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European Commission

Directorate-General for Economic and Financial Affairs

EMU@10: successes and challenges
after 10 years of Economic and
Monetary Union

EUROPEAN ECONOMY 2/2008

FOREWORD

A full decade after Europe's leaders took the decision to launch the euro, we have good reason to be
proud of our single currency. The Economic and Monetary Union and the euro are a major success.
For its member countries, EMU has anchored macroeconomic stability, and increased cross border
trade, financial integration and investment. For the EU as a whole, the euro is a keystone of further
economic integration and a potent symbol of our growing political unity. And for the world, the euro
is a major new pillar in the international monetary system and a pole of stability for the global
economy. As the euro area enlarges in the coming years, its benefits will increasingly spread to the
new EU members that joined in 2004 and 2007.

Yet important work still lies ahead. In the coming decade, we must build on the achievements of the
last 10 years, address the remaining shortcomings and prepare for the challenges of the future.
Globalisation, ageing and climate change require a more adaptable and dynamic economy. In the 21st
century, European citizens demand that economic competitiveness and flexibility be accompanied by
greater opportunities and stronger social cohesion.

I believe that there is scope to strengthen the framework of EMU and draw greater benefits from the
euro. Sound macroeconomic policies coupled with a targeted agenda of structural reforms are key to
meet our goals for growth and social justice. For countries of the euro area, ensuring good economic
policies is a matter for common concern. But we cannot rely on market discipline alone. We need to
deepen and broaden macroeconomic surveillance in EMU and encourage structural reforms by
integrating them into the process of policy coordination. We must become the global political actor
that our economic weight and international currency demands. This will only come with a well
defined international strategy and a clear voice to present our positions in the global arena. It will
require political will and determination to implement this comprehensive agenda. Moreover, the new
Lisbon Treaty, once ratified, will increase the capacity for stronger coordination and surveillance of
our economic policies.

Building on the policy agenda put forward in the Commission Communication and the extensive
analysis presented in this report I intend to launch, in the second half of 2008, a debate on the future of
EMU and promote consensus on the building blocks of such an agenda. The conclusions that we draw
from this debate will feed into new, operational proposals to be advanced by the European
Commission and will shape a longer term policy roadmap that will ensure EMU continues to flourish
in the next decade and beyond.

Joaquín Almunia
Commissioner for Economic and Monetary Affairs

ABBREVIATIONS AND SYMBOLS USED

Member States
BE Belgium
BG Bulgaria
CZ Czech Republic
DK Denmark
DE Germany
EE Estonia
EL Greece
ES Spain
FR France
IE Ireland
IT Italy
CY Cyprus
LV Latvia
LT Lithuania
LU Luxembourg
HU Hungary
MT Malta
NL The Netherlands
AT Austria
PL Poland
PT Portugal
RO Romania
SI Slovenia
SK Slovakia
FI Finland
SE Sweden
UK United Kingdom

EA-15 European Union, Member States having adopted the single currency
(BE, DK, DE, EL, ES, FR, IE, IT, CY, LU, MT, NL, AT, PT, FI, SE and UK)
EU-10 European Union Member States that joined the EU on 1 May 2004
(CZ, EE, CY, LT, LV, HU, MT, PL, SI, SK)
EU-15 European Union, 15 Member States before 1 May 2004
(BE, DK, DE, EL, ES, FR, IE, IT, LU, NL, AT, PT, FI, SE and UK)
EU-15ex5 EU-15 excluding EL, IE, LU, PT and SE
EU-25 European Union, 25 Member States before 1 January 2007
EU-27 European Union, 27 Member States

Currencies
EUR euro
BGN New Bulgarian lev
CZK Czech koruna
DKK Danish krone
EEK Estonian kroon
GBP Pound sterling
HUF Hungarian forint
JPY Japanese yen
LTL Lithuanian litas
LVL Latvian lats
PLN New Polish zloty
RON New Romanian leu
SEK Swedish krona

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SKK Slovak koruna
USD US dollar

Other abbreviations
BEPG Broad Economic Policy Guidelines
CESR Committee of European Securities Regulators
EA Euro area
ECB European Central Bank
ECOFIN European Council of Economics and Finance Ministers
EDP Excessive deficit procedure
EMU Economic and monetary union
ERM II Exchange Rate Mechanism, mark II
ESCB European System of Central Banks
Eurostat Statistical Office of the European Communities
FDI Foreign direct investment
FSAP Financial-Services Action Plan
GDP Gross domestic product
GDPpc Gross Domestic Product per capita
GLS Generalised least squares
HICP Harmonised index of consumer prices
HP Hodrick-Prescott filter
ICT Information and communications technology
IP Industrial Production
MiFID Market in Financial Instruments Directive
NAWRU Non accelerating wage inflation rate of unemployment
NEER Nominal effective exchange rate
NMS New Member States
OCA Optimum currency area
R&D Research and development
RAMS Recently Acceded Member States
REER Real effective exchange rate
SGP Stability and Growth Pact
TFP Total factor productivity
ULC Unit labour costs
VA Value added
VAT Value added tax

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ACKNOWLEDGEMENTS

EMU@10: Successes and challenges after 10 years of Economic and Monetary Union includes
the Commission Communication adopted on 7 May 2008 at the initiative of Commissioner Almunia,
and the analytical report issued under the responsibility of the Commission Services.

The analytical report was prepared under the responsibility of Klaus Regling, Director General for
Economic and Financial Affairs and Marco Buti, Deputy Director General for Economic and
Financial Affairs. It was prepared as part of the project EMU@10, with internal and external
contributions appearing in the series European Economy – Economic Papers alongside the report. The
project was managed by a Steering Group consisting of John Berrigan, Marco Buti, Servaas Deroose,
Joost Kuhlmann, João Nogueira Martins, István P. Székely, Heliodoro Temprano Arroyo and Paul van
den Noord.

