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Transcript of a Teleconference Call on Euro Area Policies
with Michael Deppler, Director, European Department
International Monetary Fund
Tuesday, August 3, 2004

MS. LOTZE: Thank you very much. Good morning and welcome to this conference call on the euro area policies. I'm Conny Lotze of the IMF's External Relations Department, and with me are Mr. Michael Deppler, Director of the IMF's European Department and Mission Chief to the euro area, and Mr. Albert Jaeger, Chief of the EU Policies Division in the European Department.

You have had an opportunity to look at the staff report, the Selected Issues Papers, and the Public Information Notice. This call is on the record, but with all the documents, it's embargoed until 10:00 a.m. Washington time, which is 1400 GMT.

Mr. Deppler will make a few opening remarks before we turn to your questions. Thank you. Mr. Deppler?

MR. DEPPLER: Thank you, Conny, and good morning, everybody. I'll just run over briefly some of the main points in the report and then open it for questions.

The first point is that basically a recovery is in the works but, in the staff's view, not yet in the bag, if I may put it that way. Clearly, there's a strong growth spurt that's coming mainly from external forces—trade with the U.S. and East Asia, in particular.

As a result of this, the forecast for GDP has been raised from what it was in the WEO in April of this year, where it was one and three-quarters percent, and we're now at 2 percent. However, as I said, it's not in the bag because we remain concerned about the pace of domestic demand.

In particular, consumption remains fairly weak throughout the region, especially in Germany. In terms of the prospect of the recovery, we are concerned about a lagging employment response. As you know, employment lagged in the U.S. recovery, and we have concerns that the same will happen in the euro area. So from our point of view, this recovery will be in the bag only once we see a sustained pickup in the labor market and domestic demand.

Inflation is above the target, but the medium-term outlook is benign. Basically, we see inflation falling below two percent in the medium term. For that reason, while we think that monetary policy needs to watch out for possible second-round effects from oil price increases in particular, it also needs to be mindful of giving growth a chance. We don't see any risks on wages for the time being, and the performance of inflation during upturns in the euro area is more benign than it is during downturns. So we remain fairly comfortable about the inflation outlook and, hence, the stance of monetary policy going forward.

Turning to fiscal policy, the basic view is that the SGP is certainly alive, but it also needs rejuvenation. In this regard, everybody agrees that the SGP is a good anchor for policy for the euro area as a whole and for many of the countries, the smaller countries in particular. And it is therefore very important to restore the credibility of this anchor for fiscal policy conduct.

At the same time there is considerable agreement that there are some changes needed, some rejuvenation would be in order. First, to focus more on sustainability questions, debt questions essentially, so as to provide a better economic underpinning for this fiscal policy framework. Also, another concern is to make sure that there are instruments there to maintain fiscal consolidation in the upswing. We are very concerned that during this upswing, as in past upswings, governments will essentially revert back to procyclical policies and use windfall revenue gains to make permanent tax cuts. This is a mistake that has been made too often and in too many places and needs to be avoided in the future.

Finally, on fiscal policy, in terms of the SGP, when countries breach the 3-percent limit established by the Maastricht Treaty, it's important that the procedures be adjusted to be able to distinguish between those breaches that are due to bad policies and those breaches that are due to an adverse economic environment. This is a basic step that needs to be made to make the implementation of the pact more realistic in the future.

Clearly the main issue on the mind of the staff and of the Board is the importance of sustaining and raising longer-term growth, essentially by accelerating structural reforms. This is key because labor utilization in Europe has been declining for 30 years and is likely to get worse given the demographic outlook for Europe.

Secondly, the fiscal and intergenerational burdens of aging populations are going to make the matter worse.

And, finally, from the International Monetary Fund's point of view, structural reforms in Europe would help resolve the global current account imbalances problem and, hence, reduce the risk of appreciation pressures on the euro in the years ahead.

We have a background paper on this latter subject, a supplementary issues paper, and clearly there's a need to be mindful about the risk of euro appreciation pressures in the future.

As regards the nature of structural reforms, where their focus ought to be, the staff feels there is some difference of views on where the priorities ought to be, as indicated in a separate statement on the staff report issued by the Executive Director for euro-area polices. The staff feels strongly that it should be aimed at raising labor utilization per capita, both in terms of employment rates and hours worked per worker. In the staff's view, the low labor utilization rates that we see in Europe are not mainly due so much to a preference for leisure but reflect policies that essentially condone paid leisure, policies which effectively made it cheaper and more attractive for people not to work than to work. This can no longer be afforded and needs to be reversed.

