Economic governance in EMU: What have we learnt?

1. Economic governance in EMU: What have we learnt? Jean Pisani-Ferry (Bruegel) LSE-European Institute seminar 7 November 2005

2. The Issue Does EMU imply / make desirable: • To create a political structure for the Eurozone? • To constrain national economic [budgetary] policies beyond what preserving monetary stability calls for? • To set up an economic/fiscal governance structure to complement (substitute?) the rules-based fiscal discipline framework? • To increase the size of the common budget for macroeconomic purposes ?

3. Outline • A long-standing debate • The experience • Models of EMU • Conclusions: What have we learnt?

4. 1. A long-standing debate Evidence of this debate can be found in: • The intellectual framework of EMU • Should fiscal autonomy be restrained for the sake of monetary stability only, or also to control the aggregate fiscal stance? • The policy discussion • German vs. French views of EMU • The treaty • Arts. 99 and 104: two views of the EMU requirements • The practice • SGP and the Eurogroup • Current discussions • Convention set up working group on “economic governance” – ended up in disagreement

5. The intellectual framework: Persistent ambiguity • Werner report (1970): "The margins within which the main budget aggregates must be held both for the annual budget and the multi-year projections will be decided at the Community level”. • McDougall report(1977): Single currency would require the EU budget to increase to 5% of GDP. • Delors report (1989): Fiscal decisions will need « to be placed within an agreed macroeconomic framework and be subject to binding procedures and rules. This would permit the determination of an overall policy stance for the Community as a whole, avoid unsustainable differences between individual member countries in public-sector borrowing requirements and place binding constraints on the size and the financing of budget deficits ». • Lamfalussy paper for Delors report (1989): « Fiscal policy coordination would appear to be a vital element of a European EMU [..]. Appropriate arrangements should therefore be put in place which would allow the gradual emergence, and the full operation once the EMU is completed, of a Community-wide fiscal policy. Such arrangements should also aim at avoiding disruptive differences between the public sector borrowing requirements of individual member countries.

6. The legal framework: A two-pillars, imbalanced structure • Art. 104(German inspiration): « Member States shall avoid excessive government deficits » • Specified target • Rules-based decisions • Stronger instruments • Detailed procedure leading to eventual sanctions • Art. 99(French inspiration): « Member States shall regard their economic policies as a matter of common concern and shall coordinate them within the Council » • General-purpose provision • Entirely discretionary • Weak instruments • Broad Economic Policy Guidelines • Monitoring and public recommendations (no sanctions) • Art 111: The Council “may formulate general orientations for exchange-rate policy [..]. [They] shall be without prejudice to the primary objective of the ESCB to maintain price stability”. • Conflicting aims • Compromise drafting

7. The initial set-up: Strong rules, some discretion • Strong rules-based arm • SGP created at German initiative • Detailed procedures for implementation of Art. 104 • Commission deprived of any discretion • Council retains formal discretion, but with hands tied • Weak discretionary arm • Eurogroup created in 1997 at French initiative • Informal, general-purposed structure without legal status nor formal powers • French 1999 suggestion to monitor EMU-wide fiscal stance rejected

8. Aggregate fiscal policy has been essentially passive since 1999 2. The experience

9. Aggregate fiscal policy has been (mildly) pro-cyclical

10. The BEPGs: An ineffective instrument • Broad Economic Policy Guidelines are issued by the Council for each country • Underlying rationale and analytical background are somewhat unclear (Pisani-Ferry 2003) • IMF-type surveillance for the interest of each country? • or in the name of EMU preservation? • Does not matter much because BEPGs are a “Brussels talking to Brussels” exercise

11. Policy episodes: Coordination can claim little success • 1998-99: Asian shock • Some agreement on desirability of « Clinton-Greenspan » policy mix • 2000: Unexpected tax receipts lead to pro-cyclical policy • Deficit is being reduced, but structural deficit increases • 2001: The Irish case • Council wrongly recommends fiscal restriction, Ireland rightly ignores recommendation • 2001: Agreement on automatic stabilisers • Avoid pro-cyclical policy in recession • 2004-2005: Increasing divergence within Euro area • No clear direction so far

12. Exchange rate policy and global coordination: Ineffective • External dimensions ranked high among motives for economic governance • However, • No attempt at global G7 coordination • Interpretation of Art 111 has confirmed prevalence of price stability • 1997 Ecofin Agreement to use 111-2 only in exceptional circumstances

13. How the policy framework has evolved: Less rules, some more discretion • SGP in trouble • Failure to enforce discipline • 2003: collapse of strict rules-based approach • 2005: SGP reform introduces leeway and discretion in implementation of deficit criteria • Slow rise of the Eurogroup • Venue is appreciated • Has taken the role of de facto caucus within Ecofin • Fixed presidency from 2005 on

14. Summing up • Economic government has not been effective despite some leverage from treaty provisions • But alternative rules-based system has not performed well either – and has been weakened by recent decisions • Battle of the weak

15. 3. Models of EMU Two concepts of EMU: • Ordnungspolitik • Create a framework with clear assignment rules and minimise spill-over effects • Coordination (among governments or with the ECB) would at least create confusion, at worst threaten monetary stability • Collective sovereignty • Create through coordination the equivalent of a national fiscal authority • Preserve discretionary decision-making • This would support, not threaten the ECB

16. Analytical dimensions Does monetary union require: • Political institutions? • Institutions to enforce fiscal discipline? • Fiscal / fiscal coordination? • Fiscal / monetary coordination? • A common budget? • Structural policy coordination?

