The Eurozone s macroeconomic framework

Growth and Prosperity Jean Pisani-Ferry Discussions on the Eurozone s macroeconomic framework have been going on since the preparations for the Maastricht negotiations in 1989. Fifteen years later, and five years after the launch of the euro, their intensity gives no sign of abating. While the common currency is firmly in place, work is still under way on the larger system of macroeconomic principles, rules and institutions. Against the background of widespread dissatisfaction with the macroeconomic performance of the Eurozone, academics and politicians alike continue arguing about the necessity and the direction of reform. The Eurozone s macroeconomic framework Jean Pisani-Ferry Does it matter? What should be done? European institutions have not been irresponsive to the debate. In May 2003, the European Central Bank (ECB) introduced changes in its monetary strategy framework. In 2003, after the European Commission s Romano Prodi had made a famous statement on the stupidity of the Stability and Growth Pact (SGP), the Convention made a (largely unsuccessful) attempt to address the issue of economic governance in the draft constitutional treaty. On November 25th 2003, the ECOFIN council put the implementation of the SGP in abeyance as no agreement could be reached on enforcing its provisions upon France and Germany. Finally, the latest proposals for repairing the SGP were issued on September 3rd 2004 by European Commissioner Joaquin Almunia and were immediately dubbed by the Bundesbank as a change in the wrong direction. Long term growth is Europe s number one economic problem. However, it is often argued that those issues are of secondary importance and that instead of wasting intellectual and political energy in arguments about the SGP and macroeconomic policy coordination, Europeans should rather concentrate on designing and implementing urgent structural reforms. There are, therefore, several topics to discuss. The first is whether the issue is worth the efforts it attracts. The second is whether the existing framework needs repair. The third is what direction should be taken. These topics are addressed one by one in what follows. Does it matter? Long-term growth is admittedly Europe s number one economic problem. Is it therefore worth devoting efforts to reforming the Eurozone s economic framework rather than focusing all intellectual and political energy on structural issues, such as education, innovation, competition, the functioning of the labour market, and so on? The short answer is yes and the reason for this does not hinge on traditional Keynesian arguments. Let us begin with the false arguments. Whatever the quality of the 26 progressive politics vol 3.3

macroeconomic policy, it cannot substitute underinvestment in education, perverse labour market participation incentives or weak productivity growth. Absent appropriate microeconomic institutions, fiscal or monetary reflation can only deliver short-lived growth episodes. The sustained increase in labour force participation and productivity Europe needs undoubtedly calls for comprehensive reforms. From that, however, it does not follow that macroeconomic policy is of little relevance. Rather, an appropriate economic framework delivers benefits in three different ways. First, whatever the potential output, the responsibility of macroeconomic policy is to make sure that the economy operates as closely as possible to it. Second, macroeconomic policy can be looked at as insurance. As individuals or companies, the economy is frequently hit by shocks: oil shocks are a familiar example, but disturbances also come from the stocks and bonds markets, exchange markets, labour markets, and so on. While observing those shocks, the first questions economic agents ask themselves are: How will the government and the central bank react? Do they have a strategy to deal with it? If agents are confident that macroeconomic policy can act and will act to counter the adverse effects of shocks, they can themselves take more risks. If not, they prefer to play safe a secure job, and low-risk/low-return investments. Good macroeconomic insurance can thus be conducive to growth-enhancing behaviour. Third, macroeconomic policy can help foster structural reforms. The reason is that those reforms frequently amount to trading short-term costs for longterm gains. This is evident if political costs and benefits are taken into account but remains true even if the calculation is conducted in purely economic terms. Reforming employment protection can, for example, imply more unemployment in the short term (as firms dispose of redundant workers) but less in the long term (as flows increase and the market for labour becomes more fluid). Thus, the inter-temporal gain from introducing a reform can be low or Economic reforms and a skilful management of aggregate demand are complements rather than substitutes. even negative if governments have a preference for the present. This is where macroeconomic policy comes in. Assume that a reform increases potential output but that the economy converges only slowly to the new, higher equilibrium (this is typically what happens if a labour market reform results in lowering structural unemployment). What macroeconomic policy can do is to change the inter-temporal distribution of costs and benefits through pushing the economy to the new, higher equilibrium. By taking advantage of the structural improvement before spontaneous convergence has taken place, it can make reforms less costly in the short term and thus more attractive for politicians. vol 3.3 progressive politics 27

