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.

On September 10, the Executive Board of the International Monetary Fund (IMF) concluded the discussion of euro area policies and the trade policies of the European Union. The background section of this PIN reflects information available at the time of the Executive Board meeting.1


A lackluster recovery during the first half of 2002 lost momentum, giving way to virtual stagnation during the first half of 2003. Since the global equity bubble burst, corporate balance sheets have been on the mend but there remain uncertainties about whether adjustments have run their full course. Indications are that labor market adjustment is ongoing, and unemployment has continued to edge up since last year. At the same time, recent indicators on recovery prospects have been encouraging, with area-wide business sentiment picking up in both the manufacturing and the service sectors.

Inflation has proven unexpectedly persistent, but has turned. While headline rates were buffeted by movements in oil prices, core inflation decelerated from 2¾ 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. Concerns a year ago that the inflation overshoot would lead to extended second round wage effects appear to have been averted. Indications are that the upward drift in wage increases since 1998 has come to a halt, and unit labor cost growth has eased.

Financial conditions in the area have improved along with those in global markets, though financial fragilities may be impairing the transmission to corporates. Equity prices continued to tumble through March of this year but have since then picked up significantly. Money market and government bond yields remain at low levels. The past appreciation of the euro, welcome from a multilateral medium-term perspective, is detracting from the area’s near-term prospects. Since January 2002, the euro has risen by around 25 percent against the dollar and 15 percent in real effective terms, with most measures of the latter at about their long run averages.

Monetary policy has continued to ease, with the ECB cutting its main refinancing rate by 75 basis points to 2 percent during the first half of 2003. Policy rates over the last few years have been in line with, and generally lower than, what standard Taylor rule yardsticks would imply. Fiscal policies in the area have been constrained by past lapses. 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. From a short-term perspective, policies allowed full play to the automatic stabilizers, and consequently Germany and France joined Portugal in breaching the SGP’s 3 percent deficit limit in 2002, while Italy avoided doing so only through various one-off operations.

The present cyclical situation is also influenced by longer-term forces which continue to shape the outlook. First, long-standing divergences in growth and inflation within the euro area persist, most notably between Germany and the other members, the latter in part reflecting the lingering effects of German unification. Second, the impulse from structural reforms, particularly in labor markets, ebbed as pressures for reform receded during the upswing and following the introduction of the euro. Finally, the euro area faces a sizeable demographic shock implying substantial declines in the working-age population. The aging of the population could entail significant declines in potential output growth and lower expected lifetime income resources, which in turn could impact adversely on the sustainability of public finances and old-age income security.

Against this background, the staff’s broadly shared short-term baseline forecast sees the prevailing area-wide stagnation being overcome gradually, with growth remaining sub par well into next year. Overall, the staff expects real GDP growth of ½ percent this year, before picking up to about 2 percent next year. 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. 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. 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. Downside risks to this baseline forecast relate mainly to continued corporate balance sheet adjustments, the risks of a faltering U.S. recovery, and the potential for euro overshooting. The staff’s forecast for HICP inflation 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 reduce headline and core inflation to about 1½ percent next year and for price pressures remaining low in the coming years.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They noted that recent developments in the euro area have presented euro area authorities with many policy challenges. In particular, economic growth has come to a virtual standstill since the last quarter of 2002, with declining net exports and investment, and unemployment is beginning to rise. Moreover, challenges loom ahead, with the demographically-induced slowing of labor force growth and ageing of the population becoming an increasing drag on potential output growth, fiscal sustainability and old-age income security. EU enlargement, while surely of benefit to all concerned, would also be a source of new challenges. Directors were of the view that meeting these challenges successfully will require a sustained shift toward more forward-looking national policies and the vigorous implementation of structural reforms. While adversity had begun to induce such forward-looking policies, notably on the structural side, it is essential that these potentially promising steps be sustained once present difficulties recede.

Directors considered that the recent weakness of area-wide activity reflected a number of shocks as well as structural rigidities and policy lapses. The shocks include the bursting equity bubble, low business and consumer confidence, reduced external demand, the correction of the euro to longer-run equilibrium levels, and geopolitical uncertainties. Rigidities in labor markets and lesser reliance on market-based financing have in some measure contained the effects of the shocks, but they have also slowed both the post-bubble and intra-area adjustments. As a result, the area-wide stagnation is expected to be overcome only gradually, with growth remaining sub-par well into next year. Directors were encouraged, however, by recent improvements in survey and confidence indicators, which signal a gradual pick-up in growth during the second half of 2003. They saw the risks to the outlook as having become more balanced.

Despite the possible implications of the recent appreciation of the euro for the area’s short-term prospects, Directors viewed the appreciation as beneficial on balance, noting that it has helped curb inflation and that the competitiveness of the euro area is back to its long-term average. Most Directors agreed that the euro area has borne a disproportionately large share of the burden of adjustment to a weaker dollar, and called for a more equitable global distribution of any further adjustment burden to reduce imbalances in the global economy and to achieve balanced growth in the major currency areas.

Directors felt that monetary policy has done well and has established its credibility. Policies have been in line with inflation and output developments, and the monetary framework has been appropriately modified based on the experience over the past five years. In particular, the ECB’s clarification of its inflation objective as being “below but close to 2 percent” substantially reduces the scope for misinterpreting its objective and provides a clear anchor for longer-run inflationary expectations. Most Directors noted that aiming for such inflation outcomes over the medium term provides scope for inflation differentials across member countries and a buffer against shocks that could lead to area-wide deflation. Directors also welcomed the clarification of the relative roles of long-term monetary analysis and short-term economic analysis in the ECB’s anti-inflation strategy. A few Directors felt, however, that the inflation objective is too tight, and that it may be difficult to accommodate high and persistent inflation differentials across countries.

