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Finance & Development
A quarterly magazine of the IMF
December 2006, Volume 43, Number 4

People in Economics

Navigating Unchartered Waters

Camilla Andersen interviews Otmar Issing

Many people can take credit for the idea of a single currency in Europe, but one man in particular was responsible for making it a reality. Otmar Issing, the first chief economist of the European Central Bank (ECB), recalls the daunting challenge of implementing monetary union. "The degree of uncertainty we were confronted with was extraordinary," he says. "Even during the best of times, monetary policy is an uncertain undertaking. Add to that the impact of the regime shift triggered by the introduction of the euro and the lack of reliable data, and I found myself asking, only seven months before the launch of the single currency: 'What is the euro area all about?'"

Today, most people take the euro for granted. But in the 1990s, many economists thought that monetary union might fail. Issing admits he would not have dared make the decision to launch the euro, but he agreed with the political logic behind the plan. "The status quo of fixed exchange rates in Western Europe was no longer viable," he says. Germany's central bank was de facto conducting monetary policy on behalf of the other European countries, and many of Europe's central banks spent billions of dollars in the early 1990s defending their currencies' peg to the deutsche mark. "So the choice was either to risk another currency crisis or to move forward," Issing says. He decided to apply his formidable intellect and what his friends and colleagues describe as an iron will to turn the vision of a common currency into reality.

Seven years later, most economists agree that monetary union represents a tremendous achievement. The euro is now the second most important currency in the world after the dollar. Inflation in the euro area (which includes the 12 countries that have so far adopted the euro) has held steady at about 2 percent despite a sevenfold increase in the price of oil. Thanks to these achievements, the ECB is now one of the most credible and powerful central banks in the world—although it has come in for its share of criticism, especially on inflation goals and how to achieve them. While Issing is proud of the ECB's accomplishments, his instincts as a central banker and economist make him cautious about claiming victory for monetary union. "Only history can tell whether it will be a success," he says.

Early years in academia

Born in Würzburg in 1936, Issing's views on Europe were shaped by his experience of growing up in war-ravaged Germany. Before the start of World War II, Nazi teachers taught him that "the enemy lives just across the Rhine." After the war, he had to walk through the ruins of his hometown on his way to school, witnessing firsthand the consequences of conflict. Once he was old enough, he started traveling in Europe and made many friends across the continent. "My personal experience convinced me that European unification matters for our common future," he says today. His views strengthened further when he began studying economics and learned about the growth potential of free trade.

Before becoming a central banker, Issing spent more than 30 years in academia, teaching and doing research at the universities of Würzburg and Erlangen-Nuremberg. In 1988, he became a member of the council of experts for the assessment of overall economic trends, a panel of wise men advising the government. Two years later, he joined the board of the Bundesbank, Germany's central bank. His experience as a university professor defined who he was as a central banker. "Once an academic, always an academic," he says, with one caveat: "As an academic, you can write a new paper if the first one is badly received. As a central banker, one misguided decision may have an impact on millions of people."

Issing's identity as a German national also colored his views on central banking. "There can be no stable society without a stable currency," he says, referring to Germany's experience with hyperinflation during the Weimar Republic, which paved the way for Adolf Hitler's election as chancellor in 1933. West Germany's new leaders took this lesson to heart, setting up a central bank that became a cornerstone of the country's economic success. "The deutsche mark was extremely important for postwar Germany. It was a symbol of stability but also a substitute for national pride. That was why it was so important to convince the Germans that the euro would also be a stable currency," Issing explains.

A controversial inflation target . . .

The first decision Issing had to make as chief economist was how to implement the ECB's mandate. After much discussion and many late nights spent in the company of his staff, he recommended a strategy that would aim to keep inflation below 2 percent over the medium term. Issing personally lobbied hard for the "below 2 percent" goal—even though most of the 11 founding members of the euro area were used to inflation substantially higher than 2 percent. In fact, not even West Germany, Europe's strongest performer on the inflation front until it was reunified with East Germany in 1989, had managed 2 percent on average.

