The continuing weakness of activity in the euro area reflects an amalgam of cyclical and long-term forces that are likely to shape the outlook and to challenge policies. Financial conditions in the area have improved along with those in global markets, though financial fragilities may be impairing the transmission to firms. The aging of the population could entail significant declines in potential output growth and lower expected lifetime income resources. Forward-looking policies are needed to improve the quality and ensure long-term sustainability.


The continuing weakness of activity in the euro area reflects an amalgam of cyclical and long-term forces that are likely to shape the outlook and to challenge policies. Financial conditions in the area have improved along with those in global markets, though financial fragilities may be impairing the transmission to firms. The aging of the population could entail significant declines in potential output growth and lower expected lifetime income resources. Forward-looking policies are needed to improve the quality and ensure long-term sustainability.

I. Introduction

1. The continuing weakness of activity in the euro area reflects an amalgam of cyclical and longer-term forces which are likely to shape the outlook and to challenge policies. In the short term, the dynamics of the global equity market boom-bust cycle, prolonged by the structural characteristics of the area and the appreciation of the euro, continue to dampen growth. From a longer-term perspective, the boom-induced lull in reforms that has prevailed until recently, the sharply divergent performances across countries, and the aging of populations are casting a pall on both short- and longer-term prospects. Against this background and continued uncertainty about the global recovery, the discussions focused on:

  • The outlook and risks. Incomplete adjustments to past shocks, both global and domestic, are limiting prospects for a robust bounce back in the near-term. Meanwhile, limitations on medium- and longer-term potential from slow structural reforms, the negative effects of population aging and associated fiscal sustainability concerns have been weighing on confidence and prospects.

  • The imperative of strengthening medium-term prospects and the need for policies to be more forward-looking. Widespread expectations that EMU would trigger increased structural reforms, essential to raising the area’s performance, have been disappointed, but there have been some hopeful signs recently.

  • The task for macroeconomic policies. Policies have generally been supportive during the slowdown but have been constrained—monetary by inflation persistence and fiscal by past failures to adjust. Receding inflation prospects have increased the room for monetary policy actions, but past lapses mean that fiscal policies need to continue to tread a fine line between longer-run considerations of sustainability and credibility and of supporting activity in the short run.

II. Background

A. Recent Developments and Cyclical Factors

2. A lackluster recovery during the first half of 2002 has given way to virtual stagnation. Household spending has been the key support of demand as the effects of past price shocks waned and disposable incomes were supported by rising real wages and widening fiscal deficits. The long fall off in investment spending in the aftermath of the equity bubble along with more modest external support, however, subdued growth. The subsequent build up of geopolitical uncertainties coinciding with the euro’s appreciation at the turn of the year resulted in effectively no growth. Confidence failed to bounce back following the Iraq war, and indicators suggest little if any growth momentum in the second quarter of this year.

(annualized quarter-on-quarter percent change)
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Contributions to growth.

3. Since the equity bubble burst, corporate balance sheets have been on the mend, but there remain uncertainties about whether adjustments have run their course. Both the Commission and the ECB agree with the staff’s earlier analysis2 that euro area corporates participated in the borrowing and spending binge during the stock market bubble with as much abandon as U.S. firms (Figure 1). Cutbacks in investment since the bubble burst and sharply lower interest rates have notably improved cash flows, as in the United States, but preliminary indications arc that the pace of adjustments in the area has been slower.

Figure 1.
Figure 1.

Post Equity Bubble Adjustment and Financial Conditions

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Sources: ECB; Federal Reserve; Datastream; and staff calculations.1/ Data for 2002 are staff projections for the euro area and outcome of the first three quarters for the U.S.2/ Spending on capital and financial assets not covered by internal funds, as a percent of GDP.3/ Defined as the ratio of debt to internal funds.
Figure 1.
Figure 1.

Post Equity Bubble Adjustment and Financial Conditions


Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Sources: Eurostat; Datastream; ECB; and own calculations.

4. Indications are that labor market adjustment is ongoing. In contrast to the last cycle, employment continued to grow well into the slowdown, though greater variation in hours worked recently renders comparisons difficult (Figure 1). With corporate profits pressured by slowing demand and increases in unit labor costs, employment came to a standstill and unemployment began to edge up last year and is expected to continue to do so. There was agreement that rigidities stemming from employment protection legislation (EPLs) in the area, though weakened in recent years, made firms hesitant to lay off workers until the case for doing so became abundantly clear, i.e., a “trigger point” in the profit squeeze was reached. With Europe viewing itself early on as relatively insulated from the new economy bubble, and the downturn short-lived, firms had been slow to lay off workers.


Unemployment fears have depressed consumer confidence

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

5. The predominantly bank-based financial system has been more tolerant of the pace of corporate adjustments, with the consequence that its balance sheets have been one of the main shock absorbers in the system. There was agreement that banks had been less prone to “pulling the plug” than capital markets are. Relationship banks, still the mainstay of European corporate finance, had been more forbearing, especially with their larger corporate clients. This feature of the economic-financial structure contributed to the larger declines in banking stocks in the area as compared, for example, to the United States, and often to proportionately larger movements in bank stocks compared to the broader market (Figure 1). Additionally, with losses of hidden reserves on equity markets, declines in capital markets activity, and credit losses, banks have seen their capital cushions grow thinner.

Corporate Financial Structure

(In percent of GDP)

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Sources: ECB; Federal Reserve.

6. Financial conditions in the area have eased along with those in global markets, though financial fragilities may be impairing the transmission to corporates. After tumbling by a third last year, and another fifth by March on rising geopolitical tensions, equity prices have recovered, trading slightly up for the year (Figure 1). Government bond yields have backed up from their recent post war troughs but remain at low levels. Balance sheet considerations and deteriorations in the economic outlook have, however, limited the feed through of lower rates to firms, particularly in the case of bank lending rates, and indications are bank lending standards for the corporate sector continued to tighten earlier this year.

7. The appreciation of the euro, welcome from a medium-term multilateral perspective, is detracting from the area’s near-term prospects. Since January 2002, the euro has risen by around 30 percent against the dollar and 18 percent in real effective terms, with most measures of the latter now at about their long-run averages. The staff and authorities welcomed the euro’s appreciation as being of an equilibrating nature from a longer-term multilateral payments perspective (Box 1). There was also agreement that the traditionally important terms of trade effect in the area associated with exchange rate movements implied favorable impacts for prices, real household incomes, and the import costs of firms. However, the appreciation was already weakening net exports, an effect likely to grow over time. In addition, the staff emphasized the adverse effects on profit margins of the export and import-competing sectors, which would weigh on the process of corporate balance sheet adjustments as would the downward valuation of foreign assets acquired, particularly in the United States, during the cross-border investment boom years.3


Euro exchange rates

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Perspectives on the Euro’s Appreciation

The euro has now sustained a 2-year long appreciation against a broad set of currencies. Several features of the appreciation are noteworthy:

  • On concerns about the strength of the U.S. recovery, mounting U.S. current account and fiscal deficits, and spurred by interest differentials, the euro’s appreciation has been most pronounced against the dollar.

  • The current level of the euro, both against the dollar and on a real effective basis, is now around the mid-point of its historical fluctuation range.

