European monetary system and european currency

As with inflation in the 1970s and 1980s, so unemployment in the 1990s - while being a European disease - is quite diversified across European countries and regions, due to differences in both policies and economic situations. It is over or around 20 per cent in the Mezzogiorno and Sachsen-Anhalt, but below 7 per cent in Lombardy and Baden-Wьrttemberg; over 18 per cent in Spain, but less than 4 in the Netherlands.

Notwithstanding the intergovernmental debates at a European level and the stated intention to undertake common initiatives, the instruments of employment policy remain in national hands, although only partly in the hands of governments. I regard this as appropriate because competition should not be suppressed from the labour market.

Adopting the appropriate policies of structural reform has proved extremely difficult in many key European countries, including my own and this one. Other countries, such as the Netherlands and the United Kingdom, have been more successful. Even the most successful experiences, however, have shown that reducing unemployment is a long and gradual process. Although some countries started labour market reforms in the early 1980s, they only reaped the benefits in the 1990s.

Unemployment will thus remain with us in the years to come and I am convinced that it should be regarded as the greatest policy challenge not only by governments and labour organisations, but by the Eurosystem as well. Let me explain why.

An economy in which unemployment drags above 10 per cent for years is a sick economy, just like one in which public finances or inflation are chronically destroying savings. To operate in a sick economy is always a risk for the central bank and for the successful fulfilment of its primary mission. In the case of prolonged unemployment, the risk arises both on a functional and an institutional ground.

On a functional ground, i.e. from the point of view of the relationship between economic variables that models usually consider, a chronically weak economy is one in which expectations deteriorate, investments stagnate, consumption declines. Structural unemployment may increase the risk of a deflationary spiral because a longer expected duration of unemployment may imply that households respond more conservatively (in terms of increasing savings) in the face of a deflationary shock. Today, we see no signs of deflation. Markets and observers who pay attention to communications by the Eurosystem know that the monetary policy strategy of the euro area is symmetrical, equally attentive to inflation and deflation. Thus, they know that if that risk became reality, the Eurosystem would have to act, and would act. But we know that monetary policy is much less effective in countering deflation than it is in countering inflation.

A more insidious threat, however, may arise on the institutional ground. It comes from a chain of causation involving social attitudes, economic theory and policy, actual economic developments and institutional arrangements. Attitudes of society respond to economic situations and policies, which in turn depend on the state of development of economics. Institutions, on their part, are influenced by attitudes of society. Both the course of economic thought and the practice of policy were lastingly altered by the Great Depression. The epitome of this historical event was the Keynesian revolution. In many countries the strong consensus about the primacy of price stability and the independence of the central bank was the outcome of the prolonged inflation suffered in the 1970s and 1980s. Here in Germany, it is rooted in the experience of hyperinflation. Would such a consensus survive if high unemployment remained a chronic feature of key European economies for many more years? And how would the position of the central bank change if that consensus faltered?

As central bankers primarily concerned with price stability, what can we do to cope with this challenge and to reduce the risks? My answer may seem disappointingly partial, as I do not think there is a miraculous medicine that monetary policy can provide. I would phrase it as follows.

Firstly, the central banker should be aware of the danger. He should know that in the future his principal objective may not receive, from the public, governments and parliaments the same strong support which has been the outcome of the two decades of high inflation. Since unemployment is what concerns the voters and the youngsters most, it may be increasingly necessary for him to play an educational role in explaining the benefits of a stable currency to those who have not directly experienced the costs of inflation. This is very much like the case of the post-war generations in Europe which, being fortunate enough not to experience the horror of World War II, need now to be reminded about the human costs of that terrible conflict.

Secondly, the central banker should avoid mistakes. It may seem obvious, but he should never forget that independence does not mean infallibility and that the likely new environment will offer no forgiveness for mistakes. A mistake would be the attempt to provide a substitute for the lack of structural policies by providing unnecessary monetary stimulus: it is not because the right medicine is neither supplied by the pharmacist nor demanded by the patient that the wrong medicine becomes effective. Another mistake would be to give the impression that the central bank has a ceiling in mind for growth, rather than for inflation. On the contrary, the central bank should make it clear that any rate of non-inflationary growth is welcomed and would be accommodated, the higher the better.

Technically, this will not be an easy task. The analytical uncertainty surrounding estimates of potential output and its growth rate might lead the central banker to respond quite cautiously to evidence of shifts in the rate of non-inflationary growth. While such caution is certainly optimal from an inflation stabilisation point of view, it might be wrongly interpreted as a systematic deflationary bias by the public and the politicians. This is a clear case in which any progress made by scholars in refining the analytical tools of the economic profession will greatly help the central banker to achieve his goals without imposing unnecessary costs on society at large.

