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(In the context of the 2000 Article IV Consultation Discussions with Euro-Area Countries)
July 5, 2000
1. The euro-area economy is doing very well. While transitory external developments are influencing the situation more than is sometimes recognized, the euro area could be set for a long and strong expansion. However, that prospect hinges on policies today being sufficiently forward-looking and effective to avoid the obstacles that have derailed past recoveries.
2. It is hard to remember a period when the fundamentals have been as good. The area-wide budgetary position is nearing balance. Inflation is low, all the more so if one abstracts from the effects of one-off shocks (the hike in oil prices and the weakened exchange rate). Moreover, there is an area-wide monetary authority firmly committed to keeping it that way. Privatizations have fostered new enterprise. Product market reforms have brought forth the merits of competition and sharply falling prices for some key goods and services. Area-wide employment is in its third year of 1½ percent growth, thanks in good part to policies aimed at increasing the demand for labor-notably, through more flexible labor market structures and tax advantages to the hiring of the low-skilled. Moreover, wage demands continue to be moderate, in part because of the discipline imposed on wage formation in a monetary union. Not surprisingly, confidence is high and area-wide growth is strong (about 3½ percent), and is expected to remain so next year. Clearly, the conditions for a sustained recovery have not been as auspicious in a long time and leave scope to realize the hopes expressed at the Lisbon summit for the European Union becoming a high-performing economy.
3. That said, two points are important to provide perspective on policy requirements. First, present growth estimates overstate the underlying strength of the euro area. The buoyancy of activity since last fall is partly due to exceptionally favorable global demand conditions and to exchange rate developments that have redirected a significant part of that demand to the euro area. While it is difficult to be precise as to how much this has affected growth rates, the margin might be of the order of ½ to 1 percent over two years. What we are seeing is in part the response of the "old economy" to influences to which it has always responded. Looking forward, therefore, there is still a need to build up the internal momentum of this recovery-all the more so since the external influences might well reverse-and, more fundamentally, to deepen structural reforms.
4. Second, Europe does not have an altogether uncheckered history in managing recoveries, with shocks tending to prompt early and messy downturns. One element is that budgetary policies focused on achieving nominal fiscal balances lose their bearings in the face of high growth and plentiful receipts. The result is to pump more and more stimulus into the economies at the moment they need the opposite. This leads to accelerating wage claims, which are exacerbated by mismatches in the labor market. Not surprisingly, the monetary authority then tightens sharply. Higher interest rates or an appreciating exchange rate in the end triggers a downturn which becomes compounded by a pro-cyclical fiscal tightening and delays in adjustment occasioned by rigidities in the labor market. Admittedly, these elements are under better control today than a decade ago, as evidenced by the budgetary and wage developments mentioned above. Nonetheless, recent fiscal outturns suggest that some of these tendencies remain in play, in a context where unemployment has already fallen by more than in any recovery since the 1960s.
5. The urgent challenge, therefore, is to implement policies that will both sustain the recovery and make it more resilient. The key requirements are obvious, and widely acknowledged: at least cyclically neutral fiscal positions; policies geared to increasing efficiency in product markets and especially to expanding effective labor supply; and given the foregoing, a monetary policy that without prejudice to price stability probes the margins of resource constraints. Our concern, however, is that, although widely accepted in principle, some of these points have yet to hold as much sway in policy decision making as would be needed to ensure a long-lasting recovery.
6. As for monetary policy, it has succeeded in maintaining price stability in a volatile environment. Oil price hikes and a prolonged exchange rate depreciation generated cost pressures which, together with the firming of activity, warranted the tightening of the monetary stance. Indeed, on present growth prospects a further modest increase in interest rates could be necessary if the euro remained as weak as expected by markets.
7. Looking forward, however, we would expect the factors that have influenced the speed of the euro-area recovery and the build-up of cost pressure either to dissipate (i.e., the buoyancy of the United States economy and the rise in oil prices) or to reverse (i.e., the depreciation of the euro, which could turn around swiftly given the magnitude of current account imbalances). Jointly, these developments will invert the external impulses now at play and restrain price increases and GDP growth, calling for a more accommodative monetary stance than would otherwise be required. In this setting, policy judgements could usefully be focused on core or expected headline inflation.
