Structural reform and its implications for monetary policy

Speech by Dr. Willem F. Duisenberg, President of the European Central Bank, at the meeting of the Executive Board of the Deutsche Bundesbank in Berlin on 10 June 2003

It is an honour for me, as President of the European Central Bank (ECB), to address the Executive Board of the Deutsche Bundesbank and its guests on the occasion of the meeting of the Executive Board in Berlin. Indeed, this is the first time that I address the Executive Board of a national central bank of the euro area in an official capacity.

Tonight, I should like to look at two issues. First, I shall – in view of my audience this evening – talk about developments in the Eurosystem, i.e. the central banking system of the euro area, which is composed of the ECB and the national central banks of the countries that have adopted the euro. In addition, I shall say a few words about structural reforms and their interaction with monetary policy – a topical subject that, on a more personal note, is also close to my heart. The reform process in the goods, capital and labour markets is of particular significance in the euro area, as it contributes to the creation of important conditions for a stability-oriented monetary policy. Reform efforts in this field will both support long-term economic growth and contribute to reducing wage and price pressures. Both of these will help monetary policy to carry out its stability-oriented mandate in an efficient way and with little delay. Moreover, a more flexible economy is better able to absorb external shocks. Therefore it is important to analyse what progress has been made so far in implementing the reform agenda within the euro area, what steps have yet to be taken and what impact this will have on monetary policy.

You might ask what the link between these two topics – the development of the Eurosystem and structural reforms – is. To some extent the Eurosystem is also still in a process of structural reform. Being a relatively new central banking system, its constituent parts are still adapting to the new situation with a centralisation of monetary policy decision-making and a large degree of harmonisation and co-ordination in other areas in line with the Treaty.

Let me give you my view on how the Eurosystem could, or perhaps should, develop – fully realising that this is a process which, inevitably, will take quite some time.

In my view, the Eurosystem can be compared to a wheel, with the ECB as its hub, and the national central banks as its spokes. And, as you know, a wheel cannot function without either one of them. Now, what would be the constituents of a "true" central banking system for the euro area?

The ECB, being the hub of the system, should, in my view, prepare the decision-making process which is concentrated in the ECB's and the system's decision-making bodies. Moreover, it should monitor compliance with the decisions taken and co-ordinate the system's overall activities.

In my view, the system's operations should mainly take place through the national central banks, in line with Treaty provisions. Given the continued differences in financial market structures and legal and institutional frameworks, a full centralisation of operations at the European level is not on the cards. The best way the system can serve its customers is still via a decentralised structure. On the other hand, a full duplication of central banking activities at all national central banks of the Eurosystem might also not be efficient, in particular with a view to the potential enlargement of the euro area to include the accession countries, although that may still take some time. The pooling and co-ordination of operations in a sub-set of central banks, serving the system and its customers as a whole, might therefore be the optimal route to take. An example of this "third way" is the decision of the Governing Council with respect to the second generation of TARGET, the real-time gross-settlement system operated by the Eurosystem.

In the eyes of some critics, the decentralised structure of the Eurosystem might be regarded as inefficient. Let me emphasise that I do not share that view. I am convinced that part of the success of the euro cash changeover can be attributed to the decentralised, though closely co-ordinated, public information campaigns of the national central banks. Moreover, national central banks play a very important role in communicating the system's policies to the general public, taking into account specific cultural backgrounds and presenting the policies in the context of national policies and frameworks. The efficiency of the system is indeed important, and we should strive for that, but not at the expense of the quality of our services, which ultimately determine the extent to which the system lives up to the tasks conferred upon it by the Treaty.

