EMU pact: no big bang reforms, but more flexibility

EMU pact: no big bang reforms, but more flexibility

Professor Norbert Walter responds to Giorgio La Malfa stressing that it would be wrong to embark on far reaching changes in euroland’s monetary and fiscal policy but asks for some improvements of the existing EMU framework.

The stability and growth pact (SGP) is under heavy fire. Even the President of the European Commission recently characterised the SGP as stupid. The pact has indeed a credibility problem. Calls for flexibility, reform and even to scrap the pact are becoming louder. In this situation Giorgio La Malfa goes even further, proposing to overhaul the whole EMU fabric of monetary and fiscal policy rules. In particular, he criticises the lack of scope for stimulatory measures in a prolonged period of weak growth. I would like to focus on his reform proposals for revising the SGP, fiscal coordination and the objective of the ECB. But let me begin with some comments on economic performance and policies in euroland since 1999.

Giorgio La Malfa concludes that the economic performance in the first three years of EMU was only “mediocre”. To be fair, in retrospect, euroland registered good growth in 1999/2000, with buoyant domestic demand and satisfactory GDP growth rates of around 3%, before economic activity weakened substantially in 2001/02. It is obvious, however, that euroland is still to a large extent dependent on the development of the US economy. Moreover, the euroland economy benefited from the weak euro exchange rate at least until 2001. With regard to economic performance it should not be overlooked that governments are responsible not only for fiscal policy but also for structural policies, which should serve to strengthen growth potential.

Unfortunately, Giorgio La Malfa does not consider the lack of structural reforms (concerning tax and social security systems and labour markets) to be a problem. Despite tax cuts, structural reforms have been disappointing in Germany, France and Italy while several other EMU countries, e.g. Ireland and Spain, have successfully pursued structural reform policies. I suspect that the long-lasting US boom and the weak euro exchange rate have caused some governments in euroland to sit back. Obviously, structural reforms are usually unpopular, cumbersome to push through in the political process and effective only in the longer term – well beyond the horizon of the election cycle.

A straitjacket for budgetary sinners

As to fiscal policy, budgetary discipline is necessary to support the monetary policy of the ECB. The SGP worked pretty well in the run-up to the euro as an orientation for sound fiscal policy (as seen by the decline in fiscal deficits throughout the EU). Unfortunately, not every government continued to aim seriously for a balanced budget during the good times of 1999/2000. The SGP would not have translated into a straitjacket during the subsequent downswing if Germany, France, Italy and Portugal had done their homework in those years. Scope for fiscal flexibility has, as a result, only been available to the countries that have stuck to the rules of the pact. But Germany, France, Italy and Portugal ran budget deficits even in boom times and now, not surprisingly, have trouble complying with the deficit limit of 3% of GDP. Portugal ran an excessive deficit in 2001 and Germany will certainly violate the pact this year, while France and Italy are at risk of becoming problem cases.

The SGP turned out to be a “straitjacket” for budgetary sinners. But there is no easy answer. I do not think that the pact will be “put aside with the Commission making pro forma protests against the violation of these rules” as this would be counterproductive in terms of credibility. Pacta sunt servanda. By the same token, the problem cannot be solved by quickly altering the SGP agreement. This would require a unanimous d ecision of the ECOFIN Council, which is unlikely at present.

In my opinion the problem has to be resolved flexibly within the existing rules. Germany has – like Portugal – to accept an excessive deficit procedure and to take measures to correct the deficit in order to avoid sanctions. Germany needs to decide on a medium-term fiscal adjustment path with a binding commitment to balance the budget, say by 2006. The quality of consolidation also counts with regard to growth expectations. Unfortunately, the new German government’s consolidation programme puts priority on growth-damaging increases in taxes and social security contributions instead of focusing on cuts in consumption expenditure and subsidies.

Two proposals for a revision of the stability pact

Giorgio La Malfa combines his call for a pact revision with two concrete proposals. I fully support his first suggestion to take into account the cyclical component of economic trends. This proposal, which differentiates between a cyclical component (which would be the subject of the SGP) and a structural component (which would have to be zero), should be realised as soon as possible. It is gratifying to note that the ECOFIN Council has already endorsed a good means of determining the cyclically-adjusted budgetary deficit (the OECD/IMF method).

Secondly, Giorgio La Malfa suggests excluding investment expenditure from budget deficit calculations. This proposal is problematic because it would open a Pandora’s box of requests to change the method of calculation. Even if governments agreed on a definition for public investment it would probably remain vague and leave much room for interpretation. Such a watered-down stability pact would not be in line with the spirit of EMU.