On the whole, however, it is part of the central banker's role to make the day-by-day decisions that, in the end, constitute monetary policy. This responsibility can be neither transferred to, nor challenged by, policy makers responsible for other areas. Last week, the Eurosystem has made, for the first time in its life, an affirmative monetary policy decision by lowering its official rates. In this way, the Eurosystem has acted in line with its monetary policy strategy and made a significant contribution towards an economic environment in which the considerable growth potential of the euro area can be exploited in full. It is now the responsibility of other sectors of economic policy making to do their part by strictly adhering to the Stability and Growth Pact and implementing decisive structural reforms.

5. Managing financial transformations

The third challenge consists in accompanying and surveying the rapid changes the European financial institutions and markets are undergoing, and will continue to undergo over the coming years, partly - but not exclusively - as a consequence of the euro.

It is sufficient to observe the US Federal Reserve System to understand the role the Eurosystem should play in the coming years: attention in monitoring changes in the financial system, active participation in the policy debate caused by such change, intense dialogue with both the Administration and Congress, influence exerted on opinions and decisions.

To a large extent the factors of change are technology determined, hence independent of the euro and even not specifically European. Technology is the driving force of the transformation in banking and finance that modifies the traditional deposit loan structure of banks. Technology also reshapes dramatically the back office and the communication with customers, thus producing massive over-branching and over-staffing in traditional banks. Also the globalisation of finance comes primarily from the combination of data processing and telecommunications.

Other changes are specifically European. Since universal banking has historically prevailed in continental Europe, the change from an institution-based to a market-based financial system is particularly significant in this part of the world. Similarly, the development of financial conglomerates is more pronounced in Europe than in the United States or Japan. Typical of continental Europe are also the labour market rigidities that make the restructuring of banks so difficult and slow.

Finally, there are changes induced by the euro. The removal of currency specificity as a cause of national segmentation of the financial industry is causing a convulsive shake-up of both institutions and markets. Since the beginning of this year, about ten banks ranking near the top of their respective national lists have concluded or started merger operations in France, Spain, Italy, the Netherlands, Belgium and Norway. In most European countries stock exchanges and other organised markets, which were legally and structurally organised as providers of a public service, have been transformed into profit-driven private institutions and are now in a process of rapid concentration. In the coming two or three years the number of banks will shrink, the largest banks will become much larger, few financial centres and market networks will replace the present one-country one-centre configuration.

In any national system the central bank would actively monitor and even guide the course of such a transformation. It would do so along with the various agencies responsible for financial supervision and competition policy, and with an involvement of the executive power itself. Although largely determined by business decisions, these developments indeed involve the public interest in various ways.

Surveying and accompanying a profound transformation of the financial industry would be a difficult task for any central bank. For the Eurosystem it will represent a daunting challenge because it will put to the test an unprecedented articulation of the policy functions that are called for. Let me briefly explain this assertion.

The institutional setting of the euro area establishes a double separation between central banking and other public functions. Firstly, a functional separation, whereby banking supervision is now assigned to institutions that - even when they are national central banks - no longer exert independent monetary policy functions. Of this separation we have many previous examples (Germany, Japan, Sweden, now the UK, etc.). Much newer is a second, geographical, separation, whereby - with only the partial exception of competition policy - the area of jurisdiction of central banking does not coincide with the area of jurisdiction of the other public functions involved (banking supervision, regulation of the securities market, etc.).

Experts, including academic people, have so far focused attention on lender-of-last-resort functions and suggested that the new setting would not be able to act effectively in a crisis. I have argued elsewhere why this criticism seems unjustified. Here, I would like to suggest that the real challenge could come, in my opinion, from tensions between the national and the euro area interest in the process of financial transformation.

The process of industry transformation will inevitably involve aspects that have traditionally been considered as sensitive by public authorities: suppression of jobs, location of facilities and headquarters. Financial transformation will also produce a hardening of competition and competition will be, to a considerable extent, one between national financial centers and industries, not only between individual banks or institutions. The propensity to defend national champions may prevail over the pursuit of efficiency. The risk for the Eurosystem to fall in the trap of an improper interplay between the EU and the national dimension of the public interest may become high. Like any central bank, the Eurosystem should be both active and neutral in the great transformation of "its" financial industry. The word "system" that is part of its own name refers, and should apply in practice, to the whole euro area.