  • The pace of the euro’s advance against the dollar over the last two years has not been unusual by historical standards.

  • The euro has borne more than its fair share of the dollar’s depreciation, rising by more than the dollar has fallen on an effective basis.

  • Multilateral assessments, based on calculations of purchasing power parities or the macro balance approach (which projects medium-term current accounts consistent with savings-investment norms), suggest the euro is currently well-aligned on a real effective basis, while the dollar remains strongly valued.

Looking forward,

  • Many observers see continued dollar weakness from limited capital flows to finance the U.S. current account deficit.

  • Interest differentials, and especially capital flows, with which the euro has been closely correlated since its inception, remain in favor of the euro.

  • Multilateral assessments indicate that a global realignment of current account imbalances would be better facilitated by a broader-based decline in the dollar, rather than a further significant multilateral appreciation in the euro.


Nominal Effective Exchange Rates

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001


3-quarter moving average of FDI and portifolio flows

(in billions of euro)

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001


Expected Interest Rates and EUR/USD

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

B. Medium- and Longer-term Factors

Euro Area and U.S. Growth Compared

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Sources: European Commission; OECD; IMF; and staff calculations.

In percent of total population.

8. From a longer perspective, the area’s low potential growth reflects in large part low population growth. Demographic trends explain much of the sustained disparity in performance with the United States, and the differential in GDP growth disappears when viewed in per capita terms.

9. However, the record in terms of utilization of labor resources is weak, and there is considerable scope for raising the level of potential output. The level of per capita income in the euro area is around a third lower than in the United States. While part of the gap reflects differences in productivity, the bulk is due to lower rates of utilization of human resources: lower hours worked, higher structural unemployment, and lower labor force participation rates. The authorities have tended to view lower hours worked and labor force participation rates in the area as partly reflecting lifestyle choices, while the staff has emphasized that these choices have been conditioned by economic incentives. Indeed, some recent research attributes the substantially lower average hours worked in Europe to the larger tax wedge between labor and consumption taxes.4

Euro area and U.S. Levels of Per Capita GDP Compared, 2001


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Sources: EC; OECD; IMF; and staff calculations.

In percent of total population.

10. In the absence of improvements in labor utilization rates, demographics point to a marked slowing of output growth over the medium to long term. The looming, demo graphically-induced contraction in the area’s working age population implies, other things equal, significant declines in potential output growth and major strains on public pension systems. In particular, potential output growth is at risk of slowing from the 2-2½ percent range currently to 1-1½ percent over the next several decades (Box 2).

Shadows on Longer-Term Performance

The euro area faces a sizable demographic shock, implying declines in the potential labor force and an aging of the population. Low fertility and migration rates imply the area’s working age population is expected to remain constant during this decade before declining. Combined with an increase in life expectancy, the dependency ratio is expected to climb from a little over 40 percent currently to about 70 percent over the next 50 years.

These trends could have two important implications:

  • Substantial prospective declines in potential output growth and lower expected lifetime income resources.

Euro Area: Population Aging and Potential Output Growth, 2000-2050

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Population aged 65 and over as a percent of population aged 15-64.

WEO projection for 2003-05. Beyond 2005, projections assume a constant employment rate, labor-augmenting technical progress of 1.5 percent a year, and a constant capital-labor ratio.

Euro Area: Potential Output Growth and Discounted Values of Future Incomes

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As a multiple of current income; discount rate of 4 percent.

  • Public finances and retirement incomes could be impacted severely.1


Pension Spending-GDP Ratio Assuming Pull Passthrough of Population Aging to Spending

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001


Required Cuts in Average Pension (2004=100) to Stabilize Pension Spending-GDP Ratio at 2004 Level

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Sources: Economic Policy Committee; and staff estimates.1 Assumes unchanged public pension system parameters during projection period. For details, see Selected Issues paper on “Aging and the SGP”.

11. Another non-cyclical factor is the marked and long-standing divergences in performance within the euro area, most notably between Germany and the other members of the monetary union (Figure 2). The sources of this divergence are not well understood, but are commonly ascribed to a mix of the following: German reunification, which induced both a boom in Germany at the beginning of the 1990s and a supply shock to the labor market in the form of steep increases in labor taxes; the broadly obverse developments in the rest of the euro area where the prospect of EMU induced reforms aimed at strengthening competitiveness and labor demand; and the advent of EMU itself which amounted to a favorable interest rate shock for most countries and, in retrospect, may not have taken sufficiently into consideration Germany’s competitiveness vis-à-vis its partners. More recent developments suggest that a process of rebalancing has been initiated: German competitiveness has been improving steadily vis-à-vis its partners, as also suggested by the strengthening of its current account and export performance compared to the rest of the union. It remains to be seen, however, whether the adjustment has come to an end.

Figure 2.
Figure 2.

Divergences in the Euro Area: Germany Versus Rest, 1991-2003

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Source: European Commission; WEO, IMF.1/ Relative to other Ell countries; based on unit labor cost for whole economy.

12. Although its influence is difficult to assess, a final factor conditioning the long-term outlook is the ebbing of the reform impulse in recent years. As noted, the prospect of EMU together with the generally adverse conditions prevailing through much of the 1990s had prompted most countries into significant structural reforms, fiscal consolidation and wage moderation policies that contributed to notable improvements in performance in countries other than Germany from the mid-1990s (Figure 2). With the advent of EMU, the global boom, and the ensuing sharp drop in unemployment rates, these politically difficult reforms had, until very recently, moved off the agenda, especially in the larger countries.

C. The Outlook and Risks

13. Against this mix of cyclical and longer-run forces, the broadly shared baseline forecast sees the prevailing area-wide stagnation being overcome only gradually, with growth remaining sub par well into next year. With muted growth the result of both exogenous (bursting equity bubble, reduced external demand, appreciated euro, and geopolitical uncertainties) and endogenous (gradual corporate and labor market adjustment) forces, the baseline foresees continued internal adjustments (rise in unemployment) to establish the preconditions for more robust growth. Overall, the staff expects growth to stagnate this year at last year’s pace of ¾ percent, before picking up to around 2 percent next year (Table 1). External demand is projected to be supportive as the recovery abroad is assumed to strengthen, but its role will be curtailed by an appreciated euro. Sustaining growth requires a strengthening of domestic demand. With household balance sheets relatively sound, private consumption expenditures are projected to pick up as real disposable incomes are supported by declines in inflation, continued real wage growth, and automatic fiscal stabilizers. However, increases in unemployment will temper the pace in the near term. With policy interest rates and real long-term yields low, capacity utilization rates not far below historical averages, and improved corporate cash flows, investment spending is projected to turn around gradually with increases in demand. Finally, re-stocking should provide some support.

Table 1.

Euro Area: Main Economic Indicators

(Percentage change)

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Sources: World Economic Outlook, IMF; Eurostat, ECB Monthly Bulletin.

WEO projections as of July 29th, 2003.

Contribution to growth.

Includes intra-euro area trade.

In percent of potential GDP.

In percent.

In percent of GDP.

Includes UMTS revenues and Italy’s real estate asset sales.

For 2003, January-July average.

Synthetic euro in 1998.

