Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 34 - Evidence
OTTAWA, Tuesday, April 27, 1999
The Standing Senate Committee on Foreign Affairs met this day at 2:55 p.m. to examine the consequences for Canada of the emerging European Monetary Union and other related trade and investment matters.
Senator John B. Stewart (Chairman) in the Chair.
[English]
The Chairman: We have before us today Mr. John Murray, Chief of the International Department of the Bank of Canada. Those of you who have been on the committee for some time will recall Mr. Murray's previous appearance before this committee. He was extraordinarily lucid, if I remember correctly, on some complicated economic questions. Mr. Murray, please tell us what has happened relative to the European Monetary Union since we made our report, which I believe was in June of 1996.
Mr. John D. Murray, Chief, International Department, Bank of Canada: We at the bank are quite interested in this topic and follow it closely, and I thank the committee for this opportunity to talk to others who are interested and to exchange views.
I have adapted an outline borrowed from a presentation that I made last month at York University. The topic was somewhat different but I have restructured it. The second page of my brief outlines what I had planned on speaking to, but if there are other issues that you wish to discuss, I would be pleased to do that. Please do not hesitate to raise questions or to redirect my presentation.
I wish to begin with a reminder of the concerns that I listed in my last presentation in the spring of 1998, in part to see how close we were to the mark and in part by way of a post-mortem to see what has happened.
A second set of issues relates to the recent economic performance in Europe. I should like to look at how Europe has done, both in terms of the real economy and in terms of its financial markets, in the run-up to EMU and the launch of the euro, through 1997 and 1998 and in then in the brief period since. We do not have a significant amount of experience post-EMU, but already I think we can see certain pressures developing, certain important issues emerging.
That will bring us to the third and perhaps most important set of issues, which I call unresolved issues. Those are the lessons and implications for Canada. They are very similar to the issues that we had identified earlier, but we can speak to them with a little more confidence now. It is still very early, so you hate to say anything too definite. However, to a surprising degree, some of the predictions we made earlier, both with regard to issues that are not important for Canada and with regard to those that might be, seem to be coming true.
Page three lists some of the concerns we noted just prior to the launch of the EMU. They are not comprehensive, but they relate to some of the short-term risks. The first and most obvious was the possibility of a speculative attack just prior to the final conversion of national currencies. People were worried that speculators would wait until the end and then make their move and try to destabilize the initiative.
Second, there was a more general concern about the macroeconomic tensions that seemed to be developing among the 11 member countries as they tried to qualify for the EMU and satisfy the Maastricht agreement. Some found it easier than others to meet the criteria.
The third point we noted related to the different views that seemed to be emerging with regard to the amount of political oversight that the Euro-11 Council would or should exercise over the ECB.
Finally, there were some concerns expressed about what EMU might do to the financial markets in Europe, particularly the banking sector. There were already pressures within Europe to rationalize their banking system. They have been terribly over-banked. Pressures already existed in the international community favouring merger activity, something we are all too familiar with in Canada. The sense was that EMU would exacerbate those pressures and potentially create short-term instability.
Obviously, some of those issues are more important than others. Most notable is the political tension that developed between the finance ministries of Germany and France with regard to the conduct of monetary policy by the ECB. That problem diminished with the departure of Mr. Lafontaine but it is still there. Politicians are not entirely comfortable with the autonomy and independence of the ECB, especially with regard to exchange-rate matters.
We will also touch on the initiatives proposed by Mr. Lafontaine in Germany and Mr. Strauss-Kahn in France, with support by Japan, for target exchange rates among the major currencies -- the U.S. dollar, the yen and the euro. In other words, many Europeans wish to go further. The launch of the euro is just the beginning. Distrustful of financial markets, they would like to see more intervention, more control of the major currencies, and they were pushing for that until recently. That, too, has eased slightly.
In terms of banking, restructuring and mergers, you are no doubt familiar with the situation in France with the Société Générale, Banque Paribas and the Banque Nationale de Paris. There is also merger activity in Italy. Earlier U.S. trends that were already evident in 1997 and 1998 have become even more important. Towards the end of my presentation we will link that with pressures in Canada and what that might say about our banks and about how big is big enough.
If you turn to page 4 and the recent economic performance, there are a number of things to note. First, taking the Euro-11 as a whole and looking at the performance of what we call the real economy as opposed to the financial markets, the results have been rather mixed. In fact, I would say that performance has been mixed to poor.
In the first set of graphs, I have tried to give you some idea of how the Euro-11 has done over the last two years compared to Canada and the United States. The first chart, on GDP growth, shows that the U.S. has consistently done very well throughout the period. There was a brief period where our growth exceeded theirs through 1997. Then we dipped, in large part, if not exclusively, because of what happened in Asia and, in turn, what happened to world commodity prices. We were more heavily affected than the U.S. by that.
Things looked very promising for Euroland through 1997. Their growth was below that of Canada and the United States but it was converging quickly. Since then, it has dropped quite significantly. In fact, it has dropped more than this graph would suggest, because not all of the Euro-11 economies have reported their results through the first quarter. Therefore, we cannot extend the graph that far. However, the early indications are that some of the major economies, and I would include here perhaps Germany, could experience negative growth through the latter part of 1998 and into 1999. In other words, Euroland is having a more difficult time with regard to real growth than this graph might suggest, even as growth in Canada appears to be nudging up.