Growth and Prosperity Jean Pisani-Ferry In other words, macroeconomic accommodation can be an incentive to structural reform. Nothing is thus less productive than the traditional debate an old one amongst social democrats between the proponents of supply-side policies and the advocates of demand management. Economic reforms and a skilful management of aggregate demand are complements rather than substitutes. Both can be conducive to growth and employment. Does the current system need repair? How does Europe s macroeconomic policy framework measure up to the requirements we have mentioned? Taking the long view first, in There is still significant disagreement in Europe on substantial macroeconomic policy principles. comparison to the US, the EU-15 of the 1960s was characterised by both high growth and a high degree of real stability. Decade after decade, it has moved down the growth ladder without making progress as regards real stability. During the same period, the US has moved up the stability ladder 1 without reducing its growth performance. This suggests there is room for improvement on both accounts. Persistent budgetary deficits are frequently regarded as indications of the stabilising role of fiscal policy in the Eurozone. This is at least an exaggeration. Not only has the aggregate Eurozone structural deficit remained nearly constant throughout the 1999-2004 period, but its (small) changes have generally been misleading. Most of the time, fiscal policy has amplified rather than softened the effects of the economic cycles. The Stability Pact cannot take all the blame for this poor performance. According to its defenders, it would have been perfectly compatible with a stabilising stance, had all Member States moved to a balanced or even surplus position in 1999-2000. This is undoubtedly correct, but neglects the fact that the SGP was precisely supposed to provide the right incentives for this kind of behaviour. What about monetary policy? The quality of the policy of the ECB has undoubtedly been superior to that of aggregate fiscal policy. Outside observers recognise that the central bank has generally moved in the right direction with respect to the economic cycle (see, for example, Sapir et al., 2004). But the ECB is frequently criticised for having set a low inflation target that it has not been able to meet in practice and for having been slow in responding to changes in economic conditions and perspectives. Fiscal and monetary policy behaviour can clearly not be given the same score. Both, however, contribute to limiting the aggregate stabilisation role of macroeconomic policy. The superficial reason for this state of affairs is that policy has been either hesitant or held back by constraints. The deeper reason is that there is still significant disagreement in Europe on 28 progressive politics vol 3.3

substantial macroeconomic policy principles. There is, for example, no consensus on the extent of overall stabilisation that is appropriate. While there is agreement to consider that automatic stabilisers should be allowed to play their role in full and that a monetary policy devoted to pursuing price stability provides built-in stabilisation in response to a demand shock, fiscal and monetary activism are both controversial. Controversies on the operation of the Eurozone s current macroeconomic framework boil down to deeper debates on the principles upon which Economic and Monetary Union is built. Europe, in a way, continues to hesitate between two views of monetary integration, which Maastricht tried to reconcile. On the one hand, there are those who seek to forsake activism and to ensure that economic policy abides by a set of fixed rules. On the other hand, there are those who regard fiscal and monetary policy as key instruments that have to be used for minimising the adjustments imposed on society by external shocks. These two views are both compatible with the goal of price stability and a scrupulous respect of the central bank s independence. But they correspond to two different policy philosophies. Summing up, the euro has certainly been a success on many counts and none of the catastrophes that its opponents had announced has materialised. But complacency would be misplaced and the partisans of the common currency should recognise that in the last five years, the overall performance of the Eurozone s macroeconomic policy system has not been satisfactory. Thus, reform must remain on the agenda. Reforming the Stability Pact: conditions for success Following the difficulties encountered in implementing the Stability and Growth Pact, the focus of current discussions is on reforming it. There has been no shortage of academic propositions to this end. Most of them are based on either one of the following three principles: The key issue is whether economic governance in the Eurozone should be based on legally binding fixed rules or collective decisions. First, move away from a focus on the deficit towards putting more emphasis on the debt ratio. A debt sustainability pact would leave more room for manoeuvre to Member States in the short run, while being more demanding in the long run. It would also be more demanding for countries whose debt ratio is high than for those whose level of indebtedness does not call for corrective action; Second, introduce some form of golden rule that would take into account the counterpart of the deficit. Countries that borrow to invest and more generally to contribute to the goals of the Lisbon agenda would be given more freedom that those who borrow to consume; Third, focus on institutions rather than on rules, namely, give more room for manoeuvre to the Member States whose domestic institutions ensure a vol 3.3 progressive politics 29