Based on normalized unit labor costs.

Based upon ECB data which excludes intra-euro area flows.

Calculated as the sum of individual countries balances.

14. Past postponements of projected recovery underscore that the forces at play are imperfectly understood, and there is agreement the risks to the forecast are on the downside. The key risks are:

  • Continued corporate balance sheet adjustment. Investment spending firmed in the second half of last year, but this reflected largely one-off effects, and a more prolonged weakness remains a risk. Pressures on the corporate sector could also be amplified by further euro appreciation and tight financing conditions as bank balance sheets in some countries remain under pressure.

  • A faltering of the US recovery. Recent developments have reinforced the notion that the fortunes of euro-area activity remain inextricably linked to developments in the United States.

  • The potential for euro overshooting. Although the exchange rate stabilized around mid-year, the U.S. twin deficits, capital flows, and interest differentials suggest the potential for further euro appreciation. For the euro to remain fairly valued on a multilateral basis requires that further dollar weakness be accompanied by euro depreciation against other major currencies. Movements during the recent leg of euro appreciation, however, which saw many currencies follow the dollar down, give little comfort such a scenario will play out.

15. However, indicators have generally been stable, albeit at low levels, with some confidence indicators ticking up lately. This suggests that the risks are more of continued stagnation rather than of a marked deterioration in activity. Moreover, the increased seriousness countries are bringing to effecting structural reforms bodes well for an improvement in performance in the medium term.

III. Policy Discussions

16. There was agreement on long-term policy requirements and on the need for policies in the short run to be forward looking and geared toward achieving long-run goals, but less so on the extent fiscal policy should trade off these objectives in the short run. An overarching priority is a much needed strengthening of medium- and longer-term prospects through structural and fiscal reforms to raise potential, improve flexibility, and address underlying social security and fiscal sustainability issues.

17. Both own and global considerations argue for the euro area to support the global recovery, helping re-balance the uneven pattern of world growth in recent years, and to advance the agenda of multilateral trade liberalization. Uneven growth explains in part the build up of international imbalances and higher euro area demand growth would, therefore, facilitate external adjustment in the world economy and possibly limit the risks of euro appreciation. On the trade front, commitments to increase access to local markets provide a signal of the resolve to tackle internal structural reforms and can impact the domestic momentum for such reforms.

Past Fund Policy Recommendations and Implementation

In concluding the last Article IV consultation on euro area policies on October 18, 2002 (EBM/02/106), Directors noted that, given the ongoing weakness in activity and expected declines in inflation, monetary policy should continue to maintain an accommodative stance. The ECB’s subsequent policy actions have been in broad agreement with Fund advice. The Governing Council’s recent clarifications regarding the price stability objective (to keep inflation below but close to 2 percent in the medium term) and the role of the money pillar (to focus the pillar on medium- to longer-term trends in inflation) were also in line with recommendations in last year’s Article IV consultation.

The Fund’s advice on fiscal policy has tried to balance shorter-term cyclical considerations and the pressing longer-term requirements of putting public finances on a sounder footing. Specifically, countries that do not meet the SGP’s close-to-balance or in surplus requirement should undertake fiscal adjustments of at least 0.5 percent of GDP per year until the position was corrected but let the fiscal stabilizers work fully around the consolidation path. The Commission has stressed, however, that countries in excessive deficit positions must bring the deficit below the 3 percent limit within the appropriate deadlines As regards a longer-term agenda for improving the SGP, staff has urged a more direct focus on debt sustainability. Most of the recommendations, including the 0.5 percent fiscal adjustment rule, were part of the Commission’s proposals that were subsequently broadly supported by Eurogroup ministers and ECOFIN. Implementation of the advice by national authorities, however, has been mixed, as detailed in the present report.

Staff and the authorities have generally been of one mind as regards the need to step up structural reforms, but progress has been slow. Ultimate responsibility for implementing key structural and fiscal reforms, however, lies with national authorities. On the EU’s trade policies, staff last year identified reform of the Common Agricultural Policy (CAP) as crucial for the success of the Doha Development Agenda. The recently adopted reform plans are an important step forward but fall short of what is needed.

A. Monetary Policy and Inflation

18. Inflation has been persistent, but has turned. While headline rates were buffeted by movements in oil prices, core inflation (headline inflation excluding energy and unprocessed food) decelerated from around 2% percent in early 2002 to around 2 percent by January this year reflecting growing economic slack, the appreciation of the euro, and the waning of price shocks. Core goods inflation fell sharply, while services inflation decelerated gradually (Figure 3). Concerns a year ago that the inflation overshoot would lead to extended second-round wage effects appear to have been averted. Indications are the upward drift in wage increases since 1998 has come to a halt, and unit labor cost growth eased.

Figure 3.
Figure 3.

Inflation Is Coming Down

(Data in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Sources: Eurostat; ECB; European Commission; Datastream; and staff estimates.1/ Standardized; i.e. charts show (standard) deviations from 1985-2002 mean.

Core inflation has fallen

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

19. With growth slower, and smaller and fewer interest rate cuts than in the United States, the ECB has been perceived as less activist, but these comparisons overlook lower potential growth and the stickiness of inflation in the area. The staff views the record of monetary policy as having been in line with inflation and output developments in the area. With the slowing in growth relative to potential in the euro area smaller than in the United States, and inflation somewhat higher, policy rates have been in line with, and generally lower than, standard Taylor rule yardsticks would imply, and are currently well below (Figure 4).

Figure 4.
Figure 4.

The Monetary Policy Stance Has Eased

(Data in percent, unless otherwise specified)

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Sources: ECB; Datastream; Bloomberg; and staff calculations.1/ Deviation from 1990-2002 mean.2/ Calculated using standard coefficients, partially forward-looking core inflation, a neutral real interest rate of 2.25 percent, and an. ECB inflation objective of 1.75 percent.

20. The shared outlook is for inflation to decelerate significantly next year. The staff’s forecast sees the cumulative effects of weakness in activity, the recent large appreciation of the euro, a continued softening of labor markets, and the fall in oil prices as combining to push headline and core inflation below 1½ percent by late next year, and for price pressures remaining low for some time (Figure 3). The ECB also saw inflation falling significantly next year, though somewhat less so when excluding energy. The Commission, whose inflation forecasts have tended to be above consensus but closer to the mark over the last two years, saw a more gradual and smaller deceleration than the staff. Although there was consensus wage growth should not give rise to upward pressures on inflation, the Commission and the ECB saw some uncertainty about wage growth moderating in line with cyclical developments, and the Commission’s estimates see less slack in labor and goods markets than do the staff’s.


The output gap points to declining price pressure

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

21. These projections are subject to important uncertainties and risks.

  • Structural persistence in inflation may be high in the area. Stubbornly above target inflation rates well after the slowdown began, raise the question of whether inflation in the area is unresponsive to demand or monetary shocks. The staff’s finding5 is that inflation persistence is only moderately higher in the euro area than in the United States, if at all, and there is little firm evidence that structural sources of persistence play a bigger role in the euro area. By implication, the sluggish response of inflation over the last two years is explained instead by the shallower downturn in activity and the scries of one-off temporary shocks.