On the topics of inflation and the CPI, all of the countries have generally done very well. We moved up for a time and then back down. However, I should like to concentrate on Euroland. The results are not very significant or large, but what might not be clear with that subtle downward trend in the Euro-11 line is that some of them technically are in deflation.
There is a measurement error that is normally associated with the CPI. There is a natural bias embedded in the CPI. If you subtract that out to get what might be called the true or effective measure of inflation, then countries such as France and Germany are now deflating, although not by a large amount. However, they have definitely overshot what one might regard as the lower bound of the inflation targets for the ECB. That is testament in part, of course, to the weak real economy.
Unemployment remains a problem in Europe. Although it has been trending down ever so slightly, on average, it is still well above 10 per cent. There are exceptions in Europe, which we will get to in a minute, but most of them, and most of the large countries, still have unemployment rates of about 10 per cent. As you know, the debate is whether this unemployment is structural or cyclical.
Canada, which is doing better than it had, and certainly better than Europe, and which is improving through time, is now back to the same unemployment rate we last saw in June 1990. We expect to do much better: 7.8 per cent is not good but it is on the way.
We often refer to the U.S. miracle. They have gone through a period where they appear to have had the best of everything -- low inflation, the lowest unemployment rate in over 30 years, and remarkable growth in real output and productivity. We would like to replicate it here.
Senator Stollery: They have also had a negative savings rate.
Mr. Murray: We share that with them, unfortunately. That is a measurement question to a degree. The capital gains realized through property investments as well as securities are not factored into those calculations, as you know. If those are added back in, there are still significant, positive savings in both Canada and the United States. The question within that, of course, is whether this will continue.
It should be noted that while Europe has not been doing terribly, there are some concerns. The performance of Europe on the real side of the economy has not been great. There is a concern at the margin with deflation; there is a concern that growth is continuing to slow; and there is concern that the unemployment rate is not coming down, at least not very quickly.
In part, this can be credited to three things. First, many countries had to institute tight fiscal policies in order to qualify or satisfy the Maastricht criteria. Second, the ECB instituted a tight monetary policy that it felt was necessary to establish its credibility early on. There was an easing in the late fall, just before the launch of the euro -- 50 basis points. Duisenberg, the president of the ECB, announced that this was the last easing for a while. Events proved him wrong, as you may know. Only two weeks ago, the ECB eased by another 50 basis points.
With their low inflation rates, however, this still leaves what we call real rates of interest: interest rates operating at less than the rate of inflation and at fairly high levels, given their stage in the business cycle. Therefore, I do not want to suggest that monetary policy in Europe has suddenly become easy or accommodating enough. Some of us would like to see somewhat more easing.
What has helped them through this period is the weakness in the euro itself. In combination with the interest rate cuts, it is helping to stimulate their economies. However, this occurs with a lag. The economy cannot be turned around instantly.
The third point relates to the financial crisis in Europe, Latin America and Russia. The countries in Europe were not as affected as Canada by these crises. I am thinking mainly of Asia. Russia, however, affected Germany. Asia affected Italy to a surprising degree. Japanese citizens as well as consumers in other countries had a tremendous appetite for Italian fashion goods and other products. When they went into crises, Italy was the one major European country that appears to have suffered. Therefore, the combined impact on Europe may not have been significant. The combined impact added to the other two factors.
People have worried that the "one size fits all" monetary policy, that now had to be conducted through the ECB, would prove very uncomfortable for some of the members. This is shown on some of the other graphs that I have provided.
On the third page is a graph that looks similar to the others. It has GDP growth, followed by CPI inflation, followed by the unemployment rate. It gives some idea of the divergence and experience across the Euro-11.
These graphs are small but they show what is happening. First, with regard to GDP growth, you will note that some countries, like Ireland and Finland, have been growing at an 8 to 10 per cent rate throughout this period. The line for Ireland may look suspicious. It is both flat and high. Ireland is unique in that it only reports annual data. I cannot give you the quarterly fluctuations and because they have not released 1998 data, and therefore the line does not go very far. The correct sense is one of tremendous growth in Ireland. Finland has also been very strong. Although it is not shown here, Portugal and Spain are very strong as well.
Other countries, however, such as Italy and Belgium, have not done as well. Indeed, if we could extend this line to the fourth quarter, you would see negative growth in Italy -- not just low growth, but negative.
I emphasize that there are different experiences in the European countries. A more accommodating monetary policy would be appropriate for Europe as a whole. There are countries, such as Ireland and Finland, where this is the last thing needed. They are already encountering some inflationary pressures.
If we turn to inflation, one can see that Portugal is shooting off the end of the page. They do not need a more accommodating monetary policy -- even as France heads in a negative direction. Finland has also been heading down, although as I noted earlier, its growth has not been that bad.