6. Coping with a lack of political union

The fourth challenge consists in coping with the lack of a political union. The relationship between monetary and political union and whether the latter should be a precondition for the former has been a central issue in the European debate well before the establishment of the Delors Committee in 1988. While I do think that there is a lack of political union and that this lack constitutes a serious challenge for the Eurosystem, I also think that the expression "lack of political union" is often used in an unclear way that blurs the issue. Let me thus first consider two meanings of this expression with which I do not concur.

First, I do not concur with the idea that there is no political union in Europe today. It is not because the content and the competence of the European Union are mainly economic, that its nature and historical role are not political. Even before the single currency, EU competence extended over virtually the whole Corpus Iuris of economic activity, from the establishment of "the free movement of goods, persons, services and capital" (the four freedoms proclaimed by Article 3 of the Treaty) to external economic relationships. To understand how very political these issues are, it should suffice to think about the place they take in the US political debate today, or have taken in the politics of our countries before the creation of the European Community. Moreover, the institutional architecture of the European Union is entirely that of a political system, not that of an international organisation based on intergovernmental co-operation: a legislative capacity that prevails over that of Member States, a judicial power, a directly elected Parliament.

Second, I do not concur with the idea that Monetary Union has developed outside the political process. Quite the contrary is true. The establishment of a single currency in the European Union has been achieved because of the strong political determination of elected governments over a full decade, from June 1988 to May 1998. It is significant that during that long period continuity has not been broken by repeated changes of political majority in virtually all countries except Germany. Technocrats, i.e. central bankers, have "only" played their role, crucial as it may be. They have provided expertise, from the drafting of the blueprint to the preparatory work for the actual start of the system. And, no less important, they have loyally accepted the limits of their role and recognised that the ultimate decisions have belonged to elected politicians. This is the meaning of the two statements of July 1988 and March 1998 with which the Bundesbank has defined its position at the beginning and the end of the crucial decade. "In der Beschrдnkung zeigt sich der Meister".

The establishment of a single currency is a strongly political event in its genesis and a profound social and cultural change in its nature. As economists and central bankers we pay limited attention to notes and coins because they are a minor and endogenous component of the money stock. For many politicians, however, Monetary Union meant little else than a common banknote. They saw, better than us, that for the people money has to do with the perception of the society to which they belong and, ultimately, with their culture. As such, money goes well beyond the economic sphere of human action. Indeed, the act whereby we accept to provide goods or services to an unknown person in exchange for pieces of paper that have no intrinsic value is perhaps the most significant and widespread testimony of the social contract that binds people. This is why coinage and money printing have always been a prerogative of the State.

Yet, for two main reasons it remains true that Europe has a lack of political union. First, the European Union is still not the ultimate provider of internal and external security, the two key functions that constitute the raison d'кtre of the modern State. Second, EU institutions still fail to comply with the key constitutional principles that constitute the heritage of western democracies: foundation of the legislative and executive functions on the popular vote, majority principle, equilibrium of powers.

Why does the lack of political union constitute a challenge for the Eurosystem? I would answer as follows.

In a period of less than thirty years money has abandoned both the anchors it has had since the earliest times: metal and the sovereign. It is true that central banks have struggled for years to free the printing press from the influence of the modern sovereign, as they struggled in the past to free it from the influence of private interests. It is equally true that the present status of the Eurosystem in the constellation of public powers is exceptionally favourable. However, only a superficial thinker could confuse independence with solitude and take the view that the lack of political union strengthens the position of the central bank and makes it freer to fulfil its mission.

The security on which a sound currency assesses its role cannot be provided exclusively by the central bank. It derives from a number of elements that only the State or, more broadly, a political union as previously defined, can provide. When we say that a currency is a "safe haven" we refer not only to the quality and credibility of its central bank, but to the solidity of the whole social, political and economic structure to which it belongs. And historical experience shows that when that structure appears to weaken, the currency weakens, irrespective of the actions of the central bank. A strong currency requires a strong economy and a strong polity, not only a competent central bank. The central bank is, and should remain, an institution with too limited a mission to replace the lack of a political union.

The problems posed by the coexistence of a single currency with a still unachieved political union will influence both practical and intellectual activity in the coming years. They will have implications for the central banker, the politician and, more generally, the citizen. For the politician the implication is that his political decision to move ahead with Monetary Union in advance of political union contains an implicit commitment to work for the completion of political union. The central banker should be aware of the special difficulties and responsibilities deriving from this anomalous condition. On the one hand he will have to cope with this situation and adapt his attitudes to a composite - EU and national - institutional architecture, one that lacks the simplicity he was used to and in which the Eurosystem now represents the most advanced supranational component. On the other he should be prepared for the further evolution of that same architecture. Finally, from the citizens that we all are, it will require a deeper reflection about the multiple "social contracts" he is part of, and the loyalties they entail.

