European Affairs

Spring 2004

 

Leader in Focus
Three Challenges for Europe—Enlargement, Growth and Fiscal Discipline
By Jean-Claude Trichet

 

The introduction of the single European currency has been a historic landmark, with important positive consequences for the 12 participant countries. For more than five years now, the European Union has had a single currency and a monetary policy conducted by the Eurosystem, consisting of the European Central Bank (ECB) and the national central banks of the euro area. The euro has been firmly and credibly established as a stable currency. The euro area has witnessed a period of moderate inflation and low long-term interest rates. In almost all member countries, market interest rates have been at their lowest levels since World War II.

Now, however, there are three key priorities, which are particularly challenging at the present juncture. These are the recent enlargement of the European Union, the need for higher growth and employment by means of structural reforms and the necessity of implementing an original form of fiscal surveillance in a single currency area.

The entry of ten new member countries into the European Union on May 1, 2004 is a cause for profound rejoicing. It is an emblematic illustration of the victory of political democracies over totalitarianism. It is a living demonstration of the efficiency of market economy rules. And it gives the founding fathers of the European Union the most extraordinary reward they could have dreamed of 50 years ago.

What would Jean Monnet have said if we had told him in the 1950s what his original vision would have achieved today? The six original member countries of the European Community have become 25, and we not only have a single currency for 306 million people but also a single market for 450 million European producers and consumers. Postwar reconciliation between Germany, France, Italy and the Benelux countries has evolved into a close union between most of Western Europe and large parts of Eastern Europe. Perhaps, he would have commented that we have succeeded in an extraordinary historical achievement, but that we shall be even more surprised in the future. As he wrote in his memoirs, “the historical evolution of United Europe is unpredictable, because nobody can say which new bold changes will be triggered tomorrow by the effects of today's changes.”

Whatever new achievements are likely in the future, the entry of the ten new member states, with 75 million people, has increased the EU population by about 20 percent, to more than 450 million. The economic weight of the new members is lower. Their total Gross Domestic Product currently represents, at market exchange rates, around 5 percent of that of the 15 older members. But their entry will bring important economic benefits. As past enlargements have shown, both new and old member states will benefit from a wider union, in particular from an expanded internal market. Trade integration has already reached a high level in the acceding countries, with the European Union accounting for 67 percent of their total exports and 60 percent of their imports.

The new member countries have made remarkable progress in recent years. They have achieved significant macro-economic stabilization and structural reforms. The eight new member states in Central and Eastern Europe, which formerly had centrally planned economies, have been able to establish functioning market economies. There remain, however, great challenges.

The key tasks are to advance real convergence while safeguarding and, where necessary, enhancing macroeconomic and financial stability. It will be of the utmost importance to lock in inflation at low levels, preserve the soundness of the financial sector, correct unsustainable external imbalances, in a few cases, and renew efforts toward fiscal consolidation.

The gap in per capita income between the old member states and most of the newcomers remains large, and in some countries the process of catching up in real incomes has been slower than originally expected. The per capita income of the acceding countries as a whole is less than half the EU average. Given the low starting point for most countries, increasing prosperity and living standards will be a major policy objective for quite some time. In view of that strategic objective, it must be stressed that prudent macro-economic policies will be essential to support and facilitate progress toward higher GDP per capita levels.

Accession to the European Union is expected to improve the new members' prospects for economic convergence with their more prosperous partners. Full integration into the internal market will increase growth prospects and foster the catching-up process, mainly through trade and foreign direct investment, together with lower interest rates. The new member states will have to implement and enforce the whole corpus of EU laws and regulations, which they have adopted in the course of recent years (except, for the time being, where transitional arrangements apply).

The European Union itself has also been taking serious steps to make enlargement work. In the field of central banking, the Eurosystem has been engaged since 1999 in a constructive and ever more intense dialogue with the central banks of the new member states. Since the signing of the EU Accession Treaty in 2003, the governors of the national central banks of the acceding countries have been participating as observers in the General Council ¹ of the ECB. The new voting modalities agreed for the General Council will allow the ECB to maintain efficiency and timeliness of decision-making once the euro area is expanded.

The new member states are expected to adopt the single currency some time in the future—indeed, as members, theyare committed to striving toward eventual adoption of the euro. The main aim of the Eurosystem in this process will be to ensure that the monetary integration of each new member state proceeds smoothly and in line with treaty provisions. In view of this challenge, at the end of 2003 the Governing Council ² of the ECB adopted a policy position paper on exchange rate issues relating to the acceding countries.

The Treaty foresees that the new member states will at some point join the Exchange Rate Mechanism II (ERM II), which will link their exchange rates to the euro within certain fixed margins. To ensure a smooth participation in ERM II, however, the new members will have to undertake major policy adjustments—for example with regard to price liberalization and fiscal policy—and follow credible fiscal consolidation paths before joining the mechanism.

