Kingdom of the Netherlands—Netherlands
Selected Issues
Author: International Monetary Fund
Publication Date:
13 Oct 1998
eISBN:
9781451829327
Language:
English
Keywords:
ISCR; CR; saving; surplus; saving surplus; bank; saving-investment balance; interest rate; saving-investment perspective; investment funds; Current account; Pension spending; Mortgages; Inflation; Insurance companies; Europe; Global; vis-à-vis Germany; demand shock; asset price inflation; wage-price flexibility; guilder-deutsche mark exchange rate; Real wages; Wage adjustments; Labor costs
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96. The Netherlands has extensive experience with economic policies under a stable or pegged exchange rate. Since the start of the Bretton Woods regime the authorities have aimed at keeping the guilder relatively stable vis-à-vis the German mark. Following a weakening of the guilder during the 1970s, there has been a de facto monetary union with Germany since 1983, which will be subsumed in the broader European Economic and Monetary Union (EMU) from January 1999. In this chapter the Dutch experience since the early 1970s is reviewed with the aim of gaining, on the threshhold of EMU, some insight into domestic economic policy making under the fixed exchange rate regime.

Abstract

96. The Netherlands has extensive experience with economic policies under a stable or pegged exchange rate. Since the start of the Bretton Woods regime the authorities have aimed at keeping the guilder relatively stable vis-à-vis the German mark. Following a weakening of the guilder during the 1970s, there has been a de facto monetary union with Germany since 1983, which will be subsumed in the broader European Economic and Monetary Union (EMU) from January 1999. In this chapter the Dutch experience since the early 1970s is reviewed with the aim of gaining, on the threshhold of EMU, some insight into domestic economic policy making under the fixed exchange rate regime.

III. LIVING WITH THE PEG AND THE CHALLENGE OF EMU42

A. Introduction

96. The Netherlands has extensive experience with economic policies under a stable or pegged exchange rate. Since the start of the Bretton Woods regime the authorities have aimed at keeping the guilder relatively stable vis-à-vis the German mark. Following a weakening of the guilder during the 1970s, there has been a de facto monetary union with Germany since 1983, which will be subsumed in the broader European Economic and Monetary Union (EMU) from January 1999. In this chapter the Dutch experience since the early 1970s is reviewed with the aim of gaining, on the threshhold of EMU, some insight into domestic economic policy making under the fixed exchange rate regime.

97. It is concluded that, until 1993, high integration largely shielded the two economies from recurrent asymmetric shocks. Subsequently, growth and inflation diverged. This reflected the turnaround in Dutch wage setting in the early 1980s following destabilizing wage-price cycles in the 1970s—together with some stresses resulting from German reunification. However, the structural reforms in the Dutch labor market during the 1980s were, in a longer run context, essential for the preservation of the peg. In fact, wage-price flexibility has been the key adjustment mechanism under the peg, as fiscal policy has not been used for stabilization, and has often been procyclical. The current situation provides a clear example of this policy setting: fiscal policy is mildly expansionary, while, with growth well ahead of Germany, monetary conditions are unduly easy. For the future, the challenge will be to complement ongoing structural reforms with a new focus on the scope for fiscal policy to help cushion cyclical disturbances.

98. The main reasons for pegging the guilder to the deutsche mark peg have been: (I) to anchor expectations to a low inflation currency; (ii) to secure a relatively low risk premium in interest rates, owing to the Bundesbank’s credibility (and the growing credibility of the DNB); and (iii) to reduce the costs of international trade and investment with respect to the country’s largest trading partner. On the downside, adjustment to asymmetric real shocks and cyclical developments is hampered by the loss of exchange rate flexibility, the associated decreased monetary autonomy, and the imposed low inflation combined with nominal wage rigidity (limiting the scope for real wage adjustments).

99. The Dutch authorities have repeatedly underscored their satisfaction with the exchange rate link, as it has contributed much to restoring price stability and financial and economic stability in general. Moreover, despite several important disturbances (changes in wage setting, oil price changes, and German unification), employment growth and output growth have developed favorably in the Netherlands since the early 1980s. Indeed, in empirical evaluations 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.43 These conclusions essentially are based on quantitative analysis of the considerations noted above.

100. The analytical framework of the optimum currency area approach is drawn on in this chapter to evaluate the Dutch experience with exchange regimes. Following an overview of the evolving monetary policy rules, economic developments under the peg are described. The ensuing analysis focuses on, first, the asymmetric shocks that have affected the two economies and, subsequently, the Dutch adjustment mechanisms for coping with such divergences. Drawing lessons from the experience so far, an assessment of policy requirements under EMU completes the chapter.

