's experience with the East Asia's current and future intellectual elite.
My speech consists of four parts:
- First, I will give a brief history of economic and monetary unification in Europe.
- Second, I will present an overview of economic policy coordination and policy
making in EMU, Europe's Economic and Monetary Union.
- Third, I will discuss the objectives and achievements of the common monetary
policy implemented by the European Central Bank (ECB).
- Fourth, I will address the importance of sound budgetary polices and the need for
structural reform for a smooth functioning of EMU.
I will then conclude with few words on the lessons from our experience and on
monetary cooperation within East Asia.

1. A Brief History of Economic and Monetary Integration

The Treaty of Rome, which was signed in March 1957, established a customs union
and, later, a common market but made no reference to EMU. Yet, just twelve years
later, European leaders declared their commitment to monetary unification. The
reason for this change was practical rather than ideological. The Bretton Woods
agreement, which had underpinned the post-war international financial system, was
struggling to maintain currency stability by the late 1960s. This instability threatened
to stand in the way of European integration by deterring trade integration and
hindering common policies, such as the Common Agricultural Policy.
Plans to establish EMU by 1980 were soon derailed. The USA's suspension of the
dollar's convertibility into gold in 1971 and the 1973 oil shock frustrated efforts at
exchange rate coordination. Undeterred, European leaders established the
European Monetary System (EMS) in 1979. The EMS was based on a fixed-but-
adjustable-exchange-rate mechanism. There were central parities defined against
the European Currency Unit – a common basket of all the Community’s currencies -
and mutual credit facilities.
The European Monetary System was largely successful, contributing to a significant
reduction in exchange-rate volatility, particularly during the second half of the 1980s.
It also exerted external discipline on economic-policy makers, helping to reduce high
inflation rates in several Member States and promoting economic convergence
within the EEC.

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Supported by this success, European leaders revived the goal of EMU at a historic
meeting in Hanover in 1988. The impetus was provided, in part, by the drive to
complete the Single European Market by 1992. It had become apparent by then that
the full benefits of free movement of goods, services, people and capital, would not
be realised without eliminating the uncertainty and transaction costs associated with
national currencies.
The goal of EMU was formally enshrined in the Maastricht Treaty, which entered
into force in 1993. Given that a high degree of sustainable convergence would be
important for the success of EMU, the Treaty sets out a number of economic
convergence criteria for Member States that want to participate. These concerned
the inflation rate, public finances (relating to deficits and debt), exchange-rate
stability, and long-term interest rates. A high degree of political commitment by
Member States and fortuitous economic conditions led to a remarkable degree of
convergence in the European Union during the 1990s.
In May 1998, European leaders decided that eleven Member States, namely,
Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, The Netherlands,
Austria, Portugal and Finland, fulfilled the necessary conditions for the adoption of
the single currency. These Member States adopted the euro on 1 January 1999,
and the European Central Bank assumed control of euro-area monetary policy.
Greece joined the euro area in January 2001 and participated with the eleven other
Member States in the historic changeover to euro notes and coins on the 1st of
January 2002.
The history of EMU continues to unfold. Of the 10 Member States that joined the EU
in May 2004, seven – Cyprus, Estonia, Latvia, Lithuania, Malta, Slovakia, and
Slovenia – are in the Exchange Rate Mechanism II, which fosters exchange-rate
stability vis-à-vis the euro.
Earlier this year, the Commission concluded that Slovenia, one of the 10 new
Member States that joined the EU just over two years ago, had achieved a high
degree of sustainable convergence with respect to all Maastricht criteria and will
become the thirteenth Member State to join the euro area on 1 January 2007. In the
coming years, more countries are expected to join, once the necessary economic
conditions are met.

2. Economic policy coordination and policy making in EMU

Now let me turn to the second part of my speech: economic policy coordination and
policy making in EMU. A high degree of policy coordination is an important
condition for the success of an economic and monetary union.
So within EMU there is a lot of interaction between the different policy actors in the
EU, including fiscal authorities, monetary authorities and the Commission. In these
interactions there is a wide spectrum of coordination methods ranging from
information exchange, discussion of best practices, policy dialogue, commonly
agreed policy rules and objectives, and peer review, up to, in some cases, jointly
determined actions.
Considerations of spillovers, common goods provision and subsidiarity are reflected
in the current practice of economic policy coordination in EMU. Policy areas that
have strong spillovers or common good characteristics are subject to stronger forms
of coordination.

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In the macroeconomic sphere the euro-area has a single monetary policy and a
single exchange rate policy. Fiscal policies are in principle determined by the
Member States. However, as sound fiscal policies are essential for the success of a
single monetary policy, there are restrictions on the size of public deficits and debt
and there is close surveillance of Member States' budgetary positions.
In the microeconomic sphere, there is a single EU competition policy. Internal
market policies as well as the main aspects of financial market integration are
subject to hard coordination. In contrast, labour market policies and social policies
are a national responsibility but some so-called “soft” coordination of employment
policies takes place. An important coordination instrument for the EU is the
Integrated Guidelines package which gives the Member States policy advice on a
range of macroeconomic and microeconomic policy issues.

