Euro-Area -- Concluding Statement of the IMF Mission on Euro-Area Policies
May 29, 2005
1. These are difficult times, but the strategy of consolidation, reform, and integration is working and needs to be sustained. Major reforms are undoing rigidities accumulated over past decades, preparing social institutions for the looming demographic shock and enhancing the euro area's resiliency to rising international competition. Unsurprisingly, this has led to stresses and strains. However, the strategy is paying off. The most telling evidence is the sea change in employment performance since the mid-1990s: wage moderation and labor market policies have helped add some 12 million jobs to the area's payrolls, recently with strong results particularly for older members of the population. Moreover, job-rich growth can be expected to continue over the next few years, in part because of the latest, significant entitlement and labor market reforms. However, structural policies are increasingly being questioned even though there is a long way still to go to achieve sustained economic growth and to prepare the European social model for the demographic shock.
2. Europe's policy frameworks and the single monetary policy have fostered macroeconomic stability and promoted the reform process. Peer-driven, multilateral surveillance has encouraged the adoption of better policies. And thanks in part to the ECB's hard-won credibility, wage pressures are subdued and long-run interest rates are at historical lows in all euro-area member countries, notwithstanding large shocks to prices. Growth divergences across countries mainly call for more determined structural reform agendas in countries where performance is lagging.
3. Europe also has an important role to play in addressing key issues facing the global economy, including the orderly resolution of global imbalances. Unsustainable global imbalances are a multilateral problem requiring a multilateral solution. Europe should do its part by pursuing a vigorous structural reform agenda that improves investment prospects and boosts growth and demand. The EU also needs to continue to lead in ensuring a successful completion of the Doha round.
Recent developments and outlook
4. The situation is uncertain, with the indicators pointing to softening activity, but the fundamental elements for a continuation of the gradual recovery seem to remain in place. Prudent wage setting, improved corporate balance sheets, accommodative financing conditions, and strong world demand have fostered the long-sought if still gradual and modest recovery in activity. However, the recent weakening of demand and of the high-frequency indicators raises questions about the robustness of this process. Do they reflect temporary factors (such as confidence) or potentially less transient ones (such as a sharper and more sustained slowdown in global growth)? The signals are conflicting, but the evidence for the latter is not yet sufficiently strong to fundamentally change our assessment of the outlook. Accordingly, we expect the recovery to slow down temporarily and regain momentum in the second half of the year. In this setting, underlying inflation should run around 1½ percent for the foreseeable future, as should headline inflation in 2006-07, given current oil price and exchange rate assumptions. However, absent stronger internal dynamics, the area-wide recovery is highly exposed to external shocks. Principal among these are further oil price hikes, multilateral euro appreciation, and a sudden reversal of benign conditions in global financial markets.
5. Given the outlook for prices and the uncertain situation, keeping interest rates on hold is still appropriate, but the need for a rate cut may be materializing. Clearly, interest rates will in time have to be raised but key considerations argue for an accommodative policy stance: (i) inflationary pressures appear set to ease and inflation expectations are well anchored, not least reflecting the credibility of the ECB; (ii) wage setting has fundamentally improved and there are no indications of second-round effects; and (iii) liquidity, credit, and asset price developments do not yield robust cautionary signals for the area as a whole. By the same token, the case for a rate cut at this juncture is not yet evident: headline inflation remains above 2 percent and signals on prospects for the recovery over the balance of the year are mixed. However, with inflation headed for rates well below 2 percent, a cut in interest rates would be appropriate if the weakening became more pervasive or the euro appreciated sharply on a multilateral basis.
Fiscal and structural policies and frameworks
6. The main requirement is for national policies to be both steadfast and ambitious in addressing imbalances and thereby instilling confidence that future challenges are being met. Population aging will accelerate rapidly after 2010 and actions will be necessary to curb rising aging-related expenditure. Progress has been made in stemming these pressures with reforms to entitlement systems, but more is needed. Moreover, structural fiscal imbalances have failed to narrow since 2000 and public debt has risen, and lately the direction of structural policies is being increasingly questioned by skeptical electorates. The changes to the SGP represent responses, but need to be shown to address these concerns effectively if they are to anchor expectations and support activity.
7. While policy requirements are qualitatively similar across the members of the union, the so-called "divergences" in growth among them point to the need for more ambition in some than others. These longer-term fluctuations in countries relative performance—the short-term ones appear to be random—have deep roots, including in starting differences in per capita income, but also in the relative rigidity of countries' structures and in the aptness of the policy responses to past major shocks, whether favorable or not. In time, these developments become reflected in long-term swings in "competitiveness" and performance. While such fluctuations are in a measure routine and normal, the difficulty of controlling them within a structurally rigid monetary union means that they become deeply ingrained and hard to reverse. In such circumstances, countries with weak competitive positions need to develop strategies that exploit fully the complementarity between fiscal and structural policies if they wish to correct the competitive weakness and strengthen performance promptly.
