The impact of war on the Eurozone
European Central Bank Executive Board Member Professor
Otmar Issing on Monday addressed the European Parliaments Committee
on Economic and Monetary Affairs. Following are extracts from Issings
speech, in which he spoke about the potential economic impact of war
in Iraq, economic and monetary developments and monetary policy decisions
of the ECB and on a number of structural reforms in the euro area
Potential impact of the war
In these days, any consideration of the current and prospective economic
situation starts and ends with the consequences of the war that started
What can central banks do under such circumstances? My main message
is: contribute to strengthening confidence, which means showing that
the central bank is up to the challenge. But it also means cautioning
against exaggerated expectations. It was in this spirit that the Governing
Council of the ECB published its statement when it met last week, announcing
its readiness to act if necessary. Financial markets can rely on the
provision of sufficient liquidity even under exceptional circumstances,
as was demonstrated in the past.
In addition, in times of severe tension, it is of the utmost importance
that policymakers do not lose sight of their primary responsibility,
so as to reduce uncertainty and strengthen confidence. The ECB will
therefore continue to evaluate thoroughly the course of events in light
of its mandate.
The impact of this military confrontation on the global economy can
vary significantly in scope and size, depending on the extent and duration
of the conflict. It is therefore not possible at this juncture to conclusively
assess the short and medium-term implications for the euro area. At
this stage, there are mainly two scenarios under discussion.
The pessimistic scenario foresees a strong and protracted increase in
oil prices, accompanied by a rather severe loss of confidence, giving
rise to expectations of subdued demand. Tourism, international travel
and trade would be affected, stock markets would decline further, and
exchange rate volatility would increase. All this would hamper both
private investment and consumption. In such a scenario, we might even
see a rise in inflation in the short term, accompanied by a weakening
of economic activity.
The other, more optimistic scenario is based on a fairly short conflict;
much of the current uncertainty would be eliminated, leading to a rebound
in confidence and a faster recovery than currently expected, as pent-up
investment and consumption plans unwind. Moreover, the turbulence in
oil and foreign exchange markets would probably diminish.
Economic and monetary
The Governing Council of the ECB decided at its meeting on 6 March 2003
to reduce key ECB interest rates by 25 basis points. Its decision took
account of the improved outlook for price stability over the medium
term. With this move, key ECB interest rates have reached very low levels.
On the basis of available information, the current monetary policy stance
helps to preserve price stability over the medium term and provides
some counterbalance to the factors which are currently having an adverse
effect on the economic outlook.
The assessment of the inflation outlook was in particular shaped by
the subdued pace of economic growth and the appreciation of the exchange
rate of the euro. In fact, the available information indicates that
economic activity in the euro area remained sluggish at the turn of
the year and that the outlook for economic growth in the euro area in
2003 has weakened compared with previous expectations, mainly due to
geopolitical tensions and the associated rise in oil prices. We now
expect only a very modest rate of economic growth this year. The sluggish
pace of economic activity should contribute to dampening inflation,
influencing price and wage-setting behaviour.
The significant appreciation of the nominal effective exchange rate
of the euro over the past year is also expected to continue to dampen
inflation. Overall, if oil prices normalise in the future, as currently
expected by markets, the most likely outcome will be that inflation
rates will fall below 2% in the course of 2003 and remain clearly at
levels in line with price stability thereafter. I should emphasise that
this expectation relies on the assumption that, especially in an environment
of subdued economic growth, wage moderation will prevail. In fact, some
recent indications suggest more modest wage developments towards the
end of last year, but this picture will need to be confirmed in the
future. In this respect, in the past we have seen that wage growth hardly
responded to a weakening in economic activity.
Let me add that we considered continued strong monetary growth as no
obstacle to our decision to reduce interest rates because it very likely
reflects an ongoing pronounced preference for liquidity in an environment
of high financial, economic and geopolitical uncertainty. Recent data
on loans to the private sector, notably the weak growth in loans to
non-financial corporations in late 2002, confirm this assessment.
While the most likely scenario is that real GDP growth will gradually
increase in the second half of this year, benefiting from a global economic
recovery and from the prevailing low levels of interest rates, our expectations
for future developments in inflation and economic activity are, however,
overshadowed by the implications of the war in Iraq.
Structural reforms and fiscal policy in the euro area
Turning to structural reforms, it is essential in a highly uncertain
environment that governments help to boost investor and consumer confidence
by taking decisive actions to support the growth potential of the euro
area and to facilitate the adjustment of euro area economies to economic
A positive sign is that policymakers and the public no longer seriously
disagree on the need for, and the broad direction of, structural reforms.
To take just one example, we no longer argue whether competition is
needed in the provision of utilities; we are now searching for the best
ways to promote and strengthen competition.
However, agreeing on the objectives is one thing; delivering them is
another. Structural reforms take a long time to implement and to produce
results in terms of higher income and higher employment. Short-term
adjustment costs and economic uncertainty should not be used as a justification
to slow down the reform process. It is particularly disappointing therefore
that the pace of reform in 2002 remained slow and insufficient for the
Lisbon objectives to be met, as the European Commission has noted in
its Communication on the implementation of the 2002 Broad Economic Policy
The pace of reform should be kept up in network industries, such as
telecommunications, gas and electricity, where the benefits of higher
quality and lower prices are now being enjoyed by consumers. Policymakers
should ensure that competition within and among EU countries is strengthened.
The current downturn must not serve as a justification to stop the process
With respect to fiscal policy, recent experiences have taught us that
ad hoc and piecemeal policy adjustments have not brought progress towards
sound public finances and strong economic growth. The Key Issues paper
for the 2003 Broad Economic Policy Guidelines therefore rightly requests
a comprehensive reform strategy that ensures long-term fiscal sustainability
and strengthens growth and employment. Strong growth helps to carry
out consolidation in the short run and supports steady debt reduction
in the medium term. This is all the more necessary in view of the projected
fiscal burdens due to population ageing.
In light of the high tax burdens and remaining imbalances, reforms in
most countries should focus on restraining the volume of, and restructuring,
Such efforts will support the framework laid down in the Treaty and
in the Stability and Growth Pact, and in doing so they will contribute
significantly to confidence and to favourable financing conditions for
the private sector. In this respect, and with regard to the updated
stability programmes, I believe that such programmes strike a reasonable
balance between letting automatic stabilisers operate and seeking further
consolidation where needed. Moreover, the ECOFIN Council is rightly
demanding the maintenance or attainment of close-to-balance or in-surplus
positions and sustainable debt positions while confirming the appropriateness
of the existing rules. In order to further boost confidence in the fiscal
framework and the economic environment, it is therefore essential that
the commitments made in the stability programmes and the request to
further improve fiscal positions, as subsequently agreed in the ECOFIN
Council, are implemented in full.