Abstract

The economic dynamism of the Netherlands in the 1994–98 period, and the advanced stage of the business cycle, began to pose new policy challenges as the economy approached monetary union. This section assesses these challenges, against the background of the Dutch experience since the early 1970s with domestic economic policymaking under a fixed exchange rate regime. It is concluded that enjoying full benefit from economic and monetary union calls for ongoing structural reforms, to enhance adjustment to economic shocks, and a new focus on the scope for fiscal policy to help cushion cyclical disturbances, at least through automatic stabilizers.

The economic dynamism of the Netherlands in the 1994–98 period, and the advanced stage of the business cycle, began to pose new policy challenges as the economy approached monetary union. This section assesses these challenges, against the background of the Dutch experience since the early 1970s with domestic economic policymaking under a fixed exchange rate regime. It is concluded that enjoying full benefit from economic and monetary union calls for ongoing structural reforms, to enhance adjustment to economic shocks, and a new focus on the scope for fiscal policy to help cushion cyclical disturbances, at least through automatic stabilizers.

Key Issues

From the start of the Bretton Woods regime the authorities aimed at keeping the guilder relatively stable against the deutsche mark. Following a weakening of the guilder during the 1970s, a de facto monetary union has existed with Germany since 1983, subsumed in the broader European Economic and Monetary Union (EMU) from January 1999. The Dutch authorities have consistently underscored their satisfaction with the exchange rate link, as it has contributed much to restoring price stability and broader financial and economic balance in general. Moreover, despite several important disturbances—energy price changes and the impact of German unification—employment growth and output growth have developed favorably in the Netherlands since the early 1980s. Indeed, in empirical studies of the desirability of currency unification, the Netherlands and Germany are often—although usually with caution, given the tentative nature of such evaluations—considered part of one optimum currency area.1

From the 1960s through 1993, the peg did not pose a serious policy dilemma, as integration largely shielded the two economies from recurrent asymmetric shocks. Subsequently, growth and inflation in the two economies diverged. This reflected the turn-around in Dutch wage setting in the early 1980s following destabilizing wage-price cycles in the 1970s—together with wage pressure in Germany resulting from the 1989 unification. Nonetheless, the structural reforms in the Dutch labor market during the 1980s were, in a longer-run context, consistent with preserving the currency peg. In fact, wage-price flexibility has been the key domestic adjustment mechanism under the peg, as fiscal policy has not been used for stabilization and has often been procyclical.

During 1997 and 1998, the risks associated with the then rapid economic expansion underscored the need for continuing reforms to increase the flexibility of the Dutch economy. After 1993, the economy experienced a sustained boom, with unemployment dropping to very low levels by the standards of the past two decades, and asset markets buoyant. As rapid consumption growth sustained the boom, there was no case for macroeconomic policies to add a further impulse. However, in 1997 and 1998, with growth well ahead of Germany, the monetary conditions resulting from the peg were easier than domestic cyclical considerations would have warranted. A core concern in this respect was the importance of preventing the boom from culminating in economic overheating—in particular, avoiding the emergence of excessive wage growth that could ultimately lead to a major setback in economic activity. With the setting of fiscal policy mildly expansionary, the onus fell to an undue extent on the structural flexibility of the economy.

In this section, the analytical framework of the optimum currency area approach is drawn on to evaluate the Dutch experience with exchange rate regimes. Brief accounts of the current economic boom, and of the fading scope for monetary policy to address asymmetric disturbances, provide the starting point. These expositions illustrate the scarcity of policy instruments for addressing macro-economic shocks. The ensuing background analysis focuses on the asymmetric shocks that affected the Dutch and German economies in a de facto monetary union and, subsequently, the Dutch adjustment mechanisms for coping with such divergences under the peg regime. Drawing lessons from the experience so far, an assessment of policy requirements under EMU completes the section.

The Booming Economy of the Mid-1990s

The strong expansion of the economy in the mid-1990s accentuated the underlying structural improvement and, particularly, the recovery of employment, which started in the early 1980s. Both the structural trend in unemployment and its fluctuations are apparent in Figure 5.1, which confirms the extent to which the economy has still been subject to—at times pronounced—cyclical developments.

Figure 5.1.
Figure 5.1.

Unemployment Rate

(In percent of labor force)

Source: IMF, World Economic Outlook

Following the international downturn of the early 1990s, economic recovery in the Netherlands gained momentum in 1994, and continued through 1998. Only in 1995 was GDP growth below 3 percent, owing to a sharp deceleration in export growth. The main sources of the striking growth performance in recent years were the positive income and confidence effects on domestic demand of the concerted economic reforms implemented over the past decade and a half. From 1993 to 1998, consumption growth was supported by substantial increases in household income, as well as by a gradual decrease in the house-hold saving ratio. Household income was boosted by rapid employment growth, even though increases in real disposable income per worker have typically remained limited to less than 1 percent a year. One factor behind the decreasing saving ratio was high and steadily growing consumer confidence, which reached record levels by early 1998 (but fell sharply in the summer of that year). A further cause was the rapid increase in house and share prices (see below), which has produced significant wealth gains.

The external environment was not consistently supportive, as the competitive position deteriorated in 1995, and external demand weakened in the second half of 1995 and 1996. Indeed, the economy was not immune to external shocks, although it demonstrated considerable resilience. Reflecting its openness, business cycles in the Netherlands and in the Euro-11 region are highly synchronized.

Employment started to recover in 1994, and since 1995, unemployment has been falling, reaching about 5¼ percent in 1998. This unemployment level in 1998 was slightly below conventional statistical estimates of the nonaccelerating inflation rate of unemployment (NAIRU), which, however, may not fully take into account the impact of recent structural reforms. Wage growth started to accelerate again in 1996, but remained moderate, and the labor unions committed to continuing wage moderation in 1998. However, with the long-term jobless accounting for roughly half of the unemployed, and with little chance of short-term unemployment falling below the 2½–3 percent range, signs of overheating emerged in segments of the labor market.

The post-1993 recovery was associated with sharply increasing prices of real estate—in particular, houses and stocks. Between 1982 (after the collapse of the 1977–79 house price boom) and the end of 1998, house prices increased by more than 120 percent, with sharp increases in the past three years (Figure 5.2 and Box 5.1).2 During the 1993–98 period, the stock market index rose by 235 percent, surpassing the increase observed in other advanced economies (Figure 5.3). The high rate of economic growth provided the macroeconomic background to the stock market boom. Current and expected future profits were also bolstered by the impact of recent structural reforms and sustained wage moderation. On the demand side, low interest rates and portfolio diversification by households and, more important, pension and life insurance companies, contributed. However, the increase probably also reflected excessive optimism. In the third quarter of 1998, there was a substantial downward correction of share prices reflecting turbulence in international markets, although this was subsequently reversed.3

Figure 5.2.
Figure 5.2.

Housing Prices and Mortgage Lending

Sources: OECD, Analytical Databases; and data provided by the Dutch authorities.
Figure 5.3.
Figure 5.3.

Share Price Indices

(1980 = 100)

Source: IMF, International Financial Statistics.

Was the House Price Increase Excessive?