3. Monetary policy
Now I come to the third part of my speech where I want to examine the objectives
and the achievements of monetary policy been under EMU.
It is widely accepted that preserving price stability is the best way for a Central Bank
to contribute to higher growth over the longer run. There are several strong
arguments why low inflation is beneficial for long-term growth.
Firstly, price stability allows households and firms to make better informed
consumption and investment decisions. Secondly, it lowers the risk premium on
assets, thus improving the efficiency of capital markets. Thirdly, it reduces the need
for households and firms to hedge against inflation. Empirical evidence from
European countries confirms that price stability is conducive to growth.
Hence, the designers of EMU built upon the prevailing consensus that the best way
to get low inflation is by creating an independent central bank and assigning it the
primary objective of price stability. The EU Treaty created an independent
European Central Bank (the ECB), thereby following a practice that is widespread in
the industrialised world.
The ECB's objective has been to preserve price stability which is defined as keeping
inflation "below but close to 2 per cent over the medium term". This definition is
important for a number of reasons and I will highlight two. The first is that, it helps to
anchor the expectations of economic agents. Thanks to its high degree of policy
credibility, the ECB has been able to keep inflation expectations low and stable
since the start of EMU, while interest rates have been low and supportive of growth.
The second reason is that there is a need to maintain a sufficient safety margin
against deflation as consumer price indices tend to overestimate inflation.
One of the main achievements of EMU, and of the convergence process that
preceded it, has been to provide macroeconomic stability. An impressive degree
of budgetary consolidation was achieved in the run-up to the launch of the euro. On
average, public finance deficits fell by more than 5% of GDP during the 1993-1998
period. The run-up to the launch of the Euro also saw a significant reduction in
inflation rates, from an average of over 4% in 1991 (and with some countries having
inflation rates of more than 10%) to 1.5% in 1998.

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During the first seven years of the Euro’s existence, inflation expectations have
been remarkably stable and within the ECB’s price-stability definition. Long-term
rates have also fallen dramatically and some countries experienced a very
significant compression of the interest rate spread with the creation of the euro. As a
consequence, the servicing of the public debt has become a lot lighter. These
achievements reflect the high credibility of the ECB’s monetary strategy. This is a
major success given that the ECB started out as a new central bank without any
track record.
A second key achievement of EMU is, of course, the elimination of the exchange
rate risk within the euro area. This was indeed the main reason for creating the
euro. The elimination of intra-EMU exchange-rate changes has significantly reduced
transaction costs for cross-border activities in the euro area, paving the way for an
increase in trade and investment. Between 1998 and now, trade among EMU
members has increased at significantly higher annual rates than the trade between
EMU members and the other members of the EU.
There is also empirical evidence that the euro has boosted the attractiveness of the
euro area as a destination for foreign direct investment.
The last success of the euro - I would like to highlight - is its increased international
role. After its launch on the 1st of January 1999, the euro area rapidly established
itself as the world’s second leading currency after the US dollar. This is, in part, a
reflection of the relative weight of the euro area in the world economy, but it is also
due to the fact that the euro is underpinned by a sound macroeconomic policy
framework. This framework helps economic agents to have confidence in the euro,
and, consequently, encourages its use as a means of payment, store of value and
unit of account – the three traditional functions of money.

4. Fiscal policy and structural reform

In addition to its supranational monetary policy, EMU entails a close coordination of
Member States' budgetary policies and a concerted effort to promote structural
reforms.
The Stability and Growth Pact ensures that Member States' budgetary policies are
consistent with the smooth functioning of EMU. It does this by prohibiting budget
deficits in excess of 3% of GDP and by encouraging Member States to pursue
sound budgetary policies over the medium-term. By following this formula, Member
States can ensure that automatic stabilisers can operate relatively freely in response
to economic downturns.
In the medium and long run, the Pact promotes sustainable public finances which
are particularly important in light of our demographic trends. It also favours a
reallocation of public resources towards a more growth-friendly revenue system and
expenditure structure.
The implementation of the Stability and Growth Pact revealed a number of
shortcomings during the first six years of EMU. In particular, we saw quite often
that countries failed to consolidate sufficiently in the upswing, thus not creating
enough room for the automatic stabilisers to work in the downturn. To correct this
situation, EU leaders agreed to revise the Pact in March 2005. This reform struck
the right balance between economic rationale and simplicity, between allowing more
room for economic judgement and maintaining the rigour of the rules-based system.

