The First 10 Years of EMU

Niels Bartholdy, Niels Arne Dam and Susanne Hougaard Thamsborg, Economics

INTRODUCTION

In May 1998, it was decided which EU member states were to make up the euro area from the outset. In June, the European Central bank, ECB, was established. On 1 January 1999, 11 EU member states adopted the euro, and since then another four have followed suit. Slovakia's entry on 1 January 2009 will bring the number of euro area member states to 16 out of the 27 EU member states¹.

After approximately 10 years and a full business cycle, it is time for a status report on Economic and Monetary Union, EMU.

At the launch of the euro in 1999, the euro area was experiencing a boom, followed by a surprisingly long period of low growth. The last few years have seen high growth again, which is now slowing down.

The idea behind EMU was to anchor economic stability in Europe. A single monetary policy was to deliver price stability, and the single currency was to eliminate currency unrest among member states. The aim was to create a framework for sustainable growth, while economic policy would otherwise still predominantly be a national matter. The principal decisions on the design and structure of EMU were taken in the period 1988-92 on the basis of the following key factors:

• The experienced benefits of exchange-rate stability in the European Monetary System, EMS, in 1983-92 contrasted sharply with the strong turbulence of the 1970s, when it became clear that exchange-rate adjustments and capital restrictions did not work as intended.
  
• The work to create the single market in the European Community was gaining momentum. This included liberalisation of capital flows as from 1990.
• The reunification of Germany in 1989-90 paved the way for agreement on the EMU project between France and Germany.

Even before the final adoption of the EMU plans, the EMS currency crisis in 1992-93 demonstrated that a broad-based fixed-exchange-rate sys tem, such as the EMS, by no means provided a solid and permanent bul wark against currency unrest. It was also widely believed that it would be increasingly difficult to maintain the fixed-exchange-rate system after the liberalisation of capital flows. EMU was presented as a natural, resili ent extension and expansion of the EMS, only with a common central bank at its heart instead of Deutsche Bundesbank that tended to con sider only the development in Germany in its policy planning².

The ECB's primary objective, modelled on that of Deutsche Bundes bank, is to maintain price stability in the euro area overall. To the extent that this objective is met, the ECB can pursue other objectives, e.g. to stimulate growth and employment by lowering interest rates.

This article looks into the economic development in the euro area in the past 10 years, focusing on inflation, growth, employment, interest rates and the ECB's monetary policy.

The introduction of the single currency has been regarded as an important step towards completion of the single market in the EU, and this article also reviews the progress of financial and trade integration in the euro area in the first 10 years of the euro, and whether inflation and GDP patterns have achieved a higher degree of synchronisation.

ECONOMIC DEVELOPMENT

Inflation
The ECB can be said to have fulfilled its primary objective of price stabil ity. The ECB has defined price stability as HICP inflation of below, but close to 2 per cent.³ The ECB has added that price stability is to be main tained "in the medium term", which is in accordance with the fact that monetary-policy transmission is subject to a certain lag.

Inflation in the euro area member states fell strongly in the years prior to the launch of the euro, when these member states sought to fulfil the convergence criteria for membership, including the criterion of low in flation. Since 1999, inflation has been relatively stable, cf. Chart 1, al though on average slightly higher than the ECB's objective. This is chief ly attributable to oil price hikes in 1999-2000, 2004-05 and especially in 2007-08, when surging food prices also contributed to inflation. As men tioned, the ECB stresses the "medium-term orientation", and the ECB's response to high current inflation depends on whether external im pulses to inflation are assessed to impact e.g. wage formation, which implies second-round effects.

Price stability in the euro area is not only attributable to the ECB's suc cessful monetary policy, but should also be viewed in light of the global trend towards relatively low, stable inflation. Central banks worldwide have successfully focused on anchoring inflation expectations and con ducting credible monetary policy aimed at price stability. In addition, globalisation, including in particular the increased integration of China into the world economy, has promoted lower inflation via import prices.