Concerns about a possible housing market bubble are partly rooted in the experience of the late 1970s: house prices more than doubled between 1974 and 1978 and dropped sharply afterwards. However, while real housing prices (deflated by the consumer price index) have increased since 1991, in 1998 they were still below their 1978 level. Also, this measure does not take into account quality improvements, or increases in incomes (Figure 5.2). Both structural and cyclical developments in the housing market appear to have contributed to the recent increase in housing prices, which was also facilitated by the continued generous deductibility of mortgage interest.

  • Intrinsically, the supply of housing is inelastic in the short run, due to time-to-build and planning lags. In the Netherlands this problem has been exacerbated by the limited availability of locations for new housing. Thus, the housing stock has grown more slowly than the number of households: between 1990 and 1998, the increase in the number of households outpaced that of new housing by some 1½ percent. Under these conditions, changes in demand could have a sizable effect on prices.

  • Cyclical developments exercised a favorable influence on the demand side of the housing market. Buoyant economic growth, declining unemployment, and rising disposable income increased households’ borrowing capacity and confidence.

  • Nominal mortgage rates dropped to a 10-year low in 1996 and declined further in 1997 and 1998, contributing to higher mortgage lending and increasing the effective demand for housing.

  • The availability of mortgages was a further factor that added to demand. The increase in the number of mortgages was partly due to an aggressive marketing by banks, which included an easing of lending practices by making temporary or part-time work income eligible for mortgage borrowing and including full spousal income when calculating mortgage limits.

  • An important cause may also have been a change in the rent control system, which allowed for higher rent increases. The government has been heavily involved in the housing market since the late 1940s, with a succession of instruments including a rent control system, public housing, and a range of subsidies for construction of owner-occupied housing. In 1993, the rent control system was changed to allow higher rent increases. In 1995, the housing corporations, which provide the bulk of rental housing, became financially independent from the government. These recent changes added to the increase in demand for owner-occupied houses, as rents started to increase making home ownership a more attractive option.

Overall, these factors might well account for all of the recent increase in house prices, without recourse to a possible bubble in the market. However, some of these causes are reversible, and a sharp decline in prices might well occur as a result of, for example, the coincidence of a decrease in consumer confidence, a tightening of mortgage availability, and an increase in the supply of new lots (which would be in line with the existing planning).

The signs of a turning point in cyclical developments appeared in 1998. Real GDP is estimated to have increased by almost 4 percent, reflecting vigorous consumption growth and improved competitiveness. Also, the swine-fever epidemic, which lowered exports in 1997, had disappear ed. by midyear, however, signs of an imminent slowdown became apparent, as consumer and business confidence weakened in response to global economic developments. The emerging market crisis had resulted in slower export market growth and bank losses, and concerns increased about a further sharp deterioration in export demand. Indeed, by the end of the year, official forecasts for growth in 1999 were revised downward, to 2¼ percent.

During the buoyant growth phase of 1997 and 1998, several policy issues surfaced, relating in particular to labor and asset markets. Of course, high growth in activity and employment, combined with subdued inflation, and a fiscal deficit that has fallen to a level well below the 3 percent target set by the EMU Stability and Growth Pact are, by themselves, impressive achievements. Also, the weakening in external demand in 1998 might well induce a timely and measured slowdown from an unsustainable growth path. However, rapid expansion, reflected in wages and asset prices, carries the risk of a subsequent sharp downturn, and policies may be crucial in ensuring continued stability. With monetary policy no longer available for domestic adjustment, fiscal and structural policies have to bear the brunt—an issue discussed more fully below. As a preliminary, it is worth considering in some detail the way that the economy operated under the peg.

Experience with the Deutsche Mark Peg

The degree to which monetary policy has been available as an instrument to counteract cyclical disturbances has been limited and decreasing over the past two decades, as preserving exchange rate stability became the prime goal.4 In the 1960s, exchange rate stability had been maintained under the Bretton Woods system (1958–73), until this regime started to collapse at the end of the decade. In 1972, the Snake arrangement of European Community member countries was created to promote exchange rate stability. Under that system, with a 4½ percent fluctuation band, the Netherlands followed only partly, and with some delay, two early revaluations of the deutsche mark in 1973 (Table 5.1). Subsequently, and as discussed in Section II, the peg was subject to several attacks and two actual 2 percent devaluations (in line with the Belgian franc), as declining competitiveness rendered the peg insufficiently credible.

Table 5.1.

Changes in the Guilder-Deutsche Mark Central Rate, 1970–98

(In percent)

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Source: De Nederlandsche Bank, Annual Report, various issues.

Since 1983, the peg has been maintained within the exchange rate mechanism (ERM) of the European Monetary System, ending a period of instability. The monetary authorities at the end of the 1970s favored a firmer link to the deutsche mark to reduce inflation, which averaged almost 8 percent between 1971 and 1978. While the establishment of the EMS created a timely setting for such stability, the guilder did not follow a 2 percent revaluation of the deutsche mark in September 1979, shortly after the start of the new regime. The last devaluation against the deutsche mark occurred in 1983, against the advice of the central bank, and was soon considered a policy mistake by the government as well, as it triggered an increased risk premium that lasted until 1988 (see Figure 5.4). Afterward, the central bank maintained a narrow exchange rate margin vis-á-vis the deutsche mark, within the 4½ percent EMS band. The 1992 and 1993 EMS crises illustrated the restored credibility of the peg of the guilder to the deutsche mark, as at no point did the guilder come under attack. While the EMS fluctuation margins were widened after the 1993 crisis, the central bank has maintained the existing narrow band to the deutsche mark under a bilateral agreement with the Deutsche Bundesbank. With inflation under control, interest rates closely linked to those set by the Bundesbank, a deficit well below the 3 percent limit, and a decreasing ratio of government debt to GDP, the Netherlands easily qualified for participation in EMU.

Figure 5.4.
Figure 5.4.

Interest Rate Differential

(Guilder versus deutsche mark)

Source: IMF, International Financial Statistics.

The main reasons for pegging the guilder to the deutsche mark were to (1) anchor expectations to a low-inflation currency; (2) secure a relatively low risk-premium in interest rates, owing to the Bundesbank’s credibility (and the growing credibility of the DNB); and (3) reduce the costs of international trade and investment with respect to the country’s largest trading partner. On the downside, in case of asymmetric real shocks and cyclical developments, adjustment was hampered by the loss of exchange rate flexibility and the associated decreased monetary autonomy, while the imported low inflation, combined with nominal wage rigidity, limited the scope for real wage adjustment.

Until the late 1980s, the central bank to some extent combined its exchange rate policy with separate policies for controlling money and credit.5 The exchange rate was targeted through an active money-market interest rate policy, combined, if necessary, with interventions in the exchange market. At the same time, domestic credit expansion was restrained through a succession of direct and indirect controls, with the aim of managing the money supply. This money supply policy was aimed mainly at stabilizing the liquidity ratio to contain inflation over the medium term, rather than for short-term macroeconomic stabilization. As capital account transactions were progressively liberalized between 1977 and 1983, the distinction between the two separate forms of monetary policy became increasingly untenable. Indeed, from 1986 until their abolishment in 1989, the main aim of the credit controls was to help underpin the exchange rate target. From 1990 to 1999, maintaining the exchange rate link with the deutsche mark was the overriding aim of monetary policy, and official interest rates provided the main instrument.