B. The Exchange Rate Constraint on Monetary Policy

101. While exchange rate stability relative to the German mark was an important policy goal during the 1970s, declining competitiveness rendered the peg insufficiently credible, and there were several devaluations. Before that, exchange rate stability had been maintained under the Bretton Woods system (1958-73), until this regime started to collapse at the end of the 1960s.44 In 1972, the Snake arrangement of European Community member countries was created to promote exchange rate stability. Under the latter system, with a 4½ percent fluctuation band, the Netherlands followed only partly, and with some delay, two early revaluation of the deutsche mark in 1973 (Table 22). Subsequently, the peg was subject to several attacks and two actual 2 percent devaluations (in line with the Belgian franc).

Table 22.

Changes in the Deutsche Mark-Guilder Central Rate, 1970-97

(In percent)

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Source: De Nederlandse Bank, Annual Reports.

102. Since 1983, the peg has been maintained within the Exchange Rate Mechanism of the European Monetary System (EMS), ending a period of instability. The monetary authorities favored a firmer link to the mark already at the end of the 1970s, to reduce inflation which averaged almost 8 percent between 1971 and 1978. But, while the establishment EMS created a timely setting for such stability, the guilder did not follow a 2 percent revaluation of the mark in September 1979, shortly after the start of the new regime. The last devaluation vis-à-vis the mark occurred in 1983, against the advice of the Netherlands Bank (DNB), 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 15). Afterwards, the DNB maintained a narrow margin vis-à-vis the 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 mark, as at no point did the guilder come under attack. While the EMS fluctuation margins were widened after the 1993 crisis, the DNB has maintained the existing narrow band to the mark under a bilateral agreement with the Bundesbank. The Netherlands easily qualified for participation in the fixture EMU—albeit with a waiver for the convergence criterion on government debt.

FIGURE 15
FIGURE 15

NETHERLANDS: Dutch and German Exchange Rate Changes and Interest Rate Differentials

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Source: IMF, International Financial Statistics.

103. Until the late 1980s, the central bank to some extent combined its exchange rate policy with separate policies for controlling money and credit.45 The exchange rate was targeted through an active money-market interest rate policy, combined, if necessary, with interventions. At the same time, domestic credit expansion was controlled through a succession of direct and indirect controls, traditionally with the aim of managing the money supply; but from 1986 to 1989, the main aim was to help underpin the exchange rate target. As capital account transactions were progressively liberalized between 1977 and 1983, the distinction between the two separate forms of monetary policy became increasingly untenable. Since 1990, maintaining the exchange rate link with the deutsche mark has been the overriding aim of monetary policy.

104. In line with the above, the degree to which monetary policy could be used for counteracting cyclical developments has been limited and decreasing. Before the mid-1980s, when there was still a separate money supply policy, this was aimed mainly at stabilizing the liquidity ratio to contain inflation over the medium term, rather than for short-term macroeconomic stabilization. Since 1983, the exchange rate goal has 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.

C. International Price Linkages and Cyclical Developments

105. 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 arid production factors (rate of return on capital). Given a credibly fixed exchange rate such arbitrage becomes more effective. Prices of non-traded 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.

106. A comparison of Dutch and German inflation illustrates the above principles. The purpose of such an exercise is twofold. First, it gives a structured overview of the strains on the exchange rate link. Second, it provides insight into the suitability of the link. On the second 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 union-wide price stability, and thus of the desirability of the arrangement.46 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 (see Section E).

107. Given the stable guilder-deutsche mark exchange rate, wholesale price developments in the Netherlands and Germany have been largely similar (Figure 16).47 The wholesale price index (WPI) mainly relates to tradable goods. Taking into account actual devaluations, the ratio of the Dutch to the German WPI decreased somewhat between 1970 and 1979 and has been almost constant since.

FIGURE 16
FIGURE 16

NETHERLANDS: Ratios of Dutch to German (Western) Inflation and Exchange Rates

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

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

108. By implication, relative nontradables prices 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.

109. Figure 16 shows that, adjusted for the exchange rate, 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 23 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 more pronounced. The period in 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 gave a positive impulse to German, and, to a lesser extent, Dutch, output, wage costs, and inflation.

Table 23.