Growth and Prosperity Jean Pisani-Ferry high degree of fiscal discipline in the long run. In its communication of September 3rd 2004, the European Commission leant toward the first and hinted at the second and the third, but its main focus was on introducing suppleness in the implementation of the pact. It proposed to move away from the one-size-fits-all approach to fiscal discipline of the earlier pact and when making a decision on a country s fiscal situation, to take into account the country s debt level and more broadly the sustainability of its public finance, as well as the economic conditions and perspectives. Thus, a low-debt country would be given more leeway in the definition of its medium term fiscal target and should the deficit exceed three per cent in an economic slowdown, it would be given more time to correct it. Similarly, a country whose deficit originates in growth-enhancing investments or reforms would be treated differently from another whose deficits results from profligate public consumption. The difference from the original version of the pact and this new proposal comes more from a change of underlying model than from technical amendments. The original version essentially relied on the clarity and the uniformity of its rules. The logic was on defining strict numerical limits, leaving as little room as possible for interpretation and tailormade implementation. 2 With the absence of a strong political authority, it was felt that only a simple, welldefined and transparent rule could be enforced on Member States, both big and small 3. The corresponding price was a lack of flexibility, but it was deemed worth paying for the sake of ensuring enforceability and equality among Member States 4. Year after year, the Council has increasingly distanced itself from this interpretation. The first step has been to take cyclical developments into account, then to enter into discussions on the debt level and on the effects of Reforming the existing Stability and Growth Pact framework and implementing a model that relies more on analysis and judgement is no small step. structural reforms. Finally, the decision on November 25th 2003 made clear that simplicity and transparency were not enough to ensure enforceability. The new Commission proposal would lead significantly further. Instead of simple, uniform and directly enforceable rules, it is proposed to move to more complex and principles whose tailor-made enforcement requires prior analysis. The underlying model can be described as what economists call constrained discretion. Under this model, policymakers retain flexibility and discretion in defining responses to shocks while abiding by a commitment to deliver long-term policy objectives 5. Inflation targeting is an example of such a policy, because unlike a money target rule it leaves the central bank freedom to set interest rates, while imposing the discipline of keeping 30 progressive politics vol 3.3

inflation expectations close to the target. Similarly, what the Commission proposes amounts to giving states more freedom as regards the deficit, while anchoring fiscal discipline in a commitment to medium-term debt sustainability. This approach requires that the bodies in charge of conducting policy are capable of sound economic judgement, self-discipline, and consistency. These are not qualities easily at hand for a grouping of ministers, all of which see themselves as representatives of national interests and, in any case, need to respond to domestic political pressures. It is precisely for that reason that the simpler but also more robust SGP was initially adopted. The question is thus, what conditions must the EU institutions fulfil for the newly suggested approach to be successful? The first condition is that surveillance be based on thorough professional assessment. Decision on individual cases inevitably involves lengthy discussions, bargaining and strategic voting. For consistency to be maintained across states and over time, those decisions must be underpinned by high-quality expertise relying on standardised methods. The new framework requires equipping the Commission with the means of providing authoritative assessments that is, professional staff in sufficient numbers, the ability to investigate, and independence in formulating policy recommendations. This does not mean that the Commission should be given more executive powers in any case it has very few such powers in the macroeconomic field, and there is no room for a third executive player alongside the Council and the ECB. But it means it should be given all the powers that are necessary to exercise a thorough surveillance function. Beyond the right to issue early warnings introduced in the draft constitutional treaty, this means that the Commission should be able to investigate the state of public accounts in the Member States in the same way that the IMF does when conducting field missions and to make its conclusions public. 6 The second condition is to upgrade the economic content of policy discussions. Rules that are not underpinned by common policy principles, even legally binding ones, lack credibility. Treaty provisions cannot substitute for the absence of a shared philosophy. They risk being regarded by national policy-makers and public opinion as outside constraints for which there is no ownership. For those reasons, working out a set of common economic policy principles that goes beyond the provisions of the treaty a charter or a code of conduct and forging a consensus around those principles would help in making policy more predictable and in convincing private agents that participants in the euro work on common assumptions as regards economic targets and mechanisms. The EU has already moved in that direction when reacting to events. More should be done, probably with the help of outside expertise. The third condition is to decentralise fiscal discipline and to create appropriate incentives for it. In several countries of the Eurozone, the SGP has had the effect of delegating discipline to Brussels. While fiscal sustainability vol 3.3 progressive politics 31