In line with the above, after 1983, the exchange rate goal greatly limited the latitude for attuning official interest rates to cyclical stabilization. Still, in September 1997, for example, an official interest rate increase, while largely following an increase in the Bundesbank’s rates, was also partly motivated by concern over excessive domestic demand pressure and asset-price inflation.

Developments Relative to Germany

A comparison of the economic shocks that have affected the Netherlands and Germany during the past decade and a half illustrates adjustment problems that may arise under monetary union.6 Given the exchange rate link to the deutsche mark, the loss of monetary policy autonomy posed potentially serious challenges to other policy instruments, in the case of asymmetric shocks relative to Germany. In the past two decades, the reversal of earlier excessive wage increases in the Netherlands in the early 1980s and shifts in German wage setting in the after-math of unification in 1989 have been the most important shocks. However, whereas the first shock was essential in restoring Dutch competitiveness, and thereby helped solidify the peg, the second one posed new strains to the system.

The exchange rate regime shapes the pass-through of shocks and cyclical developments into prices. Under stable exchange rates, international arbitrage tends to equalize prices of traded goods and production factors (rate of return on capital). Given a credibly fixed exchange rate such arbitrage becomes more effective. Prices of nontraded goods and production factors (wages and prices of physical assets) then reflect supply and demand on the domestic market. It follows that even for a country that has anchored its currency to a large low-inflation country, domestic price stability still depends on the bilateral similarities in these demand and supply forces.

Given the stable guilder–deutsche mark exchange rate, it should come as no surprise that wholesale price developments in the Netherlands and Germany have been largely similar (Figure 5.5).7 The wholesale price index (WPI) mainly relates to tradable goods. Expressed in a common currency, the ratio of the Dutch to the German WPI decreased somewhat between 1970 and 1979, but has been almost constant since.

Figure 5.5.
Figure 5.5.

Ratios of Dutch to Western German Inflation and Exchange Rates

(1970 = 100)

Sources: IMF, International Financial Statistics; OECD, Analytical Database; and Deutsche Bundesbank.

By implication, relative prices of nontradables determine the overall bilateral inflation differential, as reflected by the ratio of the Dutch to the German consumer price index (CPI). The development of the CPI ratio is determined by a range of factors. In the short run, it mainly reflects the relative cyclical stance and cost shocks (e.g., in taxes). In the longer run, structural supply factors, typically reflected in unit labor costs, are expected to dominate.

Figure 5.5 shows that, relative to Germany, and expressed in a common currency, the Dutch CPI increased sharply from 1973 to 1978, by about 12 percent; but this real appreciation was gradually undone over the 1985–93 period. Table 5.2 indicates that, on average, both the Netherlands and Germany enjoyed high growth during most of the 1970s and between 1984 and 1989, but combined with high inflation in the former and more moderate price increases in the latter period. This change in inflation was more pronounced in the Netherlands than in Germany; and whereas inflation was, on average, 2.6 percent higher in the Netherlands during 1971–78, it was slightly lower than in Germany during the 1984–89 period. In terms of wages or unit labor costs the change was even larger. The change between the two periods reflected the end of the wage-price cycles in the Netherlands, as social partners agreed on a strategy of wage moderation in response to sharply increasing unemployment (see Section III). The period between included the 1979–81 recession and the unstable first phase of the EMS. Developments since 1989 have been heavily influenced by the consequences of German unification, which, initially, gave a positive impulse to German, and, to a lesser extent, Dutch, output. However, it also triggered an increase in German wage costs, the negative employment repercussions of which soon more than outdid the effects of the initial demand impulse. A more detailed overview of the relevant divergences between the two economies is presented in Box 5.2.

Table 5.2.

Selected Dutch and German Economic Indicators1

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Sources: IMF, International Financial Statistics; OECD, Economic Outlook; and Deutsche Bundesbank.

Figures refer to western Germany only.

Since 1991, including eastern Germany.

Strains on the Dutch-German Exchange Rate Peg

Relative price developments in the Netherlands and Germany between 1980 and 1998 reflected the following factors.

A turnaround in Dutch wage setting. During the 1970s, the Netherlands was subject to a wage-price spiral, which was only partly reflected in nominal devaluations, as the monetary authorities were reluctant to accommodate this inflationary process (Table 5.2). Increasing wage costs resulted in a sharply increasing labor income share and weakened the business sector (Figure 3.12). The subsequent slowdown in employment induced by the 1979–80 oil price shock and the world recession was more pronounced in the Netherlands than in Germany. The shock, however, triggered a turnaround in Dutch wage setting (see Section III). Following a 1982 framework agreement on wages between unions and employers’ organizations, the slow-down in wage increases was more pronounced in the Netherlands than in Germany, and from 1983 to 1998, Dutch nominal and real wages rose less, both on average and in almost every single year. Accordingly, higher Dutch nontraded goods price and CPI inflation in the 1970s was followed by lower price increases after 1982, in accordance with moderate increases in unit labor costs (ULC), and an associated increase in the participation of low- and medium-paid workers.1

German unification was a prime example of a large asymmetric shock within the EMS. The initial demand effect led to a real appreciation of the deutsche mark, which took the form of increased German wage growth and inflation (see Table 5.2). Reflecting the high degree of integration of the two economies, the external demand effect on the Netherlands was relatively strong, and the resulting export boom helped prolong the boom of the late 1980s. Consequently, the bilateral real exchange rate change remained limited. The positive demand shock was followed by a symmetric negative monetary shock, as the Bundesbank attempted to stem the inflationary process, and other ERM countries followed the increase in interest rates.

Oil price changes affected Dutch and German economies and inflation differently, both through their terms of trade effect and through their effect on domestic energy prices. As is evident from Figure A, oil price changes were mirrored in the German terms of trade, while, given roughly balanced energy trade, the Dutch net trade prices were much less affected.2 However, as about three-fourths of gas export revenue was captured by the government, the terms of trade for the business sector did deteriorate substantially in 1973 and 1979–80, fueling economic downturns, and negating an opportunity to limit the devaluation need vis-à-vis the deutsche mark. The German terms of trade changes were reflected in a 1979 real effective depreciation of the deutsche mark and a reinforcement of the real appreciation in 1986. Given the exchange rate link, the Netherlands followed these adjustments. Dutch consumer price inflation has reacted to oil price changes with a time lag, as natural gas features more prominently in Dutch than in German consumption, and Dutch gas price adjustments have been based on discretionary policy decisions.

Figure A.
Figure A.

Dutch and German Terms of Trade and Oil Price Index

(1973 = 100)

Sources: IMF, International Financial Statistics and World Economic Outlook.

Tax policies at times exerted significant sudden changes in relative price levels; an example was the 1989 increase in German excise duties, while value added tax rates were reduced in the Netherlands.

Business cycles. As is clear from Figure B, until 1993, the turning points of the Dutch and the German business cycles generally coincided. Only after 1993 was there a strong recovery in the Netherlands that was not mirrored by German developments. High consumer confidence and sustained wage moderation helped lift the Dutch economy out of the 1991–93 recession. In Germany, on the other hand, excessive real wage costs continued to hamper economic growth. This helps explain the stabilization of Dutch-German price ratios in recent years, as Dutch inflation edged up, while German inflation declined. During cyclical upturns, relative nontraded goods prices are likely supported by wage pressure—and, more fundamentally, the associated demand increase for nontraded goods can be satisfied only by increased domestic supply, which requires a relative price increase.