As these countries differ greatly in terms of economic structure, exchange rate and monetary regimes, and in the degree of nominal and real convergence already achieved, no single path towards the euro can be identified or recommended for all of them. Various strategies may be feasible, provided they are based on sound economic reasoning, conform to the existing institutional framework and contribute to the high level of sustainable convergence that is essential when joining the euro area. Progress toward the adoption of the euro will thus need to be assessed on a case by case basis.

At the same time, the principle of equal treatment will continue to apply throughout the entire process of monetary integration. Adopting the euro is an irrevocable decision and it is of the utmost importance that countries first fulfill the required convergence criteria, not only nominally but also in a sustainable manner, as required by the Maastricht Treaty. There will be no additional criteria, but the existing criteria will not be relaxed either. Structural reforms will be required in both new and old member states. In March 2000, EU leaders meeting in Lisbon set the European Union a new strategic goal for the next decade, namely “to become by 2010 the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion.”

The ECB very much welcomes and supports the impetus given by the Lisbon summit meeting to the economic reform process, embodied in the so called Lisbon agenda. The Bank also welcomes the message of determination and confidence reinforcing the validity and relevance of the Lisbon process endorsed by EU leaders at their summit meeting in spring 2004. Four years after the launch of the Lisbon agenda, however, the pace of reform needs to be stepped up significantly to meet the ambitious targets set in Lisbon.

There are several reasons why the ECB is inviting member states to pursue structural reforms. Such reforms increase employment opportunities and real income, and thus support the sustainability of social security systems. It is widely recognized that structural reforms in labor, product and capital markets are needed to improve the prospects of the euro area. Structural reforms permit a higher level of sustainable long run economic growth by increasing the supply of production factors and improving the efficiency with which they are used.

Such reforms also enhance the capacity of the economy to cushion macro-economic shocks. The more flexible labor, product and financial markets are, the lower the employment and income losses in response to adverse domestic and global economic developments will be. Moreover, given that demographics in the euro area are less dynamic than in other economies, including the United States, we need even more improvements in terms of higherproductivity growth, rising labor force participation and declining structural unemployment. The case for decisive structural reforms is therefore pressing.

Structural reforms are generally associated with changes in an economy's long-term balance between supply and demand and in the relative prices of goods and services. The transition from pre-reform to post-reform equilibrium conditions normally takes time, and during this period some resistance and uncertainty may occur. For this reason the implementation of structural reforms requires strong leadership, a great deal of courage and tireless efforts to explain the process to the general public. It is very important to make clear to the public that there will be significant benefits if governments, Parliaments and social partners deliver the reforms.

In capital markets, structural reforms should aim at allowing a more effective allocation of savings toward the most rewarding investment opportunities. Since the introduction of the euro, the pace of capital market reform has been impressive. This includes policy induced reform, such as the Financial Services Action Plan initiated by the European Commission in the spring of 1999 and the development of national legal frameworks governing the issuance of mortgage bonds. Reform also covers market-led initiatives, such as the development of electronic trading platforms and consolidation of the clearing and settlement infrastructure. This has been possible owing to a cohesive and effective interplay of free competition, coordinated action by all market participants and policy enforcement by public authorities. But these reforms need to be continued and completed.

Much progress has also been made in increasing competition in product markets. Substantial barriers to free competition, however, continue to exist, particularly preventing the integration of services markets and effective competition in network industries. Fostering competition in these areas should also help to lower prices. Further regulatory reforms should be accompanied by a sustained reduction in state aid—particularly if it takes the form of economically questionable ad hoc and sector- specific measures. This will help to smooth the restructuring process in product markets by promoting the entry of new players.

In the end, such reforms will enhance innovation and the efficient allocation of resources, while cuts in subsidies will reduce the tax burden. These product market reforms will contribute to prosperity across the euro area, and they will help to address the largest current economic and social challenge in Europe, namely high unemployment and insufficient employment rates.

Thus far, implementation of labor market reforms has been uneven in the euro area. Some countries have already significantly lowered unemployment. Others are lagging behind and uncertainty prevails about their future steps. In many countries, it is important to enhance the flexibility of labor contracts and the setting of wages to enhance employment growth in a lasting manner.

During the second half of the 1990s, efforts by some euro area countries to improve the functioning of their labor markets appear to have helped to foster employment growth and promote a more job-intensive output growth compared to the late 1980s. In particular, labor market reforms implemented in the second half of the 1990s seem to have benefited those groups facing particular challenges when trying to enter the labor market, such as women, the youngest and oldest job-seekers and the least educated.

Reforms are also needed to allow wages to reflect regional and sectoral productivity differences more accurately. This will make the whole economy more flexible and better able to absorb economic shocks. These measures must go hand in hand with product market reforms and reforms of pension and health care systems. Such reforms are essential to contain expenditures on pensions and health care. They will be needed not only to reduce non-wage labor costs and increase incentives for job creation but also to ensure the sustainability of the social security systems.

Europe has been very bold in establishing a single currency. The remarks made by American friends during the 1990s were easy to sum up: “You are putting the cart before the horse. You should first have set up a political federation, with a federal government and a federal budget. Then you could have introduced a single currency.” Two main arguments were advanced. First, without a significant federal budget, the policy mix would be very erratic. It would depend on the random behavior of the different national fiscal policies of the member countries of the Monetary Union. Second, without such a federal budget it would be impossible to weather asymmetric shocks hitting one particular member economy.