Conclusion

I have been fortunate to operate in an environment in which no conflict has arisen between the central banking profession I have exercised for more than thirty years and the European conviction that, like many persons of my generation, I matured in my youth. Since the early '80s I have also been convinced that monetary union, i.e. a confluence of the two motives, was desirable and possible. At the same time, the challenges for the Eurosystem originate precisely from that confluence.

The challenges are not solely economic in their nature, nor can their features be captured by the functional relationships economists are most familiar with. Although partly related to economic factors, their features are in fact tied to the special institutional environment to which the Eurosystem now belongs. They derive from the tension between the completion of the union in the monetary field and the incompleteness of the overall construction. It is a tension because in that environment the notion of the public interest is no longer as simply and statically defined as it was when the Nation-State was an all-pervasive reality and the jurisdiction of the central bank coincided with its jurisdiction. Inevitably, this tension runs through the institutions of the European Union, the Eurosystem itself, and even our minds.

A challenge is a call to a difficult task; it entails the two notions of necessity and difficulty. The problems I have tried to describe are a challenge not only for practitioners, but also for the academic profession, because their solutions can hardly be found in a textbook and will only be invented if the creativity of practitioners will be supplemented with that of scholars.

Monetary policy in EMU

Prof. Otmar Issing, Member of the executive board of the European Central Bank, Washington, D.C., 6 October 1998

Introduction

On 1 January 1999, the curtain will rise on a world premiиre. For the first time in history, sovereign states will abandon their own currencies in favour of a common currency, and transfer their monetary policy sovereignty to a newly created supranational institution. This process is all the more unusual from a historical perspective because the national currencies involved are not being abolished because of their weakness. On the contrary, proof of a large measure of monetary stability is demanded as a precondition for participation.

The decision has been taken. The Euro will start on time. It must not - and it will not - fail. The European System of Central Banks (ESCB) will devote its best endeavours to making European Monetary Union (EMU) a success.

The French president recently called this unique project a "great collective adventure". As a central banker I am generally not in favour of "adventures" - but who would deny that there are risks and uncertainties in this enterprise? You should be reassured that at the European Central Bank (ECB), we have the necessary independence, instruments and tools to deal with these risks and uncertainties in a successful way. I will discuss some of these in a moment.

Moreover, when considering the uncertainties implied by the transition to Stage Three of EMU, we should not forget that Monetary Union will also reduce, or even eliminate, a number of risks. This has already been demonstrated, even before the actual introduction of the euro. Recent turmoil in international financial markets did not cause any significant disruption to exchange rates among currencies of the designated participants in Stage Three. This is a clear demonstration of the success of the EMU process.

Today, I will address the role of monetary policy in EMU.

First, I will make reference to the final goal of monetary policy - the maintenance of price stability.

Second, I will discuss some important issues relating to the design and implementation of the monetary policy strategy at the outset of Stage Three of Monetary Union; and

Finally, I will describe some features of the operational framework of the ESCB that have recently been finalised.

Let me begin by discussing the over-riding priority we attach to the maintenance of price stability.

1. The priority of price stability

The Treaty on European Union - the Maastricht Treaty - stipulates that the "primary objective of the ESCB shall be to maintain price stability". It was left to the ESCB to provide a quantitative definition of this primary objective. At the ECB's precursor, the European Monetary Institute (EMI), it was agreed that, in the interests of transparency and accountability, the ESCB's chosen operational definition of price stability should be announced publicly. This announcement would form an important element of the overall monetary policy strategy. Simply defining price stability leaves open the question of why price stability is desirable. As a central banker, the benefits of price stability appear self-evident. Any single argument in favour of price stability cannot comprehensively describe the benefits that it brings.

For instance, concerning the United States, Martin Feldstein has recently shown that, in combination with taxes and social contributions, even quite modest rates of inflation can cause considerable real economic losses. Research at the Bundesbank has produced similar results for Germany.

But elimination of the losses caused by this channel is only one illustrative example among the many benefits of price stability. The greatest contribution that the ESCB can make to the euro area's output and employment performance is to achieve and maintain the stability of prices. Stable prices are at the core of the 'stability culture' we are trying to create in Europe, a culture that is the foundation of sustainable and strong growth in the standard of living for Europe's citizens.

