European Monetary System

slightly less than that of the United States and 125% higher than that

of Japan.

All these facts and figures which demonstrate the demographic and

economic importance of the European Union would be further

strengthened by enlargement to eastern Europe. Our continent has a

historical, cultural and geographical identity - from the Iberian

peninsula to the Urals, with certain additional external territories -

which, in the future, may also come to form an economic unit. However

that is, for the moment, a distant prospect.

The size or habitat of an economy does not only depend on

demographic or economic factors; it also has to do with the financial

base or dimension of the area. In considering the financial dimension

of the euro area, the first relevant feature to observe is the low

level of capitalisation of the stock markets in comparison with the

United States and Japan.

Although this feature could give the impression that the euro

area has a relatively small financial dimension relative to its

economic dimension, this is not the case. The lower degree of

development of the capital markets is offset by a higher degree of

banking assets. This means that the financial base of real economic

activity in Europe is founded on bank intermediation, which is also a

feature of the Japanese economy. For example, private domestic credit

in the euro area amounts to 92.4% of GDP, while in the United States

it is only 68.9%. Conversely, fixed domestic income represents 34.2%

of GDP in the euro area compared with 66.1% of GDP in the United

States (statistics from the International Monetary Fund and the Bank

for International Settlements as at the end of 1997, taken from the

Monthly Bulletin of the European Central Bank). We, therefore, have

two distinct models of private financing which clearly have to be

taken into account when assessing Europe's financial dimension

compared with the United States or Japan.

The euro, the Eurosystem's monetary policy and, in general, the

activity of the ECB and the Eurosystem play a key role in the

integration of European financial markets and all markets in general.

The euro is acting as a catalyst for European economic integration.

And more integration will lead to a greater economic and financial

dimension.

Monetary and financial integration stemming from the euro and the

activity of the Eurosystem will affect the operation of the single

European market in a positive way. The European market, with a single

currency, will tend to be more transparent, more competitive, more

efficient and will function more smoothly. This is the reason why

joining the European Union, as a general rule, will lead to joining

the euro area, once certain economic conditions (the so-called

convergence criteria) have been fulfilled.

Monetary union is always a political operation, irrespective of

its technical and economic implications. Currency is one of the most

genuine expressions of sovereignty, because the power to issue money

is one of the greatest powers in existence. The Treaty on European

Union led, first, to the depoliticisation of monetary power in Europe,

by means of granting independence to the central banks and prohibiting

the monetising of public deficits, and afterwards to denationalisation

or supranationalisation (via the creation of the Eurosystem). The

Eurosystem was not only created for the purpose of improving the

operation of the Single Market, but also in order to make progress on

the building of the European political structure.

The euro should not only be seen as a catalyst for European economic

integration, it should also be seen as a main beam necessary to

construct the European political structure. The relationship between

political power and monetary power is an interesting subject which is

open to investigation and discussion, but that would certainly go

beyond the scope of this speech. I merely wish to point out that, in

the case of Europe, it is clear that following the achievement of a

single currency, the door remains open to political union, which would

represent a crucial step in the process of integration. In conclusion,

it would seem clear that the implications of the euro go "beyond

supply and demand" (to use the title of the work of Wilhelm Rцpke). We

are now fully immersed in "meta-economy", which means it is time to

end my speech.

Keynote address to be delivered by

Dr. Willem F. Duisenberg

President of the European Central Bank

on

The European System of Central Banks

Current position and future prospects

At a Conference organised by the Royal Institute of International

Affairs on

European economic and Monetary Union

Markets and Politics under the Euro

London 27 november 1998

1. Introduction

Ladies and Gentlemen, I should like to express my appreciation at

being invited to deliver a speech at this conference organised by the Royal

Institute of International Affairs. It is a great pleasure for me to be

here, in London, today.

The topic I am going to address relates to the current position and

the future prospects of the European System of Central Banks. I feel that

this topic provides me with an opportunity to deal with the objective of

the ESCB and its contribution to the other policies in the Community. I

will also briefly touch upon the decision-making in the ESCB, recall the

main features of our monetary policy strategy and talk about our regard for

openness and transparency. The final part of my talk will cover the views

of the ESCB on recent economic developments and the future outlook for

price stability in the euro area.

2. Independence, transparency and accountability

In the Maastricht Treaty the ESCB has been given an independent

status. The reason is that politicians all over the world have come round

to the view that monetary policy decisions taken with too close a political

involvement tend to take too short a time horizon into consideration. The

consequence is that in the longer term such decisions do not support

sustainable gains in employment and income, but only lead to higher

inflation. This view is confirmed by a host of economic research.