Globalisation has also contributed to a shift in relative prices, entailing a general increase in the euro area in prices for frequently purchased "local" goods and services, while prices for less frequently purchased "globally traded" durable consumer goods and services have dropped considerably. Households tend to give frequently purchased goods greater weight in their outlook on price developments than the actual weight of these goods in the overall consumer price index. This shift in relative prices – which was particularly evident in the period around the launch of the euro in 1999 – and the rounding up of prices in e.g. res taurants and cafés on introduction of the euro caused many euro area citizens to believe that the introduction of the euro had generally led to strong price increases⁴.

"Perceived inflation" in the euro area member states was, however, considerably higher than actual measured inflation based on a typical basket of consumer goods. The introduction of the euro in the first member states taught the lesson that an intensified effort is called for to avoid unwarranted price increases in connection with other member states' subsequent introduction of the euro, most recently Cyprus and Malta at the beginning of 2008.

Growth and employment
Real-economic development was favourable in the period around the launch of the euro in 1999. The upswing, which had started in 1997 and been temporarily interrupted by the Asian crisis in 1998, lasted until 2000, cf. Chart 2. The period 2001-05 saw relatively low growth in the wake of the bursting of the dotcom bubble that led to plummeting stock prices and a global decline in growth. Germany had previously often played the role of economic locomotive for Europe, but was fur ther burdened by the costs of reunification and the absence of structural reform. An upswing did not set in until 2006. In 2008 to date, growth has declined again. Average annual growth was 2.2 per cent in the first nine years after the launch of the euro, compared with 2.0 per cent in the preceding nine years.

Employment in the euro area rose strongly by approximately 15 million people from 1999 to 2008, compared with approximately 7 million in the preceding nine years. At the same time, unemployment has fallen to just over 7 per cent by mid-2008, compared with approximately 10 per cent at the end of 1998. The combination of strong employment growth and only slightly higher GDP growth after the start of EMU reflects somewhat weak productivity growth in relation to the preceding years.⁵

Development in interest rates
Interest rates in the euro area generally fell substantially in the period up to the launch of the euro in 1999 due to economic convergence among the potential euro area member states. The yield spreads to Germany narrowed for a number of countries. Both short-term money-market interest rates and government bond yields fell in step with lower risk premiums and diminishing inflation expectations, cf. Chart 3. After the introduction of the euro, the 10-year yield rose a little, but it has been stable at around 4 per cent since 2003. Short-term interest rates have mirrored the ECB's interest-rate adjustments in the period.

The ECB's monetary policy
In light of very low inflation and an uncertain growth outlook for the euro area after the financial crises in Asia in 1997 and Russia in 1998, the ECB initially lowered its policy interest rate from 3 per cent to 2.5 per cent in April 1999, cf. Chart 3. This was a very low level by historical standards. Subsequently, the upswing in the euro area gained momen tum, rising oil prices amplified inflationary pressures, and the euro de preciated against other benchmark currencies. Against this background, the ECB initiated a series of interest-rate increases that culminated with the increase to 4.75 per cent in October 2000.

Despite the still relatively high current inflation in early spring 2001, the ECB in May 2001 initiated a number of interest-rate reductions in step with the substantial slowdown in euro area growth. The damp ening of economic activity began in the wake of the global pessimism that had followed the bursting of the dotcom bubble at the end of 2000 and the terrorist attack on the World Trade Center in September 2001. The dampening of growth and the appreciation of the euro in the for eign-exchange market were expected to lead to a gradual decline in inflation. From June 2003 to December 2005, the ECB maintained its policy interest rate at 2 per cent, which was the lowest level in Europe since World War II.

As from the end of 2005, when it became clear that an upswing was again taking off in the euro area, the ECB embarked on a new series of interest-rate increases, initially ending with the increase to 4 per cent in June 2007. The ECB has cited as the background to these interest-rate increases the "withdrawal of monetary accommodation"⁶. This reflects that after the increases, the monetary-policy stance was found to be more neutral. The outbreak of the subprime crisis in the USA in the summer of 2007 gave rise to renewed uncertainty concerning the eco nomic outlook. In July 2008, the policy interest rate was raised again, to 4.25 per cent, with reference to the need to counter second-round ef fects of the high current inflation due to surging oil and food prices.

