10 years of Economic and Monetary Union (EMU)

The euro-area authorities welcome the staff’s positive assessment of the first 10 years of EMU. The stability–orientated macroeconomic framework has helped to maintain stability during turbulent times. The disappearance of intra–euro–area exchange rate risk and lower cross–border transaction costs have helped further develop the Single Market and integrate product markets. The single currency has also acted as a powerful catalyst for financial market integration. Over the 10 years of its existence, the euro has firmly established itself as second most important international reserve and investment currency.

The euro-area authorities share the view that monetary union has been a success and that the numerous achievements that have been made over the past 10 years should not veil the fact that some economic developments, notably overall output and productivity growth, defied expectations. Economic union is not yet fully delivering. The euro–area authorities concur with the staff in this regard and clearly see the need to further pursue structural reforms and to address economic divergences in the euro area. In the reports on “EMU@10: successes and challenges after 10 years of Economic and Monetary Union” and on the “10th anniversary of the ECB” the European Commission (Commission) and the European Central Bank (ECB) respectively take stock of the past decade and look at the challenges ahead. Following the Commission’s communication the Council of Economics and Finance Ministers (ECOFIN) and the Eurogroup are currently reflecting on practical measures to improve economic policies and the functioning of EMU.

Short–term economic outlook

The global economy is cooling down markedly. So far, the slowdown in the euro area has remained relatively modest as improved fundamentals, sound budgetary positions in most Member States and past structural reforms have helped weather the strong global headwinds to a large extent. Indeed, economic growth in the first quarter surprised on the upside. However, there are divergences across Member States, reflecting, among other things, their exposure to the financial markets turmoil, external deficits as well as the ongoing corrections of housing markets. Nevertheless, as the strong first quarter was partly driven by temporary factors, a considerable moderation can be expected in the second quarter.

Survey indicators show a continued marked deterioration in economic sentiment since the peak last summer. While industrial confidence is currently still slightly above its long–term average, services and consumer confidence are already below. Also, negative news continues to flow from commodity and financial markets which could affect economic activity in a more pronounced way then expected. Additionally, the euro area has been experiencing an adverse exchange rate shock. Excessive volatility and disorderly movements in exchange rates are undesirable for economic growth. In this context, the euro–area authorities share the IMF analysis that the euro is now clearly on the strong side relative to fundamentals.

Looking further ahead, the economic outlook crucially depends on how the financial market stress will unfold and whether oil prices keep on growing, feeding into inflation. In the euro–area authorities’ view, tighter financing conditions and higher risk aversion will continue taking a toll on investment, especially on housing in some countries, and, together with declining confidence, could also dampen consumption going forward. Similarly, the relentless increase in energy prices will weigh on consumption and investment. This in turn should have a moderating effect on prices and wages.

The euro-area authorities concur with the staff that, in spite of the resilience so far, economic growth could further moderate. In their view, the uncertainty surrounding the growth outlook remains high, and the risks are on the downside.

Monetary policy and the outlook for price stability

To prevent broad–based second–round effects and counteract increasing risks to price stability over the medium term, the Governing Council of the ECB raised the key ECB interest rate by 25 basis points on July 3. The latest data that have become available since the release of the staff paper fully confirms the existence of upside risks to price stability.

Turning to the outlook for price developments, inflation has risen considerably since last autumn, reaching worrying levels of around 4 percent in mid 2008. This mainly owes to sharp increases in oil and food prices. In recent months upside risks to price stability have intensified. First, these risks relate to possible further rises in commodity prices. Moreover, the possibility of broad–based second–round effects and associated additional price pressures are of particular concern to the Governing Council of the ECB. Initial signs of such second– round effects are already emerging in some euro area countries. In this particular context, nominal wage indexation schemes should be avoided. Finally, unanticipated increases in administered prices and indirect taxes contribute to upside risks to price stability over the medium term.

The monetary analysis strongly supports the assessment of upside risks to price stability at medium to longer horizons. The sustained underlying strength of monetary and credit expansion in the euro area over the past few years has created upside risks to price stability. Over recent quarters, these risks appear to have become manifest as inflation has trended upwards. Thus, the continued strength of monetary dynamics represents an important signal of the risks to price stability over the medium term that the ECB has been addressing through its actions since end–2005. Moreover, a thorough assessment of the strength, maturity and sectoral composition of bank borrowing suggests that the correction in financial markets has, as yet, not significantly affected the availability of bank credit to the private sector.

