Staff Report on the Monetary and Exchange Rate Policies of the Euro Area; Supplement Updating Information on Recent Economic Developments and Policies in the Euro Area; Supplement on EU Trade Policies; Public Information Notice Following Consultation; Two Statements by Representative on the IMF Executive Board for France, on Behalf of Euro-Area and EU Members

For the time being—and possibly for a considerable time to come—developments and prospects for the euro area are quite favorable. This upbeat outlook is underpinned by buoyant activity indicators and a supportive policy mix. High household and business confidence, rising capacity utilization and industrial production, strong job creation, and—so far—employment-friendly wage settlements point to sustained activity in the near term. Moreover, the macroeconomic fundamentals in the euro area appear much sounder than in previous recoveries.


For the time being—and possibly for a considerable time to come—developments and prospects for the euro area are quite favorable. This upbeat outlook is underpinned by buoyant activity indicators and a supportive policy mix. High household and business confidence, rising capacity utilization and industrial production, strong job creation, and—so far—employment-friendly wage settlements point to sustained activity in the near term. Moreover, the macroeconomic fundamentals in the euro area appear much sounder than in previous recoveries.

I. Introduction

  • This paper1 marks the conclusion of a second cycle of Fund surveillance of the monetary and exchange rate policies of the euro area, which were last discussed by Executive Directors on March 23, 2000 (BUFF/00/41).

  • At that time, Directors noted that the near-term outlook for the euro area had brightened, and stressed that the key policy challenge was to create conditions for sustained rapid economic growth. To this end, they urged a monetary strategy firmly focused on price stability, national fiscal policies aimed at promoting public saving and favorable supply-side responses, and an intensification of structural reform efforts. Directors agreed that the prevailing weakness of the euro was undesirable from a global perspective but that a monetary policy reaction was unwarranted in the absence of clear risks to price stability. In acknowledging overall progress toward fiscal sustainability, Directors pointed out nonetheless that the adjustment effort had slackened in 1998–99 and should be reinvigorated. They commented that the updated stability programs for 2000–03 did not go far enough in providing the area as a whole with the necessary improvements in structural balances and reductions in the tax burden. Finally, Directors commended ongoing structural reform efforts but observed that the reform strategy was still too limited in scope to lock in durable reductions in unemployment, and urged a bolder attack on entrenched rigidities in the labor and product markets.

  • The next Board discussion of the euro-area matters covered in this paper is scheduled for the second half of October 2000, when the Article IV consultations with Germany, France, Spain, and Portugal will also be concluded. In light of this clustering, discussions at EU institutions focused on broad themes and policy desiderata for the area as a whole, rather than on individual countries’ developments and policy requirements.

II. The Economic Setting

1. For the time being—and possibly for a considerable time to come—developments and prospects for the euro area are quite favorable. With domestic demand growth maintaining the 3-percent pace of the past few years and the external environment shifting from adverse to distinctly supportive, activity has become quite buoyant. In the latest WEO, area-wide real GDP is expected to grow by about 3½ percent in 2000 and 2001, in a setting of broad price stability.2 The unemployment rate is firmly on a downward trend, and the euroarea output gap is anticipated to shrink by 1 percent this year and the next, with output exceeding potential capacity by the end of 2001.


Euro Area: Contributions to GDP Growth 1/

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

Sources: IMF and Euro state.1/ Quarterly data, annual percent change.

2. This upbeat outlook is underpinned by buoyant activity indicators and a supportive policy mix. High household and business confidence, rising capacity utilization and industrial production, strong job creation, and—so far—employment-friendly wage settlements point to sustained activity in the near term (Figure 1). Because of the weakness of the euro, monetary conditions remain supportive of activity in spite of the recent round of interest rate increases, and were in early August 2000 as easy as 10 months earlier (Figure 2).3 The constellation of national fiscal policies is also supporting area-wide aggregate demand. Abstracting from the exceptional contribution to revenues from the sale of the third generation phone licenses, the aggregate structural deficit is projected to slip by about ½ of 1 percent of GDP in 2000–01, thus marking a pause in the area-wide consolidation efforts after the overachievement of deficit targets in 1999 (Table 1).