There is also a divergence in unemployment. In Spain, the unemployment rate is barely below 20 per cent. Fortunately, they are one of the countries that has been growing quickly over the last year or two. Italy is experiencing hardly any movement. They appear to be stuck at about 12 per cent. Austria is experiencing some fluctuation. The Netherlands is dipping below 5 per cent now. The Netherlands, with the exception of Luxembourg, is the unemployment champion in Europe by virtue of having the lowest unemployment rate. These graphs are so small that you do not get a sense of the differences. However, the differences are quite large and are producing tensions in terms of policy setting in Europe.
Thus far, I have concentrated on the real side of the economy. Let us turn to the financial markets. The news is somewhat better. Everything one hoped to see with regard to interest rate convergence has happened. Short-term interest rates in Europe converged at about the German levels, as they should. Long-term interest rates, barring some minor differences in credit risk, have also converged.
The second page of graphs shows a comparison between Canada, the United States and Germany of long-term interest rates, short-term interest rates and stock market activity. Germany is used as a reference because that is where the other European countries will move. All of us have done fairly well with regard to long-term interest rates.
In regard to short-term interest rates, the U.S. interest rates were higher to start with, reflecting their position in the business cycle and their solid growth. Canadian interest rates were lower, started to rise, touched the U.S. curve and are now heading back down. It cannot be seen from the graph, but Canadian interest rates are lower than U.S. interest rates now, everywhere across the yield curve. The low long-term rates and short-term rates reflect, in part, our lower inflation rate as well as our somewhat different position in the business cycle. We have more growth and more capacity to use at this point.
Canada, with a stock market dominated by commodity producers, has not done quite as well as the Dow Jones in the U.S, nor has it done as well as the FTSE in the U.K. European stock markets have done quite well. Even though the real economy has underperformed, the stock markets seem to have liked them.
Turning to the last page of the graphs, various stock indexes in Europe have been plotted accompanied by their performance. The only one that has not done well is Austria. I note that not because it is important, but more as a curiosity, an anomaly.
The second last page of graphs gives a sense of the interest rate convergence in Europe through 1997 and 1998 and the launch of the euro at the end of 1998. The differences disappeared virtually at the long end. France, Germany and Italy have slightly wider margins separating them from some of the other countries.
The convergence on short-term interest rates is represented on the third last page. Activity in the exchange rates is represented on the fourth last page. These activities are not terribly significant. What is not evident, and might have been useful for this package, is the more detailed graph of the last four months. A graph of the last four months could show us the euro plotted against the U.S. dollar. The euro started on January 4 at a level slightly above U.S. $1.16 and is now trading at U.S. $1.05, U.S. $1.06. It has fallen a little over 10 per cent against the U.S. dollar during the four-month period.
I would stress that this activity is what is necessary; it is what is appropriate. Given the weakness in the real economy and given the position of the European economy relative to the U.S, one would hope to see a strong U.S. dollar. Germany and the rest of Europe need, at this point, a softer currency to help rejuvenate spending and stimulate exports. The financial markets are delivering what the economies need.
Turning back to page 4 of the point form notes, we have discussed the uneven performance across the Euro-11, the achievement of greater stability in exchange rates and interest rate conversions, and finally, without highlighting it, the superior performance of equity prices across Europe. They did start at a lower base than the Dow or the TSE.
Clearly the European countries have some economic challenges with which they must deal. As well, they have the unresolved role of the Euro-11 Council and monetary policy. The ECB, the European Central Bank, was guaranteed independence. However, as I noted earlier, the politicians in Europe are not entirely comfortable with that. There is a grey area in which ECB independence was not guaranteed 100 per cent. I am thinking of the exchange rate policy.
The Chairman: Please explain the composition of the Euro-11 Council.
Mr. Murray: The Euro-11 Council refers to the 11 European finance ministries. They sit on the Euro-11 Council and oversee EMU economic affairs as they relate to fiscal policy and other matters.
The Chairman: Are you saying that there could well be tension between this ministerial group on the one hand and the people who run the European Central Bank on the other?
Mr. Murray: Exactly. We have seen this through the last few months with Lafontaine urging Duisenberg, president of the ECB, and his colleagues to ease monetary policy. Indeed, I think relations were so bad for a period of time that one had a sense that the ECB was refusing to ease interest rates because it was being urged upon them by Lafontaine, Strauss-Kahn and various other members of the Euro-11 Council.
It was out of a desire to demonstrate their independence -- I would not say perversity -- and it is, perhaps, no coincidence that the easing that did occur happened after Lafontaine's resignation. Had he not resigned, I could see the stand-off continuing.
The second issue, and we pick this up on the next page when we look at Canada, concerns the representation of the Euro-11 in the G-7. Here, I am thinking mainly of the G-7 ministers and central bank governors' meetings. I do not wish to reveal all of the tensions in this group, but the Americans and others have let it be known that they think that there are already far too many Europeans in the G-7. The fact that you would have now all of the G-7 central banks and the ECB represented, as well as all the finance ministries and now the Euro-11, has encouraged the G-7 in its wish to have a representative from the European Commission there, as well as the Euro-11 president.