During the first year of the euro's existence, inflation was close to 1 percent, greatly boosting the ECB's credibility. But in the aftermath of the 2001 dot-com bubble in the United States, the risk of deflation was being discussed worldwide. To ease such concerns, the ECB redefined its medium-term policy goal in 2003 as "close to but below 2 percent." Since 2001, however, inflation has hovered above 2 percent, causing the ECB to miss its own target year after year. Many academics think the problem is with the target rather than with inflation. Charles Wyplosz, professor of economics at the Graduate Institute of International Studies in Geneva, Switzerland, argues that the ECB is undermining its credibility for no good reason. By shifting its implicit 2 percent range up by half a percentage point to 0.5–2.5 percent, the ECB would increase its success rate from the current measly 43 percent to an impressive 94 percent (Wyplosz, 2006). Paul de Grauwe of the University of Leuven, Belgium, says the band is both too low and too narrow. By targeting a rate that is too low, he writes, the ECB is contributing to structural unemployment (de Grauwe, 2002).

How does Issing respond to such criticism? Far from ignoring these and other studies, he has, in good academic fashion, taken on his critics the way he knows best: by publishing papers, participating in conferences, and giving speeches. As his colleagues and friends point out, he loves a good argument and is not afraid to let people know when they are wrong. And, in this case, he thinks they are wrong. From a purely academic point of view, there is no convincing evidence showing that an inflation rate of 2.5 percent is superior to a rate of 2 percent, he says. And then there are the policy considerations: when the ECB set out its monetary policy in January 1999, the current rate of inflation was only 0.8 percent. "To indicate a substantially higher target would have undermined the credibility of the new central bank right from the beginning," he argues. Issing also thinks that the medium-term perspective of the inflation target is often ignored. "We never intended to keep inflation below 2 percent in one year," he says. "If you have a sequence of shocks, then the medium term starts anew with every new shock. Let us not forget that when we started with the euro, the oil price was $10 per barrel. Today, seven years later, it has at times been above $70 per barrel. Under these circumstances, not to mention other shocks, the track record is pretty good."

. . . and a controversial inflation strategy

The ECB's strategy for achieving its inflation goal has also come under fire. When the ECB began operating in 1999, a number of central banks in developed countries (such as Canada, New Zealand, Sweden, and the United Kingdom) had recently adopted inflation targeting, which was considered transparent and easy to communicate. But rather than join the inflation targeting bandwagon, the ECB decided on a diversified strategy based on two pillars. The first pillar assigned an important role to money. The ECB's governing council announced a reference value of 4.5 percent for the annual growth rate of M3 (a broad monetary aggregate) that it thought would be consistent with its definition of price stability. The second pillar consisted of a comprehensive analysis of the risks to price stability in the euro area, including developments in wages and unit labor costs, fiscal policy indicators, and financial market indicators.

The ECB's decision to include money as part of its strategy quickly came under fire. To some observers, the first pillar closely resembled the strategy pursued by the German central bank, leading them to suggest Issing was concerned mainly with transferring credibility to the new central bank. What is more, the growth rate for M3 has consistently overshot the ECB's reference value, often by a large margin. For instance, M3 growth was 8.0 percent in 2003. Yet it does not seem to have affected the rate of inflation. According to de Grauwe, "this will not surprise other central bankers who abandoned monetary targeting long ago after finding out that in a low-inflation environment, money numbers are very bad predictors of future inflation" (de Grauwe, 2006).

In recent years, the ECB seems to have downplayed the role of the first pillar. But Issing continues to believe that the ECB chose the right strategy. First, he vigorously denies he was concerned mainly with importing the strategy of the Bundesbank. "Of course, transferring credibility was an important element in the construction of our strategy, but even more important was the fact that it is hard to ignore the long-run relationship between money and prices and the fact that central banking has to do with money." Second, he stresses that the monetary pillar is very broadly defined, taking into account the impact of money and credit developments on inflation. Third, he believes the tide is turning, with a renewed interest in the role of money in shaping inflation. And fourth, he believes the two-pillar strategy will serve the ECB well when it comes to future challenges, such as coping with asset price bubbles (see Box 1). "I will not pretend that the two-pillar approach is set in stone. But it is a reflection of the fact that, so far, there is no model in the world that integrates monetary and nonmonetary elements into a consistent forecast of inflation and the economy."