Figure 1.
Figure 1.

Euro Area: Recent Developments

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

Sources: IMF, World Economic Outlook; WEFA database; and Euro state.1/ Quarterly growth, annualized.2/ Contribution to growth.3/ Percent change of the average of the last 3 months over the previous 3-month average.4/ Survey, balance of responses.5/ Centered, standardized series; means and standard deviations refer to period June 1986 to present.
Figure 2.
Figure 2.

Euro Area: Monetary Conditions

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

Sources: IMF staff estimates; European Central Bank; Bloomberg.1/ Real interest rates are defined as nominal interest rates minus core price inflation in the proceeding 12 month period.2/ The MCI is a weighted average of real interest and effective exchange rates with weights in a 1:7 ratio. The real effective exchange rate is ULC-based and the interest rate is deflated by either core or HICP inflation.
Table 1.

Euro Area: WEO Medium-Term Fiscal Projections

(General government, in percent of GDP unless otherwise noted)

article image
Source: IMF, World Economic Outlook; and Fund staff calculations.

Data do not include mobile telephone license receipts.

3. Moreover, the macroeconoinic fundamentals in the euro area appear much sounder than in previous recoveries. Underlying inflation is in check and expected to remain so under the stewardship of the ECB; the aggregate budgetary position is closer to balance than at any time in recent memory; and past reforms in the product and labor markets have started to bear fruit in the form of enhanced competition and moderate increases in labor compensation despite employment growth at a pace not seen in a generation.4 Admittedly, high unemployment—the hallmark of continental Europe’s malaise—still mars the economic landscape, but is receding at the fastest pace in ten years.


Harmonized CPI of Euro Area 1/

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

Source: Euro stat.1/ Monthly data, annual inflation rate.

4. There are risks, but these appear broadly balanced and not to threaten the euro area’s near-term prospects for above-potential growth.5 The main downside risk arises from a sharp reversal of the positive external shocks that have propelled euro-area growth to new heights—the strong pickup in global demand and the prolonged depreciation of the euro that has redirected a significant part of that demand to the euro area.6 It is also possible that the ongoing steep rise in oil prices might have more insidious effects on output than supposed.7 These risks have to be weighed, however, against the still supportive stance of macro policies, the competitiveness effects of the weak euro, and the resilience of domestic demand and employment growth over the past three years, which have withstood the test of global financial turbulence and ensured a broad-based recovery. Thus, although developments may be somewhat volatile, the underlying expansionary momentum should carry forward.

5. What about medium-term prospects? Are they as robust? The cyclical history of the euro area over the past 30 years suggests caution. The upswings, while on occasion pronounced, have been both fairly short and followed by prolonged periods of sub-par performance. In the latest such episode, the euro area returned—gradually at first, and rapidly later—to potential in 1988; experienced two further years of quite rapid growth in 1989 and 1990 (at about 4 percent per annum); slowed and crashed in 1991–93; and took a long time to recover thereafter. Many, largely exogenous factors played a role in each of these cyclical developments—oil prices, the Single Market, the Gulf war, German unification, the ERM crisis, and the EMU convergence process, to name some of the more notable. Nonetheless, deep-seated internal dynamic and structural influences also seem to be at play in the area’s macroeconomic history (Box 1). In this sequence of events, the recovery—typically triggered by a favorable external and exchange rate environment—becomes in time unsustainably paced by the combination of either pro-cyclical or insufficiently counter-cyclical fiscal policies and accelerating wage claims. Against the background of incomplete or piecemeal structural reforms unable to revitalize the supply side, demand soon outstrips productive capacity and price pressures mount. With labor market institutions that resist wage differentiation, the mismatch between productivity and labor costs intensifies, especially at the low end of the wage scale, fueling cost-push inflation and further wage demands. A sharp monetary tightening that usually exacerbates an ongoing real appreciation precipitates the downturn. In a context of structural rigidities undermining the economy’s resilience to the policy or terms-of-trade shocks, adjustment takes the form of extensive labor-shedding of the unskilled, upward ratcheting structural unemployment, and prolonged output losses—again, typically amplified by pro-cyclical fiscal policies geared toward cushioning the impact of the contraction on unsound budgetary positions.