This would multiply. In other words, by introducing one common central bank, it appears to add to the number of European representatives in the G-7 meetings rather than subtract. A decision has not yet been made. It is a very hot issue between Europe and North America. There is a sense that we definitely do not want the European Commission and the European presidency there, unless it happens to be held by one of the major countries already in the G-7, such as France, Germany or Italy. That seems to be the North American position.
The Europeans do not like that position. However, if you speak to the finance ministries, they are willing to compromise by kicking out all the European Central Bank governors and have all of them represented by the ECB.
As a central banker, I hate to admit that there is a certain logic to that, if you created the ECB. The central bank governors -- that is, the Europeans in the G-7 -- are naturally reluctant to lose their seat. The debate continues.
It does not sound very significant. However, what one can see, and we worried about this earlier, is the emergence of a G-3. The U.S. and Japan may become so frustrated with regard to representation in Europe, and then worrying about the U.K. and Canada, that they may simply say, "This is nuts. Let us just hold our own meetings and decide who to invite." The U.S. and Japan will each be represented by their finance ministers and central bank governors. They would probably invite Duisenberg and maybe one or two other finance ministers from Europe, and that would be it. It would make for a very small group. Canada may find itself out of the club. We will see.
The third bullet deals with the desirability of exchange rate targets for the major currencies. I noted earlier that it seems to be off the table for now because Minister Lafontaine was the primary proponent. However, I do not think it has gone away. The Japanese were very interested in it. They would like to pick it up again. Europe is just biding its time.
The Chairman: When you say "major currencies," you do not mean within the European Union, but the U.S. dollar, the Japanese yen, et cetera, do you not?
Mr. Murray: Yes, I should be clear. I am talking about the U.S. dollar, the yen and the euro -- the three big currencies.
What is interesting here is that, first, the U.S. does not like the idea of target zones or intervention. They prefer flexible zones, as we do.
Second, if Japan and Europe decide to peg their rates to the U.S. dollar, there is nothing the U.S. can do about it. In other words, this is an action that Canada, Japan and Europe could take unilaterally, and which the U.S. would have little control over. If someone wants to peg to your currency, that is what happens. It is nicer if everyone agrees, but you do not have to agree.
The fourth bullet concerns the near-term pressures on European banks and financial markets. We spoke to those earlier. It refers to the major restructuring and rationalization and restructuring that is going on there. It hit some European banks at a time when their profits were already suffering, and it will squeeze them further. One does not see major failures. It is just coming at an inopportune moment.
The fifth bullet concerns the common currency as a catalyst for structural reform. Of course, this is what EMU and the euro were all about. We do not have enough evidence to say yet whether the euro is actually promoting or driving structural reform in the way Europe hoped. If it does not happen, they are in trouble because Europe has very rigid labour markets. Fiscal policy is handicapped through the absence of an effective central government for Europe and also because of the constraints imposed by the stability and growth pact.
Unless they reform their institutions and promote more flexible labour markets, it is not clear how their economies will adjust because they no longer have the flexibility permitted by an independent monetary policy. That is the critical issue from an economist's standpoint.
Page 6 of the point form notes lists the issues that I think are most relevant for Canada. The first bullet reminds us that the direct impact on Canada from the introduction of the euro is, and was, very limited. Canada has so much of its trade with the U.S., yet I hesitate to say that that is all that matters. However, it comes very close. Taken as a whole, Europe does not account for a significant amount of our trade. It amounts to about 8 or 9 per cent. It is not insignificant, but it is small and it is shrinking as a share of our trade, as we become more integrated with the U.S. and, to a degree, with Asia.
It is the same on the investment side. Investment is a little more important than trade from a Canadian perspective. Here, I am thinking of our links with Europe. However, the U.S. and Japan dominate here.
If you had to pick a European country that is most important with regard to investment and trade, it is still the U.K., and they are not in EMU, at least not yet.
After consulting with our trading room before coming over, there has been no obvious impact on the dollar. As you may remember, one of the issues concerned how the introduction of the euro might prejudice the behaviour of the Canadian dollar. There were two or three views. One of them was that you would be left with three big currencies: the U.S. dollar, the yen and the euro.
Small currencies, such as the Canadian dollar and the Australian dollar, would find life very difficult living with these elephants. Under that view, we would experience greater volatility, and the demand for our currency would fall. We just would not be large enough to be interesting. As these elephants, as I call them, moved and repositioned themselves as their economies needed, we could find ourselves caught between them.
The second, more positive view, would be that there would be so few currencies to diversify into, and so many semi-unemployed traders out there looking for currency plays, that, while it might generate volatility, on balance, we would find favour in the international community. We would be one of the few alternatives left, if you wanted to diversify.
We have not seen strong evidence of either effect. However, if forced to choose, it seems to have been more the latter. On balance, people like us, and we have not suffered as a consequence of the euro's launch.
The third bullet is more pressure on Canadian banks to consolidate and merge. I am not saying that the decisions that were made to prevent the mergers of Canadian banks were wrong. It is just that we are living in a world in which the trend is towards large. Canadian banks are not small, even by global standards. However, they are roughly one-fifth the size of the largest banks out there.