Other critics are of the view that the establishment of the ECB has deprived the national central banks of their tasks, leading to restructuring and organisational changes in many of them. Although it is true that national central banks have to adapt to their new role in the context of Economic and Monetary Union (EMU), I am also convinced that the establishment of the ECB and the introduction of the euro have only increased the workload of national central banks, in particular as there is a greater need for co-ordination at the European level. The fact that many national central banks are in a process of restructuring is, in my view, due to other external developments, such as changes in the cash cycle which affect central bank branch networks, technological developments, developments in financial markets and the need to work more efficiently. In other words, these restructuring processes would probably have been inevitable anyway, with or without EMU.

To conclude, and coming back to structural reforms, the general theme of my speech, there is in my view no need for change in the decentralised structure of the Eurosystem as enshrined in the Treaty, even though the constituent parts of the Eurosystem are still in the process of adaptation.

Let me now turn to the issue of structural reforms in a broader context and how they are more widely known and recognised – i.e. structural reforms in the context of the functioning of the euro area economy.

Since the introduction of the Single Market in 1992, the countries of the euro area and the EU have made major progress in implementing structural reforms in product, capital and labour markets. However, a number of obstacles remain. To ensure that these markets function flexibly, these obstacles have to be removed. The necessary reforms should not only concentrate on achieving a higher degree of market flexibility within individual countries in the euro area, but also help to remove unnecessary restrictions on the free movement of goods and factors of production.

Let us look at the progress made in all these areas.

Turning to labour markets, the ECB has been warning for some time that the pace of reform needs to be stepped up significantly in a number of countries in order to remove existing imbalances, such as high levels of unemployment and low employment rates. Urgent action is required to prevent these imbalances from becoming more entrenched, not least in view of the imminent upturn, the strength of which will also depend on, inter alia, a flexible response on the part of labour markets.

Meanwhile, both the supply of and demand for labour are being hindered by the tax and social security systems in a number of euro area countries. On one hand, these systems frequently offer little incentive to low-income earners to take up work. On the other hand, high non-wage labour costs are placing a constraint on labour demand. The process of demographic change which has begun to take place in all almost all euro area countries will place an additional burden on existing social security systems. The necessary reform efforts should thus focus in particular on reforming pension systems and adapting healthcare systems.

In addition, employment protection measures and centralised wage bargaining systems carry the risk of placing additional constraints on the labour market, thus preventing it from adapting to new economic conditions in a flexible manner. In addition, minimum wage regulations and area-wide collective bargaining agreements frequently do not allow for a sufficient degree of differentiation. Such differentiation is vital in order to respond to divergent regional developments. Alongside social considerations, the countries of the euro area must endeavour to give more weight to economic efficiency within labour markets.

As well as labour market reforms, capital market reforms can also play an important role in making euro area markets more flexible. Further integration of national capital markets towards a truly European financial market would make an important contribution to safeguarding against country-specific shocks. Furthermore, the further dismantling of capital market restrictions would result in greater availability of risk capital – particularly for innovative enterprises – and, more generally, in a reduction in financing costs for productive investments. In addition, further efforts should be made to promote foreign investment in the euro area in order to attract additional capital and promote greater technology transfer.

In addition to reforms in factor markets, greater efforts must be made to remove existing barriers in product markets. In this regard the countries of the European Union have made considerable progress, in particular in the network industries, such as in telecommunications and in the electricity sector, which for decades were characterised by state monopolies and strict barriers to entry. Since the beginning of the 1990s state enterprises have undergone extensive privatisation and market entry barriers have been lowered. Indeed, in some countries the privatisation and market opening process in this area is complete. However, this is not the case in all countries or sectors. In addition, significant barriers to a further removal of price pressures remain. For example, state subsidies and special sectoral aid are only being phased out gradually.

Moreover, greater efforts are required in some euro area countries to extend and broaden their technological base. It is clear, particularly from comparisons with the United States, that increased access to the high technology industries, such as the new information and communications industries, is necessary in order to accelerate productivity growth. Relatively low expenditure on research and development in a number of euro area countries and inefficiencies in university and vocational training systems constitute significant barriers to private investment in these industries. Reforms in this area should be geared towards the general business environment, removing barriers to the transfer of knowledge and increasing the level of involvement in university training.

