A. Prospects and Policy Requirements

7. There was general agreement that the near-term growth outlook was quite good, but perspectives on the longer term were more varied, with the staff being at the more guarded end. The more hopeful appraisals pointed to the new institutional structures of EMU (a sound, rule-based fiscal framework and a monetary policy not exclusively geared to domestic developments in the anchor country), the lack of generalized signs that capacity constraints might soon bite, and the belief that labor supply was likely to be enhanced by a “discouraged worker” effect in reverse and more flexible labor markets than immediately apparent. Expectations of sustained noninflationary growth were above all rooted in the seeming change in the wage-formation process which, because of the discipline imposed on national wage-setters by the monetary union, was delivering wage moderation even in countries where slack was being absorbed at a relatively rapid rate. Moreover, while it was acknowledged that evidence of a “new economy” taking hold in the euro area remained anecdotal,⁸ in the opinion of many officials the area’s productive potential would be boosted by a falling NAIRU, as the dynamics linking actual and structural unemployment in an upward spiral reverse. Furthermore—and in addition to the cumulative effect of past reforms—the Lisbon summit’s strategy for structural and fiscal measures aimed at boosting the EU participation rate and fostering a knowledge-based economy would support the longer-term outlook for the euro area.

8. The staff acknowledged that reforms in product and labor markets, progress in fiscal consolidation, and a possible impact of EMU on wage and expectation formation might have improved the macroeconomic structure of the euro area. Nonetheless, it cautioned that some developments might not hold up to a marked cyclical tightening. Wage increases were, indeed, quite moderate and seemed likely to remain so through next year—judging from the signaling effect that recent German wage settlements had had on the area as whole. Beyond the near term, though, prospects were less clear. If the German authorities—who, not surprisingly given the still sluggish growth of employment, have a clear preference for continued wage moderation—had their way, wage moderation might continue to prevail throughout the area as a whole for a while longer. This would clearly help sustain price stability, even if it might also slow any needed intra-area re-balancing in labor markets and slow the contribution of domestic demand to the upswing. In the staffs view, however, real wages in Germany had in the past reacted quickly to upswings (see accompanying chart). If so, wage moderation throughout the union might not withstand the test. Wage demonstration effects could in time flare up across national borders, once fear of a loss in intra-area competitiveness weakened.⁹ In the same vein, the mission noted that recoveries tended to hide the critical role of rigidities in inhibiting smooth adjustment to external or policy-induced shocks. Indeed, as the recovery proceeded, insufficient wage differentiation was likely to intensify imbalances in the labor market that would gradually erode the euro area’s resilience and come to the fore only in the next downturn. Moreover, the failure to profit from the upturn to complete needed fiscal consolidation in the area as a whole was reminiscent of past fiscal mismanagement in upswings and the associated crowding out.¹⁰ Overall, the mission saw grounds for not being complacent in taking the long-term view: past impulses seemed likely to resurface in time.

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Germany: Real Wage Growth in Manufacturing Sector and Unemployment Rate

(In percent)

Citation: IMF Staff Country Reports 2000, 146; 10.5089/9781451812961.002.A001

Sources: IMF; OECD.1/ Wages deflated by GDP deflator.

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9. With a broad consensus that prospects through 2001 were good, there was wide recognition that the core challenge was to lay the basis for a lasting and a resilient noninflationary expansion. From a regional standpoint, a durable expansion was needed to make up for the anemic performance of the past and continue to bring down the unemployment rate; from a global perspective, an economically strong euro area was key to a re-balancing of the uneven global pattern in demand. There was recognition that maintaining the momentum in world growth called for the euro area to pick up the slack in demand arising from a slowdown in the United States. There was also widespread agreement, on the corresponding policy requirements: at least neutral fiscal positions over the cycle; tax, expenditure, and structural reform policies geared toward increasing effective supply in both product and factor markets—especially labor markets; and a monetary policy firmly focused on maintaining price stability, in a context with evolving inflationary risks. It was less clear, however, how closely policies would align with these principles in practice—thus raising the concern that the policy mix might again become problematic for the area as the cycle matured.

B. Monetary and Exchange Hate Policies

10. The ECB representatives largely shared the staffs view regarding the mediumterm risks to the expansion. They fully shared the view that fiscal policies should not be procyclical, that tax cuts should be tied to at least contemporaneous (i.e., not future) cuts in expenditures, and that structural reforms were needed now to enhance effective supply and preempt the emergence of inflationary bottlenecks. While acknowledging that progress had been made over the years, these officials were skeptical whether enough was being done to strengthen the groundwork for lasting growth. Although this might in time have adverse implications for the policy mix, they considered the ECB’s role in, and contribution to, sustaining the expansion in the euro area to be that of an unwavering commitment to maintaining price stability—a task that would necessarily be conditioned inter alia by the inflationary implications of fiscal, structural, and wage policies at the national level.

11. Indeed, the ECB representatives considered monetary policy over the preceding six to nine months to have been very much in that mould, responding appropriately to an environment where inflationary risks had increased. Monetary growth consistently in excess of the ECB’s reference value, unexpectedly large and protracted increases in energy and commodity prices, lagged effects of the marked and sustained weakness of the euro, and improving prospects for the euro-area economy had all contributed to a progressive shift to the upside in the balance of risks to medium-term price stability since mid-1999. According to the ECB representatives, the tightening cycle (of 175 basis points, at that point in time) initiated last November had continued to be generally supportive of sustained non-inflationary growth and anchored inflationary expectations, as implied by the differential between yields on long-term indexed and nominal bonds.