Paul van den Noord, Senior Economic Adviser in the Directorate for Economic Studies and Research,
was the global editor of the report and Alessandro Turrini, Heliodoro Temprano Arroyo, Michael
Thiel, John Berrigan and Joost Kuhlmann were associate editors.

The report has drawn on substantive contributions by Alfonso Arpaia, Stefan Appel, Magnus Astberg,
Joaquim Ayuso Casals, Johan Baras, Johan Bendz, Nicolaas Beinema, John Berrigan,
Moreno Bertoldi, Carsten Brzeski, Guiseppe Carone, Zdenek Cech, Declan Costello,
Antoine Deruennes, Oliver Dieckmann, Adriaan Dierx, Nuria Diez Guardia, Marie Donnay,
Björn Döhring, Per Eckefeldt, Roland Eisenberg, Roberta Friz, Olivia Galgau, Christian Gayer,
Christine Gerstberger, Tomasz Gibas, Laura Gonzalez Cabanillas, Martin Hallet, Dermot Hodson,
Fabienne Ilzkovitz, Jan In't Veld, Lars Jonung, Christian Just, Daisuke Karakama, Joost Kuhlmann,
Paul Kutos, Sven Langedijk, Martin Larch, Karolina Leib, Julia Lendvai, Staffan Linden,
Luis Angel Maza Lasierra, Mihai-Gheorghe Macovei, Ulrike Mandl, Carlos Martinez Mongay,
Mary McCarthy, Kieran McMorrow, Gilles Mourre, Gaëtan Nicodème, João Nogueira Martins,
Moisés Orellana Pena, Manuel Palazuelos Martinez, Dario Paternoster, Marga Peeters, Lucio Pench,
Stefan Pflüger, Karl Pichelmann, Esther Perez Ruiz, Werner Röger, Eric Ruscher, Andrea Schaechter,
Nikolaos Sdrakas, István P. Székely, Heliodoro Temprano Arroyo, Michael Thiel,
Georges Tournemire, Sirpa Tulla, Nuno Sousa, Massimo Suardi, Alessandro Turrini,
Clairette Van der Lans, Errikos Velissaratos, Lucio Vinhas de Souza, Joachim Wadefjord,
Max Watson, Rainer Wichern, Javier Yaniz Igal and Marcin Żogała.

The report benefited from extensive comments by a staff referee group led by István P. Székely,
Director for Economic Studies and Research, with contributions by Ronald Albers, Stefan Appel,
Johan Baras, Tassos Belessiotis, Heinz Jansen, Lars Jonung, Nuno Sousa and Lucio Vinhas de Souza.
Helpful comments were also received from Elisabetta Capannelli, Francesco Contesso, Vitor Gaspar
and Gabriele Giudice.

The responsibility for the lay-out of the report was in the capable hands of George Alexakis,
Greta Haems, Virginia Giovannelli, Anita Ivan and Adam Kowalski.

Comments on the report would be gratefully received and should be sent, by mail or e-mail to:

Paul van den Noord
European Commission
Directorate-General for Economic and Financial Affairs
Directorate for Economic Studies and Research
Office BU-1 05-198
B-1049 Brussels
e-mail: paul.vandennoord@ec.europa.eu

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5. Introduction 25 2.6.2. The euro exchange rate 41 3. Catching-up within the euro area 106 8.2. The Impact of EMU on financial markets 94 7. Promoting further financial integration in EMU 101 8.2. The core mechanisms at work 55 4.4.4.3. The determinants of structural reform in EMU 88 7. A closer look at Spain and Portugal 112 vii . Concluding Remarks 51 4.1.1. Ageing-related reform 82 6.5. The impact of EMU ON financial-market infrastructures 97 7. Macroeconomic performance 27 2. Gauging the competitiveness channel 55 4.5. Introduction 94 7.4. Measuring business cycle synchronisation 43 3.6. Introduction 27 2. Introduction 52 4.3.2. The conduct of monetary policy 65 5.5.2. Business cycle synchronisation 43 3.4. Has the common currency spurred synchronisation in the euro area? 49 3. Macroeconomic policies and the policy mix 64 5.5.2.5. Some measurement caveats 94 7. Introduction 106 8.4. Growth.2. Growth accounting evidence 108 8. Labour market reform 78 6. Reforms of social systems and labour and product markets 78 6. The conduct of fiscal policies 69 5.CONTENTS Communication from the Commission 1 Part I: Assessing the first 10 years 15 Summary of main findings 17 1. Inflation performance 27 2. Financial market integration 94 7.3.1. jobs and productivity 31 2. The Impact of EMU on the banking sector 99 7. Introduction 43 3. The Stylised facts of convergence 106 8.1. Introduction 78 6. Introduction 64 5. Resilience in the face of shocks 37 2.3.6. Concluding remarks 62 5. Stylised developments 53 4. The macroeconomic policy mix 76 6. The risk premium shock 109 8. Product market reform 85 6.1.4. Recent correlation developments and stylised business cycle facts 46 3.3.4.3. The adjustment experience 52 4.1. Gauging the real interest rate channel 61 4.3.1. The role of public finances 110 8.