Figure B.
Figure B.

Cyclical Indicators

(In percent)

Source: OECD, Analytical Database.
1 Changes in unit labor costs reflect both wage cost adjustments and productivity increases. In explaining CPI developments, we focus on unit labor costs as these provide the link between wage changes and price changes.2 However, before 1982 Dutch natural gas export prices reflected oil price changes only with a lag, explaining the initial terms of trade deterioration in 1973 and, to a lesser extent, 1979.

Suggestions that—given a largely fixed nominal exchange rate—the low wage cost strategy in the Netherlands amounted to a beggar-thy-neighbor policy, whereby unemployment is lowered at home at the expense of an increase in trading partner countries, such as Germany, appear to be misguided. First, wage moderation in the Netherlands was required to address the severely distorted labor market and would have increased employment even if the economy had been closed. This is supported by the domestic employment contribution of the nontradables sector and the cost-induced shift toward more labor-intensive production (see Section III). Second, whereas the current account indeed improved at the start of the wage moderation period, this merely restored the pre-1976 surplus. And after 1984, as employment creation took off, the real effective exchange rate did not change much, and only relative to Germany was there an ongoing improvement in comparative labor costs. Third, for a real depreciation associated with an increase in total employment (as opposed to one associated with a contraction in domestic absorption), there is no a priori theoretical presumption of a resulting current account improvement, as both domestic absorption and production would increase at a given trade balance.

In regard to financial asset markets, the long-term nominal interest rate differential with Germany has gradually declined and virtually disappeared since 1988. The convergence of borrowing costs and increased capital mobility have, in turn, promoted convergence in the rates of return to capital. As the returns on fixed assets are linked to national economic growth and production costs, diverging price changes of these assets (i.e., real estate and stock prices) will reflect these factors, eliminating differences in the rates of return. Accordingly, relative Dutch-German stock prices show sharp movements, reflecting relative economic performance—rising in the 1980s until the Netherlands was struck relatively severely by the recession at the end of the decade, and increasing again after the German unification boom wore off in 1992 (Figure 5.3).

Underlying Structural Divergences

Rather than looking at actual historic price divergences, most empirical studies of optimum currency areas focus on the underlying economic characteristics that reveal either the susceptibility to, or the capacity to adjust to, asymmetric shocks.8 Overall, such analyses reveal that, owing to strong economic integration, adjustment problems between the Netherlands and Germany are likely to be limited. The relevant shocks can be local (e.g., changes in wage setting) or stem from differences in the economic structure that imply a different reaction to common shocks. Useful criteria, applied below, include similarities in the production and trade structure, openness, and the intensity of bilateral trade relations. Factor mobility, fiscal stabilizers, and wage-price flexibility are common criteria for evaluating a region’s capacity to absorb asymmetric shocks (addressed below).

The correlation coefficient between Dutch and German real GDP growth, which provides a broad picture of the degree to which the two economies have been subject to asymmetric shocks and cycles, has generally been high in comparison with other immediately neighboring countries (Table 5.3, last column).9 However, economic growth diverged between Germany and most neighboring countries in recent years. For the Netherlands, the correlation co-efficient decreased from 0.8 in 1971–82 (and also for 1971–90) to 0.6 in 1983–97. This recent divergence reflects the initial growth effect of unification on Germany, and the following recession that has hit Germany relatively hard. Growth convergence between the Netherlands and comparator countries has also decreased, as the Dutch economy has performed relatively well since the early 1980s.

Table 5.3.

Correlation Coefficients for Growth Between EU Member States

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Sources: IMF, World Economic Outlook; and Deutsche Bundesbank.

Figures refer to western Germany only.

The high degree of correlation is also reflected in largely synchronized aggregate demand and supply disturbances. Using a vector autoregression (VAR) analysis for output growth and unemployment, demand and supply shocks can be identified, following Blanchard and Quah (1989).10 The correlation of demand and supply disturbances within the European Union is illustrated in Figure 5.6. The top panel of Figure 5.6 indicates that for the 1963–97 period relative to Germany demand shocks were more closely correlated with the Netherlands than with any other country. The figure also confirms the existence of a core group of countries with highly synchronized demand and supply shocks. This group comprises Germany, the Netherlands, Belgium, Austria, and, although to a lesser extent, France and Denmark.11

Figure 5.6.
Figure 5.6.

Correlations of Demand and Supply Disturbances for EU Countries, 1963–971

Sources: IMF staff estimates.1 Demand and supply shocks identified by the procedure of Blanchard and Quah (1989).2Based on western Germany only.3EUI I includes all EU countries, except Denmark, Greece, Sweden, and the United Kingdom.

A further comprehensive measure to evaluate asymmetric shocks is the variability of the real exchange rate, on the assumption that it broadly reflects country-specific real shocks.12 Eichengreen (1990) showed that the degree of bilateral real exchange rate variability among European countries was significantly higher than among different regions within the United States, which served as a benchmark. The only exception to this finding was the guilder–deutsche mark relation in the 1980–87 period, for which the standard deviation was 1.05, compared with between 1.30 and 1.54 for inter-regional real exchange rates in the United States.13 These results are similar to those presented in Table 5.4. However, it also appears that this episode ended with German unification.

Table 5.4.

Real Exchange Rate Variability Vis-à-Vis Germany1

(Standard deviation of the bilateral CPI-based real exchange rate)

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Sources: IMF, World Economic Outlook; and Deutsche Bundesbank.

Figures refer to western Germany only.

The “uniqueness” of the Dutch situation should not be exaggerated, however, judging by the variability in relative growth and the real exchange rate of the selected EU countries, which have experienced rather similar shocks relative to Germany.

Turning to the underlying causes of real divergences, clear differences between the Dutch and the German production structure may limit the benefits of currency unification. Germany has a larger manufacturing sector, in particular for investment goods (Table 5.5). The Netherlands has large natural gas production and, overall, produces more homogeneous products. This composition also leads to a somewhat different growth pattern of the two countries over the cycle: demand for Dutch output is less cyclical (agricultural and food products) and responds relatively strongly to the early stage of an economic recovery (chemicals and other semimanufactures). This is one factor behind the relatively low variability of real GDP in the Netherlands: the standard deviation of real output growth during 1971–96 was 1.6, compared with 2.0 for Germany.14 Generally, the Netherlands and Germany are considered well diversified, notwithstanding their distinct production patterns. As a high degree of industrial diversification limits the economywide impact of sectoral disturbances, this feature constitutes a stabilizing factor for both economies.

Table 5.5.

Sectoral Composition of GDP in the Netherlands and Germany1

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Source: OECD, Economic Survey, various issues.

Figures refer to western Germany only.

For the Netherlands in 1980, included under “Other.”