At the same time, the ESCB does not operate in a vacuum. Monetary policy needs to be supported by an appropriate fiscal policy and necessary structural reforms implemented at the national level if this 'stability culture' is to be built on solid and sustainable foundations. The private sector also has its part to play, notably by exercising wage moderation, given the high levels of structural unemployment in the euro area. Progress on all these dimensions is not only desirable, but also absolutely necessary. Monetary policy alone cannot ensure strong, non-inflationary growth and improved employment prospects throughout the euro area. However, only a monetary policy focussed closely on the achievement of price stability can lay the basis for these conditions.

Of course, that is not to say that the ESCB can, or should, ignore broader macroeconomic considerations. For instance, the threats posed by deflation in combination with nominal rigidities to the real economy have to be taken into account. In order to prevent any misunderstanding, let me be very clear: my discussion of deflation has to be seen in the context of the formulation of an optimal definition of price stability for the ESCB that takes into account deflationary dangers. These dangers certainly cannot be ruled out and our definition of price stability should reflect them. However, simply recalling the current rate of inflation in the euro area - 1.2% - shows that deflation is not an immediate concern for policy-makers. While periodic and transitory falls in the price level may be normal, and should not give rise to major concerns, a prolonged deflation is clearly inconsistent with any meaningful definition of price stability. Moreover, since nominal interest rates cannot fall below zero, a prolonged deflation may render the interest rate policy of the central bank rather ineffective. What remains is out-right purchases of assets - both foreign and domestic.

Similarly, the ESCB cannot ignore the implications of nominal rigidities in wages and prices for the transmission mechanism of monetary policy. If we were to live long enough under a regime of stable prices, I would not exclude the possibility that wage and price setting behaviour would adapt, and nominal rigidities would finally disappear. This would reduce some of the potential output costs of fighting inflation, and thus increase the net long-run benefits of price stability. However, for the time being we may have to live with these rigidities and take their effects into account when deciding on our monetary policy strategy.

In this respect, the present situation is not easy for the ESCB. Unemployment in the euro area is currently very high.

However, in contrast to these persistently high levels of unemployment - which are largely structural in origin - the prospects for maintaining price stability are currently very encouraging. Inflation expectations and long-term interest rates in the euro area are at close to historical lows. Actual area-wide inflation is also very subdued.

The current low 'headline' rate of inflation has been moderated somewhat by recent falls in oil and commodity prices, themselves stemming, in part, from the economic and financial crises in Asia and, more recently, in Russia. However, this effect on inflation has been largely off-set by the impact of indirect tax rises in a number of participating countries, which have raised consumer prices for certain goods. All in all, the changed external environment contributes to an overall outlook of very subdued inflationary pressures.

In defining price stability, one might ideally refer to a conceptual measure of 'core' inflation that tries to isolate monetary effects on the price level - for which the ESCB is properly responsible - from such terms of trade or indirect tax shocks, over which it has little immediate control.

In our month-to-month communication with the public, 'core' measures of inflation may prove useful. But, in its preparatory work for Monetary Union, the EMI recognised that any sensible definition of price stability for the euro area would have to be based on a comprehensive and harmonised price measure. 'Core' measures of inflation typically exclude some items. They are unlikely to be comprehensive enough to satisfy the requirements of an index suitable for a sensible public definition. These considerations point to using the 'headline' measure of the harmonised index of consumer prices (or HICP) for the euro area in the definition of price stability.

Finally, the ESCB needs to build on the success of its constituent national central banks (NCBs) in reducing inflation and achieving price stability during the convergence process in Stage Two of EMU. Given the current generally benign inflation outlook in the euro area that is the product of these accomplishments, there is an understandable desire to 'lock-in' the current success in achieving price stability as well as the apparent credibility of monetary policy, and ensure continuity with existing central bank practice.

2. The importance of the monetary strategy for a successful start of European monetary policy

When price stability is defined using the principles just outlined, how should the ESCB proceed to maintain it? In achieving and maintaining price stability - the primary objective of the Treaty - the choice of monetary policy strategy is vital.

Within the ECB, a considerable amount of work on the monetary policy strategy has already been completed, building to a large extent on the substantial earlier preparatory work of the EMI. A high degree of consensus has been reached among the NCBs and within the ECB about the main outlines of the strategy - I will address some of these areas of agreement in a moment. The final decision has not yet been made. But you should be reassured that progress is being made at a good pace. I have no doubt that we will be in a position to announce the details of the ESCB's monetary policy strategy in good time, prior to the start of Stage Three.