4. Challenges during the transition 210 6.2.3.3. Implications of enlargement for the euro area 215 6. Regional patterns 124 9.3. The euro area and global stability 225 viii . Introduction 117 9. Raising employment rates 168 3. Introduction 178 4. Trends in the international role of the euro 117 9. Fiscal sustainability 195 5. High-quality statistics for EMU 146 Part II: Goals and challenges 149 Summary of main findings 151 1.1. Benefits from euro adoption 208 6. Trends in the international use of the euro by function 117 9.7. Progress with real convergence 204 6.5. Longer-term global trends 159 2. The euro's international potential 218 7. The path towards euro adoption 203 6.1.1.2. Introduction 218 7. Concluding remarks 177 4.4. Enlarging the euro area 203 6.6. A changing world landscape 159 2. 8.2.2. Emerging policy issues 165 3.2. The quality of public finances 198 5. The role of product and labour markets 180 4.4.3.3.2. Quality and sustainability of public finances 195 5.3. A changing typology of shocks 178 4. Introduction 167 3.1.3.4.5. Long-term projections 167 3. Benefits and costs of an international currency 221 7.5. The evolution of economic governance 133 10. Raising productivity growth 171 3.1.1. Introduction 159 2. Fiscal governance 133 10. The role of financial markets 184 4. International Governance 141 10. Governance of structural policy 138 10.4. Managing the euro-area's growing international role 218 7.2.4.7. Promoting growth and employment 167 3. Economic implications 161 2.2.1.4.4. Concluding remarks 217 7. Ensuring efficient adjustment and stabilisation 178 4. Concluding remarks 115 9. Introduction 157 2. Introduction 195 5. Concluding remarks 131 10. Introduction 133 10.3. Overall Assessment 202 6.1.5. Introduction 203 6. The role of fiscal policy 194 5.

New global challenges and responsibilities 279 3. Strengthening bilateral dialogues with strategic partners 283 3.3. Mean intra-euro-area correlation in consecutive cycles 49 I.2. Introduction 250 2. EA-correlation with outside countries (GDP) 50 I. 1999-2008 75 I.6.3. Policy synergies and trade-offs 234 8.6. Issues of policy coordination 236 8.1. Integrating structural reforms in EMU coordination framework 263 A.4.1. Two indicators of the severity of downturns (1) 37 I. Improving economic governance in EMU 286 4. Domestic agenda 251 2.4.2.3.1.3. Changes in the future system of economic governance in the euro area 291 References 294 LIST OF TABLES I. SE and US 29 I. 1999-2008 75 I. 7.2. Volatility of quarterly nominal effective exchange rates against 24 industrial countries 42 I.5.6. Determinants of structural reform scores based on alternative sources 93 ix .2. Mean euro-area business cycle correlation in recoveries and recessions 48 I. Reform data 90 I. Introduction 233 8.1. Concluding remarks 242 Part III: Policies and governance of the euro area 243 Summary of main findings 245 1.6. Recommendations and implementation scores in the Broad Economic Policy Guidelines 2000-2005 90 I.1.2. Introduction 279 3.2.4.1.2. Why consolidate external representation? 281 3.5. Rationales 251 2. Enhancing the global role of the euro area 279 3.3.2. Stronger coordination and dialogue for better governance and greater legitimacy 290 4.4.1.1.4. Inflation performance by decade: UK. Fiscal policy stance ex post.2. Broadening macroeconomic surveillance 256 2. Inflation performance in the euro area 28 I. More effective governance 285 4.3.3. Deepening budgetary surveillance 252 2.1.3.5. Monitoring intra-area competitiveness 276 3. Fiscal policy stance ex post. Exploiting policy synergies and the benefits from coordination 233 8. Macroeconomic performance indicators 19 I.2. Fiscal policy stance ex ante.5. Introduction 285 4. Concluding remarks 231 8.3.2.5. 1989-1998 75 I. Concluding remarks 283 4.4.3.1. Determinants of structural reform scores based on BEPGs 91 I.2.3.

2006 218 II. Selected Indicators on the Size of the Capital Markets.9.9. Public debt and its burden (% of GDP) 112 I.5. Labour productivity growth 34 I.2. Output growth 33 I.2.2. Potential growth and its components 108 I. A survey of recent evidence 186 II.1.3. Financial integration and risk sharing.7.8. Euro-area output gap developments from peaks 37 I.2.2. public investment and structural funds 111 I.7.5.8.2.2.3.2. I. Domestic demand after the cyclical peak.4.2. The sources of differences in per capita GDP vis-à-vis the EU15 in 2006 206 II.2.4.8. Direction of Trade in Main Latin American Regions.7.1.7.8.6.5. Quarterly interest rate volatility (standard deviation) 228 II.2. Inflation: level and volatility 28 I. and labour and product market institutions 183 II. Long-term potential Growth Rates and their Components 168 II.9. Share in international trade invoicing/settlement (1) 120 I. 2006 219 II.2.10. Inflation.3. Competitiveness.4. Functions of an international currency 118 I.6.5.3.2.5. adjustment. Contributions to euro area overall HICP inflation 30 I. Frequency of consumer price changes by product type (% of prices that change in a month) 182 II.1.4. Overall risk classification 196 II.4. Volatility of macroeconomic variables 228 II.3.4.10. Output gap developments after the cyclical peak of 2000. 1990-2005) 200 II.2.3.4.5. Output growth per capita 33 I. Timeliness of economic indicators 148 II. Decomposition contributions to participation rates 170 II.7.2. Correlation of long-term interest rate 231 LIST OF GRAPHS I.2.9. Fiscal consolidation and the size of the public sector 111 I.3.5. Difference between the observed and planned increase in real primary expenditure EU-15 explained. Key characteristics of main economies. euro area and US (in % of trend) 38 I.1.1.1.13.2. Explaining the investment-capital stock ratio 109 I.8.10.5. Countries and territories with exchange rate regimes linked to the euro 122 I. Sustainability gap indicators 196 II. Volatility of wage growth 30 I. euro area (index 100 at cyclical peak) 38 x .8.2.11. Employment growth 33 I.6.3. Currency distribution of foreign exchange market turnover 119 I.2.7.4. 2006 131 I. Volatility of import price changes 30 I. Constituencies in the IMF (as of 13 February 2008) 143 I. 1990-2006 201 II.1. Average duration over which prices/wages remain fixed (in quarters) 180 II.4.7. Fiscal Balance and Current Account Balance 219 II.2. Volatility of GDP growth 28 I.9. Real trade in goods 35 I.4.1.12. The tax mix. Influence of fiscal rules on the primary cylically adjusted balance (EU-25.2.9.1.