Openness and the country distribution of trade relations affect the suitability of an exchange regime in various ways. McKinnon (1963) argued that countries that are open in the sense of having a high proportion of tradables in domestic expenditure would be suitable for currency unification, as real wages would then be largely invariant to the nominal exchange rate, and exchange rate adjustments would result in undesirably high price instability. This argument is fully in line with the Dutch experience of wage-price cycles in the late 1970s. Openness also implies that domestic aggregate demand shocks quickly spill over to neighboring countries, dampening their impact.15 Clearly this argues for monetary unification vis-á-vis a country’s main trading partners. With combined imports and exports amounting to 101 percent of GDP in 1996, the Netherlands is a very open economy. Trade is skewed toward other EU countries, with Germany accounting for 28 percent of exports and 21 percent of imports.

Overall, and perhaps surprisingly for a much larger country, Germany is more specialized than the Netherlands in terms of its sectoral trade balances. Sectoral export-import ratios, shown in Table 5.6, reveal the economies’ susceptibility to terms of trade shocks. The difference for energy is most important: Germany is a large net importer, while the Netherlands is self-sufficient. As a result, oil price shocks have dominated their relative terms of trade developments.

Table 5.6.

Net Export Position by Sector for the Netherlands and Germany1

(100 denotes self sufficiency)

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Source: OECD, Economic Survey, various issues.

Figures refer to western Germany only.

In addition to these economic factors, institutional differences, in particular in wage determination, can also give rise to country-specific shocks. While both the end of the Dutch wage-price spirals in the late 1970s and the German post-unification wage boom were rather singular events, they were not unrelated to the institutional setting. In principle, the wage bargaining processes in Germany and the Netherlands are rather similar, with national accords providing a framework for decentralized negotiations on sectoral labor agreements. In both countries employees are strongly organized, and work councils at the firm level have a similar function and structure. However, in Germany these work councils have a strong influence on union behavior, and the increased demand for skilled workers following German unification strengthened the position of these groups even further. In the Netherlands, on the other hand, national accords carry a relatively high weight and the government has a stronger presence in bargaining. These differences help explain both the German wage shock after the unification and the relative sensitivity of Dutch wage setting to the position of outsiders.16 In addition, in small open economies, foreign competition tends to propel wage restraint, by strengthening the unemployment repercussion of excessive real wages—a lesson learned in the Netherlands after the dramatic rise in unemployment of 1982. The change in the exchange rate regime in the early 1980s may also have contributed to the elimination of Dutch wage shocks of the 1970s (to the extent that, rather than just accommodate given increases in real wages, a flexible exchange regime may induce labor unions to aim for higher wage increases). Finally, structural reform policies played a key role in shifting labor market behavior (see below).

Germany and the Netherlands have a rather similar financial structure, reflected in similarities in monetary transmission. In both countries, almost all credit is in the form of loans, especially medium and long-term bank loans in domestic currency, as opposed to securities. In 1993, fixed-rate loans to firms and households accounted for 65 percent of the total in Germany and 75 percent in the Netherlands (compared with 27 percent in the United Kingdom, for example).17 This similarity in transmission has bolstered the sustainability of the peg, as the common monetary policy has affected the countries largely symmetrically.18 Also, in both countries, most business investment is financed internally within the firm, limiting the importance of monetary transmission in general.

Adjustment Mechanisms and Policies Under the Peg

The approach to economic management under the peg to the deutsche mark from 1983 until 1999 was not classic in one interesting respect: rather than let fiscal stabilizers operate under the de facto monetary union, the authorities concentrated on improving the resilience of the economy through structural reforms in public finances and working of markets. As described earlier in this paper, the results were impressive, because the reforms proved mutually reinforcing and had powerful effects on confidence. As a result, the abandonment of monetary autonomy was followed by a period of price stability and a sustained recovery in output and employment—one of the success stories of the 1980s and 1990s. But it should also be kept in mind that the strains on the system have been limited, not the least because, in the early 1980s, the Netherlands and Germany were already notably suitable partners for monetary union. In particular, cyclical disturbances have mostly been synchronized.

The above overview of diverging shocks and cycles provides the background to a discussion of the need for, and use of, adjustment policies in the Netherlands. As mentioned earlier, exchange rate adjustments were used up to 1983, although reluctantly and to a limited extent. Thus the decline in competitiveness in the 1970s was partly alleviated through a series of small devaluations. However, as the monetary authorities emphasized, given real wage rigidity, these devaluations were rapidly incorporated in further wage increases, without effecting a lasting improvement in competitiveness and merely resulting in higher inflation.19 In fact, the resulting wage spiral implied a deterioration in competitiveness. These considerations led to the abandonment of the exchange rate instrument in the early 1980s.

With Germany providing a nominal anchor, the onus was on the Netherlands to defend the peg and provide for effective alternative adjustment mechanisms. In this respect, a distinction should be made between addressing the severe structural labor market problems that had built up by the early 1980s and coping with cyclical developments and temporary shocks. The orchestrated wage moderation since 1982 was crucial to redressing the increase in structural unemployment and to increasing labor participation. However, it took many years (and three successive governments) for the required consensus to develop, and given the combination of a low inflation rate dictated by the peg and nominal wage rigidity, the required adjustment in real wages could come about only very gradually.20

Overall, until 1993, given the high degree of cyclical synchronization, German monetary policy was also broadly appropriate for the Netherlands—and only in 1996 did the resulting monetary conditions become obviously unsuitable for the Netherlands, as illustrated by the monetary conditions index in Figure 5.7. Moreover, growth disturbances have not been excessive in the Netherlands. In this context, the positive demand effect of German unification when the 1988–89 economic upturn was wearing off was a timely stroke of good fortune. Also, the relatively cyclically insensitive production composition partly shielded export demand against the 1993 recession. And when, in 1996, exports slowed down, domestic demand took over.

Figure 5.7.
Figure 5.7.

Output Gap and Monetary Conditions

Sources: IMF, World Economic Outlook.1The index is the weighted moving average of real short-term interest (deflated by the CPI) and real effective exchange rates; weights reflect the ratio of exports of goods and services to GDP.2The index is the weighted moving average of real long-term interest (deflated by the CPI) and real effective exchange rates; weights reflect the ratio of exports of goods and services to GDP.

International factor mobility provides several important adjustment mechanisms. Labor mobility among EU countries, including between the Netherlands and Germany, is low compared with mobility within countries, and has hardly cushioned local shocks.21 On the other hand, high capital mobility allows for temporary relief through the smoothing of spending, both by households and, potentially, through the government budget (by government borrowing at a given common interest rate). Such fiscal stabilization can be an effective tool in offsetting un-synchronized cyclical developments in aggregate demand.22 For structural shocks, however, wage-price flexibility and resource reallocation will ultimately be required. Moreover, a durable fiscal response to cushion the impact of such shocks likely delays the adjustment. This was true in the Netherlands after the first oil price shock, when a mis-guided fiscal stimulus reinforced the misalignment by promoting continued wage and price increases, while moderation was required.