  • An elusive recovery has increased the weight of arguments potential growth may have slowed, and the variation in estimates of slack has risen. In contrast with the United States where the natural unemployment rate tends to be relatively stable, the well-known tendency for hysteresis effects in European labor markets—whereby in principle temporary movements become permanent—creates a basic difficulty for estimating slack. In output markets, a key question—not restricted to the area—is the extent to which this cycle, a key element of which has been a sustained decline in equity markets, entails a longer-term increase in the cost of capital and a reduction in supply.6 Against a background of substantial uncertainty, the staff’s working hypothesis is that potential growth has continued at its recent historical pace.

  • Views differed somewhat on the prospects for wage increases. The staff and the ECB saw the worrying wage increases of last year as partly reflecting compensation for inflation shocks. Looking forward, the staff saw the combination of lower inflation and ongoing weakness in labor markets as having a stronger influence in moderating wage increases than did the authorities.

  • The risk of area-wide deflation at this stage is remote. Inflation has only recently come down to 2 percent after exceeding the ECB’s price stability range for three years, and the room for lowering interest rates remains considerable. Only if the continued slowdown were to turn into a severe recession or were the euro to appreciate rapidly would a risk of deflation arise.

  • A period of declining prices, likely short, in Germany, is conceivable, but the risks of deflation small. The staff argued that monetary union can both exacerbate and limit the risk of deflation in individual members. On the one hand, the lack of monetary policy instruments limits the ability of individual countries to steer clear of deflationary dangers through early and aggressive easing. There was agreement on the other hand that it is unlikely deflation could become entrenched in a part of the currency area as long as the area-wide price level is continuously rising since traded goods inflation is closely linked across the area, and inflation expectations are partly governed by area wide trends. Falling relative prices in a region of EMU would boost competitiveness, net exports, and investment. The staff emphasized, though, the stylized fact that balance sheet adjustments tend to be more prolonged at lower rates of inflation, and that broad price declines, especially in the face of financial fragilities, could hamper such efforts further.

22. At the time of the mission, the staff saw on balance considerable scope for monetary easing, and in the event the ECB cut rates by 50 basis points in early June. In so doing, the ECB noted that the outlook for price stability had improved since it cut rates in March, and it specifically noted that the interest rate reduction took account of downside risks to economic growth.

23. In the staff’s view, uncertain prospects of even a slow recovery combined with a benign inflation outlook argue for an easy monetary policy going forward, and further easing will be needed if inflation threatens to undershoot significantly because activity fails to pick up quickly or the euro rises appreciably. The staff argued monetary policy should maintain an “accommodative bent”—a sustained easing bias—to support confidence until a self-sustaining upturn in domestic demand, especially of corporate spending, is in place. The continued sideways development of activity, the projected increase in economic slack through the middle of next year even given the recovery in the baseline, the persistence of corporate and financial sector fragilities in some countries, the risk of further euro appreciation, and downside risks to global growth suggest that the risks of undershooting the inflation objective in 2004-2005 are greater than the reverse. That these risks are also potentially the more consequential—with low inflation not helping balance sheet adjustments and providing less room for relative price adjustments within the area—strengthens the case for an easy stance. In the event, the ECB’s emphasis on downside risks to growth at the time of the June rate cut was read by markets as a signal of a more accommodative bent, and the term structure of interest rate futures shifted down. The ECB’s statements since then, however, have emphasized the record low level of interest rates, the appropriateness of rates from a medium-term perspective, and the substantial excess liquidity accumulated as a consequence of high M3 growth, thereby dampening such expectations.

24. The ECB’s review of its monetary framework has led to a welcome clarification of the inflation objective and of the role of money in its analysis. The ECB has clarified its inflation objective as being “below but close to 2 percent”. This has substantially reduced uncertainty regarding interpretation of the objective, and should provide a buffer against shocks that could threaten to lead to area-wide deflation while also providing scope for inflation differentials across countries. The ECB has moved to make “monetary analysis mainly serve as a means of cross-checking, from a medium to long-term perspective” indications coming from economic analysis (the other pillar), which is better suited for gauging near- to medium-term prospects. The format of press statements has accordingly been reworked. Both of these clarifications are in line with the recommendations discussed in last year’s consultation.7

25. The ECB is also preparing for enlargement. The ECB’s new voting modalities for future expansions of the euro area following enlargement envisage that the number of national central bank governors exercising a voting right in the Council should not exceed 15; once membership exceeds 15, a rotation system will determine members’ voting rights. Regarding euro entry, EU officials have sought to clarify the criteria, particularly as regards ERM II membership and the exchange rate criterion.8

B. Fiscal Policies: Long-Run Credibility and Short-Run Flexibility

26. There is broad agreement regarding the long-term requirements of fiscal policies in Europe. These are threefold:

  • On the structural front, countries need to scale back unduly generous benefits financed on the back of commensurately high labor taxes, which severely distort incentives and reduce supply, especially in labor markets.

  • On the macroeconomic front, in line with the SGP, budgets need to move toward balanced underlying positions so as to begin to address the fiscal unsustainability embedded in the aging of the population.

  • From the point of view of the monetary union, decentralized fiscal policies require a credible fiscal framework.

27. There is a wider spectrum of views on short-run requirements. At one end, some argue that the weakness of demand requires, if not reflationary policies, at least a neutral fiscal stance so as not to compound the weakness. At the opposite end, others, including the Commission, argue that the associated weakening of fiscal positions would undermine confidence. Credibility and growth prospects would be better served if countries lived up to their commitments under the SGP. The roots of these differences are many, varied, and deep. Views differ on the extent of downside risks to growth in the area and across countries, whether the ongoing weakness reflects demand or a longer-run slowing in potential, whether discretionary fiscal policy is viable or counterproductive, and the size and sign of fiscal multipliers. The empirical evidence on the impacts of fiscal policy on growth is mixed. The Commission’s recent cross-country work finds that growth accelerated in about half the historical episodes of fiscal consolidation in Europe, with expenditure-based consolidations being more growth-friendly than those based on tax increases.9

28. Past lapses have limited the available choices. From a medium-term perspective, running counter to the SGP requirement of moving toward underlying balance, large tax cuts initiated at the peak of the boom, combined with limited progress in reducing primary structural expenditures resulted in cyclically-adjusted deficits growing by between a ½ to 1 percent of GDP between 2000-2002 in Germany, France and Italy (Figure 5). From a short-term perspective, policies allowed full play to the automatic stabilizers, and consequently Germany and France (accounting for about half the area’s output) joined Portugal in breaching the SGP’s 3 percent deficit limit in 2002, while Italy avoided doing so mainly through various one-off operations.

Figure 5.
Figure 5.

Fiscal Policies Have Not Played by the Rules

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Sources: Eurostat; WEO.1/ In percent of potential GDP.

29. A consequence has been unsatisfactory tradeoffs between long- and short-run goals. Correcting breaches of the SGP has led to fiscal retrenchment efforts this year and, while the effects on demand can be debated, the associated controversies have almost certainly hurt confidence. Moreover, a focus on meeting short-run targets, political constraints on the budget process, and gamesmanship have meant that these efforts have run in some cases counter to longer-run structural goals (by raising taxes). In other cases they have been at best irrelevant and sometimes harmful for achieving durable long-term adjustments (cyclical social security increases, tax amnesties, and expenditure freezes), with at best nonpositive effects for confidence.