8. At the area-wide level, the key fiscal challenges are to move decisively away from the 3 percent limit and address the unsustainability imbedded in the looming demographic shock. This will require further entitlement reforms, but also achievement of a roughly balanced structural fiscal position for the area as a whole by the end of the current decade, when aging is set to accelerate. With the structural deficit presently in the 2-2½ percent of GDP range, improvements in countries' cyclically-adjusted balances need to average ½ percentage point of GDP a year (net of one-offs and other temporary measures), with more needed in countries with weak starting positions.
9. Whether at the national or area-wide level, credible rules-based fiscal frameworks will be key to meeting this challenge. The renewed commitment to an area-wide fiscal framework is a welcome signal. The greater flexibility of the reformed SGP can be a plus, particularly to the extent it prompts a more forward looking approach to policies. Some of the proposed reforms are needed, such as those that lead to a greater sensitivity to economic circumstances in the application of the dissuasive arm and that discourage recourse to one-offs and other temporary measures. But the failure in the Council report to strengthen the preventive arm is regrettable given the area's poor record of adjusting during upswings. Indeed, the quite restrictive definition of good times together with the provision to make allowances for structural reforms would seem to set the stage for a pace of adjustment well short of the ½ percent benchmark more or less indefinitely and for a repeat of the unhappy experience of the past few years. In our view, a higher standard should be sought. Similarly, while the "other relevant factors" can be a useful source of flexibility, the risk is that their application is so one-sided and the recourse to flexibility so open-ended that there is no framework left. There are admittedly some safeguards, such as the "close and temporary deviations" clause. In the end, the viability of the framework will depend on the Council's ensuring that implementation is transparent, evenhanded, and in conformity with the economic reasoning behind the added flexibility.
10. Structural policies need to focus on strengthening growth while preserving the key tenets of Europe's social model. In a nutshell, this requires adapting entitlement systems, boosting labor utilization, completing the internal market, and integrating national financial systems. A greater focus of the Lisbon Strategy on these objectives and on adopting the best practices of peers would have been desirable to help mobilize support for implementation. In general, entitlement and labor market reforms need to go hand in hand to raise incentives to work, while complementary product and services market reforms focused on increasing competition should enhance productivity and job creation. This highlights the importance of adopting an ambitious EU Services Directive. Furthermore, EU competition policy will have to play a lead role in opening national markets, to foster the spread of new technologies that improve Europe's growth prospects.
11. The reforms to the SGP and the Lisbon process increase the onus placed on nationally-led policies to deliver economic reform. Garnering national support for adjustment thus takes on renewed importance and national mechanisms will have to play a greater role. Achieving this will require that the Stability Programs (SP) and the national action plans (NAP) under the reformed Lisbon Strategy—which, through the integration of various guidelines, lays the ground for a more consistent approach to policymaking—be debated in national parliaments. Strengthening ownership will also require developing independent, non-partisan institutions reporting to national parliaments that would both inform the public about the larger strategic economic issues confronting countries and assess the implications and monitor the implementation of the SPs and NAPs. They could also contribute to improving the quality of public finance statistics, which have been shown to be deficient. Nonetheless, intensive, peer-driven multilateral surveillance of structural policies, including well-grounded benchmarking, would remain necessary.
12. Financial integration is crucial to support higher and better balanced economic growth, permit a more efficient distribution of risks, and enhance the effectiveness of monetary policy. The FSAP and the Lamfalussy process have given a strong impetus to the creation of the legal and regulatory framework for integrated financial markets and the convergence of supervisory practices. The recently-agreed Memorandum of Understanding on cooperation in financial crisis situations is another step forward. We have also noted the general expectation among officials that this mix of top-down and bottom-up processes and the reforms that are underway are beginning to deliver an integrated market. However, this undertaking is highly complex and national interests continue to slow area-wide integration. Partly for these reasons, businesses strategies for key market segments have thus far remained nationally oriented, with potentially adverse effects for competition and innovation.
13. The renewed emphasis on the effective transposition of European rules and their enforcement, including through sectoral inquiries and competition policy, is thus very well placed. The Green Paper's welcome focus on consolidating progress and improving regulations should not, however, delay necessary new legislative initiatives. In any case, key building blocks of an integrated financial sector would still be missing even after the envisaged program has been implemented. In this regard the ongoing "organic/evolutionary" approach to further integration/centralization has attractive features. However, unless this approach delivers quality regulation and supervision in a timely manner, it will act as a brake on integration and could entail unnecessarily high costs and risks. In that case, there will be a need to address the issue of how far and how fast to move to a more integrated approach to financial legislation, regulation, and supervision.
14. The EU also needs to continue to play a lead role in forging an agreement on the Doha Development Agenda. Of special importance would be for the EU to offer greater access to its agricultural market and to strictly limit the use of sensitive product exemptions from tariff reductions. We welcome EU support for strengthened WTO rules over regional trade agreements. Recognizing the importance of developing countries' own liberalization for economic development, we encourage the EU to work with these countries, including through Economic Partnership Agreements, to liberalize their trade regimes on a most-favored-nation basis. Following the long phase-out period for quotas under the Uruguay Round Agreement on Textiles and Clothing, we encourage the EU to avoid imposing import safeguards.