Ultimately, stronger efforts are required to further reduce barriers to trade and the free movement of factors of production. Action must be taken to ensure that resources can move freely not only within one country, but also in other countries of the euro area. This requires the further dismantling of bureaucratic barriers and, where necessary, the harmonisation of existing regulations, in particular in the services sector.

Structural reforms in capital, labour and product markets are important for the success of Monetary Union and the long-term economic development of the euro area.

On the one hand, structural reforms play an important part in creating the conditions for long-term economic growth, which is affected primarily by the efficiency of microeconomic relations. A high level of innovation and the rapid spread of technological progress in all parts of the euro area economy will support long-term growth, without contributing to inflationary tendencies.

In addition, a more flexible economy will increase the speed with which euro area countries adapt to economic shocks. While a highly regulated economy tends to adapt to external influences only after considerable delay, and tends to react more strongly to negative than to positive influences, the same shocks are absorbed significantly more quickly and at lower cost – such as an increase in unemployment or a decline in growth – in the case of flexible markets.

Finally, it should not be forgotten that developments in prices and inflation are largely dependent on the competitive situation in labour and product markets. Increased competition in these markets will also allow lower relative prices and reduced wage and price pressures. This is of particular importance in the service industries, which are less exposed to international competition and which account for a major part of the economic activity in the euro area. Here structural reforms can contribute to a further reduction in price pressure, and at the same time create conditions for moderate wage development.

So, taken together, structural reforms promote a long-term economic environment which is characterised by high productivity gains and low levels of inflation, thus making a significant contribution to a successful stability-oriented monetary policy.

In addition to their effects on the real economy, structural reforms can also have very significant consequences for the transmission of a monetary policy which is committed to price stability. In more rigid economies interest-rate changes are transmitted to prices after a longer delay, and structural impediments can prevent the economic efficiency gains sought through the stability-oriented objective of monetary policy from being fully realised. These gains in efficiency can only be realised if structural reforms make it possible to adapt more flexibly to changes in economic conditions.

Moreover, the ability of euro area countries to adapt will also have an impact on how they absorb sustained asymmetric shocks. Because these countries, since joining the euro area, are no longer able to react to such shocks using monetary or exchange rate policy, such shocks can only be absorbed by reallocating resources within the euro area countries. In the event of persistent price and wage rigidities and obstacles to the free movement of factors of production within the euro area, these shocks could result in a decline in long-term growth and a rise in unemployment.

In this regard, it is important to mention the close interplay between rigidities in capital, labour and product markets, which can reinforce one another. These interdependencies mean that structural reforms in any one of these markets will have an impact on the functioning of the others. Thus, for example, the dismantling of market barriers in product markets will, in the long term, result in stronger employment growth. On the other hand, efforts to improve skills levels in the labour market enhance the potential for innovation and thus productivity growth. It must therefore be emphasised that only a comprehensive reform programme can create the necessary preconditions for stronger economic dynamism within the euro area.

Let me conclude by addressing the economic policy-makers in the euro area. I am convinced that economic activity in the euro area can only be lifted to a structurally higher level by far-reaching and progressive structural reforms. The only contribution monetary and fiscal policy can make in this respect, is to maintain a stable macroeconomic environment, entailing price stability and sound public finances. Moreover, as I have already argued, the effectiveness of both monetary and fiscal policy in bringing about macroeconomic stability hinges on the functioning of the euro area economy, which can only be enhanced by embarking on structural reforms. In other words, structural reforms not only increase the potential of the euro area economy, but also facilitate both monetary and fiscal policy.

I am pleased to observe that a number of countries in the euro area have realised that the only solution to addressing the current economic slowdown lies in structural reforms to strengthen the functioning of the economy. I warmly welcome the efforts of the governments of those countries and sincerely hope that their example will be followed by others.

Thank you very much for your attention.