Memorandum by Alan Ahearne, Research Fellow,
Jean Pisani-Ferry, Director and André Sapir, Senior Fellow,
Bruegel
Are there any lessons to be drawn from the changes
in euro exchange rates since 1998?
1. During its first two years of existence
the euro displayed considerable weakness in foreign exchange markets,
depreciating nearly 15% on an effective trade-weighted basis between
1999:Q1 and 2000:Q4 (see figure on next page). The surprising
weakness of the common currency during that period threatened
to push up inflation in the euro area, implying higher euro interest
rates. The authorities responded to the drop in the euro by intervening
in foreign exchange markets in late 2000. In the event, the euro
began to recover in early 2001 and has been on a steep upward
path since then. Over recent months, against a backdrop of a pick-up
in economic growth and rising interest rates in the euro area,
the euro has posted sharp gains vis-a"-vis the dollar and
has soared to record highs versus the yen. The euro-pound exchange
rate has remained stable within a relatively narrow range over
the past four years.
2. Ambiguities remain about who is responsible
for exchange rate policy in the euro area. These ambiguities complicated
efforts to coordinate intervention in foreign exchange markets
in autumn 2000. According to the EMU Treaty, responsibility for
exchange rate policy is divided between the Council of Ministers
and the ECB. The Council chooses the exchange rate regime under
certain provisions and subsequently the national central banks
in the euro area carry out the interventions. Article 111 of the
Treaty does give the Council power to "formulate general
orientations for exchange rate policy." These orientations
have not yet been used and it is unclear how the Council might
use this power.
3. The euro's position as an international
currency has been increasing since its launch in 1999, but so
far the euro has posed less of a challenge to the U.S. dollar
as a global currency than observers had expected. The dollar remains
the world's premier invoicing currency, and the vast majority
of foreign-exchange transactions involve the dollar. Moreover,
the bulk of official reserves continue to be held in the form
of dollar assets.
4. A major concern for policymakers in the
euro area is that a disorderly unwinding of global current account
imbalances may lead to an excessive appreciation of the euro.
While the euro might reasonably be expected to strengthen further
against the dollar in the context of global adjustment, further
appreciation of the euro on an effective trade-weighted basis
does not seem justified. It follows that currencies in Asia will
need to appreciate significantly both on an effective basis and
against the euro.
Euro: Nominal Effective Trade-Weighted Exchange Rate
1995: Q1 to 2006: Q4
Was the recent reform of the Stability and Growth
Pact appropriate?
5. Few issues have stirred as much controversy
since the launch of the euro as the Stability and Growth Pact
(SGP). To its supporters the pact is the cornerstone of the rules
governing the single currency, which must be upheld to ensure
monetary stability and economic growth. To its detractors the
pact is "a nuisance", whose strict application is detrimental
to short-term or even long-term economic performance. One reason
why the SGP generated so much controversy was that there is no
consensus over its rationale. In fact, it was designed to address
three main issues: avoiding that fiscal profligacy in one country
spills over into other countries; ensuring sufficient macroeconomic
stabilisation; helping fiscal consolidation in the face of ageing
population. Over time, the third factor has gained clear prominence
and is now often seen as the primary motivation for the SGP.
6. Fiscal consolidation is clearly needed
in many euro area countries to ensure sustainable public finances.
However, it is doubtful whether the SGP is the right instrument
to address this issue and above all whether the electorate's perception
matches the view of their economic authorities. Take the issue
of pensions, which is clearly a primary concern for most European
voters. Most citizens seem to be aware that important reforms
are needed to ensure the sustainability of their pension system.
But very few perceive a link between the SGP and pension reform,
which is normal since the original pact had no reference to public
finance sustainability or pensions.
7. In the mind of the public, the SGP basically
means that government deficits must remain below the 3% limit,
although this obligation was already contained in the Maastricht
Treaty. By contrast, the central tenet of the pact, namely the
requirement to respect "the medium term objective of budgetary
positions of close to balance or in surplus", was never grasped
by the public. The upshot is that fiscal consolidation stalled
as soon as the single currency was adopted, despite the fact that
five of the eleven initial members had actual deficits of around
3% at the launch of the euro, indicating potential problems for
respecting the "close to balance or in surplus" requirement.
Four of these countries had deficits above 3% for several years
after the 2001 economic downturn, which shows that the SGP suffered
from two mutually reinforcing problems: a lack of political ownership
by national authorities and the public; and an absence of a clear
timetable for compliance with the medium-term objective of the
pact.