12. Since the discussions, inflation risks have increased: oil prices have continued to rise and the euro has slid to a new low against the U.S. dollar. The direct inflationary impact of these combined events is not likely to be trivial, notwithstanding the much lower oil content of aggregate production since the energy crises in the mid 1970s and heightened competitive pressures. The possibility of sizable second-round effects cannot therefore be ruled out.¹¹

13. Looking ahead, ECB officials thought at the time of the mission’s visit that areawide inflation would—on unchanged interest and exchange rates, and with oil spot prices falling in line with those in futures contracts—hover close to the upper bound of their target range through 2001, but they also pointed to the existence of inflationary pressures over the longer term. This projection reflected expectations of further exchange rate pass-through (as importers’ margins were reconstituted) and second-round effects that would in time push up core inflation and wage demands.¹² Regarding inflationary developments at the national level, officials at the ECB (and the Commission) agreed with the staff that price pressures in the more cyclically advanced economies reflected a variety of factors, including real convergence,¹³ and needed to be dealt with through fiscal and structural measures at the national rather than the area-wide level. In particular, they agreed that, where the analysis suggested overheating risks, special efforts should be made to accelerate structural reforms that would raise potential output and to front-load progress toward medium-term budgetary goals. More broadly, ECB representatives reiterated that monetary decision making was grounded exclusively on area-wide aggregate inflationary developments and was not directly shaped by country-specific circumstances.

14. The staff concurred that, overall, monetary management had been appropriate. The external shocks—oil, global demand, and the depreciation of the euro—had been unexpectedly large and sustained. As a result, headline inflation had crept up above the ECB’s target range and seemed likely to remain there for a few months. Moreover, the shocks had become sufficiently sustained, and the pace of activity sufficiently buoyant, as to justify worrying about forestalling second-round effects.¹⁴ The monetary tightening thus was understandable in the context of establishing the credibility of the new regime and of the need for the young central bank to steer inflationary expectations. Indeed, the staff noted that further modest increases in interest rates could be in order if the euro remained as weak as participants in the forward and options markets anticipated, and if the evolution of core inflation implied more entrenched wage and price pressures (Box 2).

Box 2.

Euro Area: Near-Term Inflation Outlook

With (monthly) headline inflation near the upper bound of the ECB’s definition of price stability, forecasting price developments in the euro area has taken on added importance. Although the outlook for inflation remains positive, a number of recent developments have contributed to a more cautious view of inflationary risks than at the time of the last staff visit at end 1999. Several factors account for the deterioration of the inflation outlook.

First, oil prices are higher than previously forecast. Second, on the strength of private credit demand, growth in broad money has continued beyond the reference value that the ECB considers consistent with medium-term price stability, in spite of rising interest rates. Third, defying most analysts’ predictions, the euro has remained weak through mid 2000. Fourth, expectations for euro-area growth in 2000 have bounded ahead: the Consensus Forecast went from 2.7 percent in November 1999 to 3.4 percent in August 2000. Finally, the external environment has improved considerably. The world growth rate for 2000 has now been revised upwards to 4¾ percent from 4¼ percent in May 2000 WEO.

The staff estimated a VAR model for the euro area over 1980Q1–2000Q1, and used it to make dynamic projections for inflation over 2000Q2–2003Q4. The specification models the growth of money, prices, GDP, and interest rates, with the rates of change on the price of oil and the real effective exchange rate given exogenously. Two scenarios are presented for the real effective exchange rate. In the baseline, it is assumed that the real effective exchange rate remains unchanged throughout the forecast period. In the second scenario, a 5 percent real effective appreciation is assumed to take place over 2000–01. The latest WEO assumption on future oil prices is used in all projections, and the assumed interest rate path reflects forward rates embedded in the yield curve as of August 2000.

The figure shows the projected inflation path in the near term has the heavy line. The model predicts that the headline rate will hover around the 2 percent upper bound of the ECB’s reference band for price stability, in the constant real exchange rate scenario. Under the second scenario of a modest appreciation of the euro, the inflation rate is projected to fall by about ¼ of 1 percent in 2001 (as shown by the thinner line in the figure).

In general, these results are in line with various studies that have examined the economic effects of a change in the external value of the euro. They should nonetheless be interpreted with caution, in particular because the model may overplay the role of money in the short run, while it ignores the wage moderation trend prevalent in the euro area, as well as the effect of deregulation and discretionary indirect tax cuts. This may explain, in part, why the model’s projections differ from the WEO inflation forecasts, which are a weighted average of national inflation rates.

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Inflation Forecast

Citation: IMF Staff Country Reports 2000, 146; 10.5089/9781451812961.002.A001

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15. The staff commented that policy appeared to have been strongly influenced by the external shocks and would need recalibrating as the impact of these shocks waned. In its view, the factors that had sped up the pace of the euro area’s recovery and the buildup of cost pressures were in time likely either to dissipate (e.g., the buoyancy of the United States’ economy and the surge in oil prices) or to reverse (e.g., the depreciation of the euro). A turnaround of the external impulses would call for a flexible response on the part of the ECB and a more accommodating monetary stance than would otherwise be required.

16. In reply, the ECB representatives stressed that the institution’s monetary framework was by construction symmetric and prescribed responses in either direction as the balance of inflation risks shifted. Policy decisions had been symmetric in the past and there was no reason to think that they would cease to be so in the future. Changes in the external value of the euro would—as in the past—affect policymaking only to the extent that they impinged on medium-term price stability and not because the exchange rate was a direct policy objective of the ECB. The mission did not dispute the point,¹⁵ but cautioned that monetary decision making might become more difficult in the future, if—as expected—domestic and external developments called for opposite policy actions. It shared the view, though, that policy should not target the exchange rate per se and that robust growth and sound policies in the euro area would ultimately be reflected in a stronger domestic currency.

