Euro Reflections - interview with Otmar Issing - Interview

International Economy, The, May, 2001 by Otmar Issing

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.