ECB's success proves sceptics wrong

The European Central Bank is key to a flourishing euro zone 10 years after its foundation, writes ALAN AHEARNE.

TEN YEARS ago this weekend, European Union leaders established the European Central Bank (ECB) - part of their decision to push ahead with the final stage of monetary union and create a single currency for Europe, the euro.

At the time, there was much scepticism among academics about whether a group of very different economies could form a sustainable currency union.

People in Germany were especially apprehensive, as they were about to abandon their cherished D-mark to share a currency with inflation-prone countries such as Italy, Portugal, and Spain. Financial markets were worried about possible technical glitches on the euro's first day of trading.

In the event, the launch of Economic and Monetary Union (EMU) on January 1st, 1999, was remarkably smooth. Since then, the euro zone has expanded from 11 to 15 members. There are many countries wishing to join the euro zone and none seeking to leave.

On many important dimensions, the single currency's first decade has been remarkably successful. Inflation in the euro zone has been low and stable over most of the past decade. Until recently, inflation fluctuated within a narrow band of between 1.5 per cent and 2.5 per cent, generally in line with the ECB's target.

The newly created ECB quickly gained credibility as an inflation fighter and its success in anchoring expectations of inflation has helped to bring down interest rates to their lowest levels in a generation.

The ECB has proved more pragmatic than many of its critics had feared. In particular, it deserves much praise for responding aggressively to recent events in credit markets by providing large amounts of liquidity to the banking system.

These achievements have boosted the euro's status as a major international currency. A quarter of global foreign exchange reserves are today denominated in euro, and the euro is widely used in many central and eastern European countries. Some economists believe that the currency will overtake the dollar as the world's dominant reserve currency in the next 10 years.

Though the euro initially weakened on foreign exchange markets, it has since rebounded very strongly. It has contributed to economic integration in Europe. This is especially true for financial markets, such as the money market and to a somewhat lesser extent the markets for bonds and equities. Arguably, the common currency has also boosted trade flows between member states.

Along with these successes, however, have come disappointments.

EU leaders had hoped that the creation of the single currency would provide a boost to economic growth in Europe. The loss of the exchange rate instrument to respond to shocks at the national level was expected to increase the incentive to carry out much-needed economic reforms.

Instead, the euro so far appears to have insulated member economies from acute crises. In fact, some economists argue that monetary union may actually have slowed the pace of reform.

As a result, the euro zone's average growth performance has been disappointing. GDP growth per head averaged about 1.5 per cent over the past decade, down from 2 per cent during the 1990s. Growth rates in the three largest euro-zone countries - France, Germany, and Italy - were well below that in the United States, notwithstanding the recent pick-up in German growth.

The euro zone scores poorly in terms of labour utilisation and productivity growth compared to other developed regions of the world. Employment in the euro zone has begun to move up recently, but it still lags behind other advanced economies, and these gains have been obtained at the expense of productivity growth. The euro zone seems to be confronted with a trade-off whereby it only succeeds in increasing employment when productivity growth is slow and vice versa. This is especially true for the larger member states that have dragged down growth in labour productivity.

Fiscal discipline has been another area of disappointment. Several countries, notably France and Italy, have recorded persistently large fiscal deficits since 1999. Germany's fiscal performance was poor until its recent dramatic improvement.

Moreover, the aggregate budgetary policy of the euro zone has been pro-cyclical. Fiscal policy has therefore exacerbated the fluctuations in economic growth over the past decade. In addition, fiscal policy at the individual country level has generally not responded appropriately to country-specific shocks. In several member states, fiscal policy has added to inflationary pressure and has contributed to deterioration in competitiveness.

Another set of concerns relates to the large divergences in inflation that have emerged across member states. Of course, to the extent that inflation differentials reflect the catching-up process, they are desirable. But some of the developments in wages and prices in countries such as Ireland and Spain that have experienced housing booms and busts probably owe more to inappropriately low interest rates than to shifts in economic fundamentals. EMU's one-size-fits-all monetary policy may be severely tested over coming years as these imbalances unwind.

Alan Ahearne is an economist at NUI Galway.