Exchange rate
In the foreign-exchange markets, the euro weakened in the first few years after its launch, but since then it has strengthened considerably. The euro was traded in Europe for the first time on 4 January 1999 at 1.19 dollars per euro. It depreciated to 0.85 dollar per euro in 2000-01, but has since rebounded to stand at around 1.45 dollars per euro at the beginning of September 2008. In effective terms, i.e. measured in rela tion to major trading partners, the euro has shown a similar pattern. The trend towards strong fluctuations in the euro/dollar exchange rate over time is not a new phenomenon. The D-mark/dollar rate also fluctuated considerably.

ONE SIZE FITS ALL?

In the EMU planning phase it was discussed whether the potential mem ber states constituted an "optimum currency area"⁷. According to the theory of optimum currency areas, the countries needed to meet a num ber of conditions before the benefits of a single currency would exceed the costs. The conditions were close economic integration, cyclical syn chronisation and a high degree of economic flexibility (as regards prices, wages and the mobility of labour and capital). Other sources pointed out that the introduction of a single currency would in itself reinforce closer integration, synchronisation, etc.⁸

The development in integration and cyclical synchronisation in the first 10 years of EMU is reviewed below together with the implications of having a single monetary policy in the euro area despite the persistence of some divergence among the member states.

It should be emphasised that the theory of optimum currency areas probably had little influence in practice on the political decisions on the establishment of and participation in the euro area. The key factor was more likely the idea of the single currency as the natural completion of the single market. The alternative to a fixed-exchange-rate system and a single currency, i.e. floating exchange rates among all EU member states, was never really on the agenda.

Financial and trade integration
Financial integration in particular, but to some extent also trade integra tion has advanced across the euro area member states since the launch of the euro.

Financial integration is important to liquidity in the financial markets and contributes to more efficient monetary-policy transmission across the euro area member states. The introduction of the euro virtually eliminated a number of factors impeding cross-border financial activ ities. These factors included exchange-rate risk, inflation and interest-rate differentials and transaction costs for large-value payments.

As regards the money market, the very high degree of integration has been supported by the ECB's development of a single payment system for large-value payments, i.e. Target and Target2.⁹ Advanced integra tion is also observed in the market for government bonds, as appears from Chart 4 (left), which shows less dispersion, especially for the (uncollateralised) money-market interest rates of the euro area member states, but also for government bond yields, since 1999. Housing and mortgage-credit loans also indicate stronger financial integration, but to a lower degree, cf. Chart 4 (right). As for the equity market and re tail banking, the degree of integration is still low, but on the increase.

All other things being equal, the introduction of the single currency was expected to entail greater trade integration among the partici pating member states as a result of diminished uncertainty concerning returns and exchange-rate gains. According to the ECB's estimate, the growth rate of trade in goods in the euro area member states has in creased by 2-3 percentage points on average¹⁰. Since the introduction of the euro, intra-euro area trade in goods has grown from 25 per cent of GDP to 33 per cent of GDP, cf. Chart 5. A corresponding increase has been observed in extra-euro area trade.

Intra-euro area trade as a ratio of GDP has increased slightly more than the ratios for trade with the euro area for the non-euro area mem ber states Denmark, Sweden and the UK. In the UK especially, trade with the euro area as a ratio of GDP was lower in 2007 than in 1999.

However, it is difficult to make a more accurate assessment of the role of the euro in trade, because it is virtually impossible to distinguish be tween the effects of the single market, the single currency and the general development in global trade.

Synchronisation of business cycles
Increased trade and financial integration can be expected to contribute to cyclical synchronisation¹¹.