Looking forward, Directors agreed that the ECB needs to guard against downside risks to inflation, noting that inflation pressures have subsided. While the downside risks have become somewhat more balanced recently with the pull-back in the euro, the cumulative effects of weakness in activity, a continued softening of labor markets, and the significant past appreciation of the euro should combine to push headline inflation well below 2 percent by late next year. Directors saw the costs of undershooting the inflation objective as greater than those of overshooting it. Low inflation would not help balance sheet adjustments, and would provide less room for, and hence increase the costs of, relative price adjustments across the area. This, together with the risk of euro appreciation, strengthens the case for monetary policy to maintain an accommodative bent in order to support confidence until a self-sustaining upturn in domestic demand is in place.

Directors stressed the need for forward-looking fiscal policies to improve the quality and ensure the long-term sustainability of the public finances in light of potential fiscal pressures created by population ageing. In this regard, they noted that fiscal developments have not been positive, particularly in the three largest economies where most policies have had a short-term focus and fiscal excesses during the boom years contributed to current difficulties in observing the nominal deficit ceiling. Directors agreed that these developments underline the need for a fiscal framework in EMU. Directors felt that from a longer-term standpoint the basic parameters of the EU Treaty and Stability and Growth Pact (SGP) are broadly appropriate. Noting the current focus on breaches of the 3 percent deficit limit, Directors stressed that past lapses in fiscal discipline, and not the fiscal framework itself, have been responsible for the limited amount of fiscal leeway in the three largest euro area economies. The ageing of the population requires that most euro-area countries move at least toward underlying balance over the medium term. If they did so, there would be room for the automatic stabilizers to work, and the 3 percent limit would not be binding aside from exceptional circumstances, which the pact allows for.

Directors noted the potential conflict between the short-term need for fiscal stimulus to boost economic growth and the need for fiscal consolidation to restore the credibility of the SGP and to achieve fiscal sustainability. However, they believed that more forward-looking fiscal policies could provide a bridge to long-term sustainability while permitting greater short-run flexibility. They agreed that the SGP should indeed focus on growth as well as stability, but that growth means first and foremost structural reforms rather than short-term demand management. Within such a framework, most Directors acknowledged that there is scope to trade short-run fiscal consolidation for credible multi-year commitments to growth- and consolidation-oriented structural reforms, notably by cutting spending and increasing incentives rather than raising taxes. Although it was recognized that this entails credibility risks for the SGP insofar as it implies further breaches of the 3 percent deficit limit, Directors agreed that the standard remains that countries with weak underlying positions should take discretionary fiscal policy actions to achieve underlying high-quality fiscal adjustments of 0.5 percent of GDP a year. Many Directors agreed with the view, however, that, where underpinned by meaningful gains on the long-run structural and macroeconomic fronts, delays that meet the standard on a cumulative basis, i.e., 1.5 percent of GDP during 2004-06, would also strike an appropriate balance between long-and short-run goals. A number of Directors, though, cautioned against departures from commitments to achieve a steady underlying fiscal adjustment of 0.5 percent of GDP a year.

Directors called for more sustained and vigorous implementation of structural reforms. They noted that while the area’s low underlying growth reflects in large part low population growth, there is considerable scope for raising rates of utilization of labor resources and for increasing rates of technological progress and innovation. Long lags in effecting increases in labor force participation rates require early concerted actions to slow—if not reverse—the ageing-induced fall-off in potential per capita growth and deterioration in public finances. In this context, Directors emphasized the importance of labor market and pensions reform. The loss of the exchange rate as an adjustment mechanism within the monetary union, particularly in the context of limited labor mobility, imposes a further requirement on flexibility in goods and labor markets.

Directors welcomed the promising reform steps recently taken in some countries, but emphasized that much more is needed to achieve the goals set out in the Lisbon agenda agreed by the European Council in 2000. Directors were particularly encouraged by progress in creating a single market for financial services. Moreover, 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. Directors also observed that 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 and varies across countries, while resistance to reform remains strong and is likely to strengthen as the economic situation improves. Directors considered it essential that the new reform momentum not become simply a response to economic adversity but be sustained for many years to come. Directors, therefore, welcomed 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.

Directors welcomed the recent decision to reform the Common Agricultural Policy. The agreed “decoupling” of agricultural supports from production will lessen downward pressures on world prices. Many Directors noted that greater commitment to opening EU markets will be crucial to achieving the Doha round objectives, and that creating a multilateral trade environment supportive of economic development and poverty reduction would require more concessions by the EU and other advanced economies to developing countries.

It is expected that the next consultation on Euro Area Policies will be held on the standard 12-month cycle.

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF’s assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

Euro Area: Selected Economic Indicators

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Sources: IMF staff and European Central Bank.

Staff projections; WEO, September 2003.

Harmonized definition.

In percent of labor force.

June 2003.

Calculated as the sum of individual euro-area countries.

Total reserves minus gold (Eurosystem definition).

For 2003, average January-August relative to 2002 average.


Under Article IV of the IMF’s Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country’s economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country’s authorities. The ECB’s observer at the Fund participated in that meeting.

Euro Area Policies
Author: International Monetary Fund