1975m7-2007m7) 47 I.2.2.6.2.4.4. Fiscal and monetary stance in the US 76 I. Change in primary expenditure ratio to GDP 70 I. Real effective exchange rate based on GDP deflator 58 I.1.11. Household real disposable income after cyclical peaks. NAWRU by country 81 xi . Euro area-US short-term interest rate differential and annual percentage change in the EUR USD exchange rate 41 I. Short term interest rate in the euro area: actual and implied by a normative Taylor rule 68 I.4. Determinants of cost competitiveness.13.3.4. Discretionary fiscal policy in major downturns. euro area (index 100 at cyclical peak) 38 I.2.5. index. Real short-term interest rates during major downturns.9.5.5. Euro-USD and effective exchange rates against 41 countries (monthly data. Mean euro-area correlation and recession phases (IP data) 47 I. euro area (in %) 39 I. Investment after cyclical peaks. The unemployment rate and the NAWRU in the euro area 80 I.3.4.6. Output gap estimates for the US 72 I.20.3.3.5. Development of fiscal positions 69 I.1.2.4. Money and credit growth 67 I. Employment rate by country 81 I.5.6.3. euro area (index 100 at cyclical peak) 38 I. Monetary conditions index 68 I.12.4. Cumulated change in real house prices 54 I.2.5. Inflation in the euro area 66 I. Output gap estimates for the euro area 72 I. Jan 1999=100) 41 I. Rolling correlations (GDP. Real effective exchange rate based on GDP deflator 56 I.9.4. Real effective exchange rate based on Unit labour costs 58 I.4. Current account positions 54 I. Daily exchange rate volatillity against the USD (st'dev in %) 42 I.4.15.14. IP 46 I.5.8.5.6.6. Mean euro-area correlation.2.4.2. Real effective exchange rates and the trade contribution to growth 58 I. Cumulated real per capita GDP growth relative to aggregate 1999- 2007 53 I. Real effective exchange rate based on unit labour costs 56 I. Standard deviation of euro-area output gaps 45 I.11. Fiscal and monetary stance in the euro area 76 I.7. Change in revenue ratio to GDP 70 I.5.12. 1999-2006 60 I. Euro-area business cycle phases (IP.15.3.2.5.5.16.4.5.2.5.5.17.4.1. Residential investment as a share of GDP 54 I. Cumulated consumer price inflation relative to aggregate 1999-2007 53 I.I. Official and short-term interest rates 67 I. Consumption after cyclical peaks.5. 6-year window) 1 50 I.21. euro area (index 100 at cyclical peak) 38 I.10.4.8. Cumulated change in relative unit labour cost 54 I. Short term interest rate in the euro area: actual and implied by a positive Taylor rule 69 I.6.3. euro (cyclically adjusted primary balance in %) 39 I.5.5.5. Mean euro-area correlation and recession phases (GDP data) 48 I.2.18.4. Change in expenditure ratio to GDP 70 I.1.13.3.3.2.4.14.7.3.19.10. Real interest rates 54 I. Development of gross public debt 70 I.

5. Currency in circulation.5.7.4.5. Real wage and productivity growth.9.2. Currency breakdown of stocks of international bonds and notes (shares of total in %) 129 I.9.5.3. Slipping fiscal targets 134 I.7.4. Overall risk classification and the sustainability gap 197 II.10. Difference between the male and female participation rates 170 II.1.7.9.8.3.4.2. Indicators of product market regulation 86 I. Stock of international debt securities: narrow definition 118 I.2.6.9. Evolution of 3-months interbank rates (in %.6. annual data) 96 I.2.6. Stock of international debt securities: broad definition 118 I.3. 2005) 125 I. Fiscal balance projections in Spain 114 I. Euro area government bond spread over Bunds 104 I.7.8. Value of M&A deals performed by EU banks 99 I.8.1.3.9. Currency in circulation.2. EUR and USD.2.1. 28 Industry Breakdown of total TFP Contribution to Value Added Growth US minus EU-15ex5 (1996-2004) 172 II. Age-related expenditure in the euro area (% of GDP) 163 II. Participation rates by age profile 170 II.7.7.3. Consolidation of post-trading infrastructures in the euro area 98 I. Reserves of Central Bank of Russia 127 I. Public perception of reform needs 140 II.10. Interest rates and the cycle 164 II.5.1% income shares 164 II.3.4. Number of payment systems in the euro area 98 I. EU share in SSA trade of goods (1995-2005) 128 I. User cost of capital 110 I. Real wage and productivity growth. Gross issuance of euro denominated bonds since 1999 (in EUR bn) 96 I.2. 2006) 126 I.7. levels 121 I. GDP Per Capita in 1999 106 I. EUR and USD. Currency shares in global foreign exchange reserves 124 I.6. I. Debt developments in the euro area.7. % of GDP 121 I.9. Structural unemployment in euro-area 171 II.9.9.10.4.2.4. Market share of global stock exchanges in 2006 (by turnover) 98 I.8.4. Size of government and real GDP growth in the euro area 199 xii .3.3.9. Average share of foreign establishments (in total domestic banking assets) 100 I. Convergence dynamics1999-2008 107 I. annual data) 95 I.12.9. Concentration in the euro area banking sector (CR5 ratio) 99 I.9.5.11.11.8.7.9. Labour market reform and the change in the employment rate 81 I.2. Trade invoicing in euros (% of total.6.4.9.1. 2005-2050 197 II. The euro as domestic banking currency in the Western Balkans (% of total.8.7.2.1. Import invoicing in some Asian countries (2003 and 2004) 129 I. Fiscal balance projections in Portugal 114 I.1.7. Japanese exports to the EU 130 I.2. Labour market reform and the change in the NAWRU 82 I.3.7.5.6.5. pre-EMU 184 II.3. Beveridge curve for the euro-area 171 II. Top 0. Euro area and US shock spillover intensity in the equity market 97 I. Potential growth rates: 'Catching-up' countries vs rest of euro area 108 I.12. post-EMU 184 II.3.7. Residential mortgage credit outstanding in 2005 (in % of GDP) 103 I.6.10.2.8.1.8. Evolution of 10-year government bond yields (in percent.9.7.1. Total cross-border asset and liabilities as share of GDP 160 II.

