Concluding Statement of the IMF Mission on Euro Area Policies
May 28, 2003
1. Against a backdrop of continued uncertainty about global prospects, growth in the euro area appears set to disappoint for a third year running. The slowdown reflects shorter-term cyclical forces but also underlying limitations in longer-term performance. Greater decisiveness in addressing longer-term challenges holds the promise of strengthening confidence and securing a sustained improvement in the area's performance. We are not unhopeful such policies may be on offer.
2. Growth in the area has wobbled around 3/4 percent for over two years. In this period, forecasts have repeatedly projected an upturn premised on the waning of past shocks and global recovery. Unfortunately, recent developments point to another postponement:
- Adjustment in the corporate sector to the over-leveraged positions built up during the boom continues. At least this is how we read the absence of the hoped for bounce back in confidence following the war in Iraq, despite the related declines in oil prices and improvements in financial conditions of the corporate and financial sectors. Indications are that the rebuilding of corporate balance sheets in the aftermath of the equity market bubble will continue to weigh on investment plans and employment, and hence on growth.
- The euro has appreciated sharply. Viewed from a historical or multilateral payments perspective, the appreciation to date has been of an equilibrating character and, therefore, welcome. The appreciation also has favorable implications for prices, the real incomes of households, and the import costs of firms. However, the effects on profit margins of the export and import-competing sectors are adverse, and will feed into lower sales volumes. It could also weigh on the process of corporate balance sheet adjustment through the downward valuation of foreign assets.
- Weak medium- and long-term prospects are increasingly casting a shadow over near-term prospects. Demographic trends imply an aging of the population, with adverse implications for old-age income security, fiscal sustainability, and economic growth.
3. While the baseline prospect remains one of gradual recovery, there remains considerable uncertainty about its timing and strength. With external demand curtailed by uncertain prospects of a recovery abroad and an appreciated euro, sustaining growth clearly requires a strengthening of domestic demand. Incomplete adjustment to past shocks and tepid medium-term prospects imply, however, that the conditions necessary for a self-sustaining recovery do not yet appear to be in place.
4. The challenge to policies has thus been notched up yet again. It is clear that the way forward is that meld of policies that both speeds adjustment to past shocks and strengthens medium-term prospects, with the two reinforcing each other. As regards the medium term, this points to the overwhelming need for structural reforms to raise potential, and to address the underlying social security and fiscal sustainability issues within a disciplined context of strengthened incentives to work. As regards the short term, this means policies, consistent with longer-term commitments and objectives, that use the available margins to favor growth. From a global perspective, there is also a need for a more cooperative approach, most especially as regards making progress on the Doha round.
5. Only bold structural reforms can dispel the clouds over the area's longer-term prospects for growth and fiscal sustainability. The Lisbon agenda points the way to tapping the area's large potential. While the main items on the structural reform agenda are well understood and agreed upon, the problem has been implementation at the national level, and we welcome the recent shift to such a focus. We are also encouraged by the recent reform discussions in some countries, particularly on labor markets and public pensions. We would emphasize the potential synergies between structural reforms, improved economic performance, and fiscal sustainability. An increase in the effective retirement age, for example, would increase labor supply, raise growth, and reduce pressures on the public pension system. Similarly, the evidence suggests that recent labor market reforms-such as the rationalization of unemployment benefits and reductions in tax wedges-have indeed motivated improvements in underlying activity rates.
6. The particular challenge of putting pension systems on a sound longer-term footing illustrates both the urgency of, and opportunities from, structural reforms. Aging populations will constrain contributions while boosting entitlement expenditures, and create a growing imbalance in public pension systems. The unavoidable cutbacks in the generosity of benefits should be balanced by increasing the incentives for retiring later and by reducing public debt. But sustainability also requires a time-consistent strategy. Since older voters will form an electoral majority in most countries at a time when cuts in pension benefits are still being phased in, there is a need to develop significant private pension pillars to complement the smaller public pension pillars. Given the long implementation lags of pension reforms, time for action is running out fast. A key ingredient for successful pension reforms is a better public understanding of the risks to pension finances. The publication of regular reports on the longer-term outlook of public pension finances by independent and credible national agencies with no direct interest in reform outcomes could have a catalytic role.
Fiscal Policy Requirements
7. The potential for synergy between the short and long term is perhaps greatest in the fiscal area, but also the least exploited. The potential is large because the composition of fiscal adjustment is key to both short- and long-term performance, e.g. via non-Keynesian effects on demand and strengthened incentives to work. But it is also largely unexploited as indicated by the larger countries' excessive reliance on tax increases and one-off measures, or deliberate inaction. The end result has been a perception of policies being adrift in the countries concerned and a sustained pressure on the fabric of the SGP, most notably in the form of breaches of the 3 percent deficit limit.