8. The combination of tough but ill-grounded
and weakly enforced rules that characterised the original pact
was bound to break under the weight of repeated violation by the
four countries, which together account for more than 70% of the
euro area GDP. The question now is whether the revised SGP adopted
in 2005 will fare better than its predecessor. The new SGP is
definitely more flexible than the old one. So the question really
is whether it offers better grounded and more strongly enforced
rules than its ill-fated forerunner.
9. The new SGP is certainly clearer in terms
of rationale. In particular, it now states unambiguously that
its main concern is fiscal consolidation, including pension reforms.
But will the new pact be enforced better than the old one? Enforcement
should be easier now that the pact has a stronger and clearer
economic rationale. But effective enforcement also requires that
national authorities share a sense of ownership towards the rules
of the pact in general and towards fiscal sustainability in particular.
A positive development in this respect has been the change of
German leadership and the determination of Chancellor Merkel to
abide by the German-inspired rules. Her determination seems to
have been noticed by the governments in the other delinquent countries
which have also adopted measures to respect the limit of 3% of
GDP. But the real test of the new SGP will come when the next
downturn occurs.
What effect has the introduction of the euro had
on individual member countries' economic development?
10. In the eyes of its promoters, the single
currency had three main internal economic objectives: to ensure
lasting macroeconomic and especially price stability in participating
countries; to facilitate economic integration within the EU; and,
indirectly, to foster growth.
11. The first objective has by and large
been achieved. Consumer price inflation in the euro area has remained
very close to the "below, but close to 2%" target of
the ECB. Furthermore, long-term price expectations derived from
the market for inflation-indexed bonds are in line with this objective
(see figure on next page). This is a remarkable achievement for
an area composed of countries whose inflation record is far from
homogenous.
12. Two provisos should nevertheless be
added, The first is that throughout the euro area, perceived inflation
differs from measured inflation: Surveys consistently indicate
that households blame the euro for higher inflation. The explanation
is that on the occasion of the changeover in 2002, several service
sectors experienced very significant price hikes. While the corresponding
items do not have a large weight in price indices, they often
correspond to frequent purchases and therefore have a larger weight
in perceptions. This has contributed to a gradual weakening of
popular support for the euro. The second proviso is that price
developments are far from homogenous in the euro area. Inflation
in Spain, Portugal and Ireland has exceeded average euro area
inflation by more than one percentage point per year. While in
the case of Ireland this reflects a catching-up phenomenon, the
same cannot be said of Portugal, nor probably of Spain. The risk
is that sustained divergence in inflation rates will result in
the overvaluation of real exchange rates in certain countries
and as a consequence will require a painful correction process.
13. Economic integration within the euro
area was expected to result from the elimination of exchange rate
uncertainty and transaction costs as well as from increased price
transparency. The corresponding process is by nature long-term
and the full effects of the euro remain to be observed. So far,
only its impact on financial markets has been dramatic. The money
market has become completely integrated and yields on euro-denominated
bonds and other assets of the same class have converged. Furthermore,
the share of bonds and equities of other euro area countries in
national portfolios has risen significantly. Domestic and foreign
investors tend to consider the euro area as a single entity. Only
credit markets remain fragmented, due to regulatory and tax differences
across countries and the very limited extent of cross-border competition
among banks. In the case of trade, nothing of this magnitude can
be observed, yet careful evaluations suggest that the single currency
has already increased trade within the euro area by about 10%,
certainly much less than some analysts had expected but nevertheless
a non-trivial effect. Labour markets, however, remain as fragmented
as ever. The process of integration triggered by the euro can
therefore be described as effective, but uneven.
14. The growth effect of the euro has not,
at least not yet, been observed in the area as a whole. Countries
in which convergence came late such as Spain and Portugal have
benefited from the demand effect of the drop in long-term nominal
interest rates, but on the whole the supply-side effects widely
expected from the move to a single currency have not materialised.
Evidence is scant, but if anything the euro does not seem to have
acted as an accelerator of structural reforms. It may even have
had the opposite effect due to the removal of the threat of exchange
rate crises and to the constraints placed on using monetary and
fiscal policy to alleviate the short-term costs of reforms. Here
again, however, it is too early to tell whether the adoption of
the euro will ultimately lead to structural changes.
Market expectations of inflation at various horizons, euro area
Euro area real and nominal yield curves
10 March 2007
10 April 2007
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