17. The discussions of the reasons behind the protracted weakness of the euro added little to the view developed in the course of the previous staff visit to EU institutions, in part because the exchange rate had firmed up some by mid-June 2000. Since then, however, the euro has weakened further, to the point that the authorities have recently reiterated their concerns about the disconnect between markets’ perceptions and economic fundamentals, and hinted at the possibility of official intervention on the foreign exchange market. The staffs latest assessment based on a saving-investment approach suggests that the undervaluation of the euro is on the order of 10–20 percent in effective terms and 30 percent or more against the U.S. dollar. A host of factors was generally seen at play, most notably the continued appetite for U.S. dollar-denominated assets, reflecting the desire of euro-area investors to rebalance their portfolios in light of higher expected real rates of return in the United States.¹⁶ The staff argued that such a portfolio adjustment would eventually run its course, leaving room for the growing current account imbalances to redress the exchange rate. There was agreement that influencing the pace of this adjustment was beyond the reach of monetary policymaking at this stage. Rather, to the extent that the euro s weakness stemmed (perm from structural deficiencies in the euro area, more rapid progress in structural reforms could have a positive impact on investors’ perceptions and, thus, on the external value of the currency. In this view—the staff noted—the case for (sterilized) intervention rested mostly on the likelihood of a positive signaling effect.

Euro Area: Balance of Payments.

(In percent of GDP)

Source: ECB Monthly Bulletin, August 2000.

Euro Area: Balance of Payments.

(In percent of GDP)

	1997	1998	1999	2000Q1
Current account	1.4	0.7	0.4	-0.1
Direct and portfolio investment	-1.3	-3.2	-2.7	-0.7
Other transactions	-0.1	2.5	2.4	0.8

Source: ECB Monthly Bulletin, August 2000.

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Euro Area: Balance of Payments.

(In percent of GDP)

	1997	1998	1999	2000Q1
Current account	1.4	0.7	0.4	-0.1
Direct and portfolio investment	-1.3	-3.2	-2.7	-0.7
Other transactions	-0.1	2.5	2.4	0.8

Source: ECB Monthly Bulletin, August 2000.

18. Turning to some institutional and operational aspects of EMU, the ECB officials were pleased with the results of the first variable-rate auction format for their refinancing operations, where the chronic overbidding of the past had been resolved without—in their opinion—any loss in the signaling content of the policy rate, at least so far. On financial sector matters, the staff discussed a number of trends apparent in the euro area’s markets, including strong competitive pressures and the tendency toward an accelerated consolidation of institutions—albeit mainly along national lines at this stage. Against this background, the staff probed the case for intensified supervisory coordination, for centralized monitoring of market positions, and, over time, for consolidating supervision of the financial institutions that constituted the core of the euro area’s financial markets and payment systems.¹⁷ In response, both the Commission and the ECB officials argued that the present decentralized national arrangements were adequate for the task, although Commission officials saw a need for enhanced coordination among the relevant national authorities. In light of the depth and pace of change in euro-area financial structures, these officials were of the view that the present arrangements ought to be kept under regular review. Finally, the ECB representatives reaffirmed their intention to proceed with the publication of official economic forecasts including any for inflation, although the matter had not yet been vetted by the ECB Governing Council. The main concern was how to do so without (in their words) “complicating the communication of monetary policy decisions within the ECB’s monetary strategy,” which in the staff’s view meant leaving the erroneous impression that the ECB was shifting to an inflation targeting framework.

C. Fiscal Policies

19. Fiscal policies were viewed as facing a threefold requirement.¹⁸ First, they should avoid being pro-cyclical and instead use the recovery to achieve lasting consolidation. Officials noted that significant progress had been made in reducing deficits, and that there was reason to expect this progress to continue. Indeed, some countries had established significant surpluses. Nonetheless, a number of euro-area countries were using cyclically buoyant revenues to reduce tax burdens (or, in some cases, increase government spending) rather than to hasten fiscal consolidation. As a result, fiscal consolidation in the area as a whole was not keeping up with the expansion (Figure 3 and Box 3)—a pattern that concerned officials at both the Commission and the ECB. Admittedly, the staff noted, the discretionary easing in 2000–01 remained moderate in the aggregate and was projected to give way to further consolidation in later years—in which case, it would not materially upset the current policy mix. However, these assessments were contingent on growth assumptions that were low by the standards of past upswings. By those standards, fiscal impulses could become significantly more expansionary as the recovery proceeded if the nominal targets in the Stability Programs were not revised and the expansion gathered as much steam as in the late 1980s.¹⁹ The political reluctance to target surpluses accentuated these concerns. Some national officials countered that the staffs concerns did not make allowance for the likelihood that budgets would overperform, partly because they had been premised on cautious assumptions. In reply, the mission noted that the experience to date suggested that better-than-expected outturns had translated into pressures to cut taxes and increase spending that in the event were (or would likely be) accommodated by sticking close to the pre-set nominal deficit targets.

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Euro Area: Fiscal Balances and Output Gaps, 1998–2001. ^1/

Citation: IMF Staff Country Reports 2000, 146; 10.5089/9781451812961.002.A001

Sources: IMF, September 2000 World Economic Outlook; European Commission.^1/ Fiscal balances in percent of GDP, excluding 3G-phone license receipts. A positive output gap means that output exceeds potential. Positions on the dotted lines are in structural balance, with the slope of the lines reflecting estimates of the sensitivity of budgets with respect to changes in output gaps. Hence, countries’ fiscal positions are the stronger the higher they are in relation to the dotted lines, and the more cyclically neutral the more they evolve in parallel with the dotted lines.