We do not need a new SGP now. But a careful review in the light of the experience gained from at least one full business cycle could be helpful. More flexibility is required: for instance, the concept of cyclically-adjusted budget deficits should be implemented, and more fiscal leeway given to countries with relatively low public debt. Furthermore, I am in favour of strengthening the monitoring role of the Commission, which should have the right to issue an early warning to budgetary sinners. The way in which Germany averted a warning in February 2002 – by obtaining a qualified majority in the ECOFIN Council – was certainly problematic.

New functions for the Euro-12 Group?

I am sceptical whether the proposal to increase the role of the informal Euro-12 committee (within the decision-making ECOFIN Council) could strengthen fiscal coordination in a system in which national governments still have fiscal responsibility. Coordination depends on political willingness, whether there is a formal SGP agreement or not. Peer pressure, although sometimes helpful, is no panacea. It is proposed that the SGP might be eased in a new fiscal coordination regime. But the aims and the strategy remain vague and several questions are open. For instance, should fiscal coordination only be organised in periods of weak growth, i.e. to stimulate the economy? Are all countries to be “forced” to participate in pushing the economy irrespective of their domestic economic situation and their level of public debt?

There are also economic policy coordination issues that extend beyond EMU and concern all EU countries. Cases where coordination failed were, for instance, the different policy responses to the oil price hike and the different treatment of 3G licences (UMTS). Voluntary coordination is urgently needed in such cases, but it can only be achieved by an agreement in the ECOFIN Council and implementation at the national level. An increased role of the Euro-12 Group could detract from this and endanger cohesion within the EU.

Unfortunately, Giorgio La Malfa’s proposal that monetary union should be complemented by a fiscal union is not s pelt out in detail. One thing I think we do not need is a new bureaucracy-creating institution for fiscal coordination (“economic government”) as a counterpart to the ECB. No doubt, the EU needs more efficient decision-making structures to ensure its ability to act following enlargement. The European Convention on the Future of Europe is the forum for relevant proposals. A rule-based system (if possible reasonable rules) is certainly to be preferred over an arbitrary institutional set up with little transparency; besides, an element of competition between policymakers enhances the freedom and wealth of the citizens.

ECB goals should remain

The ECB has done a good job so far. It has not focused only on inflation, however, but has also flexibly lowered interest rates in times of weak growth (in April 1999 and 2001). The ECB, therefore, does not have a purely anti-inflationary bias. Nevertheless, it could have done more in 2002 to support growth. The ECB, although independent, does not, for course, operate in a political vacuum and it will definitely have a credibility problem if inflation is dead but at the price of a recession.

I do not share Giorgio La Malfa’s conclusion that the stability objective of the ECB should be replaced by a broader objective including price stability, growth and employment, like that of the US Federal Reserve. There is the risk that the European stability consensus would be endangered. Moreover, the objectives of the Federal Reserve are, on occasion, inconsistent. A clarifying interpretation would be necessary as the Federal Reserve has never given a precise definition of price stability or specified other nominal anchors. In fact, the nominal anchor right now is Alan Greenspan. Obviously, the Federal Reserve model cannot be copied.

In my opinion, it is important to focus on the weak spots of the ECB’s monetary policy with regard to strategy, transparency and communication. In particular, the two-pillar strategy of the ECB (based on money supply growth and a set of economic and financial indicators) is too complicated, too difficult to communicate and sometimes contradictory. I therefore plead for the alternative approach of inflation-targeting which is more transparent and consistent, thus fostering credibility and transparency.

Particularly at a time when demand for euros is anything but stable (in part because of uncertainty about the extension of the euro area) a reference value for M3 expansion may create more confusion than orientation. I have doubts whether the proposed publication of the minutes of ECB Council meetings would be helpful as it could easily lead to public pressure on Council members and impair the ECB’s independence. I am, however, convinced that transparency can be improved if the ECB communicates not only the pros of its policy decisions but also the cons.

In summary, the scope for action in monetary and fiscal policy is limited but should be used as far as possible. It would be wrong to embark on far-reaching changes in the monetary and fiscal policy framework that could damage credibility. But improvements within the existing EMU framework in the light of experience since 1999 are certainly welcome.

Professor Norbert Walter is Managing Director, Deutsche Bank Research, and Chief Economist of Deutsche Bank Group.

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