Selected Dutch and German Economic Indicators 1/

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Sources: FS; OECD Economic Outlook; and Bundesbank.

Figures refer to western Germany only.

Since 1989, including eastern Germany

110. Based on this framework, the reversal of earlier excessive wage increases in the Netherlands in the early 1980s and shifts in German wage setting in the aftermath of unification in 1989 have been the most important shocks that help explain the 1970-97 relative CPI changes. A more detailed overview of the relevant divergences between the two economies is presented below.

  • 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 23). Increasing wage costs resulted in a sharply increasing labor income share and weakened the business sector (Figure 17). 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. This shock, however, triggered a turnaround in Dutch wage setting. Following a 1982 framework agreement on wages between unions and employers’ organizations, the slowdown in wage increases was more pronounced in the Netherlands than in Germany, and from 1983 to 1991, Dutch nominal and real wages rose less.48 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-skilled workers.49

  • German unification was a prime example of a large asymmetric shock within the EMS. The initial demand effect lead to a real appreciation of the mark, which took the form of increased German wage growth and inflation (see Table 23). 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 up to mid-1991. Consequently, the bilateral real exchange rate change remained limited (Figure 16). 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 have 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 18, oil price changes were mirrored in the German terms of trade, while, given roughly balanced energy trade, the Dutch net trade prices were not affected much.50 However, as about three-quarters 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 mark. The German terms-of-trade changes were reflected in a 1979 real effective depreciation of the mark and a 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.

  • At times, tax policies have exerted significant sudden changes in relative price levels; an example was the 1989 increase in German excise duties, while VAT rates were reduced in the Netherlands.

  • As is clear from Figure 19, until 1993, the turning points of the Dutch and the German business cycles generally coincided. Following the crisis of the early eighties, both countries recovered at approximately the same speed, until they were both hit by the less severe economic slowdown of 1984-87. Only after 1993 is there a strong recovery in the Netherlands that is 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 have continued to hamper economic growth. This helps explain the stabilization of Dutch-German price ratios in recent years, as Dutch inflation has edged up, while German inflation has 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 17
FIGURE 17

NETHERLANDS: Labor Income Shares and Unemployment Rates

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Sources: IMF, World Economic Outlook; and OECD, Analytical Database.Countries are: NLD=Netherlands, DEU=Germany.
FIGURE 18
FIGURE 18

NETHERLANDS: Dutch and German Terms of Trade and Oil Price Index

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Sources: IMF, International Financial Statistics; and World Economic Outlook.
FIGURE 19
FIGURE 19

NETHERLANDS: Cyclical Indicators (A)

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Source: OECD, Analytical Database.Countries are: NLD=Netherlands, DEU=Germany.

111. The sequence of events that shaped Dutch-German real exchange rates is also reflected in Dutch and German ULC-based real effective exchange rates as depicted in Figure 20. Wage adjustment was reflected in real depreciation of the guilder from the late 1970s up to 1984. Since then, the ULC-based real effective exchange rate has remained fairly stable, while the mark has appreciated considerably in real terms.51

FIGURE 20
FIGURE 20

NETHERLANDS: Effective Exchange Rates

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Source: IMF, International Financial Statistics.Countries are: NLD=Netherlands, DEU=Germany.

112. Suggestions that—given a largely fixed nominal exchange rate—the recovery in the Netherlands based on a low wage cost strategy 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 sector52 and the cost-induced shift towards more labor intensive production.53 Second, whereas the current account indeed improved at the start of the wage moderation period, this merely restored the pre-1976 surplus (see Chapter I). 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.

113. Turning to financial asset markets, the long-term interest rate differential with Germany has gradually declined, and virtually disappeared since 1988 (Figure 15). The convergence of borrowing costs and increased capital mobility have also induced a 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 21).

FIGURE 21
FIGURE 21

NETHERLANDS: Share Price Indices

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Source: IMF, International Financial Statistics.

D. Underlying Structural Divergences

114. 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.54 Such shocks can stem from local disturbances (e.g., in wage setting) or 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 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 in the next section).

115. 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 24, last column).55 However economic growth has diverged between Germany and most neighboring countries in recent years. For the Netherlands, the correlation coefficient decreased from 0.79 in 1971-82, and also from 1971-90, to 0.65 in 1983-96. 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 24.

Correlation Coefficients for Growth Between EU Member States

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Sources: IMF, World Economic Outlook; and Bundesbank.

Figures refer to western Germany only.