A more European view, if I may put it that way, is that raising productivity needs to get equal attention, basically in order to maintain Europe's competitiveness in a globalized world and to keep Europe ahead of competitors. The staff is all in favor of raising productivity but makes four points. Productivity is not Europe's problem. The productivity levels per hour in Europe are basically on a par with those of the United States, and there is no lag there. The real lag is in terms of use of labor, and that's where the catch-up needs to be.

The other issue in this context, of course, is that in terms of the synergies with fiscal policies and fiscal consolidation, raising productivity basically costs money, whereas raising labor utilization basically saves money in terms of achieving fiscal objectives.

For these reasons, the staff argues for a prioritization of the Lisbon Agenda. The Lisbon Agenda has been a very useful focus for reforms in Europe, but it's an agenda which sets no priorities. You may know, there's something called the "Washington Consensus" on the policies needed to spur growth. The Lisbon Agenda is something you might call the "Brussels Consensus," which is that everything is a priority and, hence, nothing is a priority. In our view, governments in Europe need a more prioritized "Brussels Consensus," which would help fostering structural reforms and, hence, we would very much want to see a prioritization of the Lisbon Agenda focused on raising labor utilization and incentives to work in the years ahead.

Those are the main points made in the various papers, and we'll be glad to answer your questions.

MS. LOTZE: Please go ahead with questions.

QUESTIONER: Good morning. I was wondering if you could go back to the question of changing the SGP. When you say it should focus on sustainability and debt questions, could you spell that out more, what it focuses on now and what you want it to change to?

MR. DEPPLER: The SGP is essentially focused on a flow rather than a stock criterion; that is, it focuses on the fiscal deficit, without sufficient attention, I think everybody would agree, on the present and pending fiscal liabilities that countries face. And as a result, it doesn't distinguish between conditions applying to countries which have very low debt versus countries that have very high debt. It also doesn't distinguish between countries that have a relatively small aging problem and countries that have a relatively large aging problem. And everybody agrees that this is not a particularly desirable feature and that going forward the pact needs to put more emphasis on these stock phenomena.

From the point of view of the area as a whole, such a shift really is not too critical or too damaging for the pact because for the area as a whole, the present stock level and the notion of having fiscal balance in the medium term are sort of the numbers that are in the same ball park. But when you look at the situation in individual countries, if you, say, compare Ireland and, say, Germany or Italy, you'll see that when you take into account the sustainability considerations, you end up with rather different requirements for fiscal policies in the medium term for these countries. And this is going to be a bit problematic for the pact because right now there's not this differentiation across countries.

QUESTIONER: Good morning. I have some—two questions, in fact, the first just on labor utilization. Would it be correct to assume that the sorts of deals that have been reported quite extensively in Germany and across Europe at Siemens and Daimler-Chrysler on increasing working hours are the sorts of things that you have in mind when you talk about increasing labor utilization?

And my second question is a slightly more technical question. At the beginning of your—in your information notice, you talk about indications that earlier expectations of underlying potential growth could have been too optimistic. I haven't found any more detail of that in the actual report we've got in front of us except for one reference to earlier projections of the area's potential growth being revised down by about half a percentage point to 2 percent.

I just want to make sure I'm reading that correctly and this is referring to sort of the underlying non-inflationary rate of growth for the euro area. Have you really revised it down by half a percent, or am I misreading this report?

MR. DEPPLER: Okay. The hours worked issue at plants in Germany and France that you raised, I mean, what you saw there was a spontaneous private sector reaction to developments, basically competition from Central and Eastern Europe. And in our view, it's a very sort of appropriate response, and the labor unions also realized that this was the appropriate response.

But by the same token, you need to bear in mind that the policies for several decades now have been focused on trying to limit labor supply. Think of the disability schemes in the Netherlands, early retirement schemes, the 35-hour week in France. All of these schemes are essentially schemes to limit the supply of labor because of concerns of unemployment.

In our view, the problem in Europe going forward is precisely the opposite. Labor supply is going to be limited, and in order to protect social insurance systems, we need to reverse this mindset towards limiting labor supply and move into a, you know, let's get people working mode.

Now, on your second question, the answer is yes, that is, we've basically cut potential output growth, which four years ago we thought was running at about 2.5 percent we have now basically reduced to something like 2 percent. We are now at a quite low rate in this regard, although, frankly, it's not necessarily a low because if you look at the demographic changes, and without changes in labor utilization, the rate of growth of potential in the medium term could decline further to about 1.5 percent, something of that order. And, therefore, this really adds impetus to the call for structural policies aimed at raising labor utilization.