After a period in the 1970s, when fiscal policy was actively used for stabilization, and with a sharply increasing deficit by the end of the decade, fiscal consolidation became the overriding objective. The actual deficit was reduced from 6.6 percent of GDP in 1982 to well below 1 percent in 1998.23 However, there is a conflict between the fiscal rules that have been instrumental in reducing the deficit since 1982 and cyclical stabilization. The practice in fiscal policy in the 1980s and up to 1994 of targeting the actual fiscal deficit, rather than a cyclically adjusted measure, did not allow for automatic, let alone additional discretionary, fiscal stabilization. As a result, fiscal policy has often been procyclical (see also Table 3.1); this was especially so during 1978–83, when the structural deficit increased sharply from 1978 to 1980 and was then contained once the recession had set in. The sharp increase in the structural deficit in 1986 did not entail a corresponding fiscal impulse, as it was an immediate result of a loss of gas revenue. The increasing structural deficit in 1989 and 1990, however, did imply an unnecessary fiscal impulse. The subsequent fiscal consolidation in 1993 was also cyclically “ill-timed,” although the confidence effects of consolidation in fact helped sustain demand.

Since the decision to move to EMU and the adoption of the Stability and Growth Pact, the awareness of the desirability of automatic fiscal stabilizers has grown.24 The 1994–98 government shifted the focus of its fiscal rules to lay emphasis not on annual actual deficit targets but on an expenditure framework in which real expenditure growth was determined at the start. This approach was less prone to result in procyclical policies, as it only eliminated the scope for automatic stabilization through government spending. However, in practice, on the revenue side, the phasing of tax cuts interfered with the operation of stabilizers. For example, tax cuts increased the 1998 structural deficit at a time when economic growth was well above potential.

Compared with exchange rate adjustment, wages and prices change only sluggishly. Moreover, the moderating effect of a rise in unemployment on real wages builds up only slowly in the Netherlands, as in all ERM countries (Englander and Egebo, 1993). Such real wage rigidity implies a low labor market adjustment speed regardless of the exchange rate regime. Measures to improve labor market flexibility and, more recently, product market flexibility have thus been helpful, both to increase labor participation over the medium term and to increase the economy’s adaptability to shocks. These measures clearly contributed to the relative resilience of the economy during the 1991–93 downswing. However, their effectiveness in the context of the economic boom that began in the mid-1990s, as well as their continued functioning during future cycles, remains to be seen.

The Challenge of EMU

EMU implies the complete loss of national monetary autonomy. For the Netherlands, given the undisputed currency link of the past fifteen years, the change is small. There are no significant adjustment costs associated with joining a stability-oriented monetary union, as policy preferences and inflationary expectations were already fully in line with the expected future monetary policies. However, this does not imply that further reforms are dispensable for the economy to meet the challenge of EMU and benefit fully from its opportunities.

The Dutch experience in a de facto monetary union has provided several important lessons and in-sights that should inspire reforms in the early years of EMU:

(1) Developments in the 1970s illustrated the limited effectiveness of the exchange rate as an adjustment mechanism for a small open economy in the presence of real wage rigidity. A second finding was the inefficacy of fiscal policy to address structural cost misalignments. By contrast, experience in the 1980s illustrated the effectiveness of subordinating national monetary policy to contain inflation, given both a fully credible peg and the Bundesbank’s stability-oriented policies.

(2) Experience of the past three decades overall is indicative of the long-term nature of structural cycles in a monetary union, as policymakers have no direct tools to adjust real wages, even in case of nominal but only partial real wage rigidity.

(3) Experience in the 1980s and 1990s showed the crucial nature of labor market policies in addressing diverging shocks and cycles given a largely fixed exchange rate (especially if fiscal policy is not used, or not available, for cyclical stabilization). The example of the relative success of the post-1982 adjustment and a lasting increase in labor and product market flexibility may facilitate future adjustment.

While the monetary and exchange arrangements of the past decade and a half amount to a de facto monetary union, there are, nonetheless, several no-table differences for the Netherlands between the previous and the new monetary arrangement.

(1) In the case of the peg, there was no convergence progress ahead of time to establish credibility on the Dutch side. Quite the contrary. The Netherlands entered the arrangement to import credibility in circumstances of economic crisis—indeed it was this sense of crisis that triggered a far-reaching program of structural, as well as macroeconomic, reforms. EMU, on the other hand, was preceded by a concerted effort to achieve economic convergence.

(2) The commitment to the peg by the Netherlands was one-sided, whereas EMU is a more sym-metric arrangement. Monetary policy is tuned to conditions in the union as a whole, as compared with the Bundesbank’s primary focus during most of the past fifteen years on the German economy. In dealing with asymmetric shocks originating in Germany, this change should be benign for the Netherlands, while for shocks originating elsewhere in the union (or outside the former core-ERM), the Dutch-German union obviously lost an adjustment tool.25 Also, there was no sharing of decision-taking under the old regime.

(3) EMU comprises members that are more dis-similar in a structural sense than the Dutch-German union, or the extended grouping that also included Belgium, Austria, and France. This will likely complicate the design of a monetary policy suitable for all member states.

(4) Budgetary incentives will be affected. The Stability and Growth Pact puts limitations on the scope for running budget deficits, through the stipulated deficit ceiling. Without these limits, EMU might have reduced the incentive for individual member states to pursue sound fiscal policies by reducing the exchange rate and interest rate repercussion of higher government borrowing. On the other hand, the pact may limit the scope for stabilizers to operate, unless the structural fiscal position is maintained sufficiently close to balance.

(5) To the extent that EMU will promote integration among the member states, synchronization of aggregate demand shocks will be strengthened, but the effectiveness of fiscal stabilization at the national level will be limited further. Also, as stressed by Krugman (1991), EMU may increase the regional concentration of industrial activities, and thus increase the occurrence of asymmetric shocks.

On balance, it appears likely that even for the Netherlands, adjustment instruments other than the exchange rate are, if anything, needed more under EMU.

Current and Future Policy Issues

Current policy issues reflect the importance of having adequate adjustment mechanisms under monetary union. This was illustrated well during the buoyant growth phase of 1997 and 1998, when economic growth and asset prices moved ahead of the levels in Germany—implying that the monetary conditions flowing from the peg had become easier than domestic considerations would have warranted. While no overall economic overheating developed, both labor and asset markets have showed trouble-some signs. Between 1996 and 1998, wage increases became higher from year to year, as unemployment kept falling. With growth in 1998 clearly in excess of the longer-term potential rate, employment again expanded significantly, and the unemployment rate fell below previous estimates of the NAIRU. It seems likely that without the evolving Asian and Russian crises, overheating could have developed in 1998. Regarding asset markets, house prices are high but not clearly out of line with fundamentals. On the other hand, until mid-1998, equity markets likely responded with unsustainable buoyancy to strong economic growth and relatively easy monetary conditions.

In the labor market, recent experience has exposed the difficulty of lowering inactivity. Even in a period of rapid employment growth, few inroads were made in reducing the stock of long-term unemployed and disability claimants. There is, furthermore, a possibility that lags in real wage adjustment could harm the medium-term employment outlook. High generalized wage increases could damage employment in services; even in manufacturing, momentum to increase wages could build and become a problem as cyclical developments in productivity and domestic or foreign demand are projected to become less favorable in 1999 and beyond. This pattern would be reminiscent of developments in the beginning of the 1990s, when delayed wage responses reinforced the economic slowdown.