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20. Second, while fiscal policies should avoid stimulating demand, they should simultaneously seek to reinvigorate supply by cutting taxes. High tax burdens and marginal rates continued to depress the return to human and physical capital throughout much of the euro area and constrained its productive potential. Moreover, disincentives continued to issue from the interaction of national tax and benefit systems that boosted the reservation wage of the marginal non-employed and stunted participation in the labor force. With a solid upturn now seemingly underway, alleviating these disincentives was becoming more and more important. A particular challenge—highlighted by the Lisbon summit—was to begin to raise labor participation rates after decades of policies headed in the opposite direction. To that end, tax reductions ought to redress the most distortionary marginal effective rates with a view to sharpening incentives to work, and ideally complement comprehensive benefit reforms aimed at correcting high average replacement rates of incomes in and out of work.²⁰ Corporate tax relief in selected cases would also help to safeguard the euro area as a desirable business location and foster capital formation. Overall, officials viewed countries’ tax reform plans as reasonably ambitious and supply-oriented, as evidenced in many cases by the emphasis on income tax cuts. The main concern was that tax cuts seemed to be outrunning the will to cut expenditures.

Box 3.

Euro Area: Revenues from the Allocation of Third-Generation Mobile Phone Licenses

The allocation of third-generation (or 3G), broad-band mobile telecommunications licenses is scheduled to be completed by the end of 2001. In selecting an allocation method, European governments have opted for either a simple auction, a “beauty contest” format—whereby regulators review business plans and the quality of existing services to select which companies will be offered the opportunity to buy a license for a flat fee—or some combination of the two. So far, the process has been completed in four euro-area countries. While the beauty contest approach in Spain and Finland resulted in minor revenue gains for the national treasuries, auctions in the United Kingdom, Germany, and the Netherlands yielded substantial windfalls. The allocation process in France and Italy is also expected to yield sizable amounts of resources.

Euro Area: Third Generation Mobile Telephone Licenses

Source staff estimates.

^1/Estimates for countries that have not completed the process are irom press accounts.

Euro Area: Third Generation Mobile Telephone Licenses

			Amount to be raised 1/		Stage of the Process
Country		Process	EUR billions	Percent of GDP
Euro area		…	100.1	1.6	…
	Germany	auction	44.0	2.5	completed
	France	beauty contest	20.0	1.3	set for 2001
	Italy	combination	30.0	2.6	set for Fall 2000
	Spain	beauty contest	0.5	0.1	completed
	Netherlands	auction	2.7	0.9	completed
	Belgium	auction	1.5	0.5	set for end-2000
	Finland	beauty contest	0.0	0.0	completed
	Austria	auction	1.0	0.5	set for Fall 2000
	Portugal	combination	0.4	0.4	set for Fall 2000
	Ireland	beauty contest	…	…	set for Fall 2000
Memorandum Item
	U.K.	auction	36.5	2.5	completed

Source staff estimates.

^1/Estimates for countries that have not completed the process are irom press accounts.

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Euro Area: Third Generation Mobile Telephone Licenses

			Amount to be raised 1/		Stage of the Process
Country		Process	EUR billions	Percent of GDP
Euro area		…	100.1	1.6	…
	Germany	auction	44.0	2.5	completed
	France	beauty contest	20.0	1.3	set for 2001
	Italy	combination	30.0	2.6	set for Fall 2000
	Spain	beauty contest	0.5	0.1	completed
	Netherlands	auction	2.7	0.9	completed
	Belgium	auction	1.5	0.5	set for end-2000
	Finland	beauty contest	0.0	0.0	completed
	Austria	auction	1.0	0.5	set for Fall 2000
	Portugal	combination	0.4	0.4	set for Fall 2000
	Ireland	beauty contest	…	…	set for Fall 2000
Memorandum Item
	U.K.	auction	36.5	2.5	completed

Source staff estimates.

^1/Estimates for countries that have not completed the process are irom press accounts.

How these funds are recorded in the fiscal accounts has implications for the interpretation of reported fiscal data and the assessment of underlying fiscal positions.

Eurostat, the EU statistical institution, has recommended a common treatment for EU member states in recording the sales of mobile telephone licenses. The transaction should be treated as the disposition of a non-financial asset and the sale proceeds should be included “above the line” in general government revenues at the time the license is awarded, with an associated improvement in the actual budgetary position. (In special situations characteristics of the contract may allow the transaction to be viewed as a rent for the use of a non-financial asset, and thus recorded over the lifetime of the license. In this case, the effect on the budget would be spread throughout the duration of the contract.)

Although Eurostat’s proposal is in line with the current version of A Manual on Government Finance Statistics (IMF, 1986) and its handling of similar transactions (e.g. privatization receipts), the statistical convention of recording exceptional revenue gains “above the line” has often been regarded as unsatisfactory for fiscal analysis. Indeed, fiscal accounts compiled by the IMF staff increasingly record privatization receipts as an element of deficit financing.

Receipts from the sale of licenses (e.g., broadcast or phone licenses, fishing or mining rights, emission rights, landing rights, or Internet domain names), proceeds from long-term lease contracts, or the outright sale of government assets have characteristics that warrant differentiating them from other government revenues in the design and assessment of fiscal policy. In particular, these receipts represent one-off resources which should not be counted upon to support the fiscal position permanently. Moreover, their lumpy and uncertain nature can distort the analysis of the underlying deficit and provide a misleading view of the sustainability of the fiscal position. These considerations suggest that it would be preferable to treat these proceeds as a “below the line” financing item in fiscal accounts. At a minimum, the receipts from the sale of 3G-phone licenses should be netted out in the calculation of structural balances and fiscal impulses.