QUESTIONER: Sorry, can I just come back? Can you tell us why you've revised down your forecast? Is it simply because of the labor supply problems? And am I—I'm slightly confused about whether we're talking about this is a long-run trend rate of growth or whether this is just really your outlook for the next year as a potential growth rate.

MR. DEPPLER: Okay. The rates I was referring to are what we refer to as potential output growth rates. They take into account various things, including expected growth in population, including past increases in investment and, hence, in the capital stock, but also views about what the likely path of so-called TFP, total factor productivity, is.

Now, all of these things are longer-term developments, but they do have somewhat of a cyclical pattern. If you are thinking about this in terms of an output gap, basically we would be—if growth started to reach above 2 percent, the output gap that is presently out there now at about 2 percent would be starting to be reduced. In the event our forecast for 2004 is for 2 percent, somewhat more in 2005, and, hence, there's no change in the output gap this year and only a very minor one next year.

QUESTIONER: Thank you very much.

QUESTIONER: Hello. What is your assessment on Italy's fiscal policy?

MR. DEPPLER: We do not deal specifically with the policies of individual countries in the euro area staff report. This is basically the subject of the Article IV's for the individual countries. Germany and France and Italy are all coming up in the next six months or so.

In the case of Italy, the only thing I can tell you is that according to the plans of the government, which estimates the deficit next year to be 4.4 percent on unchanged policies, but basically they are taking actions to contain it to 2.7 percent.

Whether these policies actually deliver that kind of outcome is something which we need to study more and analyze.

In the main, we have this series of questions of enforcement under the SGP. There is a supplementary paper on this topic in the background materials. It's very clear that the SGP has been quite effective for containing deficits in smaller so-called commitment states, as described in that analysis, and much less effective with the larger so-called delegation states. Clearly the big three countries have all had greater problems in following the strictures of the pact than the smaller countries. This is a rather structural feature of the pact, and in our view going to be an enduring problem. But, frankly, if big states do not begin to respect the pact more, the smaller states are not going to respect it either, and this would be quite problematic for the region. So our general advice to the big countries including Italy is keep up the pace of fiscal consolidation.

In this context, you know that Italy is starting to think about tax cuts. I mentioned earlier about the need to avoid tax cuts during recoveries until you achieve fiscal consolidation. Whether the Italian package actually delivers that remains to be seen.

QUESTIONER: Thank you.

QUESTIONER: Hello, good morning. I would like to focus a little bit on Germany. A couple of things that you mention in your report, do you see that—or are you aiming that particularly at Germany? For example, you want to see more leadership. Are you seeing a lack of leadership from the German Government? You see political resistance to reform. Is that a problem particularly in Germany? And what needs to be done about the Agenda 2010?

MR. DEPPLER: Okay. The first point I would make is that over the past year or two, there actually has been a fair amount of reform. I think of the French pension reform, the German Agenda 2010, and the Italian Parliament recently has also approved the pension reform.

Now, these are, in our view, all things which are necessary and good, but as you know, there's been a huge political reaction in all three countries to precisely these kinds of reforms. And this is where governments have become more careful about the pace of reform going forward.

Now, in our view, this is unfortunate because the problem remains out there. There's a need to continue to press ahead with all of the reforms in all of those areas, including Germany's Agenda 2010, which is a good first step that needs to be continued. And it's because these governments have tried to reform and because they face large domestic political resistant that we see a need for Brussels to take on more of a leadership role vis-à-vis the euro area as a whole to help governments in overcoming the political resistance to reform.

So I would say that unquestionably there's a need to continue reform, but governments have sought to do so, and I would say the emphasis in the paper is that there's a need to help governments overcome the political resistance to reform.

QUESTIONER: Thank you.

QUESTIONER: Yes, good morning. I'd like to go back to this question of labor supply. It's in your mind now clear that there is no connection or link between labor supply and working hours and unemployment [inaudible] hour week a clear failure [inaudible]. Should Europeans increase their working hours by going back to seven-day working week and ten-hour working day?

MR. DEPPLER: I mean, you obviously think we are plus royal que le roi, as the French say. This is not the intention. Basically, Europe for 30 years has been coping with an unemployment problem, and it has coped with this problem essentially by two methods: first, by reducing labor supply, and those policies have continued, as I mentioned before; and then most recently by increasing labor demand, all sorts of policies aimed at increasing labor demand but particularly wage moderation.

Now, those policies have worked in a measure. The increases in labor demand are quite striking. Some people don't realize that between 1997 and 2002 or 2003, the euro area created more jobs than the United States did. I think the numbers were 12 for the euro area and 10 million for the United States. So these policies were undoubtedly successful.

