Governance of the euro zone

9 October 2007

Jean-Claude Trichet, President of the European Central Bank (ECB), reminded the audience that the euro area is made up of 13 countries and 317 million people, increasing to 15 countries and 320 million inhabitants at the beginning of next year. This makes it comparable with the US, the world’s only other industrialised economy of a similar size.

Sound economic management is essential to manage such a vast currency area, with its inevitable economic diversity, said Mr Trichet. The euro zone encompasses countries with differing demographic trends and productivity growth rates but, despite this, “inflation dispersal” in the zone has declined considerably from the 6 percentage point level of the 1980s and 1990s to just 1 percentage point now - putting it on a par with the US.

Output growth differentials in the euro area have also remained broadly stable, with the average “dispersion” of annual real GDP growth between 1999 and 2006 standing at around 2%. This compares favourably with the current 2.5% dispersal rate across all 50 US states, but less well with a 1.5% rate across its eight statistical regions.

However, one area of concern in the euro zone is the persistently high level of differing growth outputs in euro-area countries, particularly compared to the US. While there is now a stronger common euro-area cycle, with member countries reacting in similar ways to outside shocks, such as the end of the boom, differences in growth trends remain.

The changes in costs and price competitiveness between countries, mainly reflect changes in unit labour costs and persistent inflation differentials. Between 1999 and 2006, there was a 20-25% difference in the cumulative growth of unit labour costs between those with the largest and smallest increases.

Mr Trichet believed that this was justified in countries still involved in a “catching-up” process, such as Germany after re-unification, but not in other countries such as the Netherlands, which were losing out because their labour market policies were insufficiently flexible.

Maintaining stability is crucial

The ECB President stressed that it is crucial to maintain economic stability, and said the EU’s Stability and Growth Pact (SGP), is a “prerequisite for sound economic policies”.

He reminded the audience that the single currency had been criticised for “putting the cart before the horse”, since the euro zone did not have a federal political system, as in the US, to help individual countries resist “asymmetric shocks”. However, he said the SGP performs this function in the euro zone by ensuring that no member country can impose a burden on others because of “bad fiscal behaviour”.

Sound fiscal policies create the necessary conditions for flexibility within economic cycles, cushioning the effects through automatic stabilisers. Mr Trichet said the SGP gave the euro area “three cartridges of 1% of GDP” which could be “fired when necessary”. It also operates as the “political branch” of EMU – the E – because of the possibility of imposing sanctions on countries which breach its terms.

The single market is the second important principle of sound economic management. It helps to ensure that the single currency operates smoothly, and, conversely, the euro in the drive to achieve a genuine single market. However, there is “still work to do” in this area, as the services sector (which represents 70% of euro area GDP) is “far from being fully integrated”, and national financial markets also need to be fully integrated, as this could play a decisive role in absorbing shocks.

Mr Trichet said the third principle is the need to monitor closely the implementation of structural reform in all markets, as annual progress in improving labour productivity plays a key role in achieving growth. Reasons for disappointing levels of growth potential include insufficient flexibility, excessive labour market regulation and imperfect competition.

All euro area countries could benefit from structural reforms, said Mr Trichet. These would increase productivity, create new jobs, and achieve lower prices and higher real incomes while taking into account the appropriate levels of social protection in each country.

The Lisbon Strategy has highlighted the major areas where changes are needed. These include innovation and education “of excellence”, where there is still a lot of work to do, said Mr Trichet, particularly given the discrepancy between the funds spent and those required by science and technology sector. He believed “benchmarking” would help to identify what initiatives had been successful and pinpoint where reforms are needed.

The last principle for sound economic management is to monitor national competitiveness and unit labour market costs, said Mr Trichet. While some dispersion and differentials among euro-area countries are to be expected, governments and social partners must act to address “excessive wage developments” and strengthen productivity growth. There is also a need to examine public spending as a percentage of GDP, highlighting the “enormous differences” between countries.

Mr Trichet concluded by saying that if, at the beginning of 1998, he had predicted that after just eight and a half years, the single currency would be “credible and confidence-inspiring” and have created 15 million jobs, this would have seemed far too optimistic. But this is what had happened.