Being a new institution, the European Central bank must be prepared to come under intense scrutiny right from the start. In particular, the international financial markets will monitor its every decision like hawks. Facing this environment in the run-up to Monetary Union, the ESCB must ensure that everything possible is done to make the launch of Stage Three as tension-free as is possible. Choosing and announcing an appropriate monetary strategy is crucial.

The monetary policy strategy is, in the first place, important for the internal decision-making process of the ESCB - how the Governing Council will decide on the appropriate monetary policy stance, given the economic environment. Above all, the ESCB strategy must lead to good - that is to say, timely and forward-looking - monetary policy decisions.

But the strategy is also of the utmost significance in communicating with audiences outside the ESCB. It should stabilise inflation expectations. The more the strategy helps to promote credibility and confidence in the ESCB's monetary policy at the outset of EMU, the more effective that policy will be - and the easier the ESCB's task of maintaining price stability will become.

In deciding upon the appropriate monetary policy strategy, the following aspects must be seen as essential requirements. The strategy must:

reinforce the ESCB's commitment to price stability, the primary and over-riding task stipulated by the Treaty;

it must clearly signal the anti-inflationary objectives of the ESCB, and serve as a consistent benchmark for the

monetary policy stance; and, it must be transparent and explained clearly to the general

public - only then can the strategy serve as a basis for the ESCB's accountability to the public at large.

The realisation that achievement of an optimal, non-inflationary macroeconomic outcome may founder on the private sector's distrust has been central to the monetary policy debate of the nineteen-eighties and 'nineties. The search for answers to the questions raised by this debate has spawned an enormous economic literature. The keywords "time inconsistency" and "credibility" draw forth an almost unmanageable flood of publications that have appeared in the wake of the pioneering contributions of Kydland / Prescott and Barro / Gordon.

The need to establish a credible and consistent monetary strategy in the face of the well-known time inconsistency problem faced by policy makers - the dilemma highlighted by this economic literature - is especially important for the ESCB at the outset of Monetary Union. As a brand new institution, the ESCB will have no track record of its own.

Building its reputation, and the associated credibility of monetary policy, is vital. But the process of doing so is complicated by the relatively high level of uncertainty surrounding the transition to Monetary Union itself. The transition to Stage Three is a unique event, and will create unique opportunities for many - but it will also create some unique problems for monetary policy makers. At the ECB, we are addressing these problems and are confident that the risks can be managed successfully. Many of the difficulties we face will be overcome through our own efforts over the coming months.

Among these problems are the difficulties involved in creating a comprehensive and accurate database of euro area-wide statistics. Running a single monetary policy for the euro area requires timely, reliable and accurate euro area data. In some cases, the euro area statistics simply did not exist until quite recently. In others, the statistics are based on new concepts, and the properties of the data series are not yet well known. The long runs of high quality back-data required for empirical economic analysis may be unavailable. Those that do exist are likely to have been constructed using some degree of estimation and judgement, possibly rendering the econometric results produced with them questionable.

Furthermore, the regime shift associated with the adoption of the single monetary policy may change the way expectations are formed in the euro area, and thereby alter forward-looking economic behaviour. Monetary policy's effects on consumption, investment, and wage bargaining - and therefore the whole transmission mechanism of monetary policy to developments in the price level - would be among the important economic relationships to be affected in this way.

This may be no bad thing. Indeed, using the regime shift implied by the transition to Stage Three to change both public and private sector behaviour in favourable directions may be one of the largest gains that the euro area can extract from Monetary Union. Nevertheless, these changes are likely to complicate the implementation of certain important elements of a monetary strategy, at least in the short term, as past relationships between macroeconomic variables may break down. What is good for the euro area economy as a whole may create some practical problems for the ESCB.

One example of this so-called 'Lucas critique' phenomenon is the impact of current, very low rates of inflation on private behaviour. For many countries participating in Monetary Union, there is simply no - or only very recent - experience of how the private sector will behave in an environment of sustained and credible low inflation. Instability in past relationships may result, should behaviour change in this new, low inflation environment. I have already argued that these structural changes will benefit Europe's citizens - price stability will allow markets to work more efficiently, thereby raising growth, and improving employment prospects. But these changes may also complicate the ESCB's assessment of economic and financial conditions.