But, frankly, those policies of increasing demand have come to the end of the road. What you need to do now is policies to increase labor supply, and that means reducing the incentives to retire as opposed to continue to work and pay for your pensions; reduce the constraints on people wanting to work more. There's a need to change the mindset, not in terms of forcing people to work longer but simply giving them the option to work as much as they desire to work for whatever the rate of pay is.

You take this as being sort of cruel on our part. I mean, I would argue very strongly that Europeans need to do this in order to pay for their social insurance schemes. There's a massive fiscal unsustainability problem out there that needs to be incorporated in the mindset of the people. The main way you can pay for those social insurance schemes is to have more labor employed because taxes on labor are the main basis of the funding of these systems.

So this is a problem, a quintessentially European problem which the continent needs to come to grips with and resolve.

QUESTIONER: Hello, Mr. Deppler. Can I just check with you on the Article IV consultations with the ECB and the Commission and just—the article reports quite extensively on those discussions, and I just wondered if they were still relevant to the positions held in May or if they had been updated or clarified by the ECB or EU since.

MR. DEPPLER: Well, I can assure you these reports—the staff report in particular, the staff papers, reflect the views of the staff. We do report the views of the authorities during our discussions, but the rest are the unvarnished views of the staff, just to make sure there's no ambiguity there.

In terms of whether there's been an evolution in the thinking since the discussions in May, the answer to that is yes. Clearly, the rebound in growth in the world economy and the effect that this has had on Europe is much more evident today than three months ago. And as a result of that, the staff's assessment of its prospects but also the staff's assessments about the requirements of monetary policy have evolved somewhat.

At the end of the mission in May, we had a concluding statement which was released by the ECOFIN or the Euro Group, and you'll see there basically we take a view that the ECB should have remained open to consider a cut in interest rates. That aspect is no longer in the report you see today because, clearly, growth is better and the risks on the inflation side, the oil price increases in particular, have changed that assessment. So there has been a change, and that's, I think, the main one that's out there.

QUESTIONER: Okay, thanks.

QUESTIONER: Yes, first of all, I just would like to clarify something you said earlier about Italian tax cuts. Is this the gist of your statement that Italy should—that you're advising Italy not to—not to cut taxes in the near future?

And my other question is about—you talked about pension reforms in various countries facing political reaction. Italy has just approved a pension reform starting in 2008. Is your assessment that this should be brought forward? 2008, is that too late for the start of this new reform?

MR. DEPPLER: On the tax cuts, there is two points to make here. First of all, all of the big countries have a deficit problem. And in our view, reducing those deficit problems should be the priority. And we are quite clear that in cyclically adjusted terms, each of the three countries should improve its fiscal balance by at least a half of percent of GDP each year.

The second point is if beyond that you are able to put into effect tax cuts because you have additional expenditure cuts to match those tax cuts, then we are all in favor of that as well.

However, the problem traditionally is that countries promise tax cuts long before they are in a position to deliver the expenditure cuts, and so what you end up with is a situation where the underlying fiscal position is worsened rather than improved. And this is a phenomenon that we have seen time and time again in Europe for years. I mean, you know, it is very clear from the French experience; it is very clear from the German experience as well. And this is the concern in the case of Italy. Do not promise tax cuts until you have first taken account of the fiscal situation and improved it by at least half a percent of GDP, and then move on to tax cuts once you have the associated expenditure cuts in the bag.

Now, what the situation in Italy is today I can't really tell you. This requires a detailed assessment, which we haven't done, and it will be done in connection with the Article IV for Italy.

On the issue of pensions, we are very pleased to see that the pension reform has, in fact, been adopted, and we view that as a positive step. I am not quite clear on the specifics of that, what exactly was passed, so I can't really speak to the issues or features of it. The notion of having some delay in implementation is, you know, fairly traditional. That is not per se necessarily a problem.

QUESTIONER: Yes, good morning. A clarification on staff projections about deficit-to-GDP ratio on Italy. I see that the new projection for 2004 is 3.6 percent and 3.4 percent for 2005. These projections are quite different from that of the World Economic Outlook in April. And I would like to know if these projections considered the extra budget approved a few weeks ago or not or if these are based on unchanged policies.

Thank you.

MR. DEPPLER: The answer is that the numbers are on the same basis as WEO numbers of last April, updated to reflect later staff estimates. They do not incorporate the measures embedded in the latest government plans. And they do reflect basically unchanged policy.

QUESTIONER: Thank you.

MS. LOTZE: If there are no further questions, then we will end the conference call here. Thank you very much, and please observe the embargo for 10 o'clock or 1400 GMT. Thank you very much for joining. Good-bye.

[Whereupon, the teleconference call was concluded.]




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