It is not clear that the economies of scale are so important that you must be large to profit or survive. However, it has had an effect, in terms of public perception, right or wrong. Banks in France have been merging. Banks in Italy have been merging. Banks in Germany have been merging with American banks. Major Swiss banks have been merging, and U.S. banks have been merging. It is becoming more like the auto industry, in which in every country there will seem to be one, two, or three major players. They all compete internationally, but there are very few of them.
Where Canadian banks will fit into this is unclear. However, certainly, various credit-rating agencies have taken note of developments in Canada and recently downgraded Canadian banks because the mergers did not go through and because, in quotes, "they were regarded as suffering from a hostile government."
It is the perception contrary to the international trend that has had an effect.
The fourth bullet is increased risk of trade frictions and protectionism. If fiscal policy is constrained, if labour markets are very rigid, and if you have lost the flexibility of an independent monetary policy, then you are running out of policy options and there is a concern that Europe, when under pressure, will revert to protectionism. We have seen some examples of this recently with agricultural policy. There was the infamous banana fight between Europe and the U.S. Europe is now threatening to prevent U.S. beef from being imported into Europe. I am not sure that these threats have anything to do with the employment problems in Europe. I think they are specific to agriculture. However, there is a taste for protectionism there. What is interesting is that the one country that is running massive deficits, the United States, has so far restrained itself in the main, while it is the area with a large net surplus, Europe, that seems to have been more protectionist.
The fifth bullet is the uncertain future of the G-7 and other international groups. We have already talked about that. Canada may find itself in a situation where we are too small to play with the big guys and too large to want to play with what is left.
The international community is still sorting itself out. One of the groups that used to be very important to us seems to be disappearing in terms of influence and interest, and that is the G-10. The G-10 no longer seems to be a natural collection of countries. It had some justification after the Second World War, through the 1960s and 1970s. Actually, it is a creature of the 1960s, which is when it first emerged, but it is now disappearing. It is an odd assembly. Even the G-7 is under pressure. We will see which way things go.
The sixth bullet, if I am counting correctly, is renewed interest in a common currency with the U.S. We predicted this a year ago, and it has come upon us with a vengeance. It seems like very odd timing, because we have just had the Asian crisis, and we have just had difficulty in Russia and in Brazil. If there was one lesson from this crisis -- and there were many -- it was that pegged or fixed exchange rates are probably the least sustainable of all currency arrangements. For that reason, it seems like very odd timing and it is very surprising to have Canadians show a renewed interest in a fixed currency arrangement with the U.S. I am not saying it is wrong or inappropriate. I think there are three factors that you can cite to explain it.
I believe David Laidler may have been here earlier speaking to a Senate committee, although I am not sure if it was this committee, about the virtues of a flexible exchange rate. However, the three factors he might cite would be as follows. The first would be the demonstration effect of the euro, a sense among Canadians that, if it is a good idea for Europe, it is something at least worth investigating here.
The second factor is the dismay Canadians experienced over the dramatic decline of their currency for the last two years as it hit record lows. Here, there was a sense that surely a fixed exchange rate could have prevented this and the implied loss in income. I am not sure that that is clear, but there was a frustration and an embarrassment associated with our northern peso, as I will call it, and a desire to look at alternatives.
The third and final factor is the interest shown by countries like Argentina and Mexico in dollarization, and a question in the minds of some Canadians as to whether it might not be a good idea for Canada and that we do not want to be left behind if it is.
Therefore, it has come to the table. The Bank of Canada is still of the view that flexible exchange rates have served us well. There would be, undoubtedly, what I will call significant microeconomic benefits to having a common currency with the United States. I would not wish to dismiss those. For example, to trot out the well-known statistics, almost 45 per cent of our GDP now is exported and, of that, over 80 per cent goes to the United States. That is a significant amount of transactions that, if you denominated in a common currency, you would not have to convert. Accounting would be made easier. To a degree, Canadians are already used to denominating things in U.S. dollars. The press must be careful, when it quotes a figure, to note whether it is Canadian or U.S. dollars, because there is a sense it could be either. We get much of our information and entertainment from the U.S.; so there is a naturalness to the common currency idea.
However, it is difficult to imagine how certain regions of the country would have survived had it not been for the flexible exchange rate and the depreciation of the last two years. We think this is proof, at least on the macro side, of the need for a flexible exchange rate. However, the debate continues.
The final bullet is greater appreciation of the benefits of floating. I guess I have just inadvertently spoken to that.
As we look at some of the problems that are emerging in Europe, we appreciate the advantages of flexible exchange rates and an independent monetary policy.
The U.S. and the Canadian economies, as I noted earlier, are at different points in the business cycle. What was appropriate for the U.S. over the last year or so in terms of high interest rates and an appreciating dollar against the euro and the yen was clearly inappropriate for Canada. We needed that extra degree of freedom, that independence, to see us through.
It was still a rough year in 1998, but real growth was nevertheless close to 3 per cent; better than many other countries. However, had it not been for the depreciation and the flexible exchange rate, we would have been in difficulty.