30. The picture for fiscal policies in 2003 is mixed and uneven across countries, with some area-wide consolidation envisaged. Present staff projections see the area-wide deficit in 2003 widening further to 2¾ percent of GDP, with projected structural tightening (of ¼ percent) being more than offset by the operation of automatic stabilizers (½ percent) as the output gap widens. The bulk of the area’s structural adjustment is projected to come in Germany ¾ percent of GDP) from a variety of revenue raising measures. This adjustment comprises increases in social security contribution rates mandated by the pay-as-you-go system, in effect representing a temporary and procyclical increase in labor income taxation that harms employment, and other tax increases. A small adjustment ¼ percent) in Italy reflects in part tax amnesties that risk weakening future tax compliance. Net of one-off measures, the structural balance is projected to remain unchanged. In France, no adjustment is foreseen. Both Germany and France are expected to remain in breach of the 3 percent limit during 2003 and in 2004.

31. The immediate issue confronting the SGP is how to deal with the series of breaches of the 3 percent deficit ceiling in an environment of weak growth. The pact requires that, under normal circumstances, excessive deficits be corrected no later than the year following their identification. In practice this means deficits cannot exceed the ceiling for more than two years before risking sanctions. The SGP also foresees the possibility of “special circumstances”, in particular unusually weak growth, in assessing a country’s progress in correcting excessive deficits.

32. The Commission emphasized the moral hazard and credibility risks for the area’s fiscal framework were the 3 percent reference value not to be respected rigorously. While sensitive to the weak growth conditions prevailing in the area, the Commission, based on its Spring 2003 forecasts, took a cautious view as to whether Germany would qualify for the special circumstance exemption that would allow the deadline for correcting the excessive deficit position to be extended. This assessment was based on estimates of current and prospective output gaps made using the commonly agreed methodologies between the Commission and member states. The Commission noted that the rules under the pact for correcting breaches “quickly” were clear. Relaxing agreed-to rules when they became binding could only increase the moral hazard in the system and damage credibility. The 3 percent deficit ceiling was necessary for encouraging countries to move toward appropriate medium-term balances, the other pillar of the pact, and softening it would run counter to such an objective. If persistent deviations were looked on benignly, especially ex ante, this would reduce the peer pressure for other countries to adjust. The Commission fully supports the focus on cyclically-adjusted—rather than nominal—balances in monitoring fiscal performance, and its proposals to this effect were endorsed by the Council earlier this year. It argued, however, that given the controversies surrounding practical estimation, a nominal anchor was also necessary, and would be needed in any workable multilateral fiscal framework.

33. While sympathetic to these arguments, the staff favors an approach that places a larger premium on the durable achievement of long-run goals. The staff argued at the time of last year’s consultation for balancing longer-run and cyclical considerations by requiring that countries with weak underlying positions take (ex ante) discretionary fiscal policy actions ensuring a sustained improvement of their structural balances by at least ½ a percent of GDP a year, but allowing (ex post) automatic fiscal stabilizers to play freely around the consolidation path. It has since argued that the same standard be applied even in the event of successive breaches, i.e., conditional on a minimum standard of ex ante consolidation measures, the stabilizers should be allowed free play even if this implies successive breaches of the 3 percent ceiling. The staff noted that over the last year it had become evident that the quality, durability, and evenness of fiscal adjustment efforts across countries left much to be desired. This experience suggests that for countries in a position to do so, credible and meaningful gains on the long-run structural and sustainability fronts would be worth trading off for delays in consolidation efforts to meet the SGP’s medium-term norms. But short-run flexibility requires long-run credibility, and such delays could only be part of a politically credible longer-term structural-cum-fiscal process of stabilization and reform. Thus, underlying fiscal adjustment of at least ½ percent of GDP a year should remain the standard. Any delay in the pace of consolidation in 2004 needs to be compensated for by credible commitments to meet this standard on a cumulative basis, i.e. at least 1½ percent of GDP during 2004-06. Moreover, the overall pace of underlying fiscal adjustment may fall short of the standard in 2004 only if budgets include well-specified quality longer-term measures that add up to gross savings of at least ½ percent of GDP such as through quality expenditure adjustments.

34. Looking to 2004 and beyond, there was agreement it is necessary for budgets to look hard at making progress toward achieving longer-term goals, aiming for higher quality, multiyear consolidation efforts which strengthen incentive systems and thereby alleviate the underlying unsustainability. While there is broad agreement on both the long-run structural and macroeconomic requirements of fiscal policies in the area, progress in the three large countries has been limited. Progress is necessary both to strengthen the area’s long-term potential and to enhance credibility (and hence mitigate the demand implications) of consolidation efforts. There is a need to impose a higher standard on the composition of adjustments than has been the case recently. Specifically, there is a need to eschew tax increases or recourse to one-off measures in favor of multiyear actions to curb current spending, especially on transfers and public sector employment.

35. While there is wide agreement that a monetary union requires a fiscal framework, it remains controversial whether the SGP is the right framework. In light of breaches of the parameters, recent controversy has focused in particular on:

  • Are annual nominal flow deficit limits necessary? It is generally accepted that markets discriminate insufficiently among members to provide the necessary discipline. Hence, the need for rules that prevent negative externalities in the form of higher required interest rates for all members in a monetary union from fiscal unsustainability in one member is widely accepted. Many argue, however, that a framework based more directly on the “fundamentals” of fiscal sustainability—on monitoring debt levels and contingent liabilities—would be both forward-looking and sufficient, obviating the need for flow constraints. The counterarguments are that just as markets discriminate insufficiently amongst countries they do so insufficiently early enough to discipline errant fiscal behavior on the part of one, thereby ultimately punishing all when they do react. Further, market imperfections imply that “flows”, i.e., new supplies of debt, do matter in that increasing flow deficits impact yields even when sustainability is not in question. From a political economy perspective, flow constraints are viewed as mechanisms to compensate for the failure of the political system to induce forward-looking policy adjustments during upswings. With the system otherwise tending to be asymmetrically pro-cyclical in upswings, flow constraints are devices to prevent the deficit from ratcheting (too far) off course over the cycle. Unfortunately if unavoidably (given the premise), this is achieved by imparting a correspondingly procyclical adjustment in downswings, making the output path more volatile.


EMU sovereign spreads are significantly more compressed than other asset classes

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

  • Is 3 percent too tight? There are three broad points here. First, some countries’ underlying fiscal positions are inherently more sustainable (low debt and contingent liabilities) and the SGP could be viewed as unduly constraining for these countries.10 The Commission has acknowledged the need to incorporate the sustainability of public finances more systematically into the assessment of countries’ budget positions. Second, however, this debate is irrelevant for the current breaches. Addressing the fiscal implications of the aging of the population requires the 3 large countries to move at least to underlying balance. If they did so, and indeed had already done so, the 3 percent limit would likely not be breached except in extreme circumstances that would clearly quality for special circumstances. Third, there are a number of arguments for why the flow limit chosen for EMU should be “conservative”. A feature of the euro area, compared for example to the United States, is lower prospective potential growth rates of output and, therefore, a lower present value of tax revenues, the primary asset of the government. Since the intent is to limit negative externalities from any one member, it is also the case that in a monetary union with varying initial debt levels and historical proclivities for fiscal imprudence and, therefore, different degrees of fiscal credibility, the flow deficit limit needs to be set at a low enough prudential limit.