116. A second 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.56 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 to between 1.30 and 1.54 for inter-regional real exchange rates in the United States.57 These results are similar to those presented in Table 25. However, it also appears that this episode ended with German unification.

Table 25.

Real Exchange Rate Variability vis-à-vis Germany

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

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Sources: IMF, World Economic Outlook; and Bundesbank.

Figures refer to western Germany only.

117. 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 also experienced rather similar shocks to Germany.

118. 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 26). The Netherlands has large natural gas production, and, overall, produces more homogeneous products. Importantly, 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 semi-manufactures). This is one factor behind the relatively low variability of real GDP in the Netherlands. Generally, the Netherlands and Germany are considered well diversified, notwithstanding their distinct production patterns. As a high degree of industrial diversification limits the economy-wide impact of sectoral disturbances, this feature constitutes a stabilizing factor for both economies.

Table 26.

The Sectoral Composition of GDP in the Netherlands and Germany 1/

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Source: OECD, Economic Surveys.

Figures refer to western Germany only.

119. 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.58 Clearly this argues for monetary unification vis-à-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 towards other EU countries, with Germany accounting for 28 percent of exports and 21 percent of imports (Statistical Appendix Table 24, SM/98/104).

120. The high degree of integration is reflected in largely synchronized aggregate demand cycles. Several studies have confirmed that the cyclical behavior of a core group of ERM countries has exhibited a high degree of synchronization since the late 1970s, both compared to earlier periods and to other country groups.59 This group comprises Germany, the Netherlands, Belgium, Denmark, Austria, and, with less unanimity among the studies, France and the United Kingdom.

121. 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 27, 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 27:

Net Export Position by Sector for the Netherlands and Germany

(100 denotes self sufficiency)

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Source: OECD, Economic Surveys.

Figures refer to western Germany only.

122. 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 employers 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, the government has a strong presence in the bargaining process. 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.60 In addition, as stressed by Calmfors (1993), in small open economies, foreign competition propels 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).

123. 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 to 27 percent in the United Kingdom, for example).61 This similarity in transmission has bolstered the sustainability of the peg, as the common monetary policy has affected the countries largely symmetrically.62 Also, in both countries, most business investment is financed internally within the firm, limiting the importance of monetary transmission in general.

E. Adjustment Mechanisms and Policies Under the Peg

124. 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, up to 1983 exchange rate adjustments were used, 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.63 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.

125. With Germany providing a nominal anchor, the onus has been 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 has been crucial to redressing the increase in structural unemployment and to increasing participation. However, it took many years (and three successive governments) for the required consensus to develop, and given the combination of low inflation rate dictated by the peg and nominal wage rigidity, the required adjustment in real wages could come about only very gradually.64

126. Overall, until 1993, the need to adjust to asymmetric shocks vis-à-vis Germany was limited (see Section C and Figure 22). As a result, German monetary policy was also broadly appropriate for the Netherlands—only since 1996 are the resulting monetary conditions unsuitable for the Netherlands, as illustrated by the monetary conditions index in Figure 23. Moreover, growth disturbances have not been excessive in the Netherlands: the standard deviation of real output growth during 1983-97 was 1.0, compared to 1.8 for Germany. 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 22
FIGURE 22

NETHERLANDS: Cyclical Indicators (B)

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Sources: IMF, World Economic Outlook and International Financial Statistics.
FIGURE 23
FIGURE 23

NETHERLANDS: Output Gap and Monetary Conditions

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

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

127. International factor mobility provides several important adjustment mechanisms. Labor mobility among EU countries, including between the Netherlands and Germany, is low compared to mobility within countries, and has hardly cushioned local shocks.65 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 unsynchronized cyclical developments in aggregate demand.66 For structural shocks, however, ultimately wage-price flexibility and resource reallocation will be required. Moreover, a durable fiscal response to cushion the impact of such shocks likely delays the adjustment, as was the case in the Netherlands after the first oil price shock. A misguided fiscal stimulus reinforced the misalignment by promoting continued wage and price increases, while moderation was required.

128. After a period in the 1970s, when fiscal policy was actively used for stabilization purposes, resulting in a sharply increasing deficit by the end of the decade, fiscal consolidation became the overriding objective. The actual deficit was reduced from 9.5 percent of GDP in 1982 to 1.4 percent in 1997.67 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 to 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 (Figure 24); this was especially the case 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 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.

