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Working papers / Bard College, Jerome Levy Economics Institute 323
At the start of 1999, a new policy regime was introduced in Europe that included the launch of the euro and the establishment of a centralized control over monetary policy common to the eleven European Union (EU) countries that decided to participate.(2) The objective of this paper is to assess the experiences over the new regime's first two years, particularly the performance of the European Central Bank (ECB) in charge of conducting area-wide monetary policy. The following recent developments in the euro area stand out. On the one hand, economic growth picked up markedly by mid-1999 and employment growth has been quite impressive, meanwhile lowering the rate of unemployment by some three per cent compared to extremely high levels reached over 1995-7. On the other hand, the new currency's external value had fallen by some 20 per cent up to November 2000 and inflation has increased from its very low level at the start to well above the ECB's declared tolerance level. Conventional wisdom views the former facts as being mainly driven by changing labor market institutions and wage trends (OECD 1994, 1999; ECB 2000b), and recent declines in unemployment were accompanied by downward revisions in NAIRU estimates (OECD 2000b). As regards the latter developments, the euro's plunge and the rise in inflation, there is a tendency to see them as not directly related to monetary policy itself; the tenor being that despite these failures the ECB has done a "good job". The analysis of this paper challenges this view, proposing an alternative interpretation of European growth, price, and labor market performance over recent years. In contrast to the conventional focus on labor market institutions this paper attributes a key role to demand-side factors as the driving force behind employment growth. A full assessment would have to also consider the fiscal policy shift to a more neutral stance that occurred in 1998. This paper focuses on monetary policy and the evolution of monetary conditions only. It is argued that the euro's plunge essentially resumed the trend of D-mark weakness that had started in 1996, introducing "easy money through the back door" as a magnifying factor behind the export demand stimulus that lifted Euroland out of the doldrums in 1999. To some extent, the roots of euro weakness thus lie in past: the low-growth legacies of unsound macro policies inflicted upon Europe over the 1990s. But the ECB made matters worse, first, by failing to communicate effectively and coherently with financial market participants and, second, by playing against the markets and running into the following time-inconsistency problem: attempts to prop up the euro through narrowing the current interest rate spread vis-?-vis the US $ fail if they are perceived by the markets as risking the euro zones growth prospects and hence the sustainability of tighter money in the future. Interest rate hikes may then weaken rather than strengthen the currency. A more balanced and pro-active attitude toward growth, and medium-term orientation as regards inflation, might have both reduced inflation in the short run and improved growth in the longer run. After discussing some a priori difficulties in assessing the ECB's performance in section 2, the analysis revisits the convergence process of the 1990s: section 3 concentrates on monetary conditions in Germany, while section 4 then illustrates that monetary conditions evolved markedly different in some other EU countries. A detailed discussion of the ECB's performance then follows in section 5, at first focussing on the ECB's ongoing communication problems, and then turning to the above-mentioned time inconsistency problem. Section 6 concludes.
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