As appears from Box 1, cyclical synchronisation among the euro area member states has increased, but took place predominantly in the period up to the introduction of the euro. It has subsequently remained at a relatively high level.¹²

CYCLICAL PATTERNS IN THE EURO AREA	Box 1
The plans to establish EMU led to extensive debate among research economists on the existence of a European business cycle, including the development in the cyclical syn chronisation of the European economies.1 In terms of GDP growth, considerable synchronisation has been observed in the five largest euro area economies over the last decades, although pronounced deviations have also occurred, cf. Chart 6. Episodes causing marked deviation in economic growth rates include the reunification of Germany in 1989 and the boom in the Netherlands in the second half of the 1990s. At the same time, Spain has shown a clear pattern of high growth rates compared with the other major economies since the mid-1990s; in 1995-2007, annual growth was thus 1.5 percentage points higher in Spain than in the euro area overall. The higher growth in Spain reflects a catching-up process, whereby capital and production processes were gradually brought from a relatively low starting point up to the level of the high-income member states. This results in high growth and elimination of historical income inequalities.
GDP GROWTH AND OUTPUT GAP IN THE EURO AREA	Chart 6
Note: For Germany and the euro area: level-adjusted data for West Germany before reunification in 1991. The output gap is the difference between actual GDP and potential GDP that is compatible with stable economic development. Source: OECD (2008) and own calculations.
Other member states, e.g. Ireland and Greece, have gone through similar catching-up processes. This illustrates that GDP growth is not an appropriate measure for com parison of cyclical patterns among member states, since GDP developments reflect both cyclical fluctuations and long-term trends that may vary considerably in the different member states. An obvious alternative is thus to use measures of the output gap in the various economies as this is a better indicator of the overall cyclical position. According to the OECD (2008) measurement of output gaps in the five largest euro area economies, there is a pronounced tendency towards synchronous cyclical fluctuations in the individual member states since 1980, although some of the differences mentioned above still apply, cf. Chart 6. The calculation of output gap is, however, based on a number of economic-theory assumptions and complicated calculations that can be regarded as controversial. This is one reason for the widespread use of more simple statistical filters in the literature on synchronisation of European business cycles.2 Chart 7 shows the development in cyclical synchronisation for both the euro area member states and a broader group of OECD countries. The cyclical component of each country is determined using a statistical filter that separates long-term trends from short-term and medium-term cyclical fluctuations in quarterly GDP. The synchronisation is then calculated as averages of correlation pairs for all countries over 10-year periods.
CYCLICAL SYNCHRONISATION IN EUROPE AND THE OECD	Chart 7
Note: Unweighted average of correlation coefficients for the cyclical component of GDP for centered 10-year periods. The cyclical component is isolated using a Baxter-King filter (1999) on quarterly time series for GDP up to and including 2009 (OECD estimates for the non-historical period). Due to limited data availability "Core Europe" in the calculations is made up of Germany, France, Italy, Spain, Netherlands and Belgium; "Euro area" is Core Europe plus Finland, Greece, Ireland and Portugal; "OECD" includes "Euro area" plus Denmark, Sweden, Norway, UK, USA, Canada, Australia, New Zealand and Japan. Source: OECD (2008) and own calculations.
Three trends stand out: Firstly, since the late 1980s the euro area has seen clearly stronger internal synchronisation than the broader group of OECD countries. How ever, the spreads narrowed in connection with the upswing up to the millennium rollover and the subsequent downturn when the dotcom bubble burst. This marked boom-bust pattern was global and appears in the calculations as global convergence of business cycles, cf. e.g. Artis (2003). Secondly, cyclical synchronisation in the euro area has increased considerably since the mid-1980s. This is in accordance with the fact that increased integration of both product and financial markets within the single market of the EU contributes to greater synchronisation of business cycles.3 Whether fixed exchange rates as such have been conducive to a European business cycle is still being actively discussed, cf. Dam (2008). Finally, it is evident that the cyclical pattern is not homogeneous across the euro area. On the basis of several previous studies, Dam (2008) argues that the euro area has a cyclical core consisting of Germany, the Netherlands, Belgium, France, Austria and to some extent Italy and Spain. The synchronisation among these economies is clearly stronger than the area-wide synchronisation. In particular, the global divergence observed in recent years has affected only "peripheral" member states such as Ireland, Greece and Portugal, while the degree of synchronisation has re mained high in the core member states throughout the life of the euro. Stronger coupling to the European business cycle is a likely consequence of enhanced inte gration of the "peripheral" member states with the rest of the euro area.
1. The debate and results are reviewed and put into perspective – including a Danish perspective – in Dam (2008). 2. Dam (2008) discusses the use of statistical filters versus methodologies that are more directly anchored in economic theory to identify cyclical patterns. 3 Cf. e.g. Frankel and Rose (1998) and IMF (2001). De Haan et al. (2008) contains a list of other analyses that show similar results.