These uncertainties - arising directly from the transition to Stage Three itself - are both compounded by, and inter-related with, the broader economic context in which Monetary Union will be established. The increasing internationalisation of the global economy, and the current rapid pace of technological change, have affected all sectors of the economy, and the banking and financial systems in particular. For example, at present there are many, inter-related innovations in the payments system, such as:

the introduction of TARGET (directly related to EMU itself);

greater technological sophistication of payments mechanisms, as use of computers and information technology becomes more widespread and advanced;

the additional incentive for cash-less payments that may arise from the fact that for some time to come - approximately three years - the new euro-denominated notes and coin will not come into circulation. In particular, narrow monetary aggregates might be affected by this development; and,

increased competition among banks and settlements systems, arising from globalisation and the breakdown of barriers between previously segmented national markets, which may drive down the margins and fees charged to customers.

At the ESCB we will need to keep abreast of these developments, both for their immediate impact on one of our "basic tasks" - promoting the smooth operation of the payments system - and because of their broader implications for the euro area economy. Reducing transactions costs in the way I just described will benefit European consumers and producers - but it may also change the indicator properties of monetary, financial and economic variables that national central banks have looked to as guides for monetary policy in the past.

Finally, in Monetary Union there will be some heterogeneity across countries within the euro area. Europe's diversity is one of its greatest assets. But this diversity is greater than is typically the case between different regions in the same country using a single currency. Nevertheless, the ECB Governing Council will have to concentrate on monetary and economic developments in the euro area as a whole when discussing and taking monetary policy decisions.

How should a monetary policy strategy be selected in this - for monetary policy makers, at least - potentially difficult environment? The EMI outlined a number of 'guiding principles' for the selection of a monetary strategy by the ESCB. Foremost amongst these was the principle of 'effectiveness'. The best monetary policy strategy for the ESCB is the one which best signals a credible and realistic commitment to, and ensures achievement of, the primary objective of price stability.

For many commentators, this criterion points unambiguously in the direction of so-called 'direct inflation targeting'. If monetary strategies are to be judged according to how well they achieve price stability, defined as a low rate of measured inflation, then advocates of inflation targets argue an optimal strategy would surely target this low inflation rate directly. These commentators would place explicit quantitative targets for inflation itself at the centre of the ESCB's monetary policy strategy. Their approach has been strongly endorsed in some academic and central banking circles.

But, in the current circumstances, a pure 'direct inflation targeting' strategy is too simplistic for the ESCB, and possibly even mis-conceived. The ESCB well understands the primacy of price developments and price stability for monetary policy making. Indeed, the Treaty's mandate is unambiguous in this respect. We will signal our intentions on this dimension very clearly by making a transparent public announcement of our definition of price stability. The current low level of long-term nominal interest rates in the euro area suggests that the financial markets, at least, understand and believe the over-riding priority that we attach to achieving price stability.

Regarding strategy, our choice therefore need not be governed solely by a desire to signal our intent to maintain price stability. This has already been well-established - by the Treaty, and by the success of the convergence process in reducing inflation in Europe to its current low level. Rather than signalling our intent, the strategy must constitute a practical guide that ensures monetary policy is effective in achieving the goal we have been set.

In this respect, there are considerable problems with using inflation itself as the direct target within the ESCB's overall strategy. Because of the well-known lags in the transmission mechanism of monetary policy to the economy in general, and the price level in particular, it is impossible for a central bank to control inflation directly. Therefore, 'inflation targeting' in practice means 'inflation forecast targeting' where central banks set monetary policy to keep their best forecast of inflation at the target level deemed consistent with price stability.

But recognition of this need for forecasts in an inflation targeting strategy immediately raises practical difficulties. In the uncertain environment likely to exist at the outset of Monetary Union, forecasting inflation will be very difficult, not least for the conceptual, empirical and practical reasons I outlined a moment ago. Forecasting models estimated using historic data may not offer a reliable guide to the behaviour of the euro area economy under Monetary Union. Forecast uncertainty is likely to be relatively large, possibly rendering the whole inflation targeting strategy ineffective.

To address these uncertainties, a large element of judgement would have to be introduced into the forecasting process, in order to allow for the regime shifts and structural and institutional changes that are a seemingly inevitable consequence of EMU. Simply relying on historic relationships to forecast future developments is unlikely to prove accurate or effective. While introducing judgmental adjustments into forecasts in these circumstances would be both appropriate and necessary, such adjustments are likely to compromise the transparency of the inflation forecasts and, thus, of any inflation targeting strategy. Using judgement may prevent outside observers from readily assessing the reliability and robustness of the inflation forecasting procedures used by the ESCB.

I see a distinct bias in the academic discussion of the comparative advantages of inflation targeting and monetary targeting. With good reason, many arguments are presented against the ESCB adopting a monetary target. But proponents of inflation targeting seem to forget that, in the current context, most of these arguments could also be used against inflation targeting. Above all, I have not seen any attempt thus far - even if only a tentative one - to explain how the ESCB should deal with the specific difficulties involved in making an inflation forecast at the outset of Monetary Union that could be used as the centrepiece of an inflation targeting strategy.