21. The third requirement facing fiscal policymakers was to consolidate expenditures, with a view both to aligning tax cuts with the fiscal deficit targets and to strengthening incentives and resource allocation through public spending reforms. With higher disposable income having an expansionary impact in the short run, officials at EU institutions and the mission shared the view that tax reductions required matching—and permanent—expenditure cuts in order both to contain the stimulus to aggregate demand in the current cyclical setting and to ensure their durability. In Commission parlance, with deficits approaching balance, attention now needed to be trained as much on the “quality” (i.e., the tax and expenditure composition) as on the “quantity” (i.e., deficit dimension) of the adjustment. In this vein, tax cuts needed to be carefully limited to those that had the most beneficial supply effects—e.g., reductions in income and labor taxes rather than in consumption taxes. Correspondingly, expenditure cuts should focus on sharpening the incentives embedded in the transfer systems and on increasing efficiency in the provision of public services, e.g., through better use of technology. Experience in this regard was recognized as mixed, with only limited progress throughout the euro area on structural rather than across-the-board cuts in public spending—Germany in 2000, for example, providing a welcome exception—and tax cuts running as a rule ahead of meaningful expenditure curtailment.

22. Opinions differed on how fiscal policymaking could best implement a strategy built around these three requirements. At one end, the Commission, the ECB, and Fund staff look at budgetary developments in cyclically adjusted terms. From that perspective, recent budgetary developments in several euro-area countries were clearly of some concern, although opinions varied as to their significance (in part, as a result of underlying methodological differences). The focus on structural balances is often criticized, however, particularly by national officials, on the grounds that the estimates are artificial constructs unintelligible to the general public; vary widely across analysts; are sensitive to the choice of underlying methodologies; and are inherently opaque and susceptible to manipulation. In this view, structural budgetary objectives were clearly inferior to the nominal targets featured in the Stability and Growth Pact (SGP), which had the advantage of being transparent (because they did not require potentially controversial cyclical adjustments), credible (because they were readily ascertainable), and not necessarily inconsistent with fiscal prudence (because they could be set to attain any desired structural position). While acknowledging many of these points, the mission noted that none of this spoke to the basic objection, namely that nominal targets to be achieved independently of activity risked condoning fiscal profligacy in good times and austerity in bad—the opposite of what would be called for in a well-functioning monetary union. Thus, while the simplicity of nominal targets had avowedly been useful during the period of necessary fiscal consolidation, it risked becoming increasingly costly in the years ahead, exacerbating cyclical developments and complicating the conduct of monetary policy. What was needed was the political willingness to view the fiscal targets as contingent on the stated growth assumptions and to interpret fiscal requirements not as applying “year-by-year” but “over-the-cycle,” i.e., as surpluses in good times, deficits in bad, and balance on average (Box 4).

23. On the whole, a reorientation of the fiscal framework toward promoting sustained fiscal discipline and a sustained expansion was recognized at EU institutions as desirable but politically daunting. Securing surpluses in good times would require convincing national constituencies of the virtues of making contingency provisions in the public finances. The staff thought that the upcoming demographic shock offered a compelling argument for doing so, and noted that the establishment of reserve funds dedicated to prefunding future pension liabilities had proved in some cases a politically expedient means to safeguard revenue windfalls. Yet, it acknowledged, mobilizing popular support for structurally balanced budgetary positions as the linchpin of the medium-term strategy represented a core issue for euro-area policymakers—a task that had successfully been accomplished elsewhere. The general success in earmarking the revenues from the sale of broad-band phone licenses for debt reduction gave hope, however, that such support could indeed be garnered. Looking ahead, the staff thought that a reorientation of the fiscal framework toward emphasis on structural balance would have manageable consequences for future budgets: maintaining structural balance for the euro area as a whole in 2001–03 would call (under current WEO growth projections) for sustaining an aggregate nominal surplus on the order of ¼ of 1 percent over this period, or a cumulative improvement of about 1¾ percent of aggregate GDP in the area’s underlying fiscal position, spread over three years. Were this goal to be twinned with the objective of a 2 percent of GDP reduction in the aggregate tax burden (from 47 percent of area-wide GDP in 2000 to 45 percent in 2003), real public spending would have to grow in real terms by about ½ of 1 percent each year less than currently projected by staff on the basis of present policies.²¹

Box 4.

Euro Area: Is the Stability and Growth Pact EMU-Friendly?

Institutional History. A key provision of the Maastricht Treaty, which launched the process toward EMU, required each Member to reduce its fiscal deficit to no more than three percent of GDP by the time decisions were to be made on membership. The Stability and Growth Pact (SGP) transformed this membership criterion into operational guidelines on the conduct of fiscal policy under EMU. The key provisions enshrine the three-percent ceiling, with breaches triggering a range of moral and financial penalties; specify that members should achieve balance or a small surplus over the medium term; and require members to submit annual plans (the Stability Plans) describing how they intend to achieve these objectives.

Fiscal Requirements of a Smoothly Functioning Monetary Union. It is widely agreed that the loss of monetary sovereignty embedded in monetary union puts a premium on allowing full play to the automatic stabilizers if the union is to deal successfully with shocks. This is all the more so if labor markets are not especially fluid and there is no centralized mechanism for fiscal transfers as in the United States. Absent such stabilizers, all of the stabilization burden associated with symmetric (common) shocks would fall on monetary policy and prompt potentially damaging fluctuations in interest and exchange rates; and asymmetric shocks would prompt undesirable cyclical tensions within the union, straining its value.

