Figure 1. Behaviour of the ECB: is it behaving like the Bundesbank? or the Fed?

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1 H9 C41 EUROPE: Economic Policy and Structural Change BLOCK 4. EMU 1. Monetary policy Figure 1. Behaviour of the ECB: is it behaving like the Bundesbank? or the Fed? Giavazzi & Favero (2003) Ch 11 of HMT "Submissions on EMU from leading academics" Treasury website or directly EUEONIA is the actual interest rate: (NB The authors should have plotted the rate set by the ECB as the solid line not the market rate. To find it go to and use the main refinancing rate. ) EUEONIA_T.Rule is the rate predicted by a Taylor rule using the parameters listed at the top of each figure. 1

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3 Fig. 2. Academic ideas for ECB reform Source: From the Treasury s EMU Studies: HM Treasury (2003) Policy Frameworks in the UK and EMU Box 3.5: Academic ideas for ECB reform Improving objectives: There is a wide consensus in the economic literature that symmetric inflation targets improve both transparency and clarity, enhancing credibility. For instance, Svensson (2002) argues that A symmetric explicit point inflation target... would be better and provide a better anchor for inflation expectations (page 2). Some have also argued that the inflation objective should be somewhat higher than the ECB s current strategy. Artus and Wyplosz (2002) argue that a range from 1 to 4 per cent would be more appropriate, reducing the risk of deflation. While acknowledging that the ECB does not use monetary data in a dogmatic manner, a number of commentators have also called for a move to a single-pillar strategy, in an attempt to increase the clarity of its objectives. For instance, Begg et al. (2002) argue that data from the monetary pillar provide unreliable, or downright mistaken, guidance and conclude that Cracked beyond repair, the monetary pillar should be dismantled (page 20). Aiding credibility: Baldwin et al. (2001) recommend that, in the light of enlargement of EMU, monetary policymaking should be delegated to a committee of independent experts, made up of the six members of the ECB s Executive Board and five other members appointed by Heads of Government on recommendation by ECOFIN. They believe that this would reduce the number of individuals responsible for taking monetary policy decisions, enhancing effectiveness, de-nationalise monetary policy and enhance the individual accountability of each committee member.a As set out in Box 3.2, the European Commission (2003) have also suggested that some form of monetary policy board might be one way to arrange monetary policy decision making following any enlargement of the euro area. Improving transparency: Buiter (1999) argues that publication of anonymised minutes of Governing Council meetings could be an important component of a culture of openness and accountability. Favero et al. (2000) agree, stating that summary minutes not attributing individual views would be possible and helpful (pages 37-38). While applauding the ECB s decision to begin publishing its projections for inflation and other economic variables, Alesina et al. (2001) argue that the publication of more forward looking information would aid predictability. In particular, they argue that the forecasts should be made, and eventually published, using the predicted paths of interest rates... (page 46) rather than on the basis of a constant interest rate assumption. (The Bank of England publishes its forecasts on the basis of both a constant interest rate assumption and using market interest rate expectations). Along similar lines, Svensson (2000) calls for a greater discussion of future prospects in the ECB s monthly bulletins, describing them as at present essentially backward-looking... (page 5). Increasing accountability: Favero et al. (2000) argue that accountability and legitimacy could be improved were the ECB s specific target to be set by ECOFIN and/or the European Parliament. They suggest that this would enable the ECB to focus on the technical task of meeting this target. It would also allow democratically elected representatives to change the monetary policy objectives if these differed from those of the public. Favero et al. claim that such a move would also contribute to fewer national tensions in policy-making and to less contentious appointments.... The goal could be set at regular, say three-year intervals... (page 70). a See also Giavazzi (2003), who writes that Best practice in central banking strongly argues in favour of delegating interest rate decisions to an independent committee. 3

4 Fig. 3. Soskice-Iversen diagram: Implications for equilibrium unemployment of switch from ERM to EMU w e(m 0 ) e(m 1 ) e(m 2 ) WS 0 W non G W G 1 WS 1 PS e(m(w); m=m 2 ) e(emu) e(erm nong) e(erm, G) e 4

5 2. Fiscal Policy Table 1. Government financial balances, debt interest and debt ratios EU Latest (2003 projection) Financial balance/gdp Net debt interest/gdp Net debt/gdp Structural balance Real interest 1980s: s: : 1.6 rate Growth rate 1980s: s: : 2.0 US Financial balance/gdp Net debt interest/gdp Net debt/gdp Structural balance Real interest 1980s: s: : 1.4 rate Growth rate 1980s: s: : 2.2.OECD Economic Outlook, various years. Note that to calculate the primary balance, you need to exclude interest payments from the financial balance e.g. for EU, a deficit of 4.9 becomes a deficit of 1.1 when interest payments of 3.8 are excluded. 5

