(In the Context of the 2008 Article IV Consultation Discussions with the Euro-Area Countries)
May 28, 2008
1. Ten years after its launch, monetary union is a distinct success. The union has been expanding, with Slovakia now set to become its newest member, and the macroeconomic policy framework has made the euroarea a zone of stability in the international economy. Also, despite labor market inefficiencies and major terms of trade shocks, labor costs have been subdued and employment growth remarkably strong. Economic union, however, remains work in progress. Productivity has been disappointing and intra-area economic disparities are pronounced. The relative protection offered by the euro must not be allowed to distract attention from the challenges of building a vibrant economic union as a matter of common interest and destiny.
Near-term economic prospects
2. After exceeding 2½ percent in 2007, activity is set to decelerate significantly, mainly in response to global shocks. Thanks to the enhanced resilience of the euro-area economy, the impact of these shocks is still contained, as evidenced by strong growth in the first quarter of 2008. But it will intensify; in particular:
• Rising commodity and food prices will cut into consumption. Also, the real estate market, despite divergent trends across the area, will dampen aggregate construction and household wealth and spending.
• The global financial turmoil has led to a tightening of financial conditions. While appreciable progress has been made with respect to banks' loss recognition and recapitalization, many financial markets have yet to return to normal. The pressure on firms and households from higher risk premia and stricter lending standards, though not yet evident, will build considerably over time.
• The slowdown in global demand will weaken exports, as will the real effective exchange rate of the euro, which is now on the strong side of medium-run fundamentals, having borne a disproportionate burden of the depreciation of the US dollar.
Accordingly, we project euro-area real GDP growth to slow substantially in the coming quarters. As the effects of the various shocks unwind, growth should reaccelerate to trend late in 2009, making for a mild slowdown by the standards of recent history. At this stage, we expect annual average growth of around 1¾ percent in 2008 and 1¼ percent in 2009, with the forecast being refined in the context of the IMF's interim World Economic Outlook in July. Risks remain large, notably on account of the ongoing financial turmoil.
3. While headline inflation has reached at uncomfortably high levels, second-round effects have essentially been kept in check. Exceptionally large commodity price rises have pushed HICP inflation above 3 percent, where it is likely to remain for the near future. Concomitantly, labor cost growth has been relatively subdued, helping keep HICP inflation excluding food and energy below 2 percent. Generally restrained wages, subdued underlying inflation, and stable inflation expectations have been hallmarks of EMU, reflecting the high credibility of the ECB, the increased weight given by social partners to combating unemployment, and global competitive pressures.
Monetary policy
4. The central question for monetary policy is how to balance the risk of a broad-based increase in inflation with the prospect of gradually building disinflationary forces generated by the economic slowdown. At this difficult juncture, much hinges on how labor costs evolve over the medium run. We project inflation to gradually return to below 2 percent in late 2009, but this path is subject to an unusually high degree of uncertainty, particularly on account of commodity and food prices. As regards labor costs, it is not clear to what extent the projected slowdown in demand for labor and the pressure on employers' margins will act as a restraining force, thereby offsetting the ongoing catch-up of wages in competitive parts of the area and the general pressure for pay hikes from higher headline inflation over the near term. The outcome crucially depends on how well inflation expectations remain anchored. In these circumstances, it is appropriate to keep policy rates on hold. Looking further ahead, policy prospects would shift if, consistent with our baseline projection, forward-looking indicators point to growing spare capacity and receding inflationary pressures.
5. The monetary policy framework has supported the success of the euro. Money influences inflation more than some critics let on and monetary analysis has proven useful in understanding the recent financial turmoil and its possible impact on economic growth. Thus, monetary analysis should continue to be part of the ECB's overall monetary strategy. However, relative to other economic factors, the contribution of monetary aggregates in predicting inflation over the medium run needs to be put into perspective. Accordingly, we welcome ongoing efforts to broaden the analysis of the determinants of inflation, including financial market and asset price developments. This work could usefully lead to a unified presentation of policy decisions, integrating monetary and economic analysis and thereby providing a clearer narrative of the relative role of monetary aggregates in influencing the policy stance.
Financial sector policy challenges
6. The ECB's liquidity management has been timely and proactive and the flexible framework has proven a crucial stabilizer during the turmoil. The broad list of eligible collateral and counterparties has been a key advantage and relatively high but flexible reserve requirements have provided a welcome buffer to banks. However, banks' balance-sheet stresses and fears of heavy market punishment for running into liquidity constraints seem likely to remain an obstacle to normalizing term spreads for some time. To forestall similar stress in the future, Europe's financial integration, notably that of secured money markets, has a key role to play. While this will require work on many fronts, the integration of clearing and settlement systems is now even more critical.
