European Affairs

Spring 2002

 

Special Report: Managing Europe's New Money
EU Economic Policy Coordination Must Be Strengthened
Pedro Solbes Mira

 

The issue of European economic governance has become especially topical now that monetary integration has in a sense been completed with the introduction of euro bills and coins at the beginning of this year. Moreover, the upcoming enlargement of the European Union will require a smoothly functioning framework for coordinating economic policies. The costs of inadequate coordination may rise more than proportionately to the number of member states.

The way forward for EU economic governance will also be influenced by the outcome of the European Convention that is currently considering the key issues arising for the Union's future development. Looking at the balance of power and the division of responsibilities between the member states and the Community, and at the future shape of the EU institutions, it is bound also to consider questions of economic governance. In discussing economic policy coordination, it is important to understand that the term "policy coordination" applies to a number of different areas, ranging from fiscal and monetary coordination to the mutual enhancement of macro- and micro-economic policies. "Coordination" is thus used as an umbrella term, covering an entire spectrum of interactions among policy actors.

The key motive for coordination is to deal with "spillovers" of national policies across a country's borders. Today, a policy decided by one country may affect economic conditions in other countries much more than in the past.

Better coordinated policies to deal with these spillovers would contribute to a better allocation of resources and higher potential growth. The greater the actual or likely spillovers, the more need there is for effective policy coordination, and the spillovers are likely to increase as economic integration deepens.

Nevertheless, the benefits of coordination have to be weighed against its costs. In this respect, tensions may arise with respect to the preservation of democratic legitimacy and the respect of different national preferences. We must also respect the concept of subsidiarity, according to which decisions should be made at the most appropriate level, whether in Brussels, in national capitals or in regions.

The need for stronger coordination is particularly cogent for the euro area where an additional channel for spillovers has opened up. A national policy action that has an impact upon the average euro area inflation rate, for example, will in turn influence the European Central Bank's decisions on interest rates. In this way, national policies can affect all other members of the Economic and Monetary Union. Strengthened coordination is needed to take account of these effects of national policies within the euro area.

This coordination should not be limited to the twelve euro area member states. Economic integration is continuing throughout the European Union. Whereas in some fields additional coordination may be needed within the euro area, in general all 15 EU members must be involved in strengthening economic governance.

Although an elaborate coordination framework already exists, it has become exceedingly complex. The complexity of the system is largely due to the incremental manner in which it has developed - new procedures are added when deficiencies are discovered in earlier procedures - and only a very few specialists understand how it all works.

The system needs to be streamlined and simplified, and a key priority should be to ensure coherence between the policy recommendations that emerge from the various different procedures and a strengthened focus on key priorities. If not, we risk confusing the public with a multitude of different voices and endangering the credibility and effectiveness of the whole coordination framework.

The European Council has repeatedly confirmed that the Broad Economic Policy Guidelines, which define our main priorities each year, are the lynch pin of economic policy coordination. The guidelines cover the general orientation of economic policy and make specific recommendations to the EU institutions and to each member state.

The general policy orientations are developed further through specialized instruments, which include the Stability and Growth Pact for budgetary policy; the European Employment Guidelines for labor market policy; the Cardiff process for product and capital market reforms, and the Cologne process for macro-economic dialogue.

Nobody disputes the need for close coordination of macro-economic policies, notably budgetary policies, in view of the effects of national fiscal policies on euro area interest rates and the serious risks to the area's stability that could be posed by fiscal imbalances. This recognition is reflected in the Treaty, which expressly forbids excessive national budget deficits of more than three percent of GDP. Because of their importance, these provisions have been further clarified in the Stability and Growth Pact (SGP) in the form of strict rules and surveillance procedures.

Moreover, the SGP requires member states to attain budgetary positions of "close to balance or in surplus" over the cycle. This is not only to ensure sound public finances in the long run. It also creates room for automatic stabilizers to cushion economic fluctuations.

Once the member states have completed the transition to a medium term budgetary position of "close to balance or in surplus," it will be possible to adjust the policy mix smoothly to changing economic circumstances. In deep recessions, however, the leeway for stabilization may be insufficient. In that case, an escape clause allows temporary overshooting of the three percent ceiling.

Nevertheless, there is still a widespread tendency to associate fiscal discipline with a "straitjacket." I do not share this view. In my opinion, the system ensures sound fiscal behavior, predictability, and a fair amount of flexibility to cope with cyclical developments. It should be clear that the Stability and Growth Pact is not an arbitrary legal constraint, but the operational application of general principles of sound fiscal behavior.

Balanced budgets will allow us to make speedier progress to reducing public debt as a percentage of GDP. In turn, this reduces the debt service burden and helps to improve the structure of government budgets - which is imperative in view of the aging of European populations and the fact that pension systems are generally not funded, i.e. no capital has been accumulated to cover future pension liabilities.

Fiscal policy coordination has generally worked well. Admittedly, some problems have surfaced in a few member states, but that was because sound budgetary positions had not yet been achieved. This lengthened the transition to cruising speed. We have always stressed that we will have to learn as we go along, and our coordination procedures are gradually being streamlined and strengthened.

Surveillance has recently been improved by extending it to include the long-term sustainability of public finances. This is important in view of the budgetary consequences of aging. Increased focus will also be given to the analysis of cyclically-adjusted budgets rather than nominal targets alone.