Box 1
Pricking the bubble

A big challenge for central bankers around the world is trying to figure out how to tackle asset price bubbles. The example of Japan, where the bursting of a huge bubble in the early 1990s was followed by a deep recession and deflation that the economy is only now recovering from, looms large. Most central bankers do not want to publicly acknowledge that they are targeting asset prices in any way. "There is a broad consensus that central banks cannot and should not target asset prices and that they should not try to prick a bubble," Issing says. But he does not think that is a satisfactory response. "If you look back in history, the biggest macroeconomic disasters happened when bubbles burst. Banks', companies', and households' balance sheets were destroyed. Given these experiences, central bankers cannot simply say that their only role is to provide liquidity once the bubble has burst."

Issing acknowledges there is no simple answer to the asset price dilemma. But he thinks that the ECB's two-pillar strategy gives the bank an edge in responding to bubbles. Since almost all asset price bubbles in history were accompanied—if not preceded—by strong increases in liquidity or credit, a central bank whose policy framework allows it to also act on money and credit information is better placed to lean against suspected bubbles. "We are far away from having a perfect model. But if we see a combination of strong money and credit developments and strong increases in housing and equity prices, then it would be hard for the central bank to ignore this information." Buttressing Issing's claim is the fact that Japan's central bank has just announced a new "two perspectives" monetary strategy that resembles the ECB's two-pillar framework. The bank has said its choice was motivated in part by a desire to avoid future bubbles.

Price stability is not everything

For those claiming success for monetary union, the biggest elephant in the room is the lack of growth in the euro area. The 12 economies grew by a disappointing 1.3 percent a year on average between 2001 and 2005—despite a strong global recovery. As a result, living standards have fallen further behind those in the United States, with the gap in GDP per capita widening to more than 30 percent. While the euro area is finally enjoying a recovery, its growth potential remains low and may decline further because of an aging population.

But it's not as if Issing has ignored this elephant. He and his colleagues at the ECB have warned repeatedly that countries must reform their economies to stay competitive. In a monetary union, there is no simple fix. As Issing once famously put it, "one size must fit all" when it comes to monetary policy in the euro area (Issing, 2001). Using fiscal policy to stimulate demand is not an option either, given that the euro area countries have committed themselves to implementing the revised Stability and Growth Pact. In the end, the only option left for euro area policymakers to recapture lost ground is structural adjustment—increasing flexibility and competition in areas ranging from labor markets to the financial sector. The European Union (EU) itself has embraced this advice in the form of the Lisbon Agenda, its blueprint for improving competitiveness. Issing underscores that "ambitious reforms to increase flexibility in labor and product markets, improve productivity, and ensure continued wage moderation represent the only way out." Even so, he worries that poor economic performance and painful reforms will encourage national governments to pin the blame on the ECB, just as the European Commission has routinely been used as a scapegoat for everything from reductions in fishing quotas to increases in the value-added tax. "We knew from the start that we would become the perfect scapegoat. This is true for any central bank, but it is even more true for a supranational institution," he says.

Issing believes that the ECB should defuse such criticism by making more efforts to convince the public about the benefits of price stability. And, for now at least, the consensus is that monetary policy in the euro area should not be used to stimulate the economy. Tommaso Padoa-Schioppa, a former member of the ECB's governing council and now the finance minister of Italy—arguably the most troubled economy in the euro area—wrote not long ago: "What can the eurosystem do to pass the trial of slow growth and high unemployment in euroland? The answer is 'very little,' because there is no miraculous medicine that monetary policy can provide to these two evils" (Padoa-Schioppa, 2004).