Growth and Prosperity Jean Pisani-Ferry is primarily a domestic issue, because it affects the intergenerational distribution of income, it has increasingly been perceived as a topic for discussions with EU institutions and partners. However, whatever the strong justifications for ensuring fiscal discipline in a monetary union, the burden of irresponsible behaviour still falls first and foremost on a country s present and future residents. Furthermore, putting in place domestic institutions that are conducive to fiscal discipline would relieve the EU institutions from part of the burden of ensuring it and give them more leeway to refine the Stability Pact. Hence, the suggestion by the Sapir (2004) report (echoed in the Commission communication) to create national fiscal audit committees that would publish independent assessments of the state of fiscal affairs. 7 The fourth condition is to create the right environment for informed collective decision making within the Council. An additional improvement is the upcoming move to a stable presidency instead of the rotating one. This will help in ensuring consistency in the decisions and should be taken as an occasion to make the decisions and their underpinnings more transparent. Further steps could be taken in the direction of turning the Council into a collective executive body, such as vesting a Eurozone council with the power to decide on issues specific to the countries participating in the single currency 8 and making it more accountable to parliamentary scrutiny. Finally, the Council should be able to concentrate on issues of major economic significance for the Eurozone rather than risk wasting authority and political capital in micromanaging a variety of situations. For that purpose, it should concentrate budgetary surveillance on the issue of sustainability. Unsustainable debt evolutions represent a real threat to the stability of Monetary Union, and for that reason, the EU is entirely justified when making recommendations to reverse course. It is advisable to move towards a sustainability pact that would give more fiscal margin of manoeuvre to low-debt countries and concentrate surveillance on where real danger lies. Those five conditions in the end boil down to a very simple concept: legitimacy. Moving away from a fixed rules approach toward a constrained discretion approach requires that decisions by the Council convey technical, economic and political legitimacy. Technical legitimacy must be based on the quality of the expertise; economic legitimacy on the fact that beyond legal underpinnings, a convincing case can be made for the policy decisions that are advocated; and political legitimacy on quality and transparency of decisions processes as well as on ultimate accountability. Conclusions This article has argued that the quality of the macroeconomic policy frameworks is a first-order issue; that the Eurozone s present framework is in need of reform; and that the Commission proposals for adapting the Stability Pact are a step in the right direction, provided precise conditions are met. The significance of the debate that will take place in the coming months should not be underestimated. The key 32 progressive politics vol 3.3

issue that clearly emerges is whether economic governance in the Eurozone should be based on legally binding fixed rules or on collective decisions underpinned by economic principles. The first model has been tried until politics reclaimed its rights. The second has not yet been tried but the evidence is that it cannot be made successful in the absence of technical, economic and political legitimacy. If no agreement is reached, or if the second model fails, the Eurozone is likely to adopt some kind of revamped version of the Sinatra doctrine 9 which is certainly not the best way to manage a currency union. Reforming the existing framework and implementing a model that relies more on analysis and judgement is no small step. It requires that the Council takes existence as a collective body which is capable of defining its policy doctrine and implementing it in a consistent way. This implies sharing assessments and making informed judgements on policy directions while avoiding decisions being captured by ad-hoc coalitions. Beyond technicalities, whether or not the Eurozone council will be capable of behaving in this way is essentially a political issue. This is an abridged version of an essay originally published in Economic Reform in Europe: Priorities for the Next Five Years (Policy Network, 2004) Edited by Roger Liddle and Maria João Rodrigues. Jean Pisani-Ferry is professor at the Université Paris-Dauphine. He is a member of the Conseil d analyse économique. He was co-author of the Sapir report from the High-Level Study Group appointed by Romano Prodi in 2003. He is currently project manager for a European centre for international economics. 1 An exception has to be made for the 1970s, in which the oil shocks reduced stability in both the EU and the US. 2 On the genesis of the SGP, see Stark, (2001). 3 For a discussion along these lines, see Buti, Eijffinger and Franco (2003). 4 German MOF officials, among which some of the negotiators of the pact, recently emphasised that the initial pact "was not a mechanical concept" (Höppner, Kastrop, Olbermann and Westphal, 2004). It is correct that the initial German proposal included a "Stability Council" entrusted with the responsibility of assessing national situations and deciding on sanctions. Furthermore, there were escape clauses in the pact. But the pact was entirely designed to limit the ability of the Commission to exercise judgement when preparing a recommendation to the Council on the existence of an excessive deficit. Only the Council retained a margin of flexibility and in the end it made use of it by refusing to approve the Commission s recommendation to enforce the pact on France and Germany. 5 See Bernanke (2003). 6 The Commission is also right to mention the need to check that the status of national statistical institutes makes them able to produce reliable public finance data. 7 The inspiration for this proposal came from Charles Wyplosz s idea of giving responsibility for fiscal policy to independent national councils. See Wyplosz (2002) 8 See Coeuré and Pisani-Ferry (2004) for developments along those lines. 9 The Sinatra doctrine, named after the Frank Sinatra song My Way, was the name that Mikhail Gorbachev used to describe the policy of allowing neighbouring Warsaw Pact nations to determine their own internal affairs. What followed is known. vol 3.3 progressive politics 33