The recent monetary policy decision demonstrates the ECB’s strong determination to keep long–term inflation expectations firmly anchored in line with price stability, in accordance with its mandate. It is the ECB’s contribution to preserving purchasing power over the medium term and supporting sustainable economic growth and employment in the euro area. In its current assessment, the Governing Council believes that the monetary policy stance following the decision to raise rates on July 3 will contribute to achieving price stability over the medium term. The Governing Council will continue to monitor very closely all developments over the period ahead. As has been repeatedly stressed, the Governing Council does not pre–commit to a specific course of action in the future.

Liquidity Management

In the last few months, the ECB has continued applying its existing framework for liquidity operations with a view to alleviate tensions in the euro money market and to continue steering very short term money market rates to the minimum bid rate. First, the ECB continued “frontloading” its liquidity supply over the reserve maintenance periods to properly respond to banks’ liquidity demand pattern and in accordance to reduced tensions recently observed in the market, yet maintaining the average supply of liquidity unchanged over the entire maintenance periods. Second, the ECB continued providing temporary refinancing at longer maturities, by renewing in May and June 2008 the two supplementary three–month longer–term refinancing operations (LTROs) initiated in August and September 2007, and by introducing supplementary LTROs with a six–month maturity, in April and in July 2008. Third, the ECB continued the conduct of term auction facilities in cooperation with the US Federal Reserve System and other central banks. Accordingly, it provided US dollar liquidity to euro area banks, secured with Eurosystem eligible collateral. As on similar occasions, these operations did not affect the supply of euro liquidity. Overall, the fact that a broad range of counterparties has access to the Eurosystem’s large scale refinancing operations against a wide range of eligible collateral, allowed the ECB to effectively counter the stressed conditions in the short–term part of the money markets without having to change the framework itself.

Fiscal developments and fiscal policy

The euro-area authorities share the staff’s assessment of the improved budgetary situation in 2007. However, significant budgetary challenges lie ahead. In particular, the euro–area authorities welcome the staff’s overall positive assessment regarding the functioning of the reformed Stability and Growth Pact (SGP). Countries with excessive deficits have made significant structural efforts to correct their deficits within the deadlines established under the reformed SGP. Consequently, no euro–area Member State is currently subject to the excessive deficit procedure.

Despite these improvements, the euro–area authorities agree that in certain countries more ambitious fiscal consolidation is needed, partly as a result of insufficient progress towards the medium–term budgetary objectives during the upswing. In these countries safety margins vis– à–vis the 3 percent of GDP reference value are insufficient to make full use of the automatic fiscal stabilizers to smooth the economic slowdown without excessive deficits emerging.

In this context, the euro–area authorities also highlight the risk related to the reversal of accrued windfall revenues which could accentuate the budgetary effects of the economic slowdown. As rightly pointed out in the staff’s assessment, while the jury is still out on the actual drivers of the tax buoyancy in recent years, experience suggests that a significant part of it may be short–lived. With growth abating, a reversal in revenue windfalls would strain the budgetary situation of those Member States which have not made sufficient use of the upturn to improve their budgetary positions, further reducing their capacity to let automatic stabilizers play.

The euro-area authorities confirm their strong commitment to the reformed SGP which provides the best guidance for the conduct of fiscal policies at the current juncture. Stability– oriented fiscal policies, in line with the SGP, allow achieving and maintaining sustainable fiscal positions before the effects of ageing populations fully set in. Thereby, the SGP supports confidence of consumers, producers and financial markets. Further progress towards the medium–term objectives, in particular by expenditure restraint, contributes to alleviating inflationary pressures, fostering an environment of sustainable growth. At the same time, the working of the automatic stabilizers dampens the impact of the global economic slowdown.

It is worth noting that Member States progressively develop strategies to improve spending efficiency with the use of performance indicators and of medium–term budgetary frameworks. Pursuing effective medium–term budgetary frameworks and fiscal rules at national level not only contributes to ensuring rigorous budgetary execution and compliance with plans, but it also contributes to improving the quality and sustainability of public finances. Increasing the efficiency of public spending and re–orientating it towards growth– enhancing components can contribute to managing the ongoing growth slowdown and accelerating the pace of the recovery.

In line with the conclusions of the June 2008 ECOFIN meeting and the principles set in the Manchester 2005 ECOFIN meeting, the euro–area authorities concur with the staff’s view that tax policy should not be used to limit the pass–through of rising energy prices. Considering that supply is highly inelastic, offsetting price increases with compensating tax cuts would distort necessary adjustment to higher energy prices and risk adding to the terms–of–trade loss experienced by the euro area as a net importer of energy. Other policies to protect vulnerable groups are likely to be more effective and efficient.

