The case for adapting the policy framework in the euro area

By: Jean Pisani-Ferry, André Sapir and Alan Ahearne

This time last year, optimism about the euro area’s growth prospects was relatively high, inflation was comfortably below the ECB’s target of 2 percent, and financial conditions were supportive of continued economic expansion.

 

 

What a difference a year makes! Inflation has jumped to above three percent, growth is slowing, financial market turbulence is everywhere and the euro has appreciated to record levels against other major currencies. Two key questions are whether the euro area is fully equipped to face this less favourable economic situation, and if not, what changes to policies and policymaking might make the euro area better able to face the important challenges and significant risks on the horizon. A new report published last week by the think tank Bruegel attempts to answer these questions.

 

 

To look forward, it is perhaps best to begin by looking back at EMU’s record so far. The overall performance of the euro area since the launch of the new currency has been mixed.  On the one hand, inflation and expectations of future inflation have been low and stable over most of the past decade, though they both have moved up recently. Long-term interest rates have been kept at low levels, and the euro has become a major international currency.

 

 

On the other hand, however, the euro area’s growth performance has been less than outstanding, despite the boom in 1999-2000 and the 2006-2007 upturn. One of the most disappointing aspects of EMU has been that reform efforts have not accelerated. Instead of increasing the incentives for economic reform, as many expected, the single currency seems to have insulated members from acute crises and may, in fact, have slowed down the pace of reforms. Fiscal discipline remains poor and the euro area lags behind other advanced economies when it comes to structural reform. Other risks stem from the appreciation of the euro to record levels against other major currencies. In addition, despite the view of policymakers that a single currency would promote convergence in growth and inflation rates, the economic performance of the member states is uneven and the risk of asymmetric shocks therefore remains.

 

 

Another challenge facing the euro area relates to enlargement. The enlargement of the euro area has become a divisive issue. Although Slovenia, Cyprus and Malta have joined the single currency, most new member states (except Slovakia) are a long way from fulfilling the Maastricht criteria, or are openly lukewarm about joining. The EU institutions insist that the same criteria that were employed in 1998 should be used for the new applicants, but this ignores the fact that inflation in catching-up economies is an equilibrium phenomenon. To request a country already in a fixed exchange rate regime vis-à-vis the euro to lower inflation enough to fulfill the Maastricht criterion makes no economic sense and involves political risks. This is why the report advocates a reinterpretation of the criteria that takes economic realities into account.

 

 

The question is how do we identify shortcomings in the current functioning of the euro area? Our approach is based on our view that the EMU framework should fulfill four conditions. It should first deliver stability – taking into account that price stability is only one aspect of it. Second, it should ensure predictability—that is, provide clear and transparent rules on how the various policy players should behave in the common interest. Third, it should provide strong incentives for policies that are appropriate both from a national and from a European point of view. Fourth, it should be adaptable in order to evolve on the basis of experience and adjust to changes in the world environment. 

 

Against these yardsticks, we consider that progress is desirable on all four fronts. We think that the concept of stability emphasised in the Maastricht Treaty was too narrow and that, although this has to an extent been taken on board in practice, a more comprehensive formulation of the objective is in order; that predictability has improved, at least for monetary policy, but that there would be value in going further, especially in view of the enlargement of the euro area; that the incentive dimension has been taken into account on the occasion of the reform of the Stability and Growth Pact but that more is needed to spur actions that are in the common interest; and that due deference to the Treaty should not be an obstacle to learning and adapting.

 

What specific changes to monetary, fiscal, and exchange rate policies might help? On the monetary policy front, the ECB should improve its policy framework by taking the full steps to an inflation target regime. The Bank should integrate its economic analysis and monetary analysis into a single analytical framework. We recommend that the ECB set a band around its de facto inflation target of 2 percent, make it explicitly symmetric and implement the targeting in a flexible manner.

 

In addition, the ECB should publish forecasts for inflation and GDP that reflect the views of the Governing Council. An inflation target, together with forecasts, will provide a better foundation for communication. It would provide a good basis for a dialogue with the Eurogroup. Being able to motivate decisions in a rigorous way may also be important for the ECB because of the greater economic divergences within the euro area.

 

The ECB should also voluntarily inform the Eurogroup that it has adopted a reformed inflation target, and the Eurogroup should respond with an unequivocal endorsement (through an exchange of letters perhaps) to show public support for the improved framework.

 

 

None of those proposals would imply changing the Treaty. Nor would they imply any formal consultation between the ECB and the Eurogroup.

 

In terms of fiscal policy, the focus of EU surveillance should increasingly be put on a comprehensive concept of debt sustainability. Initial focus on the deficit was justified, because this was the only variable governments could control in the short run. What matters most for EMU partners, however, is the sustainability of the budgetary position. Sustainability assessments should be enhanced through taking into account government assets and off-balance sheet liabilities, which in turn requires developing a proper accounting framework for evaluating implicit age-related liabilities on the basis of methods agreed on at EU level.

In addition, the EU should recognise progress in home-grown fiscal discipline through granting increased national fiscal autonomy to countries that have put in place credible and appropriate national fiscal policy rules and institutions. This should be done through defining minimal requirements for national fiscal frameworks and assessing the quality and the record of domestic fiscal rules and institutions. A country that meets those requirements could be given more leeway in the conduct of its policy over the cycle. This proposal does not require changes to the Treaty, provided that the country remains within the (3 percent, 60 percent) Treaty limits.

 

On the issue of exchange rates, the euro area should not be shy to express its views on the exchange rate policies of its main partners. However, verbal discipline on the exchange rate is a prerequisite. Even under good conditions, when the views of all concerned are well coordinated, exchange rate policy is a difficult matter with mixed results. If heads of state and governments publicly disagree with each-other and with the EU institutions chances are at best slim that the European policymakers will be able to influence exchange rates.  The bottom line is that there is a need for the euro area to speak with one voice on exchange rate matters. The president of the Eurogroup should be the natural spokesperson.

 

More generally, we see the Eurogroup as the essential institution potentially capable of fostering change. But the Eurogroup itself needs changes to its governance. There is a need for a clearer distinction between the legally binding decisions aimed at preserving the proper functioning of the EMU on one hand, and proposals aimed at improving the quality of economic policies on the other. Formal Council recommendations should be reserved for serious threats to the euro. Additionally, it should be possible to hold Council meetings in euro area format, including at the level of heads of state and government.

 

Our main message is that the maintenance of a learning mindset and a willingness to adapt the policy framework in light of the experience gained is crucial to the long term success of the euro. In the end, the return on the major investment made by the creators of the European currency will be determined by the ability of all participants to learn from experience and to improve.

 

 

Jean Pisani-Ferry, André Sapir and Alan Ahearne are members of the working group that produced the report:   “Coming of age: Report on the euro area” Bruegel blueprint Vol IV, Jan 2008, downloadable here.

 

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