“It is in the nature of beginning that something new is started which cannot be expected from what may have happened before. This character of startling unexpectedness is inherent in all beginnings.” – Hannah Arendt, The Human Condition, 1958.
January 1st, 1999 marked the beginning of the euro area. The euro became the single currency for more than 300 million people, living in eleven countries, speaking different languages, characterised by different historical memories, traditions, customs, habits, behaviour patterns, cultures and institutions. The introduction of the euro ten years ago is a defining moment in the history of European monetary, financial, economic and political integration. It was an event of world significance.
Meanwhile, the process of enlargement of the euro area is on-going. Of the ten member states that joined with the fifth enlargement, four have already joined the euro area, with Slovakia – which will join the euro area on 1 January 2009 - being the first member from the former Soviet bloc.
The euro area was designed to become an area of macroeconomic stability. It provides a coherent framework for stability-oriented macroeconomic policies. The institutional set-up of the Maastricht Treaty is centred around a single monetary policy, assigned to an independent central bank – the European Central Bank – with the primary objective of maintaining price stability over the medium term, and national but coordinated economic policies, most notably rules aimed at ensuring budgetary discipline. Stability-oriented macroeconomic policies, in conjunction with open market economies with free competition, were considered to provide the best environment for sustainable growth and development.
Nevertheless, in the beginning, success could not be taken for granted. Otmar Issing1 conveys the message most vividly:
"As a central banker involved in monetary policy making, I have been dealing with uncertainty and its consequences for a large part of my professional life. From my experience as a member of the Board of the Bundesbank, I have vivid memories of the challenges posed by German reunification and the turbulence surrounding ERM crises. But never have I felt the impact of uncertainty as acutely as in the weeks that preceded and followed the introduction of the euro and the birth of the single monetary policy. (...) when the Governing Council made its final announcement on the monetary policy strategy and was getting ready for the Changeover Weekend, the uncertainty was at its peak. Nothing could be taken for granted, no matter how careful the preparatory work had been."
The text transmits the "startling unexpectedness of all beginnings," to use the words of Hannah Arendt. But the challenges involved in the creation of the euro area went well beyond the irrevocable fixing of the exchanges rates. It is important to insist that the euro area is characterised by an unprecedented institutional architecture. The single monetary policy and the European Central Bank interact with a large number of EU Member States, with their own competences in the areas of economic and fiscal policies. The relation between the single monetary policy and the multiplicity of economic and budgetary policies constitutes a novel feature of the euro area. Elements of tension could not be excluded – and did actually occur occasionally. Many other questions loomed large at the beginning. For example, would the transition from eleven national currencies to the euro proceed smoothly? Would the single monetary policy be perceived as credible? Would the fiscal rules – embodied in the Stability and Growth Pact – ensure budgetary discipline? Would the institutional architecture of the euro area prove flexible enough to withstand the pressure of unforeseen change? Would a monetary union be sustainable in the absence of a political union?
After 10 years, it is clear that the conduct of monetary policy has been successful.
A decade of success
During the first decade, inflation in the euro area was, on average, close to but not below 2%, as the definition of price stability by the Governing Council prescribes. Specifically, excluding 1999 (on the ground that given transmission lags the ECB could not be held responsible for the outcome) inflation averaged 2.2% over the period. However, the deviation can be attributed to unforeseen (and sizeable) oil and commodities price developments. Excluding energy and unprocessed food prices, the average inflation rate would have been 1.8%. Perhaps more importantly the ECB has maintained well-anchored inflation expectations. Moreover, expectations have been largely unaffected by temporary price developments, that, unavoidably, affected both headline inflation and short-term inflation forecasts2. The degree of credibility of the ECB is particularly remarkable given that it was, at the beginning, a new institution without a track record. Although the cash changeover, in January 2002, is estimated to have led to a temporarily higher inflation by 0.3% and created disconnect between inflation and inflation expectations, such misperception did not affect public trust on the ability of the ECB to deliver price stability.
