Euro Reflections.

A TIE exclusive interview with the ECB's Otmar Issing.

TIE: The euro's relative weakness against the dollar has been a bit of a mystery. For many, the euro's performance in the short run is hard to understand, in terms both of interest differentials and of growth differentials as well. It almost seems as if when there is good news about Europe, the euro weakens, and when there is bad news about the United States, the euro weakens. What is your take on the euro's performance to date? Where do you see things going from here?

OI: It is true that the weakness of the euro is puzzling when one gauges it against fundamental economic facts and economic reasoning. The external value of the euro does not currently reflect its internal stability.

Looking at the internal value of the euro, one has to recognize that we have managed to keep inflation under control despite the price pressures caused by the past sharp rise in oil prices, and more recently by the outbreak of foot and mouth disease and other food hygiene concerns affecting the price of food in Europe. I think we can say that we are on track to achieve our objective of medium-term price stability, and this is reflected in low inflation expectations in the euro area, both over the medium and long term. It is also a fact that the real growth rate of the euro area currently exceeds that of the United States. Not only that--according to projections by the main institutions, real growth in the euro area will continue to outpace growth not only in the United States, but also in Japan and other major countries in 2001.

When one takes into consideration this better outlook for growth and the expectations of price stability in the euro area, I think one can safely say that the odds are currently clearly in favor of a stronger euro, because over time the internal solidity and stability of a currency should be reflected in its external value.

TIE: In a related question, some observers tie the euro's weakness directly to the fact that the largest country in Europe--Germany--is quickly becoming the sick man of Europe. By that they are not referring merely to cyclical macroeconomic weakness, but more to fundamental structural weakness within the economic and political system. The view is that the Schroeder government enjoyed a strong beginning, quickly enacting impressive tax reforms. Since then, however, the goal of achieving structural reform has faced one failure after another. Pension reform is a disappointment. The labor market reforms being called for by the government, including co-determination proposals, are reminiscent of the left-wing policies of the late 1960's. Is Germany (and perhaps also Italy) quickly becoming the anchor holding back the euro's ability to strengthen against the dollar?

OI: I should like to point out that the ECB does not make specific comments on individual countries within the euro area. This said, there can be little doubt that Germany has been among the growth laggards within the euro area since the start of EMU, and there seems to be little indication that this could radically change any time soon. This highlights the challenge facing the German government to improve structural conditions in order to raise potential output growth.

In general, comprehensive structural reform policies should aim to remove structural rigidities from the labor markets and to diminish adverse incentives in the tax, benefit, and pension systems. It is also crucial to improve investment incentives through measures such as deregulation, further privatization, and tax reform. As regards the relationship between the German economy (or the Italian economy) and the euro, I do not think that any development in one single country of the euro area can substantially affect the exchange rate in the long run. What matters is the euro area performance--and this has been very positive and is also currently quite good.

TIE: One of the big stories of last year was the overwhelming level of capital flows from Europe to the United States, sometimes running at an 8 to 1 ratio. It was as if European firms and investors saw the need to tie in somehow with the more flexible labor dynamic of the U.S. system. Do you see this investment phenomenon continuing? If so, what are the policy implications of such a development?

OI: During 2000, the United States was indeed a major destination for capital outflows from the euro area, in particular for direct investment. To a large extent, those outflows were related to mergers and acquisitions reflecting the efforts of euro area companies to reach the "critical mass" to become a global player, to gain access to innovations, for example in computer technology or bioscience, and to get a foothold in the perceived "New Economy" of the United States. This wave of mergers and acquisitions peaked around mid-2000 and subsequently declined.

Against this background, the high volume of capital outflows to the United States observed in 2000--and this may hold not only for direct investments, but also for portfolio equity investment--could be largely one-off. It may, however, also partly reflect the stronger dynamics of the U.S. economy and should in this context be interpreted as a major challenge to foster structural reform in the euro area.

TIE: A decade ago, it would have been unheard of for European policymakers --particularly German policymakers--to fix a policy eye on the stock market. Yet the psychology of the German investment and capital formation community appears to be influenced now by dramatic movements in the market.

Are you seeing the same phenomenon? To what extent has the steep sell-off in global stock markets affected the European investment psychology?

OI: The objective of the ECB's monetary policy is price stability. To the extent that stock prices have an impact on price developments, the ECB monitors stock price development. Our stability-oriented monetary policy strategy is well designed also in this respect. Under the first pillar of our strategy, we assess general and stock prices and their potential influences specifically on monetary aggregates and credit (and vice versa).

Under the second pillar, in addition to information on expectations of future economic conditions, we monitor the extent to which stock prices may influence macroeconomic conditions through the following three main channels: cost-of-capital effects on investment spending by firms, wealth effects on consumption by private households, and confidence effects on consumption and investment. Through these transmission channels, sustained stock price changes may affect the balance between aggregate demand and supply in the economy as a whole. This, in turn, may have implications for the inflation outlook and thus for monetary policy.

