Europe and the euro 20 years on
Speech by Mario Draghi, President of the ECB, at Laurea Honoris Causa in Economics by University of Sant'Anna, Pisa, 15 December 2018
Next month, we will celebrate the 20th anniversary of the launch of the euro.
The two decades in which the euro has existed have perhaps been exceptional. The first was the culmination of a 30-year upswing in the global financial cycle, while the second saw the worst economic and financial crisis since the 1930s. But, exceptional as they were, these two periods can teach us some useful lessons about what still needs to be done.
Monetary Union has succeeded in many ways, but it has not delivered the gains that were expected in all countries. This is partly the result of domestic policy choices and partly the result of Monetary Union being incomplete, which led to insufficient stabilisation during the crisis.
The way ahead, therefore, is to identify the changes that are necessary to make our Monetary Union work for the benefit of all member countries.
We need to make these changes as soon as possible, but we also need to explain why they are important to the people of Europe.
The rationale for one market, one money
The Single Market is often seen simply as an expression of the globalisation process, which over time has even eliminated exchange rate flexibility. But the Single Market and globalisation are not the same thing.
Globalisation has led to higher overall welfare for all economies, and for emerging markets in particular. But it is now clear that the rules that accompanied this process were not sufficient to prevent it from causing severe distortions. Open markets have heightened economic insecurity for people exposed to intensified competition, and added to their sense of being “left behind” in a world where the great wealth created has been concentrated in a few hands.
From the outset, however, the Single Market was designed to reap the benefits of openness while also tempering its costs for the most vulnerable; to promote growth while protecting the people of Europe from the injustices of untrammelled free markets. This was undoubtedly also the vision of Jacques Delors, the architect of the Single Market.
The Single Market was conceived during a period of weakness in the European economy. Annual growth had averaged just 2.2% from 1973 until 1985 in the 12 countries that would go on to form the euro area1, down from 5.3% between 1960 and 1973. Growth potential had also fallen from about 5% per year at the beginning of the 1970s to around 2% per year by the beginning of the following decade.
The typical response of governments to low growth was to increase fiscal deficits. From 1973 to 1985, public deficits in the euro area 12 averaged 3.5% of GDP, while in Italy the average was 9% of GDP. Unemployment rose from 2.6% in 1973 to 9.2% in 1985 for the euro area 12. In Italy, it climbed from 5.9% to 8.2% over the same period.
But the EU had a powerful tool at its disposal to raise growth: the common market.
One reason that growth potential had decelerated was that intra-EU trade growth had stalled in the early 1970s, because the common market covered mainly intermediate goods where growth was already saturated. Trade in sectors with high R&D and skill content was restricted by non-tariff barriers, preventing productivity spillovers.2
The Single Market offered a way to remove these barriers, reverse the decline in economic potential, and bring more people back into work.
Yet the Single Market was never just about this. It also aimed to protect people from some of the costs of the changes that would inevitably arise. This, in turn, would create a more favourable political environment for advancing the process of European integration, following the setbacks of the 1970s.
Unlike the wider process of globalisation, the Single Market allowed Europe to impose its values on economic integration – to build a market that, to the extent possible, was free but just. Product rules could be used to protect consumers from lax standards in other countries, and protect producers from unfair competition. And production rules could be used to protect workers by putting a floor on “social dumping” and upholding labour standards.
This is why the launch of the Single Market agenda in the mid-1980s went hand in hand with a strengthening of common rule-making in the EU and of powers of judicial review. The opening of markets was accompanied by the creation of a strong European authority to safeguard fair competition; product standards became tighter, with the introduction of the geographical indication protections for specific foods, for example. And safeguards central to the European social model were progressively embedded in EU law, in areas where the EU had the power to act.
The Charter of Fundamental Rights has prevented a “race to the bottom” in terms of workers’ rights. Legislation was adopted to curtail unfair labour practices, such as the revision of the Posted Workers Directive this year. EU legislation also protects those in less secure employment. One example is the Directive on part-time work in 1997, which sought equal treatment for part-time and fixed-term employees. Last year the EU institutions endorsed the European Pillar of Social Rights to support equal opportunities and access to the labour market, fair working conditions, social protection and inclusion.