Clearly the success of the euro area goes beyond price stability3. During the last decade, all nominal variables have displayed remarkable stability compared with previous decades (including, for example, short-term and long-term interest rates which have been low and stable). At the same time, volatility of real variables, like output, has also moderated. Although real GDP growth average has remained virtually unchanged at slightly more than 2%, during the period since 1999, more than 18 million jobs have been created (much more than in the previous decade): while it would be incorrect to attribute job creation mainly to the euro, the environment of macroeconomic stability and the ensuing labour market reforms in the run-up to EMU contributed to making the labour market more flexible4. Monetary unification has also been associated with important integration dynamics. Those relate to increased trade and financial integration. They derive from "One Money, One Market" mutually reinforcing virtuous circles.5
One of the acid tests for the macroeconomic architecture of the EMU was the interplay between the single monetary policy and decentralised fiscal policies. Would the removal of the 'carrot' of euro area entry lead to opportunistic fiscal policies especially in traditionally undisciplined countries? Or, would the implementation of the Stability and Growth Pact imply a suboptimal degree of fiscal stabilisation? Neither fear was realised. Public sector budget deficits fell to a record low of 0.6% of GDP in 2007. This compares well with averages of close to 4% in the 80s and 90s. Fiscal discipline improved in particular after the reform of the Stability and Growth Pact in 2005, which strengthened the political ownership of EMU's budgetary rules. This went hand-in-hand with a correction of the pro-cyclical fiscal behaviour that traditionally affects EU countries. Indeed, the room for manoeuvre created in many countries in the past several years will allow fiscal policy to play an expansionary role in the current economic crisis.
The current challenge
Most observers deem the euro a resounding success. However, in doing so, they often forget the magnitude of the original challenge. In this short article, we tried to look at the first decade of the euro area going back to its beginnings.
The story is not over. Significant challenges lie ahead. As we write the world is living a financial and economic crisis of truly global proportions. For the euro area, the global crisis brings into sharp focus the challenges of maintaining macroeconomic stability and financial stability.
During the crisis, the role of the ECB and the Eurosystem in managing liquidity has been very visible. Liquidity management strived to maintain orderly market conditions in money markets and more broadly to contribute to orderly market conditions. It aimed, at the same time, to mitigate financial stability risks and disturbances. By doing so, it has muted the effects on economic activity. Participation in the euro area also contributed to insulating participating countries from some adverse effects that the crisis might otherwise have had on their economies.
The financial and economic crisis is leading to unprecedented co-operation and co-ordination at European and at global levels. One particularly telling example is the cooperation between the Federal Reserve, the ECB, and other major central banks to manage liquidity provision globally. However, it is also clear that the crisis made apparent the need to enhance co-operation and surveillance at the European and at the global level. One important example is the need to strengthen co-operation between supervisory authorities responsible for large cross-border financial institutions. Crisis prevention – including the overall framework of regulation and supervision – and crisis management are also sharply in focus.
At this time, the US has been declared in recession, since December 2007, the euro area has already recorded two consecutive quarters negative growth, and the slowdown in economic activity is spreading globally. It is a unique, unprecedented historical development. Uncertainty is unusually high. Clearly, the crisis constitutes a major challenge for the euro area. The first decade was truly a decade in between two major challenges. It is worth remembering the magnitude of the original challenge in order to use the crisis as an opportunity to strengthen governance at the European and global level. It has often been the case that crisis and uncertainty broke free from the resistances of the past and begat the wonders of the unexpected new.
1 Otmar Issing, "Monetary Policy of the ECB in a World of Uncertainty" contribution to the policy panel at the ECB, CFS Conference "Monetary Policy Making Under Uncertainty", Frankfrut am Main, December 3-4 1999. For a complete account of the start of the euro area see Otmar Issing The Birth of the Euro Cambridge: Cambridge University Press, 2008.
2 The important issue of anchoring inflation and inflation expectations is discussed in detail in the contributions by Petra Geraats, Manfred Neumann and Frank Smets to M. Buti, S. Deroose, V. Gaspar and J. Nogueira Martins (eds.), Euro: The First Decade, Cambridge: Cambridge University Press, forthcoming. The crucial importance of credibility was one of the important lessons from the experience of the Great Inflation. See also Andreas Beyer, Vitor Gaspar, Christina Geberding and Otmar Issing, Opting Out of the Great Inflation: German Monetary Policy After the Break Down of Bretton Woods, NBER Working Paper 14596, December 2008.
3 For a comprehensive assessment of the first decade of the euro, see European Commission EMU@10: Successes and Challenges After Ten Years of Monetary Union.
4 As shown by Marco Buti, Werner Roeger and Alessandro Turrini in "Is Lisbon Far from Maastricht? Trade-offs and Complementarities between Fiscal Discipline and Structural Reforms" (CES-Ifo Economic Staudies, forthcoming), the tightening of the fiscal rules after the launch of the second phase of EMU in 1993 – culminated in the adoption of the Stability and Growth Pact in 1997 – boosted the incentives to adopt labour market reforms for electorally motivated governments.
5 See contributions to M. Buti, S. Deroose, V. Gaspar and J. Nogueira Martins (eds.), Euro: The First Decade, Cambridge: Cambridge University Press, forthcoming. Francesco Paolo Mongelli, "The OCA Theory and the Path to the EMU" provides a critical overview of the argument.