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Our initial experiences with the revised Pact have been encouraging. Six cases
where countries have breached the rules have been dealt with under the revised
Pact during the last twelve months. In all cases, the response has been to apply the
rules according to the letter and spirit of the Stability and Growth Pact.
Additionally, the Lisbon Strategy promotes structural reforms in European product,
labour and capital markets. As the EU's competence in this field is limited, it
ultimately falls to Member States to implement the reforms. Nevertheless, the EU
has a key role to play by issuing advice to Member States on reform priorities, by
stimulating debate on best practices on reform issues, and by continuously
monitoring their reform efforts.
Let me stress that Structural reforms are essential for the smooth functioning of
EMU and I would like to list three key reasons why.
- Firstly, structural reforms are necessary for achieving higher rates of potential
growth in the euro area. This is paramount given the euro-area's sluggish
recovery from the 2001-2002 slowdown. Structural reforms are also important in
view of Europe's ageing population, which is likely to reduce potential growth to
1.3% between 2031 and 2050 – roughly half its current rate – unless policies
change.
- Secondly, structural reforms can help to promote greater flexibility in product,
capital and labour markets in the face of economic shocks. The first seven
years of EMU suggest that some Member States have been slow to adjust in
this regard, leading to persistent cross-country growth and inflation differences in
the euro area.
- Thirdly, structural reforms are essential for safeguarding Europe's highly valued
social models. Europeans are rightly proud of their social models which have
achieved notable successes in reducing income inequality and poverty and
securing universal access to primary and lower secondary education, basic
health-care systems, and adequate incomes in retirement. To secure these
benefits for current and future generations, structural reforms are essential.
There is, for example, an urgent need to raise the participation rate so that all
people that are able to work would have jobs. Moreover, we have to prepare for
the increased budgetary costs associated with Europe's ageing populations.
There is a growing consensus among economists that EU Member States have
actually implemented a number of structural reforms in recent years which are
beginning to bear fruit. For example, the partial progress achieved in liberalising
gas, electricity and water utilities has contributed to downward pressure on prices. In
addition, these reforms have contributed to an impressive increase in labour
productivity in these sectors. In the labour market, the benefits of reforms to tighten
the eligibility criteria for early retirement are also beginning to materialize. The
participation rate of older workers has increased considerably in recent years in a
number of Member States.
In spite of this progress, the pace of structural reforms needs to be stepped up
to further improve the functioning of European markets. Recognition of this fact was
central to the re-launch of the Lisbon Strategy by EU leaders in March 2005. The
EU's new-look reform agenda identifies a range of priorities for achieving higher
growth and jobs in Europe. It has also invited the individual Member States to draw
up National Reform Programmes for growth and jobs with a view to promoting
greater ownership over reform efforts at the Member State level.

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5. Lessons from EMU
I now come to the final part of my speech, in which I will draw some lessons from
the experience with EMU:
- Monetary integration and economic integration should be seen in relation
to each other. Europe adopted a monetary union when it was recognised that
the full benefits of free movement of goods, services, people and capital would
not be realised without eliminating the exchange-rate uncertainty and transaction
costs of different currencies.
- A fully-fledged economic and monetary union like EMU requires a high degree of
policy coordination in macro and microeconomic policies. It not only involves a
single monetary and exchange-rate policy, but also puts restrictions on the size
of Member States' public deficits and debts to avoid negative spillovers for other
countries. Moreover, single policies or strong forms of coordination are needed
for trade and common market policies.
- A successful monetary union requires an independent central bank that
has the primary objective of price stability. European experience has shown
that this can create macroeconomic stability, eliminate exchange-rate risk and
promote the international use of the common currency.
- To establish sound budgetary policies in the Member States of a monetary union
there is a need for a rigorous rules-based system which also allows room for
economic judgement. Within EMU the reformed Stability and Growth Pact
performs that function.
- Finally, structural reform can help the Member States of a monetary union
to become more resilient to external shocks. Structural reform is key to EMU
because of the low potential growth rate in the euro area and the need to
safeguard the highly-valued social models for current and future generations.
Let me finish with a few words on monetary cooperation in East Asia. Trade
integration in East Asia has increased in recent years, which has raised interest in
possible exchange-rate cooperation. Financial market integration in your region is
considerably lower than trade integration, although there are significant differences
among the various countries. However, I think we would all agree that financial
market integration within East Asia would yield substantial benefits to the region by
improving efficiency and resource allocation and by making it more resilient to
swings in global capital flows. Accordingly, there is much to be gained by lifting
capital controls and promoting currency convertibility in East Asia.
Financial market integration spurs to convergence of interest rates and paves the
way for monetary cooperation. This is important because history has shown that
fixed-but-adjustable exchange rates are prone to speculative attacks if there is not
sufficient economic and political convergence.
The choice is yours, and certainly you will find the model that would best suit East
Asia, your level of economic and political ambitions, and that of the citizens in your
region.
Thank you for your attention.