A second set of policy issues concerns financial markets. Wealth effects resulting from the mortgage and asset market boom could unwind sharply, and banks could strengthen credit requirements. The Central Planning Bureau (1998) has estimated that household debt in terms of disposable income increased from about 60 percent in 1985 to almost 110 percent by mid-1998. In this period, share holdings increased from almost 25 percent to about 100 percent of household income. In case of higher interest rates and lower prices of houses and shares, the increased financial vulnerability of households could have sharp consumption effects and also damage the soundness of lending institutions. Unchecked, current trends could thus impart a degree of instability to the financial and real economy. In this context, the importance of stepped-up prudential supervision was discussed in Section IV.

Finally, in terms of the macroeconomic framework, the rapid economic expansion, especially in 1997 and 1998, raised questions on the overall stance of policies. With monetary policy determined by the exchange rate link, only fiscal policy was available to address such concerns. More forceful fiscal tightening could have offset some of the wealth effects on demand and dampened asset prices and mortgage lending through its effect on incomes and expectations. In addition, such fiscal consolidation would have created more room for stabilizing policies during a subsequent downturn.

As to the longer-term issue of coping with the loss of monetary authority, flexibility in the real economy and the operation of fiscal stabilizers emerge, at the end of the day, as complements. The challenge for the future is twofold. First, deepen the process of structural reform in labor and product markets (see Box 5.3). Second, ensure that the fiscal stance contributes to preserving stability, while continuing to chart a decisive medium-term course for public finances that blends further deficit reduction with a continuing lightening of the tax burden on labor income.

Product Market Reforms

Government intervention in product markets has been reduced since the early 1980s, initially through changes in industrial policy, and, in recent years, by liberalizing product market regulation. The reorientation of industrial policy, away from attempts to rescue ailing industrial enterprises, was buttressed by the 1983 bankruptcy of a large shipbuilding conglomerate (RSV), despite prolonged government support. At the same time, the government started selling a large part of its stakes in high-profile enterprises involved, for example, in steel production (Hoogovens) or the airline industry (KLM).

Overall, however, until recently the regulatory regime remained stifling. Traditionally, Dutch product markets have reflected a social preference for formalized horizontal structures for cooperation that still characterizes, for example, labor market relations. In product markets, this corporatist regime included widespread self-regulation at the sectoral level (for example, for consumer protection and labor force training, and was often government-sanctioned) and authorized cartels. In a comparison of the regulatory regimes of western European countries, Koedijk and Kremers (1996) found that the Netherlands was characterized by a very lax competition policy and heavily regulated business establishment and shopping hours. On the other hand, regarding public ownership and business support, the regime was considered relatively liberal.

Product market reforms have only moved to center stage since the early 1990s but have since been implemented in a wide range of areas: anti-cartel measures, regulatory changes to enhance competition, and the introduction of market forces in (heretofore) semipublic sectors. These reforms were aimed at increasing efficiency and innovation. Estimates on the potential benefits have indicated substantial scope for cost reductions, for example, in electricity and telecommunications.1 A further beneficial effect might be an increase in price flexibility and intersectoral reallocation in response to sectoral demand and supply shocks.

Policy changes in the Netherlands were partly triggered by earlier steps by the European Union. Member countries are required to liberalize the utilities and public transport sectors at the national level, as a necessary step toward liberalization of intra-European trade and investment. Also, stepped-up competition policies by the European Commission were becoming incompatible with the less forceful Dutch policy stance.

Utilities and Public Services

Market forces have been introduced in various public service areas. The postal and telephone services company was split up and privatized in 1994–95, and the resulting telecommunications company, KPN, is facing increasing competition from newly licensed operators in specific fields, including the telephone market.2 The market is supervised by an independent body, OPTA, established in 1997. As the existing public provider was already relatively efficient, the main gains from the liberalization will likely be in speeding up the introduction of new products and technologies and in lower tariffs.3

Competition in local and regional public transport has been slow to take off, in spite of regulatory changes. Competition in regional bus services, which until recently were firmly lodged in the public sector, was introduced through several trials for competitive bidding for routes. Also, new providers of rail transport are being allowed. However, the former national railroad company, which was made an independent (government-owned) enterprise in 1995, has maintained a dominant position. The company now receives government financing only for the operation of specified loss-making services.

A new law on the electricity sector was adopted in early 1998, introducing competition between electricity producers and allowing users to choose among suppliers, including through imports. Under the new regime, the grid will be made accessible to all suppliers and users on the same terms. Currently, most electricity is generated by four large public power-generating companies. Power distribution is in the hands of a large number of public distribution companies that are also major shareholders of the generating companies from which they derive most of their supply. Changes will be introduced gradually, as small users will not be allowed to sidestep their regional distribution company until 2007. Privatization of the power-generating companies is not envisaged for the coming years. Given the close ties between generating and distributing companies, the high degree of concentration, and existing overcapacity, competition in the sector may be slow to build up.4 For the gas sector, a law along the lines of the one for electricity is in preparation.

Product Market Regulation

Recent regulatory changes have strengthened market forces in a range of sectors. In 1994, the government initiated an extensive project to promote better market functioning, deregulation, and the quality of regulation. Within this set up, interdepartmental working groups propose changes for specific sectors. So far about 30 sectors have been examined, although in many cases the recommendations have yet to be implemented. Notable results have included the liberalizing of lawyers’ tariffs and the extension of shop-opening hours. Shop-opening hours were extended significantly in 1996. Previously, shops were not allowed to be open after 6 p.m., or on Sundays. Under the new law, shops are allowed to remain open until 10 p.m., while municipalities may decide to allow additional night openings and up to 12 Sunday openings. By mid-1998, supermarkets, in particular, had made use of the relaxed regime.

Business-licensing requirements were liberalized in 1996, lowering an important barrier to entry. Previously, Dutch business-licensing requirements were comprehensive and stringent, specifying substantial education and training in sectors such as construction, retail trade, and various services. Under the new law, many sectors have become free of such restrictions, while for most others, only basic business skills are required.

Competition Policy

In 1993, when the government started tightening its competition policy, there were about 760 officially registered cartels. The new measures consisted of the general prohibition of price fixing from July 1993, and of market sharing and collusive tendering from June 1994. This was done on the basis of existing law—which allowed cartels unless they were specifically prohibited.

A new Competition Law went into effect in 1998. In line with European competition law, the new law is based on the prohibition principle for cartels. Given the widespread cartelization in the past, the new system has amounted to a regime shock. A second difference from the old law was that the new one included merger controls. Under the new law a separate, and largely independent, Competition Authority has been established to monitor compliance.

Corporate Governance

In recent years, the discussion on corporate governance has intensified in the Netherlands, as in many other countries. Under the existing regime, management of larger enterprises is monitored by an independent supervisory board, with limited influence of share-holders. In 1996, a private sector initiative was started to increase transparency and shareholder influence through self-regulation (see Box 4.2). The exercise did not aim for a fundamental overhaul of the existing system, which includes the various widely used anti-takeover devices. Instead, the aim was to introduce modest changes within the existing regulation. Furthermore, there was no proposal to introduce accountability of the supervisory board to actual stakeholders.