EU legislation has not led to a complete harmonisation of labour protections across Europe. But it has meant that the gap in labour standards across countries has gradually narrowed, even as lower-income countries have joined the EU. Research finds a process of upward convergence in significant areas of social expenditure in the EU since 1980, although this has tailed off in recent years.3 The same cannot be said at the international level.
But the Single Market required greater exchange rate stability than a free trade area, and this resulted in significant trade-offs for economic policy. These were well-articulated by Tommaso Padoa-Schioppa in his famous “inconsistent quartet”.4 If European countries wanted to have the benefits of managed open trade, they could not simultaneously have capital mobility, independent monetary policy and fixed exchange rates.
Governments initially responded to this conundrum by maintaining fixed exchange rates and introducing capital controls on short-term flows, which allowed a degree of monetary policy autonomy. But as financial integration deepened and capital controls were progressively eliminated during the 1980s, fixed exchange rates became unsustainable.
Due to the international financial storms raging at the time, the countries that had pegged their currencies to the Deutsche Mark (DM) within the European Monetary System (EMS) had to periodically decide either to maintain an independent monetary policy and devalue, or to maintain parity with the DM and lose any sovereignty over their monetary policy.
Given the frequency with which policymakers had to make these decisions, some countries lost both the benefits of exchange-rate stability and their monetary policy independence. The social costs were high. This process came to an end with the ERM crisis in 1992-3, when it ceased to be credible for countries entering a recession to follow German interest rate rises.
At the same time, devaluing repeatedly was becoming incompatible with the deep Single Market that countries were trying to build.
Indeed, the prevailing view on devaluations was captured well by Nobel laureate Robert Mundell, who developed his theory of optimal currency areas in the belief that, “I could not see why countries that were in the process of forming a common market should saddle themselves with a new barrier to trade in the form of uncertainty about exchange rates”.5 Exchange rate flexibility would have undermined the Single Market in two ways.
First, it would have weakened incentives for firms to raise productivity, because they could have lifted competitiveness – if only temporarily – by devaluing rather than increasing output per head.6 Yet Europe had witnessed time and again that such actions did not lead to lasting welfare gains.
From the launch of the EMS in 1979 to the ERM crisis in 1992, the Italian lira was devalued seven times against the DM, losing around half of its value cumulatively vis-à-vis the German currency. Yet average annual productivity growth7 in Italy was lower than in the euro area 12 over this period, Italy’s GDP growth rate was roughly the same as that of its European peers, and its unemployment rate went up by 1.3 percentage points. At the same time, consumer prices in Italy grew cumulatively by 223%, compared with 103% in the euro area 12.8
Second, support for the Single Market would be undermined in the long run if firms that did invest in raising productivity could be deprived of some of the benefits by “beggar-thy-neighbour” behaviour through competitive devaluations in other countries. Open markets would not have lasted.
Europe had experienced the problems created by exchange rate flexibility in the 1960s with the common agricultural market. Absent a single currency, the common agricultural policy was based on prices quoted in units of account. But successive currency crises, in particular a revaluation of the DM and a devaluation of the French franc in 1969, jeopardised trust in the market, as the farmers affected demanded compensation for their losses.
The issue was smoothed over by introducing monetary compensatory amounts to mitigate sudden changes in farm prices caused by abrupt adjustments in exchange rates. But the system proved difficult to implement and sustain as it was virtually impossible to avoid distortions of production and trade, which poisoned intra-Community relations.9
So, faced with an “inconsistent quartet” of policy choices, a single currency provided, at least in principle, a way to resolve them. It would allow countries to maintain stable exchange rates and therefore benefit from openness within the Single Market, while managing as far as possible its costs.
Not all countries that had joined the Single Market also joined the euro, of course. Some countries, such as Denmark, pegged their exchange rates to the euro. For other countries, the Single Market represented the gateway to the euro. Five additional countries10 joined the euro in its first decade and three more in its second, but other smaller economies have stayed out so far.
Finally, there is the United Kingdom, the only large economy inside the Single Market that chose to stay out of the euro area. The United Kingdom is a particular case, not only for political reasons but also for structural reasons, such as the relatively low exchange rate pass-through it had in the past.11
The benefits of one market, one money today
We should consider what gains have been made as a result of having one market with one money.