6 Table 2. Maastricht definition of general government gross public debt Austria Belgium Denmark Finland France Germany Greece Ireland Italy Netherlands Portugal Spain Sweden UK Source: OECD Economic Outlook June 2003 Annex Table 58. 6

7 Fig. 4. Comparison of UK and EU Fiscal Policy frameworks Source: From the Treasury s EMU Studies: HM Treasury (2003) Policy Frameworks in the UK and EMU 7

8 Fig. 5. Comparison of UK and EU Fiscal Policy stance: pro-cyclical or counter-cyclical Source: From the Treasury s EMU Studies: HM Treasury (2003) Policy Frameworks in the UK and EMU 8

9 Fig. 6. Comparison of UK and EU Fiscal Policy stance: pro-cyclical or counter-cyclical Source: (as for Fig. 5) 9

10 Fig. 7. Academic ideas for the reform of the Stability & Growth Pact: (as for Fig. 5) Box 4.5: Academic ideas for SGP reform Debt rather than deficits: Many commentators think the SGP should focus on debt levels rather than deficits, since debt levels are most important for fiscal sustainability. Pisani-Ferry (2002) envisages a Debt Sustainability Pact, which would allow a country to opt-out of the SGP provided that its debt remains below, say, 50 per cent of GDP, that it publishes a comprehensive government balance sheet, including future liabilities, and that it sets a target for the public debt to GDP ratio. Any sanctions would result from high debt levels, not high deficits, providing more flexibility and more responsiveness to economic conditions, to those countries that are in a sustainable position.a Countries whose budgetary positions were not yet clearly sustainable would continue to be subject to the existing SGP. Allowance for public investment: Blanchard and Giavazzi (2003) argue that the capital budget of Member States should be excluded from the SGP, permitting borrowing for net public investment. They argue that this would increase transparency, bring governments budgets in line with best practice in private companies, permit quality investment, and prevent pro-cyclical tightening of fiscal policy in the short run.b A permanent balance rule: Buiter and Grafe (2002) favour a permanent balance rule, whereby the share of government taxes in GDP is kept constant at a value no less than the permanent public spending share in GDP, adjusted for expected future inflation and real growth, and taking into account the initial debt stock. Although some of the variables are not directly observable, Buiter and Grafe see the benefits of allowing for counter-cyclical policy and public investment that generates future cash flow for the government, outweighing any implementation costs. Institutional proposals: While many academic economists agree that the SGP could be improved by a greater focus on debt levels and cyclically-adjusted deficit figures, there is less consensus on the institutional changes that might be helpful. Some examples are: Fiscal policy committees Wyploszc argues that major institutional changes are needed to improve the functioning of the SGP, including through the creation of new fiscal policy committees in each Member State. These would have authority over the annual deficit in each country, but no say on the size and composition of expenditure and taxes. They would be given the long-term mandate of maintaining debt at a certain target, but would be able to vary the deficit in the short term to stabilise the economy. Because, like independent central banks, they would have no incentive to jeopardise the long-term goal, they could have more flexibility than elected governments in the short term to promote economic stability. New monitoring institutions Though more sophisticated rules might be economically sensible, they place greater pressure on surveillance, particularly if accountability and transparency are to be preserved. This places a premium on ensuring the integrity and credibility of the body undertaking the surveillance. For this reason, Begg et al. (2002) argue that the EU should delegate monitoring to an independent body. This would avoid concerns that estimates of the structural deficit would be subjective or open to political manipulation, enhancing the credibility of the Pact. Tradeable deficit permits Casella (2001) argues that the rules-based approach of most proposals should be replaced by a market-based solution. He proposes the establishment of tradeable permits to run deficits, akin to those used to reduce pollution at the lowest possible cost. Countries that wanted to run higher deficits would have to buy such permits from others before they could do so. a Other writers to suggest a focus on debt levels include Gros (2003) and De Grauwe (2002b). b Balassone and Franco (2001) also discuss the idea of providing greater room for investment in the SGP. c In his contribution to the EMU study Submissions on EMU from leading academics and expanded in Wyplosz (2002). 10

11 Table 3. Sources of budget consolidation in the EU countries in the 1990s (Changes over in percentage points of potential GDP) (1) (2) (3) (4) (5) (6) (7) (8) Consumption Transfers Investment Other capital Subsidies Total taxes Property income Primary balance transactions Germany France Italy UK Austria Belgium Denmark Finland Greece Ireland Netherlan ds Portugal Spain Sweden EU Note: Columns (1) to (5) record changes in expenditure items; columns (6) and (7) record changes in revenue items. Primary balance (8) = [(6)+(7)] [sum of (1) to (5)] Source: OECD Economic Outlook, December 1998, p

The Stability and Growth Pact Status in 2001

4 The Stability and Growth Pact Status in 200 Tina Winther Frandsen, International Relations INTRODUCTION The EU member states' public finances showed remarkable development during the 990s. In 993, the