Real GDP Growth Rates 1/

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

Source: IMF, World Economic Outlook.1/ Shaded areas represent periods of positive output gaps (i.e., output exceeding potential).

6. From this angle, the core issue looking forward is whether the factors that eventually undermined earlier upswings may still be at play for the area as a whole, and—if so—what policy requirements may prevent a repetition of the past. Arguably, the euro-area economy has changed in profound ways, but the longer-term prognosis for the ongoing expansion remains clouded by uncertainties about the scope of these changes and their effectiveness in reinforcing the economy’s resilience. What is clear is that keeping noninflationary growth on track beyond the next few years hinges on policies that avoid exacerbating demand pressures and reinvigorate the supply side of the euro area.

Euro Area: Will Economic History Repeat Itself?1

Over the last two decades, the economies of the euro area have, by and large, pursued policies which, in the context of the area’s structural rigidities, resulted in a consistently lackluster growth performance. The sustainability of expansions has proven especially problematic, as deep-seated rigidities in labor markets—often evidenced by rapidly rising real wage costs as slack was being taken up—caused inflationary pressures to mount in the early stages of an upswing. These pressures tended to be aggravated by insufficiently counter-cyclical (or outright pro-cyclical) fiscal policies in key countries, and elicited a swift monetary response that—as a rule—precipitated a downturn.

Indeed, a few observations provide a first characterization of the euro area’s experience in managing its recoveries over the last two decades or so:

Competitive currency positions provided initial support to an expansion and the exchange rate appreciated as the cycle matured: The evolution of the (synthetic) euro’s external value, both vis-à-vis the U.S. dollar and in effective terms, suggests that competitive exchange rate positions helped to push the euro area out of its economic doldrums in the mid-1980s. Although a gradual appreciation of the exchange rate had started to impact the recovery by 1987, a sharp depreciation in 1988–90 triggered a new upturn.

Insufficiently counter-cyclical or pro-cyclical fiscal policies exacerbated inflationary pressures during upswings. Persistent deficits and growing stocks of debt were the hallmark of the euro area’s fiscal policies in the last two decades. However, aggregate indicators of fiscal stance are misleading as fiscal policy in many countries was shaped by the pursuit of an exchange rate target. Focusing instead on the core countries reveals a tendency toward a deterioration in the structural fiscal position in both Germany and France during the upswing (for Germany, see SM/99/254; for France, see the 2000 Article IV staff report). A pro-cyclical bias persisted in contractions, as budgetary austerity was imposed to cushion the impact of the downturn—and rising unemployment—on unsound public finances.

Real wages accelerated quickly in response to improved cyclical conditions: In a context of declining inflation, nominal wage growth had generally been on a downward trend since the late 1970s. Real wage growth, though, rose sharply at the outset of the upturn in the mid-1980s, perhaps reflecting the difficulty of inflationary expectations in catching up with the ongoing disinflation. The same pattern reappeared in the late 1980s as unemployment finally started to edge down for the first time in over a decade: wage compensation rose quickly again, with real wage growth approaching four percent.

The monetary authorities’ response to a deteriorating inflationary environment was swift and marked: Throughout most of the period under consideration, short-term interest rates had fallen from their late-1970s highs as the monetary authority in the anchor country—the Bundesbank—lowered policy rates gradually in line with declining inflation. With inflationary pressures building up in Germany and elsewhere near the peak of the economic cycle in the late 1980s, the Bundesbank raised interest rates by some 400 basis points in two years, with other national monetary authorities following suit. In the early 1990s, the outbreak of hostilities in the Gulf region heightened inflationary expectations and led to further interest rate hikes.

1 Shaded areas on the figures represent periods of output exceeding potential.

III. Policy Discussions

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.


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.

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).

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.


Inflation Forecast

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

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)

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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.

Figure 3.
Figure 3.

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.

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.

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

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Source staff estimates.

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

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.


Fiscal Balances

(In percent of GDP)

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

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.

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

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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.


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.

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

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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

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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.

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.