With the euro protecting the Single Market, trade growth has increased, with intra-EU exports rising from 13% of EU GDP in 1992 to 20% today. Intra-euro area trade has risen both in absolute terms and as a share of total trade with advanced economies12, even as emerging market economies have entered the global market. Foreign direct investment (FDI) flows within Europe have also grown13, with inflows from the rest of the EU to Italy increasing by 36% from 1992 to 2010.14
Behind the growth of intra-EU trade lies perhaps an even more important development, which is the much closer intertwining of European economies through the deepening of value chains. Since the start of the 2000s, supply chain linkages between countries within the EU have intensified at a faster pace and were more resilient during the crisis, compared with their supply chain linkages with countries outside the Single Market.15
The removal of customs barriers as part of the Single Market agenda has facilitated multiple border crossings during the production process. Europe-wide standards have boosted intra-EU value chains by providing more certainty for firms about the quality of production in other countries and encouraging the fragmentation of the production process that is typical of value chains.16 And the single currency has further enhanced the process by eliminating the costs of foreign exchange payments and settlements and of hedging exchange rate risk.
Participation in these value chains has brought gains for all countries, especially in terms of productivity spillovers. The imported inputs used in value chains generate a tangible boost to productivity.17 And higher productivity in turn leads to higher wages. Integration within value chains is associated with an increase in hourly compensation for all skill groups.18
Moreover, integrating into value chains has improved risk-sharing among European countries, since it has allowed the gains (and losses) of trade with the rest of the world to be more evenly spread. Within the EU, close to 20% of export-supported jobs are located in a country other than the one that exports the final product.19
Around half a million Italian workers are involved in the production processes of companies located in other EU countries that export to the rest of the world.20 Italian firms themselves participate strongly in global value chains and this is positively associated with labour productivity.21
It is often this link to value chains that allows in particular the SMEs that are so typical of Italy’s manufacturing sector to survive and grow. In a world that is increasingly dominated by scale, this permits Italy to retain one of its fundamental characteristics. Italy, through the Single Market and the single currency, is deeply integrated into the European production process.
The closer intertwining of European economies has had two significant effects on exchange rate relationships for euro area countries
First, the cost of not being able to devalue within Monetary Union has fallen. ECB analysis finds that misalignments of real effective exchange rates are smaller – albeit more persistent – for euro area countries than those between advanced economies or countries linked by pegged exchange rates, and these misalignments have actually become smaller in the second decade of EMU relative to the first decade.22
At the same time, value chains have blunted the short-run benefits of competitive devaluations.23 Since exports contain a greater share of imports, any boost to external demand associated with a hypothetical devaluation is now offset by higher input costs from imported intermediates. As a result, participation in value chains has been found to reduce the responsiveness of export volumes to movements in the exchange rate.24
So, any country hypothetically looking to devalue to regain competitiveness would have to do so to a much larger extent than was necessary in previous decades. And devaluations of such size would not only threaten the existence of the Single Market. They would also result in a substantial loss of welfare within the country carrying out the devaluation owing to the greater negative impact it would have via higher import prices. And studies on non-EU countries suggest that the welfare loss would be greatest for the poorest in society, since poorer households tend to spend a larger share of their income on tradeable goods than richer households.25 This is also typically the case in euro area countries.
But does being outside the euro provide additional benefits in terms of monetary policy sovereignty? This is not so obvious.
First, the single currency has actually allowed countries to regain monetary sovereignty compared with the fixed exchange rate regimes of the past. Decision-making over monetary policy, which effectively belonged to Germany under the EMS, is now shared among all euro area countries. And the size of euro financial markets has made the euro area less vulnerable to US spillovers, even as global financial integration has accelerated.
Second, it is worth noting that the supposed advantages of monetary sovereignty – such as the ability to engage in monetary financing of government spending – do not appear to be valued highly by countries that are members of the Single Market but not the euro. Such countries have a weighted average public debt of 68% of GDP (44% of GDP if the United Kingdom is excluded), compared with 89% for countries that use the single currency.
In any case, as the history of Italy has shown, monetary financing of government debt did not lead to real long-term benefits.26 In periods where debt monetisation was more common in Italy, such as in the 1970s, maintaining a growth rate similar to its European peers required repeated devaluations. Inflation reached unsustainable levels and hit the most vulnerable in society.
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