Another long-term challenge for the ECB is figuring out how to fulfill its responsibilities without a political union, which some commentators still believe is a long-term requirement for monetary union. While the mood in Europe might be slightly more upbeat these days, thanks to the recovery, there still appears to be little appetite for further European integration, be it in the form of a revised EU constitution or something else. But Issing believes that Europe's leaders will have to think of something. "Europe cannot in the long run avoid answering the question: What kind of political arrangement is the right complement to monetary union?" Indeed, the problems of having a monetary union without political representation are vividly illustrated by the IMF's current attempts to reform its system of governance (see Box 2).

Box 2
Can the European Union fit into one IMF chair?

As the IMF tries to increase the voice of emerging market economies—most notably, by boosting the size of their quotas, which determine voting power—pressure has been growing on Europe to unite its representation on the IMF's Executive Board into one or maybe two chairs. This would be a major change for the EU, which jointly holds more than 32 percent of the total voting power, split over 7 different chairs out of a total of 24 chairs. Although this share is larger than the United States' 17 percent, Europe's voice is diluted because its 25 member countries often do not coordinate their positions. On the face of it, consolidating the number of European chairs, and thus its voice, should be appealing to the EU. But the devil is in the details.

While the ECB is staking out its claim to a seat at the table—it now is a permanent observer on the Board, with its role limited to discussions that relate to the euro area—the euro area's finance ministers may want someone representing their points of view. And even if the euro area countries were to agree on a common representative, support for a single euro area or EU chair is far from unanimous. Countries such as France, Germany, and the United Kingdom would have to give up their individual chairs, while the other European countries would have to rethink their representation. And if the IMF succeeds in rewriting the formula that distributes quotas, some European countries, such as Belgium and the Netherlands, are likely to lose voting power, whereas others, such as Spain, stand to gain. Issing believes that "a single representation will be the final steady-state solution," but he doesn't see a single euro area chair as realistic in the near future, believing it might have to await political union.

Investing in human capital

Looking back at his career, Issing thinks he made the best decisions he could with the information he had at the time. But he acknowledges that he and his colleagues "underestimated how long it would take the public, journalists, and the markets to become familiar with a new institution, a new currency, and a fundamentally changed environment." Issing's most lasting contribution to ensuring the continued success of the euro may well turn out to be his work away from the spotlight of decision making. According to Peter Kenen, Senior Fellow at the Council on Foreign Relations, his leadership has made the ECB's economics and research departments some of the strongest in the world, matched only by those at the U.S. Federal Reserve and the Bank of England. Given Issing's lifelong commitment to rigorous academic thought and analysis, this might be the epithet he will take the most pride in.

Issing may have retired from the ECB, but he has no intention, it seems, of slowing down. He has just accepted a part-time position as international advisor to Goldman Sachs, the U.S.-based private investment bank. His new job in the banking industry will give him a chance to work more closely with those professional investors he used to communicate with at a distance. But it may be his other part-time job, as president of the Center for Financial Studies, a think tank based in Frankfurt, that in the end will give him the greatest satisfaction because it will allow him to once again exchange ideas with students and researchers in an academic setting. "The older I get, the more I enjoy the company of young people because they allow me to better understand how the world is changing," he says.


De Grauwe, Paul, 2002, "Challenges for Monetary Policy in Euroland," Journal of Common Market Studies, Vol. 40 (November), pp. 693–718.

———, 2006, "Flaws in the Design of the Eurosystem?" International Finance, Vol. 9 (August), pp. 137–44.

Issing, Otmar, 2001, "The Single Monetary Policy of the European Central Bank: One Size Fits All," International Finance, Vol. 4 (Winter), pp. 441–62.

Padoa-Schioppa, Tommaso, 2004, The Euro and Its Central Bank—Getting United After the Union (Cambridge, Massachusetts: MIT Press).

Wyplosz, Charles, 2006, "European Monetary Union—The Dark Sides of a Major Success," Economic Policy (April), pp. 207–61.

Camilla Andersen is a Senior Editor on the staff of Finance & Development.