December 17, 2001
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(In the context of the 2002 Article IV Consultation Discussions with Euro-Area Countries) December 17, 2001 1. With the final step in the changeover to notes and coins underway, the euro is about to be transformed in the eyes of the public from an abstract icon to the most tangible element of Economic and Monetary Union (EMU). This is a matter for celebration, mainly because of the major milestone in European integration that is being passed, but also because of the considerable accomplishments already garnered under EMU. Foremost among these is the successful pursuit of stability-oriented, yet suitably flexible, monetary and fiscal policies. At the same time, the contemporaneous weakness of the euro and the current cyclical downturn underscore the road that remains to be traveled to strengthen underlying fiscal positions in the larger countries and achieve the integrated, employment-generating, and smoothly functioning markets anticipated from EMU. The advent of the physical euro needs therefore to prompt the resolve to deal with these so far more intractable aspects of monetary union. 2. Notwithstanding generally sound macroeconomic policies and financial fundamentals, the area's economy has slowed to a crawl. Basically, this is due to a series of mostly global, common shocks that have spread throughout the world economy with surprising speed, including the euro area. 3. Because these shocks are expected to fade or reverse, a gradual cyclical upturn during 2002 seems likely, but risks of a more severe downturn and a sharper increase in unemployment remain significant. The predominant expectation is that the downturn will stop short of an outright recession and be followed by a gradual recovery to above-potential growth in the course of 2002, for an annual growth rate of 1.2 percent. The key driving forces are lower oil prices; a synchronized pick up in global trade; an undervalued exchange rate; the recent easing in monetary policy; and a revival of business sentiment. Confidence indicators, however, continue to teeter on the borderline that has traditionally separated moderate downturns from recessions; domestic demand in the area's largest economy seems to be particularly hard hit; and downside risks in other major currency areas and the global synchronicity of the slowdown caution against underestimating the area's vulnerability to shocks. 4. In this evolving and difficult environment, monetary policy has kept pace with the changing risks to medium-term price stability. The ECB tightened policy as the shocks to prices cumulated (oil and food prices and the sustained weakness of the euro); paused in the face of accelerating headline rates and concerns about possible second-round effects from increased wage claims; and reversed course as inflation pressures abated and the downward momentum of the cyclical slowdown became more apparent. Indeed, following the events of September 11, the ECB lowered policy rates decisively. 5. Looking ahead, unless signs of an upturn prove unexpectedly vigorous and prompt or upcoming wage settlements undermine present prospects for continued wage moderation, we expect risks to price stability to recede further, thus making room for lowering interest rates. In our projections, inflation rates in 2002 and 2003 fall well below 2 percent. Inflation would fall further in the event of a deeper or more protracted slowdown, warranting early action. In the months ahead, short-term cyclical indicators should be monitored carefully for clear signs of a turnaround, confirming that the envisaged recovery is indeed on track. The main uncertainty is wage developments. At this point, notwithstanding recent signals of stepped-up wage demands in some countries, there are as yet no signs that overall wage moderation is jeopardized. Still, continued wage moderation should be seen as a requirement both for preserving medium-term price stability and for sustaining recent labor market gains. 6. Perceptions of the ECB's monetary framework remain considerably more mixed than of the policies instituted under that framework. While the framework is more encompassing and integrated than many critics would allow, a review of whether it does not convey impressions other than those intended would be useful. 7. On fiscal policy, we would first emphasize that the Stability and Growth Pact (SGP) has succeeded in terms of delivering a stability-oriented fiscal policy. The euro area as a whole entered the slowdown with a fiscal position in 2000 close to balance, a remarkable achievement in historical perspective (marred, however, by having been weakened by pro-cyclical tendencies during the upswing). Moreover, as regards developments in 2001, member countries generally permitted fiscal deficits to increase in response to the unexpected slowdown in growth, rightly allowing the automatic fiscal stabilizers to operate in the face of a large and common demand shock. 8. However, the SGP still faces two challenges to its credibility and robustness. Both are rooted in the difficulties of four of the member countries in meeting the test of "close to balance or surplus" in the medium term. The first challenge is to steer clear of a breach of the SGP's 3 percent deficit limit while avoiding unnecessarily procyclical impulses that could further weaken growth prospects. In this regard, we agree that breaching the 3 percent limit could have lasting adverse credibility effects that would outweigh the costs associated with measures needed to stay within the limit. By the same token, it is important that the SGP not be viewed as inordinately rule bound, prompting procyclical adjustments where none may be needed, particularly in cases where the difficulties do not stem in the first instance from policy slippages. While the safety margins are in some cases not ample and vigilance is required, countries should be able to avoid breaching the 3 percent limit if they stick to the medium-term fiscal adjustment path laid out in their SPs. On this view, therefore, there is no case at present either to speed up medium-term fiscal adjustment in the midst of the present cyclical downturn or to deploy discretionary fiscal fine-tuning to mitigate the cyclical downswing. 