However, from a macroeconomic point of view, stock markets are much less important in the euro area than they are, for example, in the United States. The smaller relative size of euro area stock markets implies, when judged by currently available empirical evidence on the significance of the various transmission channels, that stock price changes can be expected to affect macroeconomic conditions in the euro area only to a limited extent.

TIE: More than a few analysts have commented that in terms of the European Central Bank power structure, policymakers from the smaller countries, economically speaking, appear to have become the tail that wags the ECB dog. They indirectly are in control. Because many of these countries are overheating, the argument goes, the ECB has been slow to reduce short-term interest rates despite obvious weakness in Germany and Italy, which comprise 50 percent of the size of the Union. Who's running the show at the ECB?

OI: Quite surprisingly, you also seem to succumb to this misguided view. The "argument"--if there is one--is flawed in every respect. Let me stress that one of the most satisfactory aspects of my experience at the ECB is that we have been able--from the start--to create a team, which is fully conscious of its mandate. This mandate regards the euro area as a whole. At the ECB, all the preparation, collection of information, and analysis is directed towards the assessment of the overall economic situation in Monetary Union. Our discussions and decisions within the Governing Council have always been and continue to be focused on the euro area. I believe that all the decisions we have taken are clear evidence of this.

So, to answer your question: The decisions are taken by the Governing Council, a body composed of eighteen people who may have views that differ in many respects, but who are united by the common goal of maintaining price stability in the euro area.

TIE: Are you entirely confident that the ECB and related agencies have a firm statistical grip on the European economies as a whole? To what extent are the data reliable? Or, are the data for Europe mixed at best, with some like those coming from the Bundesbank highly reliable, but others significantly less so?

OI: Overall, at this point in time, the quality of the euro area statistics used by the ECB is deemed to be sufficient for monetary policy purposes. However, our objective must be to achieve best practices. Some statistics are already of a very high quality, while in other areas there is still scope for significant improvement in both availability and timeliness. The Harmonized Index of Consumer Prices (HICP) has reached an advanced level of harmonization and quality.

The Eurosystem's money and banking statistics for the euro area are based on harmonized definitions of the money-issuing sector, the money-holding sector, and the categories of Monetary Financial Institution (MFI) liabilities. Hence, euro area monetary data have the advantage of being fully harmonized. Moreover, monetary data encompass the full reporting population and are not based on sample surveys, which enhances their reliability. In addition, monetary data are available in a timely manner, most on a monthly basis.

Regarding financial statistics, market interest rates do not pose any problems. Securities issues statistics are also available and fruitfully used for analytical purposes.

With regard to general economic statistics, the September 2000 EMU Action Plan, drawn up by the European Commission and Eurostat in close cooperation with the ECB, should lead to significant further improvements in key areas of general economic statistics for the euro area which were clearly needed and will be greatly welcome. The Action Plan focuses on important statistics, such as the national accounts, short-term statistics, and labor market statistics, where improvements are desirable.

TIE: In the conduct of monetary policy, some analysts argue that Alan Greenspan perfected the art of "baby steps," but that the Bank of England has taken the baby step-approach to new, higher and more refined levels. The British continually reduced short-term rates by modest amounts, with little effect on inflationary expectations. Has the popularity of this approach affected the thinking at the ECB?

OI: The ECB has its own monetary policy strategy to maintain price stability in the euro area. In taking monetary policy decisions, the Governing Council organizes its analysis of information on the economic situation and the outlook for price stability in accordance with the two pillars of its monetary policy strategy.

In the literature, it is common to define interest rate smoothing as a gradual adjustment of interest rates in one direction in a restrained manner. Thus, smoothing seems to imply small moves and few reversals in policy or, in other words, caution.

So far, when the ECB has changed its monetary policy stance, it has opted to move interest rates both by 25 and 50 basis points. Under its monetary policy strategy, the Governing Council of the ECB decides on the timing and size of the changes in interest rates with the aim of maintaining price stability over the medium term. In forming an overall view of the likely effects of the decision, it takes into account the extent of the risks to price stability, the desire to bring about specific signaling effects, and the uncertainty surrounding both the monetary transmission mechanism and the information coming from the two pillars.

The ECB does not like to react mechanically to short-term developments, but rather systematically responds to identified economic shocks and clear trends in the economy, which are relevant for the assessment of the outlook for price stability in the medium term. Thus, the optimal timing and size of changes in policy rates depends on the specific situation faced by the ECB.

TIE: Finally, if the Japanese government, in total, arrived at your doorstep and asked, in a nutshell, for you to provide the formula for ending Japan's decade-long economic and financial slump, what advice would you give them?

OI: I am not one of those who claim to have a simple answer to a complex situation. Nor am I one of those who believe in the wisdom of proposing "quick-fix" solutions in public. This may be a successful strategy to generate media headlines, but it does not contribute to a better understanding of the situation and fruitful cooperation between the authorities in charge of matters of public interest.

Otmar Issing is a Member of the Executive Board of the European Central Bank.