IV. Internal Surveillance Processes and Policy Coordination

28. In the discussions on the effectiveness of the EU mechanisms for regional surveillance and policy coordination, officials at the Commission expressed overall satisfaction on how the processes in place were gaining strength and acceptability, but saw room for further improvement.24 The Commission staff claimed that greater dynamism in labor and product markets throughout the euro area was in good part due to the steadfast exercise of EU-wide surveillance, the effectiveness of which had been enhanced by the participation of social partners in the policy discussions and the explicit identification of good practices. The mission acknowledged that the modalities for EU surveillance—namely, through the “Cardiff process” for product market issues, the “Luxembourg process” for employment policies, the “Cologne process” for the macroeconomic dialogue among social partners, and the Broad Economic Policy Guidelines—had catalyzed the public debate and were providing a helpful framework for the development of reform policies (aided by the quality technical work by the Commission staff), but suggested that these processes still lacked the clout needed to promote timely implementation of agreed guidelines. In response, the officials at the Commission countered that peer pressure and moral suasion provided a powerful leverage not to be underestimated in the regional political context. They thought, nonetheless, that surveillance would benefit from more concrete, country-specific recommendations, including quantitative targets and a timetable for their achievement, and from the development of structural performance indicators that might sharpen the identification of best practices.

29. As regards fiscal policies, the Commission and ECOFIN’s annual review of the stability plans and peer pressure within the EFC were generally credited at EU institutions as having provided helpful avenues for fostering budgetary retrenchment, policy coordination, and the spread of best practices. Looking forward, however, the mission wondered whether current surveillance procedures would be as useful when the policy emphasis shifted to sustaining medium-term targets, restructuring public expenditure, lowering the tax burden, reforming the tax and benefit system, and improving the long-term viability of public pensions and healthcare systems, since these dimensions of fiscal policy were not covered in the stability programs. The Commission officials shared these concerns, but argued that the framework of regional surveillance was likely to evolve toward greater emphasis on the quality of policies. In their judgment, an additional aspect where the surveillance mechanism needed strengthening was its interface with the national budgetary processes, which remained underdeveloped and failed to provide fiscal policymakers with the support of their euro-area peers in the national debates. The mission welcomed in this connection the increasing role of the Euro Group,25 which could establish itself as a forum not only for promoting policy coordination but also for building popular support for needed reforms.

30. Finally, there was agreement that strengthening the statistical base of the euro area called for greater coordination among the producers of economic statistics at the national level. The ECB has recently released a report highlighting the need to significantly improve the collection of statistical data necessary for the conduct of monetary policy. This is hampered by lack of standardized methods, insufficient sectoral coverage in some cases, staggered publication by the national sources (which undermines the timeliness of aggregate information), and the fact that meaningful euro-area statistics are often not just the sum of data from member states. The report endorses the recent ECOFIN initiative to establish action plans identifying statistical requirements for each member state and for each statistical area.

V. Staff Appraisal

31. The euro area is doing well. The cyclical developments together with the strength of many of the fundamentals—pervasive wage moderation, fiscal positions nearing balance, supportive monetary conditions, and more dynamic labor and product markets—point to well above-potential growth over the next year. Although the external environment is generating conflicting forces that may make for somewhat volatile short-term dynamics, it basically continues to provide helpful support: aggregate real GDP growth will almost surely exceed 3 percent in 2000 and 2001.

32. The longer-term prognosis is more uncertain and not necessarily as reassuring. There is the risk of a sharp reversal of the favorable external shocks that have propelled euro-area growth to well above potential—the surge in world demand and the depreciation of the euro which has directed a large part of that demand to the euro area. More importantly, the cyclical history of the euro area over the past three decades suggests caution: all too often, procyclical, or insufficiently counter-cyclical, policies had interacted with inflexible markets to undermine the upswing and aggravate the downturn. Indeed, longstanding vulnerabilities—linked to the inability of past structural reforms to revitalize the supply side to the extent needed to match an expanding demand—call into question whether the ongoing expansion can be sustained long enough to make a durable dent in the still unacceptably high unemployment rate. These vulnerabilities are masked in upswings but are reflected in the euro area’s history of poor adaptability to shocks and less-than-optimally managed recoveries.