Financial sector issues

As pointed out by the staff, financial stability has become a focus of attention among EU policymakers. While financial integration has progressed significantly in recent years, the EU financial–stability arrangements remain very much national–based. Various measures have been taken to adapt these arrangements to reflect the growing cross–border dimension in financial activity within the EU. These measures have acquired increased importance in the context of the ongoing global financial turmoil. Particular attention has been given to strengthening the Lamfalussy framework, where the Level–3 Committees have a significant role to play in fostering supervisory convergence. Their functioning is to be improved by including an EU dimension in the mandates of national supervisors, streamlining the decision–making procedures and allocating to them specific tasks in promoting supervisory convergence.

The euro-area authorities share the staff’s view on the importance of organizing an efficient exchange of information among supervisors, both in normal times and in times of crisis. To this end, the 2005 EU–wide Memorandum of Understanding between national supervisors, central banks and finance ministries has been significantly extended with effect from July 1 2008. The extension of the Memorandum of Understanding applies to both coverage and to content. The coverage has been extended to include supervisors not only from the banking sector but also from the insurance and securities sectors. As to the content, it has been extended by the inclusion of basic principles for cross–border crisis management, a common framework for assessing the systemic nature of a cross–border crisis and some procedural guidelines in crisis management. In addition, the use of colleges of supervisors for cross– border financial groups is to be extended.

Also, the ECOFIN decided on a roadmap of actions to further enhance EU financial stability arrangements. Among the issues to be addressed are relations between home–country and host–country supervisors, the transfer of assets within a financial group, determining criteria for applying early intervention and reorganization measures for cross–border financial groups and improvements in deposit guarantee schemes. These issues are highly complex and touch upon elements of national sovereignty. Therefore, the staff is right to highlight that reforms in these areas will require strong political leadership and commitment. While complex to design, and politically sensitive to pursue, these reforms are nevertheless essential to safeguard the stability of the EU financial markets, and reap the maximum benefits from financial integration.

Structural reform

The euro area has a special interest in the success of structural reform. In a partnership approach between the Member States and the Commission, the Lisbon Strategy forms the basis for steering the reform process in the euro area as a whole and in the individual countries. The recommendations to the euro area, together with the country–specific recommendations made within the Integrated Guidelines of the Lisbon Strategy, provide the backbone for the coordination of structural reforms. The most recent assessments of progress with structural reforms carried out by the Commission and the ECOFIN show signs that the euro area countries have engaged in substantive structural reforms to tackle their economic, social and environmental challenges. Nevertheless, there remain a number of policy areas where challenges need to be tackled urgently, including strengthening the sustainability of public finances and increasing competition in product, services and labor markets.

The euro-area authorities agree with the staff that there is scope for National Reform Programs to pay more attention to the euro area recommendations, which aim to facilitate economic adjustment in the monetary union.

The euro-area authorities share the staff’s concerns about the intra–area divergences and welcome the staff’s support for improving internal surveillance. While some of these divergences can be benign – reflecting the catching–up process or even normal adjustment – they may also be harmful and the result of inefficient adjustment capabilities and/or excessive unit labor cost increases. In this case, broadened and deepened intra–area surveillance would be instrumental in early identifying of macroeconomic imbalances and competitiveness trends in euro–area countries and in helping Member States devising swift responses before divergences become entrenched. Going forward, it would be important to provide the right incentives for structural reforms at the national level and to enhance synergies between fiscal policies and structural reforms.

International issues

As noted by the staff, the EU will continue to strive for a comprehensive, ambitious and balanced conclusion of the Doha Round. EU representatives are’cautiously hopeful’ that an agreement can be reached this year, as they remain convinced that successful conclusion of the trade talks would be supportive of global growth in the longer term. The EU continues to play a key role in the efforts to push forward the negotiations. However, for negotiations to be successful, it is important that other participants are also forthcoming and take a constructive stand in the negotiations.

Parallel to the multilateral talks, which remain top priority, the EU is also pursuing free trade agreement negotiations with India, Korea, Latin America and the ASEAN countries, as well as regional partnerships with the African, Caribbean and Pacific countries. These agreements complement the multilateral framework for trade liberalization and are seen as stepping stones towards further trade integration.

Food prices are a major concern worldwide and the EU has launched initiatives to address the challenges faced by the Member States but also other countries. The European Council has endorsed several policy responses, both in the short– and in the long term. In the short term, European countries will mobilize resources for humanitarian aid to developing countries, examine the competitiveness in the food supply chain in the EU and the role of speculation in recent price developments. In the long run, the EU will promote sustainable production of biofuels and sustainable productivity growth in agriculture. It will undertake a review of the Common Agricultural Policy phasing out restrictions to production, making European farmers more responsive to price signals and to strengthen food security. The EU will also enhance support to investments in agriculture in developing countries.

By targeting development aid, ensuring that market incentives are in place for a supply response to develop, and discouraging export taxes, the EU’s aim is to ensure that barriers to international trade are lifted. Both consumers and producers will better respond to price signals and market developments.