4.1. Adjustment to credit and productivity shocks in New Member States 214 II.6.5. The fiscal stance by country 73 I.2.1. GDP per head of population before and after EU accession 204 II.6. Nominal rigidities and adjustment to shocks 181 II. Administered prices of 9 NMS (annual percentage changes) 206 II.1. EU15=100) 205 II. How Politically Costly Are Structural Reforms? 190 II. Asymmetric effects of common external shocks: model simulations 179 II.4.10.4.1. 193 II.6. Expenditure rules to curb fiscal procyclicality in good times. Assessing the cycle by country 71 I. Decomposition of changes in world output volatility by region 229 II.9.6.2.5.GDP per capita and price levels (2000 and 2006.1.5. The 2005 reform of the SGP 137 I. Foreign ownership in the NMS' banking sectors 208 II.3.6.7.5.2. Spillovers in a monetary union with nominal rigidities 241 xiii . Sectoral breakdown of activity. Standard adjustment channels and cross-country spillover effects 57 I. Fiscal rules index in the euro area 201 II.6. Growth-enhancing public spending 200 II.8.2.1.4. 2004-2006 211 II.1. Financial market integration and capital allocation 174 II. Policy assignment across areas of structural reforms 270 III.1.3.4.4.4. The impact of the single currency on labour productivity 36 I.10.6.1. NMS .1. Sequency of reform areas 274 LIST OF BOXES I.7.Share of foreign currency borrowing in domestic credit. The impact of pension reform on older workers' participation rates.2.5.3. The Optimum Currency Area theory and its implications for business cycle synchronisation 44 I.2. US external position 224 II. 2005 207 II.1.7.1.8.6.6. Gini coefficients of market income and disposable income 236 III.8.2.3.10.9.4.8.2. Current account balance (% of GDP) 219 II.1. 2004-2006 211 II.4.7. Trade integration with the EU and euro area 207 II. How do structural rigidities affect adjustment to shocks? 40 I. Comparative price levels of 9 NMS in 2005 (EU25=100) 205 II.2.2. Evolution of the Broad Economic Policy Guidelines 139 II. Real interest rate differentials: a comparison with the United States 63 I. Public finance in 2004-2006 210 II.5. Sovereign Wealth Funds 123 I.5.3. NMS .6.7.3.2. Net international investment position (% of GDP) 219 II. A Phillips curve for euro-area countries.1. NMS .2. 169 II.4. II. Regional Stabilising Effects of EMU: the case of the Western Balkans and the CFA Zone 226 II.3. 185 II. Competitiveness as an adjustment mechanism in the euro area 59 I.1.3.2.2.6.Growth of domestic credit.4.3. Investor diversification away from the dollar: a survey of the literature 222 II.7.10.2.7. Public perceptions of inflation in the euro area 32 I.2. Gini coefficients of income 235 II.4.6. Implementation of the SGP 135 I.

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THE COMMITTEE OF THE REGIONS AND THE EUROPEAN CENTRAL BANK EMU@10: successes and challenges after 10 years of Economic and Monetary Union 1 . THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE. THE COUNCIL.COMMUNICATION FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT.

European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union 2 .

marked a watershed in European integration. identify the goals and challenges facing the euro area and put forward a policy agenda for EMU’s continued success. especially welcome in the present times of financial turbulence. The launch of EMU – the most important monetary reform since Bretton Woods – was a bold move without precedent in modern European economic history and one that changed the global economic landscape. Climate change and the effects of population ageing will place additional strains on the capacity of our economies to grow. The move to the last phase of EMU – Economic and Monetary Union – on 1st January 1999. it will also increase the diversity of EMU. While the euro is a clear success. making stronger demands on its adjustment capacity. unwinding global imbalances are putting pressure on the exchange rate of the euro and the functioning of our financial systems. considered by euro-area citizens to be amongst the most positive results of European integration together with the achievement of free movement within the EU and peace in Europe. Globalisation is progressing apace and natural resources are becoming increasingly scarce. THE MAJOR SUCCESSES OF THE FIRST TEN YEARS The launch of the euro represented a sea change in the macroeconomic environment of its participating Member States and beyond. The single currency has become a symbol of Europe. In addition. EMU is an achievement of strategic importance for the EU. Output and particularly productivity growth have been below those of other developed economies and concerns about the fairness of income and wealth distribution have grown. it sent a very powerful political signal to European citizens and to the rest of the world that Europe was capable of taking far- reaching decisions to cement a common and prosperous future for a continent that had all too often suffered from wars and economic and political instability. while the progressive enlargement of the euro area will add dynamism to its economy. the euro is a resounding success. and indeed for the world at large. Moreover. The number of countries that share the euro has increased from the original eleven to fifteen at the beginning of 2008 and is set to increase further. a number of significant challenges which had not yet emerged or were only starting to become apparent when EMU was devised are now more pressing. A single monetary policy combined with national but 3 . the euro. financial integration and investment. This Communication and the accompanying Report assess the experience of the first decade of EMU. in which Europe has become a pole of macroeconomic stability. One in two people in the euro area asserts that for them. Although economic in substance. Communication from the Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union A HISTORIC STEP On 2 May 1998 Europe's leaders took the historic decision to introduce the single currency. At the same time. EMU has secured macroeconomic stability and boosted cross-border trade. Ten years into its existence. the EU means the single currency. so far it has fallen short of some initial expectations.