C. Strengthening Medium-Term Prospects: Structural Policies and Pension Reform

36. While the key imperatives of the structural reform agenda are well understood and agreed, the problem has been implementation at the national level, especially in good times. The Lisbon agenda agreed by the European Council in 2000, and its translations into specific targets by subsequent Councils, represent comprehensive goals for tapping into the area’s spare potential and improving its resilience to adverse economic shocks. Despite progress in some areas, the overall record of implementation has been disappointing. Over the last 20 years, solid gains have been made in making product markets competitive, while labor market indicators suggest overall a deterioration. Staff and the authorities concurred that while past reforms had led to improvements in employment in particular, the pace of reform has slackened. Reforms at the national level have generally fared worse than area-wide initiatives spurred by Community directives.


Euro Area: end-1990s vs. end-1970s

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Source: OECD.Structural indicators are normalized to 1 at end-1970s.(Values inside the diamond indicate improvements.)

37. Labor markets have been the Achilles heel of structural reforms. Reforms in the mid-to late-1990s drew in lower-skilled and part time workers, with “jobs-rich” growth reabsorbing labor after a long decline. However, several years of relative inaction followed and, at 64 percent, the current employment rate remains well below the Lisbon target of 70 percent. On increasing labor supply, while some progress has been made in adapting tax and benefit systems to “make work pay” and encourage the search for jobs, measures have generally been piecemeal, focusing on the tax side rather than addressing generous out-of-work benefits. Similarly, the call to raise the effective retirement age by 5 years by 2010 has yet to be followed up by comprehensive active aging policies, including reforms of pension and early retirement schemes. On the demand side, comprehensive reforms of EPLs have yet to move on to the agenda in most countries.


Euro Area vs. U.S.: end-1990s

Citation: IMF Staff Country Reports 2003, 297; 10.5089/9781451812893.002.A001

Source: OECD.Structural indicators are normalized to 1 for euro area.(Values inside the diamond indicate improvement.)

38. Contrary to expectations, the advent of EMU failed to provide an impetus to the pace of labor market reforms. This partly reflected global boom conditions in the early years of EMU, which masked the need to address structural weaknesses, while the political calendar in a number of large countries delayed confronting realities at the onset of the downturn. In emphasizing the disparity of situations across countries, the Commission noted three types of experiences that impacted the incentives and timing of reforms:

  • Labor market reforms seemed easier to implement when they were part of a broad agenda of economic reform whose benefits were clearly perceived—as was the case during the convergence process necessary to qualify for EMU membership.

  • For small open economies the loss of the exchange rate as a potential adjustment mechanism had greater costs than for the larger more closed economies, increasing the former’s incentives for establishing more flexible labor markets.

  • Recent events in Germany have reaffirmed that situations of persistent unsatisfactory performance—high and rising unemployment, unsustainable social security systems, and constrained potential growth—made the need for reform slowly self-evident to all social partners.

39. There was strong agreement that increased divergences in performance across the area recently and the imminent aging of the population made structural reforms in the labor market urgent.

  • Adjustments to asymmetric shocks within a currency union require a high degree of flexibility in goods and labor markets to compensate for the loss of the exchange rate as an adjustment mechanism. Indeed, limited cross-border labor mobility in the euro area imposes a higher requirement of flexibility than would otherwise be the case.

  • Long lags in affecting increases in participation rates requires early concerted actions to slow—if not reverse—the aging-induced slowing in potential, per capita growth, and deteriorations in public finances.

Euro Area: Potential Output Growth and Labor Utilization, 2000-2020

article image
Source: Staff estimates.

Gradual increase of employment rate from 64 percent in 2003 to 70 percent in 2020.

Gradual increase in employment rate plus gradual increase in annual working hours by 10 percent during 2004-2020 (reversing about half of the decline in hours since 1970).

40. In product markets, following major advances in the early years of the internal market, progress has slowed. Competition remains insufficient in a number of sectors, particularly in certain services. Progress in eliminating remaining barriers to cross-border trade continues to be hampered by obstacles to liberalizing the internal market for services, where differences in standards and regulations limit cross-border retailing and sales.

41. There has been encouraging progress in creating a single market for financial services. Concentrated in wholesale money and capital markets, this has provided a boost to market financing, providing a welcome counterbalance to the predominance of bank financing. Increased competition from integration should reduce the cost of capital and boost investment, while increased diversification opportunities within the union for investors should encourage savings. The momentum built up last year with agreement on the Lamfalussy process for speeding up the implementation of the Financial Services Action Plan (FSAP) in securities markets, is being followed up by its extension to the banking and insurance sectors, where integration has been slow. This momentum will need to be maintained to secure full implementation of the FSAP by the 2005 deadline. Progress in implementing the Risk Capital Action Plan (RCAP) has continued, but needs to be stepped up. Several initiatives have been launched to identify ways to reduce barriers to cross-border clearing and settlement, which remain a source of inefficiency. On the financial supervision front, several countries took steps to consolidate supervision across sectors, and a key Memorandum of Understanding between banking supervisory authorities and central banks on a set of principles for cooperation in relation to potential or actual crises with possible cross-border effects was signed.

42. While increasing integration raises the demand for public goods at the community level (infrastructure, education, and research), effective mechanisms for providing and financing these public goods will need to be developed. The present Italian presidency of the EU has launched an initiative to increase EU spending on public infrastructure by 0.5-1.0 percent of GDP, with extrabudgetary financing involving the European Investment Bank (EIB). The Council welcomed this Italian presidency priority and took note of the Commission’s intention to launch an initiative in cooperation with the EIB to support growth and integration by increasing overall investment and private sector involvement in Trans European Networks (TENs) and major R&D projects. A number of priority projects have already been identified. There seems to be general agreement that projects need to be subjected to sober cost-benefit analysis, but the details of implementation remain vague at this stage. Responsibilities for servicing contingent budgetary and extrabudgetary liabilities that would accumulate through this initiative will need to be assigned in a transparent manner.

43. A number of developments point to the increasing seriousness attaching to effecting reforms at the national level. The recent reform discussions in the larger countries, especially on labor markets and public pensions, are especially welcome. Staff also welcomed the recent shift in emphasis in surveillance at the area-wide level from the formulation of targets to implementation, evident in the streamlining and medium-term focus of the most recent Broad Economic Policy Guidelines to make them more effective11, in efforts to increase peer pressure through “naming and shaming”, and in the establishment of a European Employment Task Force charged with identifying practical reforms with the most direct and immediate impact. There was strong agreement on the potential synergies between structural reforms, improved economic performance, and fiscal sustainability. An increase in the effective retirement age, for example, would raise labor supply and growth, and reduce pressures on the public pension system.