33. Arguably, EMU has changed the macroeconomic structure of the euro area, perhaps in profound ways: a rule-based fiscal framework is in place, monetary policy is no longer shaped by domestic considerations in the anchor country, and wage formation at the national level may have become more sensitive to intra-area competitiveness. But the import of these changes has not yet been tested by adversity, and uncertainties as to their scope or permanence caution against complacency. Moreover, despite improved public finances in the area as a whole, recent fiscal outturns suggest that tendencies toward pro-cyclical fiscal policies are still at play. In fact, the Stability and Growth Pact focus on nominal balances may again leave the door open for fiscal relaxation in upswings. In previous recoveries, this procyclicality—or, at a minimum, an insufficiently counter-cyclical fiscal stance—compounded inflationary pressures in a setting of widespread structural rigidities, eventually triggering a monetary contraction and precipitating an early downturn.

34. The pressing challenge, therefore—from a regional as well as a global standpoint—is to implement policies that will both sustain the expansion and make it more resilient. The policy requirements are widely accepted in principle: safeguarding price stability, avoiding fiscal pro-cyclicality, and strengthening the supply side through tax, expenditure and structural reforms. Yet, in some instances, actual policymaking falls short of these requirements, which are needed to ensure long-lasting growth and realize the Lisbon summit’s hope that the euro area will become a high-performing economy. Meeting these goals is critical to re-balance the currently uneven pattern of world’s growth—a task to which the euro area must eventually contribute, lest the slack created by a potential slowdown in the United States dims global prospects.

35. Cautious monetary management has preserved price stability in a volatile environment. The oil price shock and the depreciation of the euro have been unexpectedly large and protracted, and on balance have warranted a rise in policy rates to forestall second-round effects and anchor inflationary expectations. In fact, further steps toward a less accommodative stance could be in order as the cycle matures, if the euro remains as weak—and oil prices as high—as anticipated by market participants and the evolution of core inflation points to second-round effects becoming more significant than anticipated.

36. However, as the effects of the external factors that have contributed to a firming up of the recovery and the buildup of cost pressures—the buoyancy of the United States’ economy, the hike in energy prices, and the weakness of the euro—dissipate or reverse in time, price pressures and GDP growth will ease, calling for interest rates to be recalibrated downward. Thus, the symmetric approach that has so far shaped policy should continue to be followed, with changes in interest rates in either direction as the balance of risks to medium-term price stability—usefully proxied by the evolution of core inflation—shifts.

37. In this perspective, movements in the exchange rate should not be a direct policy concern but be factored into monetary decision making only to the extent that they pose a threat to medium-term price stability. Regarding the level of the euro, the misalignment both vis-à-vis the United States dollar and in effective terms remains large; underlying portfolio adjustments, which are putting downward pressure on the exchange rate, will eventually run their course and this will lead to an exchange rate correction. Influencing the pace of this adjustment remains at this stage more a matter of receptiveness to structural reforms than of monetary policymaking.

38. In the fiscal domain, the key challenge is to avoid pro-cyclical policies while implementing supply-enhancing tax cuts. Meeting this challenge requires closely integrated tax and expenditure policies: tax reductions should not run ahead of offsetting, permanent cuts in public spending in order to contain the short-run demand stimulus and foster a lasting release of resources to the private sector. In addition, tax cuts should be carefully prioritized to redress the most distorted incentives to labor force participation and capital formation, and be part of comprehensive benefit reforms aimed at correcting high average replacement rates of incomes in and out of work. At the present juncture, the appetite for tax cuts appears stronger than the stomach for expenditure reductions, so that fiscal policies are pro-cyclical now in the aggregate, and risk becoming increasingly so if fiscal surpluses do not grow to be politically more acceptable, particularly in the largest countries.