and thanks to windfall gains in tax revenues in the last few years. progress has been made on many fronts. The disappearance of exchange rate risk and lower cross-border transaction costs has helped develop the Single Market and integrate product markets. interest rates in EMU have come down to levels not seen for several decades. Financial market infrastructure has advanced. Admittedly. while the Single Euro Payments Area is set to eliminate differences between national and cross-border 4 . While not fully eradicated. The euro has acted as a powerful catalyst for financial market integration.6% of GDP in 2007). and progress has been made in cross-border wholesale financial services. Inflation averaged just over 2% in the first decade of EMU. The euro-area economy has pursued a faster track of economic and financial integration than the rest of the EU and its resilience in the face of external shocks has become stronger. was the lowest in several decades. As a result. These developments have in turn produced major economies of scale. and available estimates indicate that the elimination of exchange rate volatility can explain up to half of this increase. to which the euro area's monetary policy is entrusted. intra-area foreign direct investment now stands at one third of GDP as compared to an initial one fifth. Intra-area trade flows now account for one third of the area's GDP. with the sixteen largest banking groups now holding more than 25% of their EU assets outside their home country. Fiscal policies have supported macroeconomic stability in EMU. mainly due to soaring oil and commodity prices. with an annual gross issuance of more than €1 trillion now substantially exceeding the approximately €800 billion raised through public sector issuance. the decline in risk premia built into capital cost has boosted capital formation. pro-cyclical fiscal policies have also become less common. Cross-border consolidation among banks has accelerated. with the share of equity held in other euro-area countries rising from 20 to 40%. even in those countries which enjoyed the highest degree of stability before the adoption of the euro. which has now reached almost 22% of GDP – a level unseen since the early 1990s. Indeed ten out of the fifteen euro-area countries either recorded a budget surplus in 2007 or were very close to balance.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union coordinated fiscal policies has fostered macroeconomic stability. Overall. But a return to low inflation and more normal credit conditions is expected once these external pressures unwind – even though oil and commodity prices may continue to trend up with strong demand from fast-growing developing countries. Interbank money markets in the euro area have fully integrated. Equity markets too have integrated faster than elsewhere. down from 9% in the 1990s and 12% in the 1980s. Budgetary discipline has improved significantly. What is more. no euro-area country ran a deficit in excess of 3% in 2007 and the overall deficit for the euro area (at 0. The reform of the SGP in 2005 not only contributed to greater discipline. Nominal interest rates have declined to an average of around 5% since the inception of the euro. A significant market in euro-denominated private-sector bonds has emerged. while the turbulence in financial markets has led to tighter credit conditions for households and businesses. as the following highlights illustrate. while cross-border interbank transactions have expanded steadily since 1999. quickly established its credibility. falling from 3% in the 1990s and a range of 8 to 10% in the 1970s and 1980s. inflation has increased recently. Overall.6% of GDP in 2007 compared to an average of 4% in both the 1980s and 1990s. the single currency is estimated to have boosted labour productivity per hour worked by as much as 5% since the launch of the euro. EMU has fostered economic and market integration. The exchange rate realignments that periodically traumatised the European economies have become a thing of the past. up from one quarter ten years ago. Here estimates suggest that up to two thirds of this increase can be directly attributed to the creation of the single currency. Monetary policy has anchored long-run inflation expectations at close to the ECB's definition of price stability. strengthened by the Stability and Growth Pact (SGP). In real terms. spurred competition and had noticeable effects on productive efficiency. through these various channels. The European Central Bank (ECB). but also promoted a more sustainable correction of excessive deficits by discouraging recourse to one-off measures. Likewise. Progress in fiscal consolidation has been impressive over the last few years and culminated in a deficit of only 0.

EMU has improved the euro area's resilience against adverse external developments. a credible macroeconomic framework and a sound financial system. therefore. its role as a trade invoicing or settlement currency has risen. The euro area has become a pole of stability for Europe and the world economy. the Eurogroup is well placed to develop common understandings and clear positions on macroeconomic issues pertaining to the euro area. Likewise. while the percentage of bank loans issued by euro-area banks to non-euro-area borrowers which are denominated in euro now stand at 36% as compared to 45% in US dollars. In its first decade the euro area has been exposed to a series of external shocks associated with the global business cycle. 6 that Member States should "contribute to a dynamic and well-functioning EMU". to reach more than 50% of the euro area's external trade. Communication from the Commission retail payments. In parallel. EMU has brought significant benefits to its member countries engaged in a catching-up process. a common understanding has developed among EMU Member States that sound public finances and flexible and integrated product. labour and financial markets are necessary for EMU to function efficiently. spells out in Guideline No. the euro area has been contributing to an orderly evolution of the global economy. As its informal character encourages open and frank debates. notably euro-area candidate and neighbouring EU countries. Today once again. The euro is the second most actively traded currency in foreign exchange markets worldwide. The reform of the Stability and Growth Pact in 2005 increased national governments’ “ownership” of the budgetary governance framework. Over time it has gained visibility and relevance. even during the highly turbulent period of the last few months. Euro- denominated international debt securities surpassed those of the US dollar in 2004. Thanks to the euro's rising international status and the sheer size of the euro-area economy. The euro has firmly established itself as the world’s second international currency. With an external position in balance. the euro area appears protected from the worst of the present global financial turbulence. The euro area has developed a sound structure of economic governance. the most significant being the bursting of the dotcom bubble and subsequent downturn in the US in the early 2000s. economic policies within EMU increasingly have a global impact. Not surprisingly. the positive effects of sound economic policies have been reinforced by the development and integration of national financial markets with the rest of the euro area. participation in EMU is very appealing to the twelve Member States that entered the EU since 2004. The anchoring of inflation expectations has contributed to this improved resilience. as have the reforms carried out under the Lisbon Strategy for Growth and Jobs and the renewed budgetary discipline since the SGP reform. The euro has also become very important in many third countries. 5 . While major economic policy responsibilities remain at the national level. around 60% of whose trade is now invoiced in euro. The official use of the euro has increased. The Eurogroup has served as the key forum for euro-area finance ministers to address issues relating to the single currency going beyond the Treaty-based surveillance and coordination tasks. The environment of macroeconomic stability and low interest rates coupled with the support of the cohesion policy and its Structural and Cohesion Funds have created the conditions for accelerated catching up. and is used in more than a third of all foreign exchange transactions. the key instrument for the co- ordination of EU economic policies. And the revised Lisbon Strategy for Growth and Jobs. a certain degree of regulatory and supervisory convergence has been achieved via the implementation of the Financial Services Action Plan and the operation of the Lamfalussy committees. Nevertheless. the ensuing slowdown in the euro area at the beginning of the decade was considerably more muted than in comparable episodes prior to the adoption of the single currency. indeed three have already successfully joined the euro area and Slovakia is ready to enter in 2009. with the worldwide share of disclosed reserves denominated in euro rising from 18% in 1999 to over 25% in 2007.