7. The recently-agreed policy principles that are to guide the reforms to the EU's arrangements for financial supervision and stability are mould breaking. A series of ECOFIN conclusions are setting nationally-anchored prudential authorities on a course toward more joint accountability and responsibility for EU financial stability, in line with Europe's quest to build a single financial market. This is all the more important as failure of a large cross-border financial institution, while highly unlikely, would be very challenging to handle efficiently and effectively under current arrangements-and could thus be extremely costly to the economy. In this regard, the recent Memorandum of Understanding on crisis management is a significant step forward, as is the intention to strengthen the EU Committees of Supervisors (level-3 committees). It will be important to imbue these initiatives' implementation with a strong multilateral spirit.
8. The key challenge now is to bring the legal underpinnings of national financial stability frameworks fully in line with the agreed principles; this will require strong political leadership. Action could usefully focus on two fronts. First, the planned introduction of a European dimension in the mandates of national supervisory authorities needs to be given teeth and clearly rule out any "beggar-thy-neighbor"-type policies, supported by appropriate accountability. Second, a multilateral platform for real-time sharing of systemically-relevant supervisory information among supervisors and central banks is urgently needed and should include the ECB, given central banks' roles in providing liquidity, overseeing payments systems, and assessing financial stability. Over the medium term, policymakers need to deliver on their commitments to build arrangements to minimize the collective costs of a crisis and share fiscal costs based on equitable and balanced criteria. This will require, among other things, introducing bank-specific insolvency regimes that allow cross-border pooling of assets and liabilities.
Fiscal policy
9. Fiscal performance in the euro area improved further in 2007 but new tests lie ahead. The cyclically-adjusted fiscal deficit of the euro area as a whole was the lowest in three decades in 2007 and no euro-area country is in breach of the 3 percent of GDP Maastricht ceiling. However, only about half of the countries have reached their "close to balance or surplus" medium-term objectives (MTO). The other half includes almost all those countries with high public debt. This is troubling, given that population aging-related expenditures are set to accelerate soon after 2010. Also worryingly, some of these countries' fiscal deficits risk exceeding the Maastricht limit over the near term. Finally, against the background of already some relaxation in 2008 budgets, expansionary impulses are mounting in several countries.
10. Sticking with a rules-based policy is what serves countries best in today's uncertain environment. The room for fiscal policy to adjust in response to the current downturn must therefore be a function of the fiscal space under the Stability and Growth Pact (SGP). Countries that have reached their MTO can afford some fiscal stimulus were activity to weaken more than projected. However, countries that are not close to their MTO must resist calls for discretionary action, not least because a large reversal of fiscal fortunes, as occurred during the previous downturn, remains a distinct possibility. They could, however, let automatic stabilizers operate freely, provided their budgets aim to improve the cyclically-adjusted fiscal balance by about ½ percent of GDP per annum and they stay clear of the Maastricht deficit ceiling.
11. Looking further ahead, achieving a more predictable and efficient fiscal policy remains a fundamental challenge in several countries. Stronger national fiscal rules and domestic governance mechanisms are the most promising way forward, and we welcome the related proposals in the Commission's EMU@10 report. We harbor doubts, however, about the practicality of the proposal to take account, under the preventive arm of the SGP, of trade-offs between fiscal adjustment and structural reforms that entail transitory fiscal costs but are deemed to generate higher potential growth.
Structural policy
12. Improving the euro area's capacity to adjust in response to intra-area disparities remains the main structural policy challenge. While further progress is necessary, labor market reforms have contributed to the creation of some 16 million jobs over the past decade. Remarkably, the employment ratio is coming close to the Lisbon Agenda's 70 percent target for 2010. Similarly, the single market program and product market reforms have raised productivity in affected sectors, although this is masked in the headline data by the greater employment-intensity of growth. The enhanced flexibility in some markets, however, has not extended to large parts of the all-important services sector. As a result, growth in per capita incomes and adjustment to country-specific shocks has likely been slower and inflationary pressures higher.
13. Accordingly, the reform momentum needs to be kept up and re-oriented in a coordinated manner, along the broad lines advocated in the Commission's EMU@10 report. Specifically, National Reform Programs of euro-area countries need to become more consistent with the reform recommendations for the euro area as a whole under the Lisbon Agenda. The latter rightly puts greater emphasis on accelerating services market reform (including ambitious implementation of the Services Directive) and financial integration. In this context, we support the EU-wide efforts to collect more data on the functioning of markets and the effectiveness of structural reforms, which should help in identifying those reforms that offer the highest payoff and practicality in terms of fostering adjustment. We look forward to the debate generated by the Commission's report and, in due course, concrete proposals in this domain.
Trade policy
14. Prompt action by the EU and others is needed to conclude the Doha Round and bolster multilateral liberalization. The right response to the many challenges posed by high food prices is to lower agricultural trade barriers and subsidies so as to foster the production and free trade of agricultural products. Approaches that emphasize self-sufficiency with respect to food production should therefore be resisted and biofuels policies kept under review. EU leadership in facilitating an ambitious conclusion to the Doha Round that liberalizes trade in agriculture, industrial goods, and services can provide a critical counterweight to rising protectionist pressures.