FIGURE 24
FIGURE 24

NETHERLANDS: Output Gap and Fiscal Balance

Citation: IMF Staff Country Reports 1998, 102; 10.5089/9781451829327.002.A003

Source: OECD, Analytical Database.

129. 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.68 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, which was less prone to result in procyclical policies. This 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 are likely to increase the 1998 structural deficit at a time when economic growth is well above potential.

130. Compared to exchange rate adjustment, wages and prices can change only sluggishly. Moreover, the moderating effect of a rise in unemployment builds up only slowly in the Netherlands, as in all ERM countries (Englander and Egebo 1993). 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 shock (Box 7). These measures clearly contributed to the relative resilience of the economy during the 1991-93 downswing. However, their effectiveness in the context of the current economic boom, as well as their continued functioning during future cycles, remains to be seen.

Key Structural Policy Reforms in 1982-97

  • Wage moderation—which cut the labor income share in the value added by firms by 10 percentage points—was triggered by a change in labor union attitudes, in the face of mounting unemployment and a macroeconomic crisis; but fiscal and labor market reforms played a role in sustaining the change in wage behavior.

  • Labor market and associated social security reforms focused on measures to encourage labor supply and job search as well as labor demand:

    • Measures to improve the supply of labor and job search included: lowering the replacement ratio for unemployment and disability benefits from 80 percent to 70 percent; shortening the duration period for unemployment benefits; tightening eligibility criteria for social benefits, particularly disability; cutting the tax burden on persons; and, most recently, privatizing initial sickness benefits.

    • Measures to stimulate labor demand included: substantially cutting real minimum wages, especially for youths; cutting social premiums across-the-board; reducing non-wage labor costs for the low-skilled (lowering their labor costs by currently some 5 percent), and, most recently, virtually eliminating employers’ social contributions for the low-skill long-term unemployed (cutting the labor cost of such workers by 17 percent).

  • Product market deregulation was added to the agenda more recently (longer shopping hours, tougher competition legislation, lower entry barriers, reduced administrative burden), with a view to increasing domestic competition, business creation, and jobs—notably in services.

Source: IMF Staff Country Report No. 97/69 (August 1997).

F. The Challenge of EMU

131. EMU will imply the complete loss of a national monetary autonomy. For the Netherlands, given the undisputed currency link of the past 15 years, the change will be small. There will be no significant adjustment costs associated with joining a stability-oriented monetary union, as policy preferences and inflationary expectations are already fully in line with the expected future monetary policies.

132. The Dutch experience in a de facto monetary union has provided several important lessons and insights that will remain valuable under the new system.

  • Developments in 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.

  • Experience in the 1980s illustrated the effectiveness of subordinating national monetary policy for containing inflation, given both a fully credible peg and the Bundesbank’s stability oriented policies.

  • 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).

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

133. There are, nonetheless, several notable differences for the Netherlands between the current and the upcoming monetary arrangement.

  • EMU will be a more symmetric arrangement, and monetary policy will be tuned to conditions in the union as a whole, as compared to the Bundesbank’s primary focus during most of the past 15 years on the German economy. For asymmetric shocks originating in Germany, this should be benign for the Netherlands, while for shocks that originate elsewhere in the union (or outside the former core-ERM), the Dutch-German union obviously loses an adjustment tool.

  • EMU will comprise members that are more dissimilar 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 a monetary policy suitable for all member states.

  • 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.

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

134. On balance, it appears likely that even for the Netherlands, adjustment instruments other than the exchange rate will be, if anything, needed more under EMU. In light of past experience and the differences between the old and the new monetary system, several policy issues emerge. A main issue in case of asymmetric adverse shocks affecting the Netherlands will be the scope for fiscal stabilization. In the longer run, the operation of automatic stabilizers without exceeding the agreed deficit ceiling of 3 percent of GDP will require a structural deficit of no more than 1 percent of GDP. This is, of course, fully consistent with the goal laid down in the Stability and Growth Pact of a budget “close to balance or in surplus,” a goal that was also recommended by the Tenth Study Group on the Budget Margin (June 1997), a high-level civil service advisory committee. Currently, there is wide support in the Netherlands for reducing the structural deficit to no more than 1 percent of GDP by the end of the new four year government period at the latest, and aiming over time for structural balance. For the coming years, this would somewhat increase the room for automatic fiscal stabilizers (but provide no further room for counter cyclical policy). As important, however, will be the required change in fiscal policy rules and practices, to allow for fiscal stabilization, even if only through automatic stabilizers on the revenue side. As regards structural reforms, efforts to strengthen market forces in products markets are continuing. A new emphasis on fostering entrepreneurship, by removing regulatory and financial obstacles to starters, can also help bolster economic flexibility. It will be essential, finally, to press on with labor market reforms, particularly to address hard core inactivity.