Employment has risen by almost 15% since the launch of the single currency while unemployment has fallen to about 7% of the labour force. All these positive developments have culminated in the creation of a record 16 million jobs during the first decade of EMU in the euro area. The euro is often used as a scapegoat for poor economic performances that in reality 6 . the euro area's per capita income has stalled at 70% of that of the United States. including the United States. potential growth remains too low.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union particularly since it appointed its first permanent President in January 2005. However this potential is insufficiently exploited as the euro area has neither a properly defined international strategy nor effective international representation. product markets within the euro area are still only partially integrated and cross-border provision of services remains underdeveloped. not all expectations have been fulfilled. As a result. the single currency provides a shield and can put the euro area in a unique position to play a key role in the global political arena in stemming the associated risks. Essentially. EMU'S REMAINING CHALLENGES AMPLIFIED BY NEW GLOBAL TRENDS The overall picture of the first decade of EMU is thus a very positive one. At around 2% per annum. sectors and regions. While most of the smaller euro-area economies have done exceptionally well. as well as the wage moderation that has characterised most euro- area countries. The global economic imbalances that have built up since the mid-1990s are starting to take their toll. this protracted adjustment reflects the fact that structural reforms have been less ambitious than in the run- up to the euro. The tendency for persistent divergences between euro-area Member States has been due in part to a lack of responsiveness of prices and wages. This has led to accumulated competitiveness losses and large external imbalances. and by last year's IMF-led multilateral consultations on global imbalances. Although employment has soared. The emerging economies' rapidly growing demand for scarce energy and other primary resources are hitting supply constraints. job growth outpaced that of other mature economies. Importantly. collective action taken by the euro area has led to greater external influence. However. In this turbulent environment. Finally. potential growth should have been significantly higher in some of the largest Member States. This clearly demonstrates that Europe's workforce is capable of rising to new challenges and making necessary changes that will ultimately result in further job creation and higher economic growth. sending oil. which have not adjusted smoothly across products. Moreover. As is the case within the EU as a whole. the public image of the euro does not fully reflect EMU's successful economic performance. As an international currency the euro is a major asset for all euro-area members and for the EU at large. with exchange rates excessively volatile and financial stability arrangements under heavy strain. the lowest rate in more than fifteen years. food and other commodity prices soaring as a result. On the international front. and despite the positive impact of the single currency. there have been substantial and lasting differences across countries in terms of inflation and unit labour costs. which in EMU require long periods of adjustment. the lack of a clear international strategy and the absence of a strong voice in international fora implies costs for the euro-area in an increasingly globalised world. The bulk of these improvements reflect reforms of both labour markets and social security systems carried out under the Lisbon Strategy for Growth and Jobs and the coordination and surveillance framework of EMU. the President of the ECB and the Commissioner for Economic and Monetary Affairs – in bilateral dialogues with China and other countries. productivity growth has slowed from 1 1/2% in the 1990s to around 1% this decade. as demonstrated by the engagement of the Eurogroup troika – the Eurogroup President. However.