39. Achieving that outcome would seem to require de-emphasizing the importance of achieving nominal budgetary targets and reaffirming the need to evaluate fiscal positions—in the first instance—in relation to the cycle. A general acceptance of such a fiscal framework would make it more EMU-friendly. This is needed from the standpoint of sustaining the present expansion but also, institutionally, so as to impart a proper, symmetric role to the automatic stabilizers in the fiscally decentralized monetary union. The simplest way of doing so within the letter of the Stability and Growth Pact would be to accept that the its goal of fiscal positions “close to balance or surplus over the medium term” applies over-the-cycle rather than on a year-by-year basis, and that targeted deficit paths are conditioned on the underlying GDP growth assumptions. Convincing national constituencies of the virtues of securing surpluses in good times remains a daunting, but unavoidable, task facing euro-area policymakers.

40. A helpful reformulation of the fiscal paradigm should also encompass tax and expenditure objectives. Besides attaining the appropriate budgetary position, a restructuring of taxes and public expenditure is needed to effectively bolster the growth potential of the euro area and to tackle in many countries the growing imbalances in the public pension and healthcare systems. In this connection, tax cuts need to be carefully targeted so as to have the most beneficial supply effects; and expenditure reductions should focus on sharpening the incentives to seek work embedded in the transfer system, and on increasing efficiency in the provision of public services.

41. Structural policies are critical to shoring up the euro area’s longer-term growth prospects. Much has been achieved over the last decade, but the often-mentioned skeptical assessment by market participants of progress to date bears witness to the fact that in many instances reform efforts have not been commensurate to the need. Unless the groundwork is laid now for further revitalizing the euro area’s productive potential, there is the risk that once again demand will outstrip supply, and capacity constraints will choke off the expansion.

42. In the labor markets, more remains to be done to strengthen effective labor supply. To this end, the recommendations of the Employment Guidelines should be implemented resolutely, in particular reforms aimed at keeping older workers in employment and improving the quality of the labor force through vocational training for the young and the inexperienced. Beyond that, there is the urgent need to muster the political resolve to revamp welfare systems with a view to tightening eligibility for benefits and sharpening the incentive for job search, and to foster more market-oriented wage determination mechanisms.

43. In the product markets, by all accounts there is still ample room for promoting competition in some network sectors and removing administrative barriers to business formation and some cross-border activities. Regarding the financial sector, it will be important to review the adequacy of existing supervisory arrangements once the ongoing consolidation drive finally transcends national confines, and truly pan-European institutions emerge.

44. The processes for EU internal surveillance have proved helpful but could nonetheless be reinforced. The effectiveness of regional surveillance over structural reforms could benefit from the acceptance at the political level of greater candor in the Commission’s assessments. EU surveillance over fiscal policies should continue through the annual appraisal by the ECOF1N Council of the stability programs, preferably with greater emphasis on the quality of adjustment, and will be enhanced by the increasing role of the Euro Group as a forum for peer review and policy coordination in the euro area, and as a catalyst for popular support of needed reforms. Finally, the call to strengthen the euro area’s statistical base in the dimensions most critical for monetary decision making should be heeded without delay.

45. It is proposed that the next consultation on the monetary and exchange rate policies of the euro-area countries in the context of their Article IV obligations follow the standard 12-month cycle. An interim staff report will be issued for information of the Executive Board prior to the 2001 Spring Meetings.

APPENDIX I Euro Area: Economic Indicators

(Annual percentage change)

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Source: IMF, World Economic Outlook.

WEO, August 2000.

Contribution to growth.

Includes intra-euro area trade.

Harmonized definition.

Based on national indices until 1995 and harmonized indices subsequently.

In percent of GDP.

Percentage change in the stock of M3. For 2000, annual percentage change as of June 2000.

APPENDIX II Euro Area: Real GDP, Inflation, and Output Gaps 1/

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Source: IMF, World Economic Outlook.

Output gap is positive when output exceeds potential.

APPENDIX III Euro Area: Balance of Payments

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Sources: ECB Monthly Bulletin, August 2000; IMF, World Economic Outlook; and staff estimates.

Forecast of GDP in 2000 is from WEO.

End of period stocks. The 1998 figure is as of January 1, 1999.

APPENDIX IV Euro Area: Indicators of External and Financial Vulnerability

(In percent of GDP, unless otherwise indicated)

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Sources: ECB; European Commission; STOXX Limited.

Data for 2000 refer to June 2000.

Annual-average data.

Data for 2000 refer to the average for the period January-June 2000.