The Chairman: Thank you for your presentation.
Senator Bolduc: Mr. Murray, you have spoken about the role of the Euro-11 Council in monetary policy. Would you make a small parallel with the Canadian situation? When we went to France a couple of years ago, an ex-president of the Bank of France showed us where it is written very clearly that the bank is independent from the government. I have never seen that written anywhere else.
We do not have that in our legislation. We have relative independence of the central bank from the government. They discuss the issues and somehow a monetary policy is defined. I suppose that is also the case in Britain; there is some independence from the government but not total independence from the Minister of Finance.
I understand that the new Euro-11 system is like the Bank of France and the Bank of Germany used to be: that is, clearly independent from government. Would you give us your views on the pros and cons of the two situations? I lean toward having a totally independent bank. However, I wonder whether it is possible to leave monetary policy to a civil servant. Perhaps it is better to leave it the way we have it in Canada.
Mr. Murray: I have a number of thoughts on that, some of them conflicting. However, with regard to Europe, you may remember that one of the requirements of Maastricht was that countries declare their central banks to be independent. In other words, the ECB initiative could not go forward unless it were made clear in legislation that the national central banks were independent and free of political influence. So it is no accident that the Bank of France received that legislation.
In fact, the Bank of England has received it, too, in order to leave the door open for entry to the EMU.
Senator Bolduc: I may be wrong, but I thought that the Germans included the condition that, if it were not included in a statute that the bank was independent, there would be no euro.
Mr. Murray: That is true. However, in England they did the same thing afterwards, just to leave the door open. I think they did it as well because they thought that independence was a good thing.
The second point that occurs to me is that you must be clear about how you define "independence." At the Bank of Canada, we make a distinction between what I will call goal independence and instrument independence. We think that in a democratic society it is appropriate and necessary to have the citizens, through their politicians, decide what is the objective of monetary policy and that they should have an ability to impose that wish on the central bank or on civil servants.
Having made that objective clear, we hope that you would give the central bank the independence it needs, that is, instrument independence, to achieve that target. As long as it did, you would have no cause to complain.
What is also very important for us is accountability; it is not only independence. We believe that there is a benefit to having an explicit target for monetary policy. We do not think it is necessarily appropriate for the central bank, at least unilaterally, to establish that. It should be done in concert with the government.
However, once that is decided and made explicit, we should be given the right, the power, and the independence to achieve it. If it is achieved, there should be no reason for criticism. In the context of Canada, then, if there is an explicit inflation target agreed to, and that is realized, that could be the end of the game, but it is not as simple as that. There are good and bad ways of achieving that. It is somewhat more complicated than that. That is what I mean by goal versus instrument independence in the way we see it.
The problem in Europe is that there is not really any central government. There is almost absolute independence in terms of goals and instruments, and that may create a certain tension.
The term "democratic deficit" emerged years ago with regard to the EMU debate; European populations were not being asked to vote on the initiative, it was being forced upon them. To a degree, there may be a democratic deficit with regard to policy conduct in Europe now -- a lack of accountability.
Senator Bolduc: Would you continue the comparison with the American system?
Mr. Murray: The U.S. has done remarkably well through the last few years. As Ronald Reagan once said, it is difficult to argue with success. However, they do not have a clear policy objective.
Senator Bolduc: Do you mean the president or the bankers?
Mr. Murray: Neither; they are just supposed to do good things. There is no clear inflation or growth target. They are just supposed to do good things, however defined. They report to Congress twice a year; so there is an accountability there. There is a degree of independence -- in fact, a greater degree than we have, because, once appointed, it is very difficult to dismiss the chairman of the Federal Reserve Bank or the other governors.
Senator Bolduc: Would you say that there is a parallel between the discussion the chairman has with the Secretary of the Treasury, for example, and with the head of the banking committee of the senate, and what we expect in Canada between the cabinet, the Minister of Finance and the government?
Mr. Murray: It is what we have moved toward. The U.S. was ahead of us in terms of reporting and accountability. It is, in part, a reflection of our parliamentary system as opposed to the checks and balances and the congressional system in the U.S. In the U.S., the administration is quite separate from the Congress, so there is a natural division, and it is not clear to whom the central bank should report, if to anyone.
In Canada and England, under the parliamentary system, there is the government in power. We report, for example, to the government through the Minister of Finance, technically. Technically, as a consequence, we are not really accountable to anyone else.
It is the Minister of Finance who has the power of directive and who, if he is unhappy, can insist on a policy change, have it gazetted, and issue us a directive. It is no one else. However, through time, we have seen the advantage, as has the government, in asking the governor of the bank to report more often on monetary policy. We have realized that increased communication and understanding not only breeds sympathy, hopefully, for policy, but helps us conduct it, and that the trick to good monetary policy is not surprising the public but rather cultivating it, helping it anticipate policy moves so that, in a sense, it can do the work with you or for you.
I have digressed.
The Chairman: The committee has digressed somewhat. We are now comparing financial institutions, rather than focusing on what has been happening in Europe.