The government has announced its readiness to supplement private sector initiatives to improve corporate governance by legislative changes. Accordingly, in 1998, legislation was submitted to limit the scope of firms’ defenses against hostile takeovers. A partial explanation of the widespread use and public acceptance of such defenses may be that a large part (about 40 percent) of Dutch shares is held by foreign investors.

1 See Haffner and van Bergeijk (1997).2 Until 2004, the government will keep at least a third of the shares in the telecommunications firm.3 See Baljé (1997).4 See Huygen and Theeuwes (1997).

The operation of automatic stabilizers without exceeding the agreed deficit ceiling of 3 percent of GDP will require a structural deficit of not more than about 1 percent of GDP. Currently, there is wide support in the Netherlands for reducing the deficit to not more than 1 percent of GDP by the end of the current four-year government period at the latest, and aiming over time for balance. For the coming years, this would somewhat increase the room for automatic fiscal stabilizers (but would still leave no room for discretionary fiscal policy). As important, however, will be a possible change in fiscal policy rules and practices, to allow for fiscal stabilization, even if only through automatic stabilizers on the revenue side. The 1998–2002 government program still includes a slightly procyclical budget rule, as it stipulates that a quarter of cyclical revenue overperformance or shortfalls will be allocated to higher or lower tax decreases.26

Fiscal consolidation is appropriate from a long-term perspective as well. To prepare for the aging of the population (see Box 3.1), the debt ratio and the burden of interest payments need to be reduced significantly. While pensions are in part funded, the demographic changes in prospect in the Netherlands are particularly sharp and will entail a large increase in public spending. When these demographic considerations are taken together with the Stability and Growth Pact aim of a budget “close to balance or in surplus,” the case for aiming to balance the public finances in the medium term is persuasive.

As regards structural reforms, it will be essential to press on with measures to improve the functioning of the labor market, particularly to address hard core inactivity:

(1) Stronger incentives and opportunities are needed to reduce the level of long-term unemployment, disability, and welfare recipients: while progress in attracting new participants to the labor force and cutting back youth unemployment has been striking, hard-core welfare dependency remains a major problem.

(2) Current experiments in integrating benefit, job search, and training services may help to secure a breakthrough in this regard, and the plan to involve private agencies is particularly welcome. However, to be effective, these changes need to be implemented in a way that ensures sufficiently strong incentives for benefit recipients to actively seek work or training.

(3) In addition, tax reform can contribute to improving the supply side of the labor market by widening the gap between net salary and net benefit income. This is particularly important at levels close to the minimum wage, where marginal effective tax rates are steep when the jobless reenter the labor force.

(4) Efforts to strengthen competition and dynamism in products markets are also continuing, and a new emphasis is being placed on fostering entrepreneurship, by removing regulatory and financial obstacles to starters, which can also help bolster economic flexibility (see Box 5.3).

In all these respects, the experience with fiscal and structural reforms over the past two decades illustrates clearly how much can be achieved by a medium-term orientation of policies and measures that exercise a mutually reinforcing impact on output and employment. Monetary union brings new challenges and major opportunities; much remains to be done to further raise the employment level and prepare for population aging. The evidence is persuasive not to declare victory prematurely but to press on with the reform.

2

In real terms, the increase since 1982 amounted to 63 percent, while the increase was about 15 percent if deflated by average household income.

3

A recent central bank study (Capel and Houben, 1998) indicated that the 1997 peak P/E level of 26.6 (August 7, 1997) was out of line with fundamentals. At the end of 1997, the P/E ratio had decreased to 21.6. Viewed in this light, the decrease in share prices following the July 1998 peak, which largely wiped away the gains recorded since the beginning of the year, did not appear unwarranted.

4

See Wellink (1994) for an account of the gradually increasing monetary orientation toward Germany.

6

The comparison also provides insight into the suitability of the link. On this point, two views can be distinguished. On the one hand, inflation divergences within a monetary union have been proposed as an indicator of the compatibility of fixed internal exchange rates with unionwide price stability, and thus of the desirability of the arrangement. In this view, diverging rates of inflation in a monetary union reflect changes in equilibrium real exchange rates that could, alternatively, have been absorbed through changing nominal exchange rates, without sacrificing price stability. See Vaubel (1978). On the other hand, if the desirability of currency unification is taken as given, diverging rates of inflation can be considered as an indicator of the existence of wage-price flexibility needed to allow the union to absorb asymmetric shocks.

7

Most figures for Germany refer to western Germany only, to ensure consistency over time, and because the Netherlands is mainly influenced by developments in western Germany.

8

For an overview of this literature, see de Grauwe (1997).

9

Bayoumi (1992), however, warns that the simple correlation coefficient conflates shocks hitting the economies and the responses to these shocks. In addition, shocks originating from diverging monetary policies should not be included in the evaluation, as these would be eliminated by currency unification.

10

The decomposition uses the assumption that supply shocks permanently affect output, while demand shocks only temporarily affect output growth. Comparable results were derived by Bayoumi and Eichengreen (1992), using a VAR of output growth and inflation to estimate demand and supply shocks.

11

Several studies have confirmed that the cyclical behavior of a core group of ERM countries exhibited a high degree of synchronization, especially since the late 1970s, both compared with earlier periods and with other country groups. See, for example, Formby, Norrbin, and Sakano (1992) and Bayoumi and Prassad (1995). Instead of using measures of the correlation of demand and supply, economic fluctuations in these analyses are decomposed into country-specific shocks, industry specific shocks, and aggregate disturbances. Bayoumi and Prassad found that in both the United States and the EU, aggregate shocks accounted for slightly more than a third of total short-term growth fluctuations.

12

See footnote 6. Bofinger (1994) argued that this assumption is not justified; particularly under floating exchange rates, empirical evidence of a stable relation with real fundamentals does not exist. Moreover, monetary shocks—that would be eliminated under monetary union—did seem to play an important role.

13

See also Von Hagen and Neumann (1994), who showed that during the 1980s, the conditional variance of exchange rate shocks vis-à-vis Germany and the degree of first-order autocorrelation in monthly real exchange rates were relatively low for the Netherlands, Belgium, Austria, and France, pointing to a high degree of economic integration.

14

Indeed, for this period, the volatility of growth in the Netherlands was the lowest of all EU countries.

15

This argument relates to the marginal net import share in domestic demand rather than to the share of tradables or actual trade in total income. The latter, however, is the basis for gains from currency unification through savings on transaction costs and reduced exchange uncertainty.

18

Ramaswamy and Sloek (1997) confirmed this similarity for a group of countries that also included Belgium, Austria, Finland, and the United Kingdom.

20

In fact, given the 1982 agreement on wage restraint, the 1983 devaluation may actually have been effective in reducing real wage costs and promoting competitiveness (disregarding its effect on interest costs).

22

The alternative of having explicit fiscal transfers among governments does not play an important role in the EU.

23

The structural deficit was cut from 5.0 percent of GDP in 1982, to 1.2 percent in 1998.

25

Figure 5.6 indicates that Dutch economic disturbances are slightly less correlated with those in the EU-11 than with those in Germany. This may signal that future monetary policy will be somewhat less tuned to the cyclical position in the Netherlands.

26

Once the deficit has declined to 0.75 percent of GDP, or increased to 1.75 percent, half of revenue over- or underperformance is to be reflected in additional tax measures.

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