9. The second challenge—ensuring that countries persevere in their fiscal efforts to meet medium-term deficit targets—is likely to be the more enduring and ultimately the more critical. The SGP is asymmetric. It puts an effective constraint on fiscal behavior in bad times, but not in good ones, which is when adjustment should take place. Indeed, current difficulties are rooted in a lack of adjustment during the recent cyclical upturn. More generally, the historical experience is overwhelmingly that, during periods of above-average growth, most euro-area countries have allowed their underlying fiscal positions to deteriorate, in some cases even allowing their nominal balances to deteriorate. 10. In this respect, the latest set of Stability Programs for the largest euro-area countries are potentially reassuring. In general, while these plans require closer scrutiny, they feature relatively early (and unchanged) achievement of fiscal balance in the event of strong growth and somewhat later achievement in the event of more trend-like growth. This recognition of the dependence of the nominal targets on growth is appropriate. In either case, however, relatively strong underlying medium-term adjustment is implied. This is also welcome. However, at this point, these plans are more statements of intentions than of specific policy commitments. The hard part is going to be translating these intentions into policy actions at a time when the fiscal constraints will presumably be easing and nominal targets seem more easily within reach. This has been the Achilles heel of policies in the past, and is likely to remain so. 11. This view suggests that the SGP needs to be reinforced, and endowed with procedures for monitoring underlying fiscal policy behavior that go well beyond monitoring the achievement of nominal balance targets. In this context, the increased emphasis on analyzing budgets in cyclically-adjusted terms and recent efforts to develop an agreed and standardized approach for estimating the structural balance are steps in the right direction. Structural balances are likely to encounter measurement problems, however, and to be difficult to communicate to the public. It would therefore also be useful to monitor spending relative to plans, an approach that would raise fewer measurement and control problems and would also highlight the presently pervasive occurrence of ex-post spending overruns relative to SPs in many member countries. However, changes in monitoring procedures are unlikely to be sufficient to have a meaningful impact on asymmetric policy behavior that is rooted in country-specific fiscal institutions and practices. In this regard, tackling the procyclical implications of pay-as-you-go principles for financing social insurance may require setting up cyclical reserve funds. Similarly, the lack of incentives to adhere to pre-established spending plans in a favorable growth environment may require commitments that, in upswings, nominal deficits should improve well beyond what is implied by the automatic stabilizers. 12. Turning to structural reforms, many have hoped that the euro will act as a catalyst for speeding up the implementation of the area's longstanding structural reform agenda in financial, goods, and labor markets. While there is some progress, it falls well short of expectations. 13. In financial markets, the euro has energized market forces in some segments including the unsecured interbank market, short-term interest swaps, and euro-denominated corporate bonds. But the promise of significantly more integration in a number of areas, held out by the Commission's Financial Services Action Plan, remains elusive. The challenge of overcoming national interests and harmonizing diverse historical and legal traditions of member countries looms large and has slowed progress appreciably. In this context, the Lamfalussy Report's recommendation to adopt new procedures to speed up the regulatory harmonization process in a cooperative framework is a most useful step. It is to be hoped that the outstanding issues on the competency allocation within this framework will be resolved promptly. In the goods markets, there has been progress, particularly in liberalizing the network industries, but the initial momentum has waned, most noticeably in some energy sectors. At the same time, both here and on financial markets, there are grounds for optimism that enhanced price transparency introduced by the changeover will inject new impetus to reforms. 14. In the labor market, while some countries that introduced reforms have been rewarded with markedly improved employment performances, the unfinished agenda, particularly in the largest countries, remains long. The agenda can be grouped around three priorities. First, the need for more flexible wage formation and labor regulations (where backtracking has occurred in some countries on the latter) to allow wage claims to better match labor productivities across skills, sectors, and regions. Second, the need for reform of out-of-work benefit and tax-contribution systems to match reservation wages with take-home pay on work. And third, the need in many countries for more diversified social insurance systems, reforms that would also help to meet the looming challenge of population aging. 15. It is against this background of continuing sluggishness in reform that questions arise whether the competition and dynamism unleashed by the euro is not at risk of being countervailed at least for a while by a seemingly rising inertia. With the euro having become established as a basically sound and soundly managed currency, it is critical to now focus on the real performance of the euro area and on meeting the ambitious objectives set forth in the Lisbon communiqué. |