These two economic arguments are perfectly valid and would have been sufficient to discourage the creation of the euro had we not set up a profoundly original instrument of national fiscal policy surveillance. It is this instrument, the Stability and Growth Pact, that guarantees the coherence and the consistency of European Economic and Monetary Union (EMU) as a single currency area without a political federation.

A number of other considerations are worth mentioning. In particular, a fiscal policy that is set according to rules, and is adhered to, adds to macroeconomic stability by providing economic agents with expectations of a predictable economic environment. This reduces uncertainty and promotes longer-term decision-making, notably investment decisions, and economic growth. In addition, sound fiscal policies can contribute to lower risk premiums on long-term interest rates and thus support more favorable financing conditions for the entire economy.

The fiscal rules set up under the Maastricht Treaty and the Stability and Growth Pact provide an important framework to ensure the necessary fiscal discipline. The rules are useful to help individual countries preserve budgetary discipline and sustainable public finances, which is the best contribution fiscal policy can make to macroeconomic stability and growth. In a monetary union like EMU, with a single monetary policy and national fiscal policies, there are two additional arguments. Without such rules, small countries might be tempted to pursue expansionary fiscal policies that could threaten sustainability, because their fiscal imbalances would only have a marginal effect on the common interest and exchange rates. For big countries, on the other hand, lack of fiscal discipline may affect the common interest and exchange rates, creating negative consequences for the other participants.

Compliance with the fiscal framework of the Maastricht Treaty and the Stability and Growth Pact guarantees the sustainability of public finances and the operation of automatic stabilizers to correct economic problems, while respecting as much as possible the fiscal sovereignty of member states.

Could we rely on financial markets to impose sufficient discipline on budgetary policy? In principle, growing concerns about the sustainability of a country's debt should be reflected in the risk premiums that the country would have to pay for its borrowing. It would, however, be unrealistic and very risky to rely on financial markets alone. Experience suggests that financial markets react only with a substantial lag to deterioration in a country's fiscal situation, but the reaction can then be quite drastic, coming too late for a timely correction, worsening the crisis and placing a large burden on all participants.

In view of this, the ECB's Governing Council has expressed its regret that EU Finance Ministers in November 2003 rejected the European Commission's recommendation to invoke procedures penalizing countries with excessive deficits. We also respect the Commission's decision to seek legal clarification of the excessive deficit procedure in the European Court of Justice. It would surely be wrong to declare the Stability and Growth Pact dead. On the contrary, it is very much alive.We do not believe that it is advisable to amend the text of the Pact. It would be possible to improve its implementation without actually changing the wording. This could be achieved, in particular, by better analyzing structural imbalances as well as by strengthening incentives for sound fiscal policies during periods of strong economic growth.

The introduction of such policies would also strengthen economic confidence and support demand in the short run. Indeed, confidence among European citizens is vital for a stronger economic recovery and sustained growth. The ECB's Governing Council recognizes that the current low level of consumer confidence is partly due to the debate about the appropriate path for fiscal policy and structural reform in many countries in the euro area. For this reason, too, progress in implementing the necessary structural reforms, and more determined efforts to establish sound fiscal positions over the medium term, are the keys to stronger confidence.

The ECB, its Governing Council, and the full body of the Eurosystem are doing their utmost to enable Europe to cope with its present challenges. Our best contribution, in conformity with our mandate, is to ensure price stability and to be credible in doing so, not only on a short to medium term basis but also on a medium to long term basis. In fulfilling this role efficiently, the ECB is today making a major contribution to European prosperity, growth and job creation. It is doing so in three ways. It is consolidating a low level of medium and long term market rates for the 306 million citizens of the euro area. It is preserving the purchasing power of households, which is a necessary condition for consumption growth. And it is augmenting the confidence of economic agents, which is so important at the present juncture in Europe.

Jean-Claude Trichet became President of the European Central Bank in 2003. He previously served two terms as Governor of the Banque de France, and two terms as Alternate Governor of the IMF. He also served two years as the Governor of the World Bank, and was a member of the Board of Directors of the Bank for International Settlements. He was earlier Director, Head of International Affairs, and Head of the Development Aid Office at the French Treasury Department. He has been an advisor to the Minister of Economic Affairs and to the President of France on industry, energy and research.

 

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Endnotes

Note 1: The General Council consists of the President, Vice President and Governors of national central banks. It acts primarily as an advisory board. It contributes to the collection of statistical information, the preparation of the ECB's annual report, among other projects. It will exist as long as there are EU member states that are not part of the euro area.   Back.

Note 2: The Governing Council is the decision making body of the ECB. It is comprised of the President, Vice President, the other Members of the Executive Board and the Governors of national central banks of the euro area. It formulates monetary policy in the euro area free from political interference, ensures performance of the Eurosystem, and establishes implementation guidelines.   Back.