Strengths and Weaknesses of the SGP. Through their focus on achieving specific nominal deficit targets, the SGP—and the Maastricht Treaty before it—cleariy effected a sea change in the management of the public finances in continental Europe. Moreover, the SGP allows for and supports systematic use of the automatic stabilizers as is clear from the gap between the medium-term norm of balance or surplus and the three-percent deficit boundary and further suggested by the clarification that “the time frame for interpreting the medium term would be the length of the business cycle.” In that vein, the overwhelming majority of analysts (including the EU Commission, the ECB, the OECD, and the IMF) strongly support the view that assessments of conformity with the medium-term norm should be based on “structural” or “cyclically adjusted” fiscal balances. In practice, however, the stability plans have been set out and assessed in good part simply on the basis of performance relative to the specified nominal targets—an inherently pro-cyclical exercise, given the vagaries of output over time. Moreover, governments with strong traditions of nominal deficit targeting have been circumspect—unless essentially forced to do so by economic circumstances—in setting out near-term targets that moved decisively toward balance, let alone surplus. This is hardly surprising given the political pressures such targets would prompt, but it also implies that fiscal policies have a bias toward being pro-cyclical—a bias that could well worsen as countries move toward high rates of resource utilization and the corresponding requirement for cyclical fiscal surpluses.

What does the future hold? Clearly, the framework is not per se the problem. It can allow full play for the stabilizers (as reflected in the hypothetical case A in the diagram). In practice, however, the framework has accepted outcomes that allow less than full play, and there are reasons to be concerned that the problem will worsen as a result of political resistance to targeting surpluses (case B). If so, the framework would in practice be pro-cyclical (in the measure of the vertical distance between A and B). However, present practice partly reflects a process of transition from the Maastricht three-percent entry requirement to a mediumterm balance target. It is conceivable that, once achieved, the latter might be viewed by some as a year-by-year requirement, in which case the stabilizers would be systematically offset (case C). How the framework will work out in practice will very much depend upon how effective EU institutions will be in persuading the wider public of the need for EMU-friendly fiscal policies and in pressing national authorities to follow through.

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Fiscal Balances

(In percent of GDP)

Citation: IMF Staff Country Reports 2000, 146; 10.5089/9781451812961.002.A001

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D. Structural Policies

24. Structural policy changes were viewed as essential to strengthening the supply side of the euro-area economy, both on their own and as complements to tax and expenditure policies (Box 5). The euro area’s record of short upswings and prolonged downturns provided context for the concern that without comprehensive structural improvements the targets of lasting growth, higher employment, and deeper social inclusion could not be achieved. In previous cyclical episodes, surges in demand had prematurely met the hurdle of a productive potential shackled by inflexible labor and product markets, and growth had been choked off. Indeed, policies had often added to demand pressures without commensurate efforts to provide the needed supply-side support and raise the headroom for growth. There was agreement that—past progress notwithstanding—a renewed resolve to enhance the euro area’s capacity was the key to a durable expansion, especially as tax reductions disconnected from broader reforms in public spending posed the risk that demand might again outstrip supply ahead of time. In a purely cyclical dimension, extending the envelope within which employment and growth could develop without creating inflationary pressures was widely recognized as particularly urgent in those countries fast approaching capacity constraints, since this would ease the need for restrictive macroeconomic policies for the area as a whole, contributing to growth in other economies.

25. As regards labor markets, the staff noted that the policy requirements would call for a considerable change in mind-set. The past decade had seen a constructive shift in the focus of policies from curbing labor supply and participation to increasing the demand for labor, notably through targeted reductions in social charges at low wages. The need was now to promote the effective supply of, rather than the demand for, labor. Abstracting from a few noteworthy exceptions (and the potential impact of tax reforms underway), structural policies so far had made only tentative inroads on this front. According to the mission, institutional reforms to facilitate part-time or temporary employment, as well as vocational training and social inclusion, had paid off but might also have reached their limits. What was needed now—the mission claimed—was the political resolve to increase labor supply by tightening eligibility for benefits and sharpening incentives for job search. More generally, strengthening the resilience of the euro area’s economy necessitated a greater role for the price mechanism in labor markets, so as to foster a more efficient use of human resources and relieve wage/productivity mismatches.

Box 5.

Euro Area: National Dimensions of Economic Policies

This report’s emphasis on area-wide policy issues should not divert attention from the fact that fiscal and structural policies differ widely across euro-area countries. Besides deep-seated institutional and historical factors, this variety reflects differences in cyclical positions and policy priorities, as the table below suggests.

Summary of Mawrocconomif; Indicators

Summary of Mawrocconomif; Indicators

	Output Gap	Inflation Rate	Structural Fiscal Balance
	in 2000	July 2000	1999	Change 1999–01
	(In percent of potential GDP)	(In percent)	(In percent)	(in percent)
Above Average
	Ireland(5.4)	Ireland(5.9)	Finland (2.3)	Finland(1.9)
	Netherlands (2.3)	Spain (3.7)	Irel3rd(2.0)	Portugal (0.5)
		Portugal (3–3)	Belgium (0.1)	Spain (0.6)
		Belgium (3.1)
Average
	Belgium (0.5)	Finland (2.9)	France (-0.7)	Italy (0.0)
	Finland (0.5)	Netherlands (2.8)	Germany (-0.6)	Belgium (-O.4)
	Spain (0.5)	Italy (2.6)	Italy (-0,3)	Austria (-0.3)
	Portugal (0.3)		Netherlands (-0.1)
Below Average
	Italy (-2.0)	Germany (2.0)	Portugal (-2.0)	Netherlands (-1.2)
	Germany (-0.9)	France(2.0)	Austria(-1.2)	Ireland(-1.1)
	Austria (-0.6)	Austria (2.0)	Spain(-1.0)	Germany (-0.7)
	France (-0.6)			France (-0.7)