Independence, however, requires a clear mandate. The ESCB has such a

mandate. Its primary objective is to maintain price stability. Without

prejudice to the objective of price stability the ESCB shall support the

general economic policies in the Community. Price stability is not an end

in itself: it creates the conditions in which other, higher-order,

objectives can be reached. In particular, I share the deep concerns about

the unacceptably high level of unemployment in Europe. The ESCB will do

what it can to contribute to the solution of this problem. By maintaining

price stability inflation expectations and interest rates can be kept at a

low level. This creates a stability-oriented environment which fosters

sustainable growth, a high level of employment, a fair society and better

living standards. Moreover, in specific circumstances, if production,

inflation and employment all move in the same direction, monetary policy

can play some role in stabilising output and employment growth without

endangering price stability. However, the contribution from monetary policy

can generally be only limited. Given the structural nature of the

unemployment problems the solution is to be found, above all, in structural

reforms aimed at well-functioning labour and product markets.

An independent central bank does not only need a clear mandate. It

has also to be an open and transparent institution, for at least three

reasons. First, transparency enhances the effectiveness of monetary policy

by creating the correct expectations on the part of economic agents. A

predictable monetary policy contributes to achieving stable prices without

significant adjustment costs and with the lowest interest rate possible.

The second reason is that in a democratic society the central bank has to

account for its policies. Finally, transparency towards the outside world

can also structure and discipline the internal debate inside the central

bank.

Let me now turn to the ways and means of achieving transparency. As a

first element the ESCB has defined a quantitative objective for price

stability. It reads as follows: price stability is a year-on-year increase

in the Harmonised Index of Consumer Prices (HICP) for the euro area of

below 2%. Although I do not consider deflation to be likely in the current

environment, I may add that a situation of falling prices would not be

consistent with price stability.

The Governing Council has made it clear that "Price stability is to

be maintained over the medium term". The ESCB cannot be held accountable

for short-run deviations from price stability, for example due to shocks in

import prices or specific fiscal measures. A monetary policy reaction to

short-run fluctuations in the price level would provide the wrong signals

to the market and cause unnecessary interest rate volatility. In summary,

the ESCB will react in an appropriate, measured and, when necessary,

gradualist manner to economic disturbances that threaten price stability in

the medium term, rather than in an abrupt way, in order to avoid

unnecessary disruptions of the process of economic growth. That said, the

ESCB will, whenever necessary, openly discuss and explain the sources of

possible deviations from the quantitative definition of price stability.

In addition, let me remind you that by focusing on the HICP for the

euro area, the ESCB makes it clear that it will base its decisions on

monetary, economic and financial developments in the euro area as a whole.

The single monetary policy has to take a euro area-wide perspective: it

will not react to specific regional or national developments.

The institutional implication is that the ESCB should develop into a

strong unity, with a strong centre and strong national central banks. It

should become a truly European institution, with a truly European outlook.

Of course, it may take some time to arrive where we ultimately want to be.

We have to get used to thinking in euro area-wide terms. In the ECB

Governing Council we are already "practising" that approach and are making

progress. I am confident that the ESCB will indeed act as a unity.

Transparency and openness will be apparent from the way in which the

ESCB communicates with the public. The ESCB will regularly present its

assessment of the monetary, economic and financial situation in the euro

area and provide information about each specific monetary policy decision,

be it a move in interest rates or an absence of change. This will notably

be done by way of press releases, press conferences, publications and

speeches. Press releases are made available immediately after the

fortnightly meetings of the Governing Council and, as you may know, they

always include a precise list of the decisions taken together with

background information.

There will be a monthly press conference. Such a press conference

will start with a detailed introductory statement, as has been the case so

far, and these introductory statements will also be published immediately,

without delay. In this statement the Vice-President and I will present the

Governing Council's view of the economic situation and the underlying

arguments for its monetary policy decisions, followed by a question and

answer session.

The publications of the ESCB will include, in particular, an ECB

Bulletin each month as well as an Annual Report. As from 1999, a detailed

analysis of the economic situation in the euro area will be presented in

the monthly Bulletin. Thematic articles in this Bulletin will include in-

depth analyses by the ECB on matters regarding the monetary policy of the

ESCB and the economy of the euro area. Further, you may also recall that,

as required by its Statute, the ESCB will publish its consolidated balance

sheet on a weekly basis.

My colleagues on the Executive Board of the ECB and I intend to be

very active in giving speeches dealing with all issues of relevance for the

conduct of monetary policy. I am convinced that the Governors of the

national central banks will also play their role in this respect.