17. Institutions • Intellectual underpinnings: M-money vs. C-money (Goodhart) • C-money (historical school): money is underpinned by state • M-money (economic school): money is based on economics • Political institutions: necessary (C) / useless or harmful (M) • Has played a role in the debate • Padoa-Schioppa(?): Who is my minister?, Issing: MU requires political union • Strauss-Kahn (1997), De Grauwe (1998): Coordination would protect ECB from the risk of isolation • British example of setting of inflation target by political authority • French 2005 calls for Euro-area summits • Implications: • Increasing recognition that euro area institutions do not threaten ECB, may even support it: strengthening of Eurogroup was consensual • Thus debate is now of secondary importance (but may resurface in case of controversy over monetary stance)

18. Institutions for fiscal discipline • SGP1 was rules-based, ideally without need for decision • Unambiguous criteria • Quasi-automatic enforcement procedures • Shortcomings of SGP1: • Did not lead to correcting failures in good times • 3% criterion inappropriate as lead to target the NL, not It • Weak economic content reduced legitimacy • SGP2 as reformed in March 2005 introduces: • Cyclical developments • Debt and sustainability concerns alongside the deficit • Motives for deficit (including structural reform) • Implementation cannot be left to rules, requires economic judgement • Thus governance issue becomes prominent (Giavazzi) • Council has moved away from rules-based, towards discretionary model • Combination of soft rules and weak institutions can be lethal

19. Fiscal/fiscal coordination Aggregate fiscal stance: ex-post result or ex-ante target? • In a closed economy framework, aggregate fiscal stabilisation is not required if: • Central bank provides stabilisation (Taylor 2000) • Central bank objectives are known and coincide with social preferences (Dixit-Lambertini 2001-2002) • Fiscal/fiscal coordination may thus be needed: • To avoid beggar-thy-neighbour stabilisation (Uhlig 2002) • If monetary policy is of questionable quality or unpredictable • In exceptional circumstances (zero bound, financial crisis) • Implications for EMU: • Need for fiscal/fiscal coordination is limited unless governments have reason not to trust the ECB • Lack of contingency plans for situations of severe crisis

20. The open-economy case • In an open-economy setting, • The policy-mix matters because of its consequences for exchange rate and balance of payments • Fiscal/fiscal and fiscal /monetary coordination are thus required to obtain appropriate policy-mix • Implications for EMU: • This reasoning featured high in early EMU blueprints (Delors, Lamfalussy) • Has lost importance with abandonment of exchange rate policy • Could resurface in case of precipitated unwinding of current account imbalances

21. Common budget? • Significant issue in early reflections (McDougall, Sachs-Sala-I-Martin): • For EMU-wide stabilisation • For stabilisation across countries • Has completely disappeared from discussions • No political perspective • Budgets have never been created on macroeconomic grounds

22. Structural reform • Rationale for structural reform coordination is weak at EU-25 level (Tabellini-Wyplosz 2004) • However there is Euro Area-specific interdependence • Policies that reduce inflation (productivity, NAIRU) lead to lower common interest rates • Significant cross-border effect of structural reform • Reduces benefits of / incentive to reform • This matters when reforms involve short-term costs • Implications for Euro Area • There can be gains in coordinating reforms at this level • Increasing relevance in context of EMU reform trap

23. EMU reform trap? Source: Duval and Elmeskov 2005

24. Illustration

25. 4. Conclusions: What have we learnt? • A pervasive debate • Political reasons (different visions coexist) • Economic reasons (EMU as a learning process) • A pervasive lack of clarity • A case of disagreement on the true model • [French] proponents of economic government have not been helpful: little effort to clarify the argument

26. Weak and strong arguments • Aggregate policy-mix • Does not justify day-to-day coordination, may call for procedures for joint action when required • Coordination of structural reform • Major current concern, requires political commitment rather than specific procedures • Implementation of fiscal discipline • Fixed rules have been abandon, Eurogroup needs to experiment with new “constraint discretion” model • Political commitment underpinning EMU • May be required in case of tension

27. Pending policy issues • Should a formal Euro-area council be created? • Should it have decision-making powers? • Should it set the inflation target? • How should the reformed SGP be implemented? • Should the Euro area be equipped with provisions for coordinating fiscal policies? • Should structural reforms be coordinated within the Euro area? • Should heads of state convene in Euro-area format? …More to be learnt!