I have read that the EMU was devised by politicians some of whom at least tended to be so-called "right-wing." Then last year there was a series of elections in which left-wing governments came to power. You have already referred to what has happened in Germany with Mr. Lafontaine.
How happy are these new left-wing governments with the whole idea of a common monetary policy?
Mr. Murray: That is a difficult question to answer, and I am not sure I have an accurate fix on that. My sense would be that there has been some unhappiness. I guess that is a fairly obvious thing to say. I am not sure that it is unhappiness with the fact that the monetary policy is common and they have lost independence. It is unhappiness with the lack of ability to influence that common policy and a shared sense, at least among the major finance ministries, that monetary policies should have been easier earlier. So there was frustration over the way it was conducted and frustration over their inability to influence it because of the independence of the ECB.
Senator Stollery: To follow on that subject, I should have thought that the argument between the new governments in Western Europe and the European Central Bank was an argument over the criteria of the European Central Bank. I recall the directions of Gordon Brown to the central banker, to Eddie George, and the fact that the criteria were heavily criticized in the Financial Times because they concentrated on price stability, that being their main criterion in administering monetary policy.
I read the points of resignation of Mr. Lafontaine, and we would have to say that, if the German government split on the issue, then all is not happiness. In his criteria, he had five points. I did not understand the one about atomic energy, because I know nothing about German atomic energy policy. However, the other four were things such as those you mentioned, convergence or some system of exchange rates to moderate these extremes in exchange rates. I am not saying fixed exchange rates. He had two or three other points that seemed to be not unreasonable. As you said, the European Central Bank refused even to lower interest rates, even though they must have known interest rates should be lowered; they refused because they would have appeared to be giving in to pressure on one of one of their main criteria, which is the criterion of price stability, and which, by the way, is versus encouraging unemployment. That is why he resigned.
What do you think about that? Is that not really what happened? There seems to be quite a bit of disagreement, and the fact is that the German government is split.
Mr. Murray: I have two or three thoughts, prefaced by the observation that anything that I have said about their motives and action is clearly speculation on my part and is interpretative.
Senator Stollery: However, much of it has appeared in the financial press.
Mr. Murray: As well, this is true to form in the sense that Europe asked for a Bundesbank style central bank, and that is what they are getting. Even if they did not have EMU and were still pegging to the Deutschmark, they probably would have had very similar policies. I would not lay all of this on the doorstep of EMU.
What I call a certain Germanic attitude has existed in the central bank of Germany since the end of World War II. To give them credit, they have had a fair amount of success. While they may have been on the margin by our measure, I do not know how seriously I would criticize them for that. The returns are not in yet.
Senator Stollery: Is it not true that there is a clash between two criteria, the criterion imposed by conservative governments, which were then defeated, and a different criterion that the current finance ministers would prefer to have?
Mr. Murray: As you know, that was not the only issue over which Mr. Lafontaine resigned. In large part, he had lost the complete confidence of the business community through tax measures that he had been proposing. That was probably more important in terms of his forced resignation than anything on the monetary policy front.
However, with regard to price stability as an appropriate target for monetary policy, I am less critical for the following reason: If you pick an inflation target, but insist on trying to achieve that at the expense of employment, you will not be able to maintain your inflation target. Take England as an example. They have picked 2.5 per cent, and they happen to be very close to it right now. If there is sustained unemployment in the United Kingdom, inflation will systematically fall below that target because of the excess supply in the economy. Similarly, it will go above 2.5 per cent if they try to overstimulate the economy.
Simply said, in the long run -- indeed, even in the medium run, but perhaps not in the short run -- there is a consistency between everyone's desire for full employment and the desire to achieve and maintain price stability.
We are debating the tensions that can be created in the short run and the difficult judgments that are being made as you try to look a year or two ahead, knowing the lags with which policy operates, as to whether you are likely to encounter, on balance, more unemployment than you had anticipated. The debate between Lafontaine and the ECB was not so much about the appropriateness of the objective as it was about whether, in the judgment of Lafontaine, the ECB was likely to undershoot because it was giving too little attention to growth and employment in the economy.
Senator Stollery: That is very interesting. I will not pursue that, Mr. Chairman, although the views that I have just stated were really from Financial Times' editorials about stability as a target.
The euro has come under pressure. In your graphs, which are very interesting, you can see illustrated some of the problems that this committee predicted a couple of years ago in our report and in our own discussions, for example, with convergence, et cetera. It cannot have helped the euro when the most powerful finance minister in Europe resigned because of a tax measure and the European commission also resigned. While it did not have anything to do with the euro, it seems to have had an extremely destabilizing effect at a time of introducing a new currency. This is part of what has happened.
Does this not reinforce the Bank of Canada's case and increasingly detract from the argument for a North American currency? A person who may have been all for a North American currency in January may now have doubts, especially as we approach May 1, taking into account what has happened in the last four months. I know about the Argentine business. They have a totally different reason for wanting a common currency, and you know why.
Mr. Murray: Yes. We are in different circumstances, thankfully.