G. Conclusions

135. While the monetary and exchange arrangements of the past decade and a half amount to a de facto monetary union, this should be distinguished sharply from EMU. The commitment to the peg by the Netherlands was one-sided; there was no sharing of decision-taking; and 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.

136. The Netherlands has benefited greatly from the peg. 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. However, the approach to economic management adopted by the authorities was not classic in one interesting respect: rather than let fiscal stabilizers operate under the de facto monetary union, they concentrated on giving resilience to the economy through structural reforms in the public finances and the real economy. The results have been impressive, because the reforms proved mutually reinforcing, and had powerful confidence effects. 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.

137. The impact of changes in the labor market has been sufficiently far-reaching to constitute, in itself, an asymmetric shock to the economy. Thus, while prices of tradables have converged, economic growth and asset prices have recently moved ahead of the levels in Germany—implying that the monetary conditions flowing from the peg are currently too easy. Moreover, this is occurring at a time when the stance of fiscal policy is mildly pro-cyclical. In these circumstances, the earlier abstinence from use of fiscal stabilizers needs to be rethought, and fiscal policy redirected, to underpin macroeconomic stability.

138. At the end of the day, flexibility in the real economy and the operation of fiscal stabilizers emerge as complements in coping with the loss of monetary authority. The challenge for the future is thus double. First, to deepen the process of structural reform in labor and product markets, as is currently planned. Second, to ensure that the fiscal stance contributes to preserving stability, while continuing to chart a decisive medium-term path for the public finances that blends further deficit reduction with a continuing lightening of the tax burden on labor income.

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42

Prepared by Jan Kees Martijn.

44

See Wellink (1993) for an account of the gradually increasing monetary orientation towards Germany.

46

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).

47

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

48

Some wage moderation actually started already before that, during 1977-79.

49

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.

50

Especially 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.

52

A reduction in wage costs and an increase in the effective supply of labor favors the production of nontraded goods and services, as these make relatively intensive use of this production factor. This is similar to the familiar Rybczynski theorem in international trade theory, and is associated with lower relative nontradables prices, shifting domestic demand towards these goods. For an unemployment decrease resulting from cutting above-equilibrium real wages, the analysis is more complex, but the outcome is similar, see Bhagwati and Srinivasan (1983), pp. 214-218.

54

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

55

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.

56

See footnote 4. Bofinger (1994) argued that this assumption is not justified; particularly under floating exchange rates, there was no empirical evidence of a stable relation with real fundamentals. Moreover, monetary shocks—that would be eliminated under monetary union—did seem to play an important role.

57

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.

58

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.

59

See Formby, Norrbin, and Sakano (1993) and Bayoumi and Prassad (1995). Instead of using simple measures of growth correlation, in these analyses economic fluctuations are decomposed, to separate 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. Bayoumi and Eichengreen (1992), using a VAR approach to estimate demand and supply shocks, as well as policy responses, also found a high correlation of shocks with Germany for a core group comprising the Netherlands, Belgium, Denmark, and France.

62

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

64

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).

66

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

67

The structural deficit was cut from 4.6 percent of GDP in 1982, to 1.4 percent in 1997.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Kingdom of the Netherlands—Netherlands: Selected Issues
Author: International Monetary Fund
Volume/Issue:
Volume 1998: Issue 102
Publisher:
International Monetary Fund
ISBN:
9781451829327
ISSN:
1934-7685
Pages:
110
DOI:
https://doi.org/10.5089/9781451829327.002

NETHERLANDS: Dutch and German Exchange Rate Changes and Interest Rate Differentials

NETHERLANDS: Ratios of Dutch to German (Western) Inflation and Exchange Rates

NETHERLANDS: Labor Income Shares and Unemployment Rates

NETHERLANDS: Dutch and German Terms of Trade and Oil Price Index

NETHERLANDS: Cyclical Indicators (A)

NETHERLANDS: Effective Exchange Rates

NETHERLANDS: Share Price Indices

NETHERLANDS: Cyclical Indicators (B)

NETHERLANDS: Output Gap and Monetary Conditions

NETHERLANDS: Output Gap and Fiscal Balance