44. The particular challenge of putting pension systems on a sound longer-term footing illustrates both the urgency of, and synergies from, structural reforms. Aging populations will constrain contributions while boosting entitlement expenditures, and create a growing imbalance in public pension systems12. “Parametric” reforms are clearly necessary, but they are not sufficient. Projections suggest, for example, that if pension incomes are maintained at their 2000 level, social security contribution rates would have to rise from their current level of 16 percent to 27 percent by 2050, creating serious disincentives for labor supply and increasing structural unemployment. The extent to which cutbacks in benefits will need to be made hinges on the extent to which they can be balanced by increasing the incentives for retiring later, broader-based labor market reforms that boost potential growth, and by reducing public debt in advance of the aging shock.

45. The staff pressed the cases for developing significant private pension pillars to complement smaller public pension pillars, and for improving public understanding of the imminent risks to public pension finances. Besides the arguments for a partially funded system in reducing contingent liabilities, increasing savings and hence potentially investment and longer-term growth, staff noted that older voters will form an electoral majority in most countries at a time when cuts in pension benefits are still being phased in, calling the time-consistency of policies and fiscal sustainability into question. Given the long implementation lags of pension reforms, time for action is running out fast. The staff noted that a key ingredient for successful pension reforms appeared to be a better public understanding of the risks to pension finances. The publication of regular reports on the longer-term outlook of public pension finances by independent and credible national agencies with no direct interest in reform outcomes could, therefore, play a catalytic role.

D. Trade Policy

46. Progress on the Doha Development Agenda is urgent. The staff noted that failure at the forthcoming WTO Ministerial Meeting at Cancún would foster regionalism and exacerbate trade disputes, sending an unwelcome signal at a time of fragility in the world economy. Moreover, the EU has a central role in ensuring a successful outcome, given its pivotal position in resolving differences over agriculture. While the Commission acknowledged its role, it underlined the need for parallel progress in other areas, including initiating negotiations on WTO frameworks for investment, competition, government procurement, and trade facilitation, all areas where agreements would yield significant benefits for developing countries.

47. The recently agreed internal reforms to the Common Agricultural Policy (CAP) fall short of fully correcting trade distortions. The partial decoupling of subsidies from production levels—to take effect in 2005—is a central feature of the reforms and will help counter tendencies for excess production.13 However, significant exceptions to decoupling would remain for cereals and meat production. Reforms in a number of important sectors, including sugar and Mediterranean products, remain to be decided. While welcoming the reforms as a step in the right direction, staff emphasized that they fell short of the measures needed to level the playing field in world trade. Crucially, the CAP reforms were silent on market access, which is of particular interest to developing country farmers, and the EU’s WTO proposal to cut peak tariffs by a minimum of 15 percent lacks ambition.

48. The Commission underlined the need to safeguard the interests of the poorest countries, most of whom enjoy preferential access to the EU market. MFN liberalization would erode preferences and expose these countries to excessive competition. Given important externalities in agriculture, market forces could not be relied upon to reach development goals. Nevertheless, the authorities agreed that this did not justify lasting resistance to trade liberalization but called for careful design of, and assistance in, the transition process and beyond. The staff noted that further changes to the CAP would become more difficult after enlargement in 2004.

49. EU enlargement will provide further impetus to trade integration, while trade diversion should be limited.14 Intra-industry trade has the greatest potential for growth within the enlarged EU, and would carry only moderate adjustment costs, but a certain amount of sectoral dislocation could nevertheless be expected for the poorer accession countries. The staff noted that in certain sectors, market access to the enlarged EU, especially from CIS countries, might become more difficult as a result of EU trade remedy actions and restrictions in agriculture not currently maintained by the new members. The Commission argued that third countries would generally benefit since tariffs in the new members would on the whole come down while growth would rise, and noted that an initiative had been launched to minimize any negative fallout in the EU’s new neighbors.

IV. Staff Appraisal

50. Developments during the first five years of EMU have been more challenging than expected. The global equity market boom-bust cycle has tested the mettle and foresight of policies on all fronts: monetary through an unexpectedly persistent upward drift in inflation; fiscal through a boom-bust cycle in revenues that has exposed earlier lapses in policies; and structural reforms, which moved off the agenda with the passing of the exchange rate constraint and the advent for a while of better times. These problems have been compounded by the unexpected economic weakness of the largest member of the union. The end result has been a rather disappointing performance. Looking forward, the challenges seem set to continue, with the demo graphic ally-induced slowing of labor force growth and aging of the population becoming an increasing drag on potential output growth, fiscal sustainability and old-age income security.

51. Meeting these challenges successfully requires a sustained and systematic shift toward more forward-looking approaches to the formulation and implementation of national policies. A history, particularly in the larger countries, of slighting fiscal and structural fundamentals in good times has left the union poorly poised to deal with adverse ones. While adversity has begun to induce more forward-looking policies, notably on the structural side, the deeper issue is whether these potentially promising steps will be sustained once present difficulties recede—that is, whether they are products of adversity or products of a deeper realization of the need for sustained adjustment. This uncertainty must be dispelled if trend growth is not to disappoint or policies not to find themselves in the same situation a few years hence.

52. Near-term prospects of recovery remain uncertain. The recent weakness has reflected a number of shocks: the bursting equity bubble; reduced external demand; the correction of the euro to longer-run equilibrium levels; and geopolitical uncertainties. But the dynamics of adjustment to these shocks have been impacted by structural features of the area: rigidities in labor markets and a lesser reliance on market-based financing have contained the effects of past shocks, but also slowed both the post-bubble and intra-area adjustments. It is unclear how far along these various adjustment processes are. Consequently, the near-term baseline sees the prevailing area-wide stagnation being overcome only gradually, with growth remaining sub par well into next year. Moreover, in the absence of clear evidence of recovery, the risks as regards the timing of the pickup must be viewed as on the downside.

53. Monetary policy has done well and established its credibility. Policies have been apposite to the times, and the monetary framework has been appropriately adapted to the changes in circumstances that have occurred over the past 5 years. The ECB’s clarification of its inflation objective as “below but close to 2 percent” substantially reduces the scope for misinterpreting its objective and provides a clear anchor for longer-run inflationary expectations. Such inflation outcomes over the medium term provide a buffer against shocks that could lead to area-wide deflation and provide scope for inflation differentials across countries. The echeloning of the two pillars was also right.

54. Looking forward, the ECB needs to guard against downside risks to inflation. Although persistent, inflation has turned. The cumulative effects of weakness in activity, the appreciation of the euro, a continued softening of labor markets, and the fall in oil prices should combine to push headline and core inflation below 1½ percent by late next year. The risk of undershooting the inflation objective of close to 2 percent are greater than the reverse. With low inflation not helping balance sheet adjustments and providing less room for relative price adjustments, the costs of doing so are also greater, strengthening the case for an easy monetary policy going forward. The ECB should signal and maintain an “accommodative bent”—a sustained easing bias—to support confidence until a self-sustaining upturn in domestic demand, especially of corporate spending is in place.