Since I am talking about the communication and external relations of

the ESCB, I would like to underline that I am prepared to accept

invitations to appear before the European Parliament at least four times a

year to present the activities of the ESCB and the ECB's Annual Report.

Finally, it should be noted that the ESCB will have a regular exchange of

information and views with the ECOFIN. Representatives of the ECB will be

invited to ECOFIN meetings whenever issues of concern to monetary policy

are discussed. A similar relationship will naturally also exist with the

EURO-11, whose meetings will generally be attended by the President of the

ECB, whenever matters relevant to the ESCB are on the agenda.

3. Monetary policy strategy of the ESCB

We are now approaching the start of the Third Stage of EMU. The

decision-making bodies of the ECB have made a certain number of important

decisions since the ESCB was established. As part of these decisions, the

monetary policy strategy of the ESCB was recently announced and explained

to the public. The selected stability-oriented strategy promotes as much

continuity as possible with the existing strategies of national central

banks in the EU. At the same time, its design is adapted to the unique

situation of introducing a single currency in eleven countries, which may

to a certain extent change economic behaviour. Therefore as much continuity

as possible and as much change as required is the thrust of our strategy.

Our strategy consists of two pillars. The first is an important role

for money and the second is a broad-based assessment of the outlook for

price developments in the euro area. The main reason for assigning a

prominent role to money is the empirically well-founded view that

inflation, at least in the long run, is a monetary phenomenon. This simple

and obvious observation led the Governing Council to announce a

quantitative reference value for the growth of a broad measure of money.

This choice will create a "nominal anchor" for monetary policy and

therefore help stabilise private inflation expectations at longer horizons.

The reference value will be derived in a manner that is clearly consistent

with - and serves the achievement of - price stability. It will be

constructed such that, in the absence of special factors or other

distortions, deviations of monetary growth from the reference value will

signal risks to price stability.

However, it has to be clear that the reference value is different

from an intermediate monetary target, as the ESCB has not made any

commitment to correct deviations of actual monetary growth from the

reference value over the short term. In particular, it has been

realistically recognised that the move to a single currency and ongoing

financial innovations may generate fluctuations in the selected monetary

aggregate which are not necessarily associated with inflationary or

deflationary pressures. For this reason, it is important to continuously

monitor the relevance of temporary factors or even structural changes in

order to avoid a mechanistic policy reaction to deviations of the chosen

monetary aggregate from the reference value. The results of this analysis

and its impact on the ESCB's monetary policy decisions will be explained to

the public.

Let me turn now to the second key element of the monetary policy

strategy, the broad-based assessment of the risks to price stability. The

information contained in monetary aggregates, while of the utmost

importance, will by no means constitute the whole of the "information set"

in the hands of the ESCB. In parallel with the analysis of money growth, a

wide range of economic and financial variables will be used to formulate an

assessment of the outlook for price developments. The envisaged strategy

will enable the ESCB to perform a cross-check between the information

coming from the evolution of monetary aggregates and those from other

economic and financial indicators.

4. Recent economic developments and prospects

Let me turn to the current economic situation. The euro area

experienced a strengthening of economic growth in 1997, to 2.5%, and a

further acceleration has been anticipated for this year. The global

environment has, of course, deteriorated in the meantime, but this has not

so far had an observable impact on growth which has, in any event, been

increasingly led by domestic demand. Inflation has remained subdued and

even fallen somewhat over the past year, partly as a result of the impact

of weaker global demand on oil and commodity prices. However, the

favourable pattern of inflation has also been supported by domestic

factors, such as a very moderate development in unit labour costs and

industrial producer prices.

Concerning recent price developments, HICP inflation for the euro

area fell to 1.0% in September, due to a strong impact from food prices,

but I would not want to read too much into this latest decline as some

price components can be relatively volatile over short periods. More

significantly, preliminary data suggest that various broad monetary

aggregates for the euro area are increasing at between 3 and 5%, and thus

do not appear to signal any strong incipient inflationary or deflationary

pressures. We are in line with the consensus view that inflation in the

euro area will rise moderately in 1999, but remain below 2%. I do not

consider deflation to be a serious risk for price stability at present.

So far, despite the worsening of the global environment, euro area-

wide activity has continued to expand at a fairly stable rate. At around

3%, annual real GDP growth was broadly unchanged in the first half of 1998

from the solid growth seen in the second half of 1997. Industrial

production growth has slowed somewhat since the spring. More recent

evidence, particularly that of the area-wide survey data, may also suggest

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