Despite relatively synchronous business cycles, considerable dispersion in growth rates is still observed among the euro area member states. Growth dispersion is to a great extent also a natural consequence of the catching-up process, whereby less affluent euro area member states are approaching income levels in more affluent euro area member states through periods of higher growth rates. The dispersion can also be attri buted to other factors, however, e.g. country-specific economic shocks, different responses to common shocks, inappropriate economic policies or structural rigidities.

Inflation differentials
Inflation differentials among the future euro area member states diminished considerably in the period up to the introduction of the euro, cf. Chart 8. The dispersion has since then been more or less con stant. The differentials are a natural consequence of the catching-up process, which also entails gradual adjustment of price levels in less af fluent member states to the levels in the more affluent member states¹³. However, inflation dispersion can also be attributed to national struc tural rigidities in the product and labour markets in the form of sluggish adaptation of relative prices or diverging developments in wage in creases and productivity in some euro area member states.

Payroll costs account for a considerable share of expenditure in the service sector, and the inflation dispersion has been slightly more pronounced, despite a declining trend, for the HICP service component than for HICP overall. In addition, the sensitivity to energy price fluctu ations varies across the euro area member states. The surging oil and food prices and their different weights in the price indices of the various member stares contribute to explaining the increase in inflation disper sion since the summer of 2007.

One size fits all?
Overall, the progress in economic integration has been rather subdued in the first 10 years of EMU, although stable and pronounced cyclical synchronisation is observed for at least some euro area member states.

The ECB's monetary-policy planning is based on an assessment of the area-wide economy, so it necessarily applies that it is at times better suited to the economic positions of some member states than others.

Chart 9 illustrates monetary-policy interest rates in some euro area member states and the euro area as a whole, had they been determined nationally using the Taylor rule. In somewhat simplified terms, this "rule" calculates the monetary-policy interest rate based on an overall assessment of inflation (low inflation provides for low interest rates, high inflation requires high interest rates) and growth (a recession calls for low interest rates, a boom calls for high interest rates).

For example, the Chart shows that in the period of low growth in Germany in 2002-04, when inflation was also relatively low, German interest rates should have been lower according to the rule. Conversely, interest rates in France should have been higher than the actual ECB interest rates in the same period. Spain experienced very high growth in this period, so considerably higher interest rates were warranted. For the euro area overall, the rule warrants somewhat higher interest rates for almost the entire period.

It is emphasised that these calculations are for illustrative purposes only. No central banks actually apply the Taylor rule to monetary-policy planning.

CONCLUSION

After the first 10 years, a stable economic framework for the euro area has been successfully created and maintained in terms of price stability and elimination of the internal currency unrest that characterised the preceding decades. Unlike previous episodes, the current financial tur moil, triggered by the US subprime crisis, has entailed no European cur rency crises.

The ECB has fulfilled its objective of stable inflation, although inflation has generally been slightly higher than the specific objective of "below, but close to 2 per cent". The ECB has gained respect and credibility in the financial markets and successfully anchored inflation expectations in the euro area. The inflation shock occurring in 2008 in the form of surging oil and food prices, and prospects of an economic downturn in the euro area constitute a particular challenge for the ECB's policy plan ning in the near future.

The introduction of the euro has not as such entailed any clear in crease in economic integration in the euro area, but it has provided the foundation for sustainable economic growth in the form of price stabil ity and an area with irrevocably fixed exchange rates.

LITERATURE

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