A stable macro-economic framework reduces uncertainty and risk premia, improves the allocation of resources and strengthens potential output. In this context, the best contribution monetary policy can make to sustain growth and employment creation is to secure price stability over the medium term.

That is why the maintenance of price stability was the primary objective assigned to the European Central Bank, which has been granted independence from outside instructions in the pursuit of its tasks.

Obviously, however, the ECB does not operate in a vacuum. The economic governance system set up by the Maastricht Treaty provides several channels for contact and dialogue among the various institutions. Commission representatives, for example, frequently attend meetings of the Governing Council of the European Central Bank, although they are not entitled to vote.

The budgetary authorities of member states and ECB officials also remain in close contact through meetings of ministers of euro area countries in the Eurogroup, an informal forum of Ministers of Finance and Commission and ECB representatives. They are thus in a position to exchange information, their analyses of the economic situation and ensuing policy requirements.

Overall, this framework has worked well. The macro-economic policy mix has been well geared to economic developments. In the recent economic slowdown for instance, monetary authorities judiciously used the leeway provided by declining risks to price stability over the medium term, while budgetary authorities let automatic stabilizers work within the agreed rules.

Participants in Eurogroup meetings are pleased with the frank discussions that take place in these informal gatherings. Several organizational improvements have been made since the group was set up. On substance, the most noteworthy change has been the extension of the range of topics to include structural issues.

The rationale for the coordination of structural reforms is often not fully appreciated. But there can be no doubt that effective structural reforms are essential in enhancing the overall economic performance of the European Union.

Economic reforms improve the allocation of resources, allow increases in labor supply, facilitate technological advances and encourage investment growth. In short, the reform process boosts potential output growth. This is needed because potential output in Europe is still insufficient to sustain growth rates at around three percent over an extended period, in line with the objectives agreed by EU leaders in Lisbon three years ago.

There are also strong macro-economic arguments for making headway with the reform process. First, flexible markets are essential for the smooth functioning of Economic and Monetary Union, now that interest and exchange rates can no longer contribute to economic adjustment in response to an economic shock to a single member state.

Second, failure to boost growth potential through reforms would make a sustained consolidation of public finances more difficult. And, finally, reforms that decrease inflationary pressures for the euro area as a whole help to make lower interest rates possible.

As in the fiscal sphere, Community actions in the field of structural reform chiefly concern the coordination of policies that remain in the hands of member states. When structural reforms are directly related to the internal market, however, they are subject either to a Community-wide policy, such as competition policy, or to a common set of rules, such as those contained in the Single Market Program.

Unlike in fiscal policy, where the SGP provides for sanctions in the case of non-compliance, there is no Community mechanism for requiring reforms in member states. Structural policy coordination relies on the exchange of best practices and on peer pressure.

Given the lack of an enforcement mechanism, it is not surprising that member states largely focus their efforts on relatively uncontroversial measures and refrain from tackling the more difficult issues. As a result, despite an elaborate policy coordination framework, progress in structural reforms in some areas still fails to match our ambitions.

Nonetheless, we should not underrate the process that has been set in motion. In May 1998, when it was decided which countries would be the first to move to Economic and Monetary Union, economic and finance ministers stressed the importance of market flexibility if the project was to succeed.

In Cardiff the same year, EU leaders endorsed this approach, and the Cardiff process of economic reform was born. In Lisbon, the leaders strengthened their commitment to economic dynamism, and most recently in Barcelona further steps were agreed to liberalize markets. The individual steps may sometimes be small, but the process has gathered momentum. That could not have been achieved without discussions at Community level and the resulting build-up of peer pressure.

The Commission is doing its share by clarifying its policy proposals and making them better known. It is important to communicate widely and effectively the macro-economic benefits of structural reform, and to make clear the high costs of failure to reform in terms of employment and growth.

The Commission and the member states are working on a number of other improvements, such as strengthening the statistical and analytical basis for the euro area. Much progress has been made in improving euro area statistics, but there are still shortcomings that we are seeking to remedy.

A close and frequent evaluation of the euro area's monetary-fiscal policy mix is fundamental for analytical purposes, and the Commission has started presenting such assessments to the member states.

It is also generally agreed that member states could benefit from internal budget rules so as to exercise better control over growth in budget expenditures and make different levels of government more responsible. We encourage member states to proceed on this road when necessary.

The coordination framework could also be made more coherent and predictable if actors behaved according to some general rules for the conduct of economic policies, including the use of policy instruments to react to cyclical conditions or shocks. The Commission will soon propose a set of practical standards for the conduct of economic policies in the economic and monetary union, on which we hope member states will agree.

To conclude, the EU framework for the conduct of economic and monetary policies includes a clear allocation of policy responsibilities, a set of shared objectives, common rules for the conduct of policies, and an institutional setup that provides for the use of additional policy instruments.

The framework takes full account of recent insights from economic thinking. It has functioned well during the early years of economic and monetary union. The euro has been a success, notably in delivering low inflation, low long-term interest rates, and strongly improved budgetary positions - all of which have permitted strong job creation.

In general, economic and monetary policies have responded flexibly to changing economic conditions in the short run, whilst stimulating strong employment growth and improvements in the economy's real productive capacity and safeguarding long run sustainability.

To ensure the success of economic and monetary union in the future, the way forward is definitely to build upon and further strengthen our framework. This will be part of the comprehensive examination of the future of the European Union that will be undertaken in the Convention that is now at work.