8. The collective response to this pressure has been suitably constructive. Going forward, we subscribe fully to two tenets of the Commission's latest proposed Broad Economic Policy Guidelines, namely:
- Countries with unbalanced underlying fiscal positions should undertake fiscal adjustments of at least 0.5 percent of GDP per annum in cyclically-adjusted terms until the position is corrected, and let the automatic fiscal stabilizers work around the implied consolidation path; and
- The fiscal adjustment should be quality adjustment, i.e. based on multiyear consolidation plans aimed at curbing primary spending growth, eschewing in particular past proclivities toward tax increases or one-off measures.
These two criteria admittedly may not ensure immediate corrections of breaches of the 3 percent deficit limit, which is the focal point of adjustment efforts under the excessive deficit procedure. While this limit is and must remain one of the key reference values of the monetary union, we see the credibility of the SGP in the period ahead as better served by a time-consistent and sustainable strategy that helps countries move durably back into compliance with the Pact. The foregoing tenets provide such a framework and, because of the focus on embedded medium-term structural adjustment, they begin to exploit the synergies of high quality fiscal consolidation and thereby foster the return of confidence and growth. Such an outcome would be in the interest of both the SGP and individual countries. In our view, countries should be expected to meet the "0.5 percent high quality multi-year adjustment" test, and those that do should be considered on a sustainable path toward compliance with the Pact.
Monetary Policy Considerations
9. The outlook for inflation has improved. The weakness in activity, the prospect of a continued softening of labor markets, the fall in oil prices, and the recent large appreciation of the euro all point to a significant deceleration in inflation going into next year. Thus, although inflation has proven unexpectedly persistent in the past, we project headline and core inflation to fall below 1½ percent during the course of next year and for price pressures to remain low for some time. This projection is subject to risks and uncertainties:
- While exchange rates remain difficult to predict, the most pertinent risk would appear to be that of overshooting.
- As regards wage developments, while caution is necessary, we see the conjunction of favorable price developments and weak labor market conditions as likely to continue to tilt wage increases to the moderate side. Such a tilt would be amplified if the recovery again failed to materialize on schedule.
- While we see no risk of deflation at this point in the euro area as a whole, a period of temporary price declines, likely short, in Germany is conceivable. Insofar as this reflects declining oil and other imported input prices, this is of course to be welcomed, in Germany as elsewhere, as it boosts real incomes and helps restore profitability. A stylized fact, however, is that balance sheet adjustments tend to be more prolonged at lower rates of inflation, and broad price declines would hamper such efforts further. But we see the risks of such declines getting embedded into expectations to be limited by membership in EMU: the more inflation is conditioned by area-wide inflation, the less likely it is that deflationary expectations could become entrenched, all the more so since trade elasticities within EMU are high.
10. On balance, we see considerable scope for monetary easing. We also see a need because monetary policy has a role to play in hastening the balance sheet adjustment process and fostering the resumption of growth. In that regard, we would recommend that, beyond early easing, and absent unexpected signs of cost push pressures, monetary policy maintain an accommodative bent until a recovery in domestic demand and, in particular, of corporate spending is firmly in place. We would caution, however, that we do not see monetary policy as able to play more than a supportive role in the resumption of growth in the euro area. That ultimately hinges on addressing the nexus of structural-fiscal issues that hangs over the area's prospects.
11. Finally, we strongly welcome the restatement of the ECB's monetary framework. It disposes of earlier communication problems and clarifies the objective of price stability. The objective of below but close to 2 percent provides a buffer against shocks that could threaten to lead to area-wide deflation, while also providing scope for inflation differentials across countries.
12. The Cancún Ministerial of the WTO must succeed in driving the Doha process forward. Failure to do so would provide impetus to regionalism and fragmentation, and exacerbate trade disputes. The Commission has set out a list of priorities for Cancún which, while acknowledging the importance of agriculture, underlines the scope for parallel progress in other areas. While the global agenda is a broad one, we would emphasize the importance of agriculture and the critical role of the EU in this regard to a successful completion of this round. A crucial step, therefore, would be the adoption of the Mid-Term Review proposals for reform of the CAP, within the proposed time-frame and without diluting the objective to decouple agricultural supports. There also continues to be a lack of ambition on market access. Concerns that preference erosion might hurt the poorest countries call for careful consideration of, and assistance in, the transition process, but cannot justify lasting resistance to liberalization on an MFN basis. We welcome progress towards negotiations on Economic Partnership Agreements, and emphasize that regional integration must promote an outward-looking model of development, including in agriculture.