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Summary of Mawrocconomif; Indicators

	Output Gap	Inflation Rate	Structural Fiscal Balance
	in 2000	July 2000	1999	Change 1999–01
	(In percent of potential GDP)	(In percent)	(In percent)	(in percent)
Above Average
	Ireland(5.4)	Ireland(5.9)	Finland (2.3)	Finland(1.9)
	Netherlands (2.3)	Spain (3.7)	Irel3rd(2.0)	Portugal (0.5)
		Portugal (3–3)	Belgium (0.1)	Spain (0.6)
		Belgium (3.1)
Average
	Belgium (0.5)	Finland (2.9)	France (-0.7)	Italy (0.0)
	Finland (0.5)	Netherlands (2.8)	Germany (-0.6)	Belgium (-O.4)
	Spain (0.5)	Italy (2.6)	Italy (-0,3)	Austria (-0.3)
	Portugal (0.3)		Netherlands (-0.1)
Below Average
	Italy (-2.0)	Germany (2.0)	Portugal (-2.0)	Netherlands (-1.2)
	Germany (-0.9)	France(2.0)	Austria(-1.2)	Ireland(-1.1)
	Austria (-0.6)	Austria (2.0)	Spain(-1.0)	Germany (-0.7)
	France (-0.6)			France (-0.7)

This diversity reflects a host of factors which result in rather different policy emphases across countries, even if common threads remain clear. This is well illustrated by the four Article IV consultations for EMU economies (France, Germany, Portugal, and Spain) also slated for Board Output Gap and structural Balance discussion in late October.

Differences in prospective fiscal performance are apparent from the graph on the right France and Germany envisage some deterioration of their underlying fiscal positions in the near term, which is fully reversed by 2002 only in France’s budgetary plans. The deterioration is much more marked for Germany and reflects the front-loading of its tax reform. By contrast, cyclically (more) advanced Portugal and Spain are committed to further consolidation throughout the medium term.

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Output Gap and Structural Balance

Citation: IMF Staff Country Reports 2000, 146; 10.5089/9781451812961.002.A001

Source: IMF. World Economic Outlook.1/ In percent of GDP.

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While all four countries pursue fiscal strategies centered on expenditure reform and control, they differ in the extent to which expenditure savings have been (or will be) mobilized. France experienced in 1999 slippages from pre-set norms for public expenditure growth which were not clawed back in the 2000 budget. Lack of progress so far in reforming the civil service, and the pension and healthcare systems pose a threat to prospective expenditure goals. Germany, by contrast, has implemented targeted spending cuts focused on social transfers. Overall, they are expected to yield a reduction in the expenditure ratio of some 1 percentage point per year over the medium term. A wide-ranging pension reform is also planned. In Spain, spending control has been broadly effective at both the State and local level, although at the cost of compressed public investment (which is slated to increase in the future). Reform of the pension system is however incomplete. On the whole, fiscal plans stress the need for further reducing growth of primary spending, including the public sector’s wage bill. Portugal too is aiming at slowing growth of real primary expenditure but the targeted reduction in the expenditure ratio through 2003 remains less ambitious than in the rest of the euro area. The unfinished agenda involves tackling the burgeoning public sector wage bill; controlling healthcare spending, and reducing subsidies to state enterprises. Some first steps have been taken in pension reform.

Fiscal Ratios

Source: WEO.

1/Do not include mobile telephone license revenues.

Fiscal Ratios

	Revenues		Expenditures
	1999	Change 2000–03	1999	Change 2000–03
	(in percent of GDP)
Germany	47.1	-1.2	48.6	-1.5
France	53.0	-1.4	53.7	-2.9
Spain	40.0	-0.2	41.1	-1.2
Portugal	44.7	-0.4	46.6	-1.1

Source: WEO.

1/Do not include mobile telephone license revenues.

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Fiscal Ratios

	Revenues		Expenditures
	1999	Change 2000–03	1999	Change 2000–03
	(in percent of GDP)
Germany	47.1	-1.2	48.6	-1.5
France	53.0	-1.4	53.7	-2.9
Spain	40.0	-0.2	41.1	-1.2
Portugal	44.7	-0.4	46.6	-1.1

Source: WEO.

1/Do not include mobile telephone license revenues.

The countries also differ in the extent to which expenditure control has been (or will be) used to finance tax reforms—which figure most prominently in the fiscal agenda of the two largest economies. In France, the 2000 revenue overperformance was allocated mostly to tax cuts (the one for the value added tax being the largest), but there appears to be increasing consideration of the supply-side effects of prospective tax changes. Past reform efforts have focused on reducing social security contributions at the low end of the wage scale. A multi-year plan to reduce the tax burden has recently been announced, including a reform of personal income taxation and the elimination of a surtax on corporate income. In Germany, a significant reform in direct taxation is underway, encompassing a medium-term, across-the-board reduction in personal income taxes and a deep reform in corporate taxation. Portugal does not plan any significant reduction in the tax burden (in percent of GDP) for the coming years, but is taking steps to increase the equity and efficiency of the tax system. Personal income tax reform is to take effect in 2001, but it is anticipated to be broadly revenue neutral; some streamlining of tax expenditures is planned in corporate taxation, and a reduction in the corporate tax rate is under consideration. Spain is planning a tax reform for 2002–03, in all likelihood aimed at reducing marginal tax rates across the board, but no details are as yet available.

Progress in Structural Reform

Source: Annual Report on Structural Reforms 2000. Economic Policy Committee, March 2009.

1/The X’s denote the need to further implement the specific reform recommendations.

^2/The table reproduced the qualitative assessment of the implementation of the Broad Economic Guidelines for 1999, as contained in reaction 4 of the EPC’s Report.