Calculated as: official reserves end-of-period positions / monthly average of imports. Data for 2000: official reserves refer to end-June 2000; imports refer to the period January-June 2000.

Dow Jones EURO STOXX index.

Data for 2000 refer to percentage change from December 1999 to June 2000.

Three-month LIBOR rates were used for the United States; for the euro area, up to December 1998, annual average of national three-month LIBOR. Annual averages of the three-month euro interbank offered rates (EURIBOR) thereafter.

Financial sector is defined as the Monetary and Financial Institutions (MFI) sector excluding the Euro system.

MFI Loans (excluding Euro system) granted to MFIs and non MFIs of the euro area and to non-euro area residents denominated in non-MU currencies.

Data for 2000 refer to Q2 2000, all figures are end-of-period-figures.

Foreign exchange loans minus foreign exchange deposits.

Deposits in MFIs (excluding the Euro system) placed by MFIs and non MFIs of the euro area and by non-euro area residents denominated in non-MU currencies.

Total liabilities are defined for this purpose as currency in circulation, total deposits, money market fund shares/units money market paper, debt securities issued and capital and reserves.

Real estate sector is define here as loans granted to households for house purchases.


In preparation for the paper, a mission visited the European Central Bank (ECB), where it held talks with President Duisenberg, and Ms. Hamalainen, Mr. Issing, and Mr. Padoa-Schioppa (members of the ECB Executive Board), as well as with senior staff. It also visited the Commission of the European Communities (Commission), where discussions were held with Commissioner Solbes Mira, Mr. Ravasio (Director General for Economic and Financial Affairs), and some of their colleagues. The staff presented the mission’s concluding statement to the Economic and Financial Committee (EFC) and to the Euro Group of finance ministers, which endorsed its general release and the eventual publication of this staff report. The mission took place on June 27-July 5, 2000, and the mission team comprised Messrs. Deppler (Head), Zanello, Ross, Kontolemis (all EU1), and Mr. Rosenblatt (PAR). Mr. Auboin (PDR) joined the mission during its visit to the Commission.


The Commission’s latest forecast is for growth at an annual rate of 3.4 percent and 3.1 percent in 2000 and 2001, respectively, with average harmonized index of consumer prices (HICP) inflation at 1.8 percent in 2000 and 2001.


After the 50-basis-point increase on November 4, 1999 the ECB repo rate stood at 3.0 percent. Subsequent 25-basis-point hikes were undertaken on February 3, March 16, April 27, and a 50-basis-point increase took place on June 8, 2000. The latest 25-basis-point increase on August 31, 2000 brought the ECB repo rate to 4.5 percent. Ex post real short interest rates (conventionally measured) rose from approximately 1.6 percent in July 1999 to about 3.4 percent in August 2000, roughly in line with the historical German average. However, over the same period the effective real exchange rate fell by about 12 percent.


Employment growth in the euro area has been at about 1½ percent in the last three years. A comparable performance occurred in the 1960s.


Euro-area potential growth is estimated at about 2½ percent per year.


Simulations with MULTIMOD and the OEF econometric model suggest that the cumulative contribution to growth from extra-euro-area exports in the aftermath of approximately a 1 percent increase in world demand and a 10 percent effective depreciation of the euro would be on the order of 1 percentage point over about two years.


Simulations with the OEF model suggest that a € 10 increase in oil prices depresses euroarea output growth by about 0.2 from its baseline level over 2 years. Expressed in euros, oil prices averaged € 15 in 1993–97, fell to €9 in December 1998, and reached €35 in early September 2000.


“New economy” issues are treated in detail in the forthcoming background papers for the 2000 Article IV consultations with France and Germany. Both papers reach the tentative conclusion that the “new economy” is at best only slowly making an appearance in most of continental Europe.


The leadership effects of wage-setting in Germany are discussed in Chapter IV of “EMU: One Year On,” OECD, 2000.


Cyclically adjusted balances (net of the revenue from the sale of mobile phone licenses) are projected to deteriorate in six euro-area countries in 2000, and in eight in 2001.