In many respects, a strategy giving a prominent role to monetary aggregates has considerable advantages over direct inflation targeting. Monetary aggregates are published. They are clearly not subject to various kinds of 'judgmental manipulation' by policy makers or central bank staff that might be possible with inflation forecasts. To the extent that policy makers wish to depart from the signals offered by monetary growth because of 'special factors' or 'distortions' to the data - including those distortions arising from the transition to Monetary Union itself - they will have to do so in a public, clear and transparent manner.

Moreover, a strategy that assigns a prominent role to the monetary aggregates emphasises the responsibility of the ESCB for the monetary impulses to inflation, which a central bank can control more readily than inflation itself. These monetary impulses are the most important determinants of inflation in the medium term, while various other factors, such as terms of trade or indirect tax shocks, may influence the price level over shorter horizons.

In the light of these considerations, it was agreed at the EMI that, regardless of the final choice of the monetary policy strategy, monetary aggregates would be accorded a prominent role in the overall monetary framework adopted by the ESCB.

However, the EMI also noted that certain technical pre-conditions would have to be met before this 'prominent role' could be translated into an explicit, publicly announced monetary target, guideline, benchmark or monitoring range. Specifically, such targets or ranges would only be meaningful guides to monetary policy if the relationship between money and prices - as encapsulated in a 'demand for money' equation - was expected to remain sufficiently stable.

In this regard, several existing empirical studies point towards the stability of the demand for euro area-wide monetary aggregates. However, these studies are necessarily only preliminary. The reliability of these results in the face of the uncertainties raised by the transition to Stage Three is unknown. Future shifts in the velocity of money are certainly possible - perhaps even likely. They cannot be predicted with certainty. Moreover, it is not clear whether those aggregates that have the best results in terms of stability are sufficiently controllable in the short-term with the policy instruments available to the ESCB. In these circumstances, relying on a pure strategy of strict monetary targeting is simply too risky.

Against this background, the ESCB will have to design a monetary policy strategy of its own. The chosen strategy will show as much as possible continuity with the successful strategies that participating NCBs conducted in the Stage Two. At the same time the ESCB's strategy will take into account to the extent needed the unique situation created by the introduction of the euro.

3. The new monetary policy instruments and procedures for the euro area

Having a well-designed monetary strategy is vital. But we must also be able to implement it successfully at an operational level. What instruments are available to implement this strategy?

The ECB will have a complete set of monetary policy instruments at its disposal. These instruments have been selected on the basis of their efficiency for transmitting monetary policy and their neutrality across market participants.

Three types of instruments are available to the ESCB: open market operations, standing facilities and a minimum reserve system. I will briefly present these instruments in the remainder of my speech.

3.1 Open market operations

Open market operations include, first, a weekly main refinancing operation, which will take the form of a reverse repurchase transaction with a maturity of two weeks. The main refinancing operation will be based on a tender procedure. The tender may be a fixed rate tender, with counterparties bidding amounts, or a floating rate tender, where counterparties propose bids including both amounts and interest rates.

Second, there is the monthly longer term refinancing operation, which has a maturity of three months and will always take the form of an interest rate tender. This is because the ECB will avoid signalling its monetary policy stance through these particular operations.

The ECB will also conduct fine-tuning operations, through the national central banks of the euro area or, in exceptional circumstances, on its own account. Fine tuning operations will be conducted whenever liquidity or money market conditions warrant. Fine tuning operations may take the form of reverse repurchase transactions (that is, the same type of transaction as that used in the main refinancing and the longer term refinancing operations, but with no pre-set start date nor a pre-set maturity), foreign exchange swaps or the taking of fixed-term deposits. Fine tuning operations in the form of reverse repurchase operations may be executed either through quick tenders or bilaterally. In both cases, these operations will involve a limited set of eligible counterparties that have an appropriate track record of activity in the money market. The other types of fine tuning operations will also be executed with a limited number of eligible counterparties, which will be selected ex ante by the ECB. In some countries, there will be a rotation scheme, which will aim at giving the opportunity to all eligible fine tuning counterparties to participate in fine tuning operations.

Finally, open market operations may also be conducted whenever structural reasons, such as the longer-term evolution of liquidity profiles, warrant it. These so-called structural operations may take the form of outright purchases or sales of securities or the issuance of debt certificates by the ECB.