We would agree that there are a number of reasons why we benefit from the flexibility provided by a floating exchange rate. Some of that is political. Although that is not what we emphasize at the bank, it is an important consideration. Clearly, if we had a common currency with the United States, we would have even less influence over that policy than the individual EMU members have at the ECB through their national central banks.
Italy, for example, is one of 11. All participants have roughly equal votes and, while their GDPs are not equal, at least among the major countries, they are more similar than they would be with the U.S. and Canada. It is inconceivable that if we joined a common currency with the U.S. we would have equal votes or that our economy would carry equal weight in the monetary policy decisions that would now be made jointly. There is an important political dimension; an abdication of responsibility or goal dependence on the part of Canada.
It is conceivable, however, that the economic advantages from a common currency are so overwhelming that you would be prepared to accept that and you would treat monetary policy, then, like the weather. That is to say, it is important for you, but it is determined outside.
Senator Stollery: That has not been the case in Europe, as we are only in the fourth month. Those overwhelming benefits do not seem to be clear at the moment.
Mr. Murray: That is true, but it is still early. That is why I think the European experiment is very interesting. We wish them well, although we fear there are risks there. It will be interesting to see how it develops. There is a possibility that we have underestimated the microeconomic benefits of a common currency. You cannot be absolute here.
What we do know is that on the macroeconomic side we have benefitted recently from the independence of a flexible exchange rate. We have not been quite as thorough and we do not know quite as much about the other side of the ledger and what the potential microeconomic benefits of a common currency might be.
Senator Andreychuk: One of the areas that interests me is the activity around the European Parliament. Having taken on the European Commission recently, they seem now to be taking on this issue of the euro, the bank and its independence. They have summoned some of the bankers to explain some of their policies and positions.
Have you been noting this trend? Do you think that it will have any effect in changing some of the political dynamics and, therefore, the monetary policies?
Mr. Murray: We have noted it. It is interesting, it is probably salutary or appropriate that the European Parliament is beginning to flex its muscles and assume more powers.
It is what many Europeans hoped for. One of the major reasons, if not the primary reason, for EMU is believed to have been the desire for greater political integration. I am not saying that EMU can account for the increased influence of the European Parliament, but I think this is part of a deeper trend. Perhaps Europe is starting to come together and we are seeing the beginning of a central government in Europe that will plan and coordinate fiscal policy in a more effective way. They will have a larger budget than they have in the past and they will assume greater power.
There is a need for that if Europe is really trying to do what it says it is trying to do. You need that sort of coordination and central influence. The present European model has been likened to a donut with nothing in the middle. You have various countries. While you have a central bank in the middle, it has not been accountable to any central power. It is divided among 12. The fact that the European Parliament would expect it to report to it now is encouraging the various parts to draw together. The hole in the middle is disappearing.
Senator Andreychuk: In the long term, will that threaten, either positively or negatively, the bank's independence?
Mr. Murray: I do not think so -- at least in a useful sense. By forcing it to account for its activities, it is making it more democratic, while, through legislation, it is preserving enough operational independence that short-run political pressures should not prejudice the longer-term attainment of its monetary policies.
There may be too much independence and lack of accountability right now, however, there are signs of correction. You do not wish to go too far to the other side. There is a certain advantage to maintaining some distance so that short-run political concerns begin to overwhelm the longer-term horizon within which monetary policy must be conducted.
Senator Di Nino: Our Senate will be commencing in about two minutes. I was interested in following up discussions regarding the structures, and so on. If I can focus on the impact on Canadian trade and investment, I believe your statement suggested that there is limited impact on Canadian trade and investment. That surprises me. I would have thought that the impact might have been greater.
Can you tell us why you think the impact has been so limited, apart from the predominance of our trade in the U.S.? There has been some effort on behalf of Canadian trade opportunists, if I can put it in those terms, to expand our trade opportunities and our investment opportunities with Europe. In your opinion, why are we not succeeding?
Mr. Murray: There are two reasons. First, while the introduction of the euro and the creation of EMU are significant events, they are not as important as some people believe. What was important in Europe had already been accomplished, namely, the creation of a common market and free movement in theory and in law, if not in practice, of labour and capital.
It is important to remember that many of these countries had already pegged to the Deutschmark. The euro was just the next step. It is an important one, because it eliminates the need to convert currencies and it improves efficiency. However, you already had two important elements: the common market and the free movement of goods, services and factors of production. We already had a fixed rate of exchange within most of these countries. This is just going that extra marginal step. In other words, Europe now has not been changed in every revolutionary way relative to where it was December 31. It is important to remember that it is still early, too, and that any of the structural reforms that EMU was supposed to drive and any of the efficiency and productivity gains that were supposed to be realized by the introduction of the euro were expected to be longer-term events. Therefore, I think it will take some time for this to become manifest in Europe and, in turn, for Canadians to trade on that. It is too early, especially given the marginal nature of this last step.
The Chairman: Honourable senators, I think we must adjourn the meeting at this time as other senators are arriving for another meeting, so we will have to vacate the room.
I wish to thank our witness. As before, it has been a very enlightening meeting. We appreciate your concise and informative answers. We may be seeking you again. Thank you very much.
The committee adjourned.