As a result of rising energy prices and a weakening exchange rate, the index of euro-area import prices has increased by about 17 percent since mid-1999 and the hike in oil prices is directly responsible for about half of the 1.4 percentage-point increase in the headline inflation rate since then. As for indirect effects, the ECB estimates that a permanent 20-percent increase in import prices is likely to contribute around 1 percentage point to the cumulative increase in euro-area HICP inflation over a 2–3 year period. Second-round effects from changes in import prices are however harder to gauge, since they would depend on the behavior of wages, inflationary expectations, the stage of the cycle, and macroeconomic policy responses.


The Commission has estimated a pass-through effect from the exchange rate to import prices of about 80 percent. However, the pass-through to final consumer prices could be less than complete, owing to aggressive pricing-to-market, the (presumably) temporary nature of the depreciation, and the relatively benign inflationary environment.


Policy issues faced by the fast-growing euro-area economies are analyzed from a cross country standpoint in the staffs background paper, “Cyclically Advanced Euro-Area Economies: Consequences and Policy Options,” SM/00/182.


The staffs estimate of the aggregate output gap for 2000 has been lowered by VA of 1 percent since the May WEO.


There are issues related to the ECB’s “two-pillar” framework and communication strategy, including recurring misreadings of monetary decision making by market participants and ECB watchers. The staff will revisit these issues in the course of a future mission.


In the first quarter of 2000, net foreign purchases of U.S. stocks and bonds were a record US$134 billion. According to United States Bureau of Economic Analysis, the increase was largely accounted for by an increase in European purchases. Net financial inflows for direct investment in the United States at USS42 billion were marginally lower than in the last quarter of 1999. From the euro-area side, first-quarter data show a worsening of the current account and an exceptional improvement in the financial account due largely to a one-off transaction in foreign direct investment. Net portfolio outflows were also affected by this transaction and reached €181 billion in the first quarter, almost three times their rate one year earlier.


The staffs suggestion was motivated by the forthcoming companion paper, “Euro-Area Banking at the Crossroads.”


The Commission’s view on these matters is in “Public Finances in EMU - 2000,” Report of the Directorate General for Economic and Financial Affairs, European Commission, May 2000.


If growth in 2001–03 averaged the same as in 1988–90, adherence to the nominal deficit targets in the stability programs would lead to a deterioration in the (implied) structural position of the euro area as a whole on the order of 2 percent of aggregate GDP. The latest stability programs and staffs normative scenarios are presented in the staff report and accompanying background paper issued in March, 2000 (SM/00/42 and SM/0048) and posted on the IMF external web site.


A discussion of the positive labor-supply effects of fiscal reform is in Disney, Richard: “The Impact of Tax and Welfare Policies on Employment and Unemployment in OECD Countries,” July 2000, forthcoming IMF Working Paper. See also the Selected Issues papers for the 2000 Article IV consultation with Italy, SM/00/94, and for the 1999 Article IV consultation with Finland, SM/99/230.


Table 1 implies that real public spending would grow on average at an annual rate of about l3/4 percent over 2000–03.


Updated country-specific recommendations for labor market reforms have been issued in mid-September by ECOFIN based upon an appraisal of National Action Plans by the Commission (see


The 2000 International Capital Markets report reviews in detail recent developments in the euro area’s financial sector (see


The discussion focused on areas subject to decentralized decision making, on the grounds that supra-national processes, such as those for the formulation of monetary, trade, or EU enlargement policies, involved a different type of group dynamics not institutionalized in a formal coordination mechanism or subject to formal surveillance. The mission’s discussions at the Commission on EU trade policies are reported in a forthcoming companion staff report. Issues related to the ongoing process of EU enlargement are discussed in the latest WEO (see


The Euro Group—formerly, the Euro-11—comprises the euro area’s finance ministers and generally meets on the eve of ECOFIN meetings.

Euro Area: Staff Report on the Monetary and Exchange Rate Policies of the Euro Area; Supplement Updating Information on Recent Economic Developments and Policies in the Euro Area; Supplement on EU Trade Policies; Public Information Notice Following Consultation; Two Statements by Representative on the IMF Executive Board for France, on Behalf of Euro-Area and EU Members
Author: International Monetary Fund