Other countries were ranked as having shown: “very good progress” (Netherlands);

“good progress” (Denmar, Finland, United Kingdom); “acme progress” (Belgium, Italy); and “progress” (Austria, Ireland). The Report does not rank the different initial positions.

Progress in Structural Reform

	France	Germany	Portugal	Spain
Overall progress in implant eating EU policy guidelines 2/	Some Progress	Progress	Some Progress	Progress
Product and service markets
Improve transposition of internal market legislation	X		X
Strengthen competition policy	X		X	X
Ease administrative burden on enterprises	X	X	X	X
Liberalize public procurement	X	X
Promote technological innovation			X
Reduce state aid	X	X	X	X
Captial markets
Facilitate venture capital	X	X	X	X
Stimulate portfolio diversification by institutional investors	X
Labor market
Ease tax pressure on labor	X	X
Reinforce active labor market policies		X	X	X
Facilitate labor mobility	X	X	X	X

Source: Annual Report on Structural Reforms 2000. Economic Policy Committee, March 2009.

1/The X’s denote the need to further implement the specific reform recommendations.

^2/The table reproduced the qualitative assessment of the implementation of the Broad Economic Guidelines for 1999, as contained in reaction 4 of the EPC’s Report.

Other countries were ranked as having shown: “very good progress” (Netherlands);

“good progress” (Denmar, Finland, United Kingdom); “acme progress” (Belgium, Italy); and “progress” (Austria, Ireland). The Report does not rank the different initial positions.

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Progress in Structural Reform

	France	Germany	Portugal	Spain
Overall progress in implant eating EU policy guidelines 2/	Some Progress	Progress	Some Progress	Progress
Product and service markets
Improve transposition of internal market legislation	X		X
Strengthen competition policy	X		X	X
Ease administrative burden on enterprises	X	X	X	X
Liberalize public procurement	X	X
Promote technological innovation			X
Reduce state aid	X	X	X	X
Captial markets
Facilitate venture capital	X	X	X	X
Stimulate portfolio diversification by institutional investors	X
Labor market
Ease tax pressure on labor	X	X
Reinforce active labor market policies		X	X	X
Facilitate labor mobility	X	X	X	X

Source: Annual Report on Structural Reforms 2000. Economic Policy Committee, March 2009.

1/The X’s denote the need to further implement the specific reform recommendations.

^2/The table reproduced the qualitative assessment of the implementation of the Broad Economic Guidelines for 1999, as contained in reaction 4 of the EPC’s Report.

Other countries were ranked as having shown: “very good progress” (Netherlands);

“good progress” (Denmar, Finland, United Kingdom); “acme progress” (Belgium, Italy); and “progress” (Austria, Ireland). The Report does not rank the different initial positions.

France, Germany, Portugal, and Spain also differ significantly in their efforts to pursue structural reforms. In the product markets, France has generally been slow in the adoption of EU directives for the network sector, while Germany has been a pacesetter in deregulation and liberalization in these sectors, Spain has recently implemented steps to increase competition in some key sectors (i.e., telecom, electricity, gas, retail sales, and pharmaceuticals). Portugal has a record of steady implementation of EU directives, but there remains scope for further liberalization and privatization.

In the labor markets, the national dimension of policymaking is similarly clear. France, which had aggressively pursued policies to stimulate labor demand through targeted reduction in nonwage costs, is increasingly recognizing the need to redress the ways in which the tax and benefit systems interact to make work unrewarding. Some first steps to reduce inactivity traps have been taken. (The recent focus on stimulating labor supply contrasts with an earlier emphasis on promoting work-sharing and heavily subsidized employment programs). Germany is following a strategy much more focused on containing labor costs through across-the board wage moderatioa No progress has been made (or expected) in tackling the distortions arising from open-ended unemployment assistance. Spain embarked in 1997 in a significant reform, whose centerpiece was the introduction of a new permanent contract with lower dismissal costs and lower social charges for new hires. Looking ahead, the highest policy priorities will be attached to fostering part-time work; reducing dismissal costs; and increasing the flexibility in wage bargaining. Finally, Portugal enjoys a peculiarly “non-European” labor market, characterized by low unemployment and relatively flexible arrangements. The key challenges there are to deal with the low level of educational attainment to better align skills and job requirements; and the need to increase labor sidbility, including by relaxing relatively strict employment protection legislation.

26. Officials at the Commission agreed on the need to step up reforms of the labor market, but had a more upbeat assessment of the progress so far. They thought that the Luxembourg process had proved successful in refocusing the debate from policies directed at reducing unemployment to those enhancing job creation and the employability of the nonactive labor force. The National Action Plans had, in turn, helped make employment policies more inclusive and transparent at the local level, adding to their political legitimacy.²² Gender issues and, most importantly, the need to re-evaluate the national systems of social protection with a view to fostering labor supply were also being given higher priority, as emphasized in the Lisbon Declaration. They shared the staff’s view, though, that progress in revamping the benefit systems remained lackluster.

27. Product market reforms were also viewed as essential complements to labor market policies to raise the productive potential and set the stage for a durable expansion. In the view of the Commission staff, progress has been more visible in the transposition of single market legislation and the deregulation of the telecom and electricity sectors; less progress has been made, however, in liberalizing the service sectors, and dismantling the overregulation of some cross-border activities. Financial market integration had progressed markedly with the introduction of the euro and a further impetus was expected with the full implementation by 2005 of the Financial Service Action Plan.²³ There was agreement that further progress in product market reforms and the Lisbon summit’s initiatives to promote a knowledge-based society would assist the euro-area economy in benefiting from the full potential offered by new technologies.