55. Fiscal policies have fared less well: having failed to move toward long-run goals in good times, they have run up against prudential limits, resulting in unsatisfactory tradeoffs of long- for short-run goals. While the fiscal framework has worked well for many countries, it has not for the three largest. In particular, the framework has not been able to induce these three countries to pursue meaningfully forward-looking policies, both in the boom and the bust phases. Most policies have had a short-term focus, whether in conformity with the framework or otherwise. Actions that were deemed forward-looking—tax cuts—turned out to be wishful as the boom turned to bust. The consequent need for consolidation efforts in an environment of weakness has hurt confidence. Moreover, in some cases these efforts have—by raising taxes—run counter to long-run structural goals. In other cases—through cyclical social security increases, tax amnesties, or expenditure freezes—they have been at best immaterial and sometimes harmful for achieving durable long-term consolidation, with little beneficial effects for confidence.

56. EMU requires a fiscal framework, and from a longer-term standpoint the basic parameters of the SGP seem broadly appropriate. To preempt the possibility of negative externalities for all from the errant fiscal behavior of one, a fiscal framework for the monetary union is essential. The current focus of controversies around the 3 percent limit is misplaced. The aging of the population requires the 3 large countries move at least toward underlying balance over the medium term. If they did so, and indeed if they had already done so, the 3 percent limit would not be breached except in extreme circumstances, which the pact allows for.

57. Fiscal policies thus need to become more forward-looking, an avenue that could create room for greater short-run flexibility. The SGP should indeed focus on growth as well as stability, but growth means first and foremost structural reforms rather than short-term demand management. Within such an optic, however, there is scope to trade short-run consolidation for credible multi-year commitments to growth- and consolidation-oriented structural reforms. The staff continues to subscribe to the standard that countries with weak underlying positions take (ex ante) discretionary fiscal policy actions to achieve a ½ a percent of GDP a year of structural consolidation measures. Delays that provide meaningful gains on the long-run structural and macro economic fronts must meet the standard on a cumulative basis, i.e., 1½ percent during 2004-06. Budgets in 2004 need to look hard at achieving longer-term goals, eschewing tax increases or one-off measures in favor of multiyear actions to curb current spending, especially on transfers and public sector employment, thereby fostering sustainability and creating the room for necessary tax cuts over time.

58. EMU also requires a more sustained and forward-looking approach to structural reforms. The evidence is both that the task, and the opportunity cost of inaction (fiscal unsustainability, much lower potential growth), is very large and that the pay off is considerable. The area’s low underlying growth reflects in large part low population growth, but there is considerable scope for raising rates of utilization of existing labor resources. Long lags in affecting the incentives for work and increases in labor force participation, effective retirement, and structural unemployment rates, requires early concerted actions to slow—if not reverse—the aging-induced fall off in potential per capita growth and deteriorations in public finances. The loss of the exchange rate as an adjustment mechanism within a monetary union, particularly one with limited labor mobility, imposes a further requirement on flexibility in goods and labor markets.

59. In some countries, promising reform steps have recently been taken, but many more are needed. The reform process in the larger countries, particularly as regards labor markets and social security systems, has been revived and, in some cases, progressed beyond earlier expectations. It reflects a growing political consensus in these countries that longstanding institutional arrangements in labor markets and social security systems have become a burden on growth. Moreover, there is a growing recognition of the largely unexploited synergies to be reaped between structural reforms, improved economic performance, and fiscal sustainability that hold the promise of improving medium term growth prospects and restoring the credibility of the SGP. However, the agenda of needed reforms is long, varied, and different. Moreover, resistance to reform has a long tradition, remains strong, and is likely to strengthen as the economic situation improves. It is essential that the new reform élan not become simply a response to economic adversity but be sustained for many years to come. The steps taken by the Commission, and endorsed by ECOFIN, to toughen surveillance by making the Broad Economic Policy Guidelines both more targeted and forward-looking are highly welcome.

60. The recent decision to reform the Common Agricultural Policy is welcome, but achieving the Doha round objectives will require greater commitment to opening EU markets. While falling short of the Commission’s proposals, the agreed “decoupling” of agricultural supports from production will lessen downward pressures on world prices. It also widens the Commission’s negotiating margin at the WTO and may thus help to re-energize the Doha round. Yet, creating a multilateral trade environment supportive of economic development and poverty reduction would require the EU to set far more ambitious targets for tackling tariff peaks and escalation. Risks that generalized improvements in market access would hurt preferential suppliers are easily overstated and call for targeted support to facilitate adjustment, but cannot justify lasting protection. The EU’s regional strategy for the ACP countries (based on Economic Partnership Agreements) can be a valuable tool in this regard to the extent that it helps to strengthen supply capacity and promote the diversification of exports.

61. Area-wide statistics are adequate for surveillance purposes, but further improvements are desirable to meet or exceed existing best practice. There is scope for improving the timeliness of quarterly national accounts data as well as the quality of labor market and short-term business cycle statistics. The recent publication of annual flow-of-funds data for the area as a whole is welcome, but the provision of more up-to-date and quarterly data would be useful given the increasing importance of asset price cycles in shaping the macroeconomic policy environment. The planned publication of quarterly general government data is essential for monitoring short-term performance under the SGP and should remain a priority.

62. It is proposed that the next consultation on Euro Area Policies in the context of the Article IV obligations of member countries follow the standard 12-month cycle.

Table 2.

Euro Area: General Government Fiscal Balances and Debt

(Percent of GDP)

article image
Source: WEO, July 2003.


Percent of potential GDP. Excludes one-off receipts from the sale of mobile telephone licenses (the equivalent of 2.5 percent of GDP in 2000 for Germany, 0.1 percent of GDP in 2001 and 2002 for France, 1.2 percent of GDP in 2000 for Italy). Also excludes one-off receipts from sizable asset transactions.

Percent of potential GDP.

Table 3.

Euro Area: Balance of Payments

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Source: ECB; Datastream.

End of period stocks.


Including the trade policies of the European Union.


See “Corporate Balance Sheet Restructuring in the Euro Area” (in SM/03/38).


For a discussion of exchange rate pass-through in the euro area, see the accompanying Selected Issues paper.


See “Prosperity and Depression”, 2002 Richard T. Ely Lecture by Edward C. Prescott.


See Selected Issues paper “Is Inflation Persistence Higher in the Euro Area than in the United States?”.


See Selected Issues paper “Euro Area Business Cycles: The Role of Supply and Demand Disturbances”.


See the 2002 Staff Report (SM/02/203), and the accompanying Selected Issues (SM/02/311), in particular, “The Eurosystem’s Definition of Price Stability” and “The ECB’s Policy Strategy: An Assessment of the Role of the Money Pillar”.


A staff paper on the macroeconomic dimensions of euro entry is under preparation.


See “Characteristics and Effects of Fiscal Consolidations in the EU: Evidence from Cross country Analysis”, Public Finances in EMU, European Commission, 2003.


See last year’s Staff Report (SM/02/203).


See Broad Economic Policy Guidelines, European Commission, 2003.


See Selected Issues paper “Aging and the SGP”.


The staff’s analysis of the impact of CAP reforms, “Reshaping the CAP: The Midterm Review Proposals”, is presented in SM/03/38.


See the accompanying Selected Issues paper “EU Eastern Enlargement: Impact on Trade and FDI”.

Euro Area Policies
Author: International Monetary Fund