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Speech by Mr Stanley Fischer, Vice Chair of the Board of Governors of the Federal Reserve System, at the ECB Forum on Central Banking conference "Inflation and Unemployment in Europe", Sintra, Portugal, 21 May 2015.
Although the topic of the conference is inflation and unemployment, I will take another perspective by discussing some of the past, present, and future challenges that have and may in future confront the ECB and the euro area.
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Has modern Europe developed primarily through crises? Will it be stronger when this crisis is over? And what challenges or crises is Europe likely to have to deal with in future? Despite the fact that political and economic aspects of the structure of the European economy have inherently been closely intertwined throughout history - and saying this, one thinks of the Romans and later of Charlemagne - I will focus on the economic aspects of the European project, and primarily on its monetary and financial aspects.
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The snake was a failure, a failure that created problems, though not clearly a crisis. If exchange rates among members of the EEC were to be stabilized in the new world of floating rates, the Community had to invent a substitute. In 1978, the members of the EEC created the European Monetary System, which started with an Exchange Rate Mechanism (ERM I) that limited currency fluctuations relative to a basket of national currencies. 11 All members except the United Kingdom participated in ERM I. The arrangement also committed central banks to intervene to support the resulting bilateral rates as they approached the limits of the permissible bands. Countries in the ERM also adopted policies that lowered inflation, bringing interest rates into closer alignment. The initial success of the ERM encouraged European leaders to lift capital controls and built momentum toward monetary union, which was reflected in the Maastricht Treaty (the Treaty on European Union), agreed to in 1991 and signed in 1992.
However, strains also emerged under the ERM, in an environment in which the Bundesbank emerged as the dominant central bank in Europe, and the Deutschmark as the dominant European currency. This led other countries in the ERM to follow German monetary policy. In part as a consequence of German reunification, the pressures generated by diverging fiscal policies and tightening German monetary policy contributed to the ERM crisis of 1992. Moreover, the earlier lifting of capital controls and the promises to intervene to support rates that were ultimately not credible put tremendous pressure on the pegged rates - and on relations among some members of the EEC. The crisis forced the United Kingdom and Italy out of the ERM and forced others (Portugal and Spain) to devalue their currencies.
The ERM crisis was an apt illustration of the difficulties of trying to manage exchange rates among countries operating under markedly different economic conditions. However, rather than dissuading policymakers from trying to limit exchange rate fluctuations within a system that would nonetheless preserve the possibility of some exchange rate flexibility, the experience seemed to encourage them to continue with the plan of the Maastricht Treaty to introduce a single currency and a common monetary policy at the beginning of 1999. Here indeed was an example of a crisis leading to a strengthening of the European system - though the process to create EMU - the Economic and Monetary Union, not the European Monetary Union - began well before the ERM crisis.
The exchange rate and central banking provisions of the Maastricht Treaty were introduced on the schedule set out in 1991, with the ECB coming into existence in 1999. Until about 2009, the monetary aspects of the plans for the development of the European Union (EU) seemed to be a major success - but not a sufficient success to persuade all members of the Union to become members of the ECB and adopt the euro, with the most notable standout being the United Kingdom.
The ERM crisis also drove home the need for greater coordination of fiscal policies in the run-up to monetary union. Members of the EU agreed to the Stability and Growth Pact in 1996. Although, as we all know, the conditions of the pact have not always been observed, nor enforced by Brussels, the acknowledgment of the need for a coordinated fiscal policy to complement monetary union was still a step forward - one which may be drawn on in future.
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What about the present crisis of the euro area? Two or three years ago, there was widespread skepticism on the western shores of the Atlantic and the English Channel about the viability of the monetary union, and there was much discussion of what would happen after the breakup of the present euro area - whether there would be one or two euro areas, one for the stronger countries, one for the weaker, and if so, how well each of the two blocs would fare.
With one sentence - the sentence that included the words "whatever it takes" - that skepticism was largely, though not totally, erased. With one decision - the decision to implement QE - it became clear that the ECB has the capacity both to decide to implement monetary policy at the zero lower bound - indeed below the zero lower bound - and to succeed in implementing that policy. There can be no one whose Bayesian priors have not moved in favor of the survival of essentially the present euro area, even though we still await the outcome of the Greek crisis, and even though we know that the present crisis is not yet over.
Is this an example of the success of the Monnet approach? Absolutely. European monetary policy in the earlier part of the Great Financial Crisis was innovative, particularly in the invention of full-allotment outright monetary transactions. That policy was inspired by crisis, as were the innovative policies undertaken by the Fed in the United States. More important than that: It is hard to believe that a European banking union would have been put in place by 2014 if it had not been for the crisis. And it is no less difficult to believe that a Single Supervisory Mechanism would have been set up absent the crisis. Of course, one may say that the ability to make these difficult decisions depended on the skills of the leadership of the ECB - and that is true, and will always be true. But the fact is that, when needed, Europe produced the monetary policy leadership it needed.
What of the future? What crises, what extremely difficult decisions, await the EU? Some are already visible. The decision to use the single currency to drive the European project forward was a risky one, and at some stage or probably in several stages, it will be necessary to put the missing fiscal framework into place. And that, if it happens, will be another example of a crisis - the present crisis, one hopes - whose solution will have strengthened the European enterprise. For success in this area must be one of the most difficult economic challenges facing the EU after the present crisis is over.
Also awaiting the EU are the possibilities of major difficulties associated with the current Greek crisis and, later, with a potential British exit. One can of course imagine many different types of future crises, including crises that could develop out of the worsening geopolitical situation in which the Western world finds itself. And one could go on.
Experience tells us that the best way to deal with future crises is to strengthen the economic framework in which they will be confronted. That will require a great deal of thought about how to deal with future crises that could most easily be solved by an exchange rate adjustment, and it will also require developing a better mechanism to ensure that member states run responsible financial and budgetary policies. It means also seeking solutions to the difficult demographics now confronting many European countries.
And it means the continuation of a courageous and effective monetary policy, and courageous and effective regulation and supervision of the financial system - albeit a monetary policy that could do even better if accompanied by an expansionary fiscal policy.
All that has been done so far makes it very likely that EMU - the Economic and Monetary Union - will survive this crisis. But in the longer run, EMU will not survive unless it also brings prosperity to its members. That means that the most important challenge of the future will require an increase in productivity growth in Europe - and that is a challenge that faces the entire developed world.