8. On balance, the monetary requirement calls for a mix of steadfastness and flexibility on the part of the ECB-steadfastness in the pursuit of medium term price stability; and flexibility in the choice of policy responses that will keep a non-inflationary recovery on track. Basically, the symmetric approach that has so far shaped policy should continue to be followed, with changes in interest rates in either direction as the balance of inflation risks shifts.
9. Discerning these shifts will depend in part on fiscal developments. Symptomatically, the pace of fiscal deficit reduction for the area as a whole is not keeping up with that of the recovery. While the actual deficit is declining gradually towards balance, the cyclically adjusted deficit is in fact widening, a phenomenon that risks becoming worse as economies move above potential because of the political difficulty of posting budgetary surplus targets. The implied pro-cyclical fiscal stance is worrisome-and too reminiscent of the past. While the uncertainties surrounding the degree of resource utilization are considerable, we would think it desirable for the area as whole to be in balance, if not in 2001, certainly in 2002, with policies thereafter set so that all tax receipts arising from growth in excess of potential are assigned to debt reduction or to funding future pension liabilities. In the same vein, revenues from the sale of third-generation mobile phone licenses should also be dedicated to such purposes. This strategy contrasts with the more gradual approach envisaged in the stability programs, however, which, for the larger countries in particular, do not foresee achieving balance until several years later and are largely silent regarding the handling of cyclically buoyant revenues. Given these countries' leadership responsibility, it would be especially important to outperform or update existing plans to reflect the improved prospects. As regards the cyclically advanced economies, a number of countries need to follow the example set by some to achieve or maintain sizable surplus positions.
10. If one facet of the strategy must be to avoid pro-cyclical fiscal stimulus to demand, an equally important priority must be to strengthen effective supply. This is particularly important as regards the labor market which has been a source of bottlenecks in previous recoveries and where policies over the past decade have tended to focus instead on either stimulating demand (seemingly to good effect) or reducing supply. Looking forward, the need is rather to increase the labor supply. In this regards, it is critical to implement the recommendations of the Employment Guidelines, particularly reforms aimed at keeping older workers in employment and improving the quality of the labor force through vocational training for the young and the inexperienced. Moreover, there is a need for more market-oriented wage determination mechanisms.
11. Most importantly, active labor market policies must be complemented by an aggressive mixture of tax and expenditure cuts that prompts both the unemployed and the non-participating into employment. In this regard, governments have been particularly pro-active in taking up the tax cutting dimension of supply-friendly fiscal reform (including as concerns corporate taxation), and rightly so given that the tax burden is at a historical peak and that the euro area needs to shift to economic structures that reinforce work incentives and promote entrepreneurial activities. Nonetheless, in doing so, the aggregate demand side of the equation must also be kept firmly in view: (i) by focusing the cuts on those taxes that have the most beneficial supply-and the least demand-stimulating-effects; (ii) by complementing them with expenditure-reducing reforms to benefit systems to strengthen incentives to employment; and (iii) with a balance of durable expenditure cuts sufficient to preserve the cyclically adjusted fiscal balance. While there are worthwhile new areas for spending (e.g., on infrastructure), these and the associated tax cuts can only be afforded in the context of long-term declines in spending achieved though structural reform in public administration, transfers, and entitlements.
12. Past reforms in the product markets have bolstered the supply-side potential of the euro area and need to be continued. By all accounts, there remains ample room for promoting competition in some network industries, and removing administrative barriers to business formation. In particular, following on the commitments made at the Lisbon Summit, efforts should be stepped up to foster liberalization and market access in still-sheltered sectors.
13. A year and half into the monetary union, the enterprise is proving increasingly promising. For the expansion in prospects to achieve its full potential, however, long-standing policy requirements need to be brought to term. Such a strategy would go a long way toward meeting the international community's expectation that the euro area become a main contributor to world growth.
IMF EXTERNAL RELATIONS DEPARTMENT