• Globalisation is progressing apace. innovation and human capital become ever more important drivers of economic dynamism. compared with the monetary leg. simultaneously reducing the economic growth potential. Moreover. while overall very successful. These developments may act as a constraint on growth and could impair the distribution of income and wealth given that it is the least well-off who may be disproportionally affected. These longer-term trends. reveals a number of shortcomings that need to be addressed. yielding lower prices and greater choice for consumers. Indeed. even if overall inflation was only marginally affected at the time of the changeover. its welfare systems at risk. the potential output of the area will slow to just over 1% per annum from around 2% at present. Indeed. whose effects are increasingly being felt. more generally. macroeconomic stability. Globalisation offers major opportunities for market growth. adding to the need to ensure smooth adjustment to shocks. But beyond the fulfilment of initial expectations. 7 . the portion of the population dependent on pensions will increase. further weakening its public image. has also fed the concern that the euro area is incapable of addressing the key challenges facing it. A complicating factor is that the tasks of containing climate change and keeping a lid on food and energy prices may not be easily achieved simultaneously. as elsewhere. will pose challenges for the performance of all advanced economies in terms of growth. its weaker adjustment capacity. Ageing will also make relatively large demands on public spending. occasional abusive price increases in specific sectors and countries have tarnished the image of the euro and continue to do so. • Meanwhile. and efficiency gains for producers. But they will produce policy challenges that are particularly compelling for the euro area considering its relatively low growth potential. and (c) successfully protecting the interests of the euro area in the global economy. • Food and energy prices are on the rise. globalisation further compels the euro area to take an effective role in global economic and financial governance. high public indebtedness and the strong interdependence of its economies. It will be necessary to consolidate the hard-won macroeconomic stability while: (a) raising potential growth and safeguarding and increasing the welfare of euro-area citizens. adjustment capacity. and as research. the ratio of working-age to older people is projected to halve over the next four decades and on unchanged policies. the lack of development of the economic leg of EMU. the population of the euro area. (b) ensuring a smooth adjustment capacity as EMU expands to take in new members. At the same time. Communication from the Commission result from inappropriate economic policies at the national level. Furthermore citizens in some countries believe that prices significantly increased because of the euro. the EMU policy agenda for the next decade will be marked by the emergence of new global challenges which will have an amplifying effect on the weaknesses of EMU outlined above. As a result. with emerging economies competing with developed economies in lower-skilled industrial activities and increasingly in higher value-added activities too. However. it also puts strong demands on the adjustment capacity of the euro-area members as new activities will need to replace declining industries. is rapidly ageing. These problems can affect euro-area countries differently. Climate change is also having a growing economic impact. spurred by fast growth of the global economy and changing consumption patterns in emerging economies. the sustainability of social security systems and the distribution of income and wealth. A THREE-PILLAR POLICY AGENDA FOR THE SECOND DECADE The experience of the first decade of EMU. Clearly important work still lies ahead. Ageing populations pose a serious challenge to the euro area's capacity to adjust and put the sustainability of its public finances and. and unless reforms are made to pension and health systems it will increase the share of public expenditure in GDP by an estimated 4 percentage points over the next four decades.

to broaden macroeconomic surveillance in EMU beyond fiscal policy and to better integrate structural reform in overall policy co-ordination within EMU. amplify divergences among the participating countries. To be effective. Reforms of social expenditure programmes that offer better income protection while strengthening incentives to work – the flexicurity approach – would also greatly help to enhance the sustainability and quality of public finances while ensuring that budgets support macroeconomic stability. there is a clear need to broaden surveillance to address macroeconomic imbalances. Budgetary surveillance should be deepened to cover two main areas: (i) securing the sustainability of public finances for the benefit of future generations. In this case. ensuring better value for public money.e. the Commission proposes a three-pillar agenda: • The domestic agenda aims to deepen fiscal policy co-ordination and surveillance. I. and failure to do so will be much more costly now.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Importantly. • Both agendas will require a more effective system of economic governance. persistent inflation divergences or trends of unbalanced growth need to be monitored given that the occurrence of spillover effects and the growing interdependence of euro-area economies mean these developments represent a concern not just for the country in question but for the euro area as a whole. At the euro-area level increased attention should be put on monitoring public debt developments. such frameworks should encompass well-designed expenditure rules. In other words. Developments within Member States such as the growth of current account deficits. which would allow the automatic fiscal stabilisers to operate within the limits of the SGP while attuning the composition of public expenditure to the structural and cyclical needs of the economy. But beyond budgetary surveillance. To address these challenges. THE DOMESTIC POLICY AGENDA: BETTER CO-ORDINATION AND SURVEILLANCE Deepening and broadening surveillance The corrective arm of the Stability and Growth Pact (SGP) should continue to be applied rigorously and surveillance under the SGP's preventive arm should be improved. Fiscal policy coordination should better guide national budgetary behaviour over the whole cycle. The evidence of the first ten years of EMU indicates that while market integration. particularly in financial services. by channelling public expenditure and taxation systems towards growth-friendly and competitiveness- enhancing activities. if not accompanied by appropriate policies. Moreover. (ii) enhancing the quality of public finances. is beneficial overall for EMU – as it can help absorb macroeconomic disturbances by providing risk-sharing opportunities and fostering reallocation of resources – it can also. 8 . in both good and bad times. At the national level. these efforts will have to be made in a global environment that has changed considerably since the euro was launched. long-term budgetary projections which identify the impact of ageing on public finances can support the preparation of national sustainability strategies and promote measures to reform pension and health systems and increase employment rates. the adoption of medium-term fiscal frameworks could go a long way towards achieving stable and sustainable public finances. While some of these divergences can be benign – reflecting the catching-up process or even normal adjustment – they may also be harmful and the result of inefficient adjustment. i. while medium-term budgetary objectives should be strengthened to address implicit liabilities. • The external agenda aims to enhance the euro area's role in global economic governance.

low productivity growth and entry barriers. These Treaty-based instruments are complemented by the Medium-Term Budgetary Review process undertaken by the Eurogroup in the spring of each year. those countries undertaking structural reforms can accrue more benefit while those falling behind may pay a higher price for their inaction. especially in services. The analysis of the first 10 years reinforces the case for strengthening the preventive part of the SGP. a broader surveillance of euro-area candidate countries. Surveillance must build on the existing instruments. The euro-area and country-specific recommendations of the Lisbon process are key instruments for guidance and surveillance. the Lisbon Strategy forms the basis for steering the reform process in both the euro area and the individual countries. Communication from the Commission enhanced surveillance would help the affected countries to devise early responses before divergences become entrenched. Stepping up reforms – of course welcome in the EU as a whole – is an absolute must for the euro area. Yet despite the boost given by EMU and the Single Market Programme to the creation of more open and competitive economies. akin to that proposed for current euro-area members. Importantly. Currently surveillance of prospective euro-area countries takes place via the assessment of Convergence Programmes. Empirical evidence from our analysis indicates that structural reforms in countries sharing the single currency have higher "multipliers" than elsewhere: that is. provides the basis for identifying the most pressing areas for action through Guideline No. will be crucial to help them prepare for the challenges of sharing a single currency. both of which can boost credit (typically from a low base) and result in external imbalances. this peer review mechanism should broaden its scope to make the Treaty-based surveillance more effective. This should not mean imposing any additional constraints on euro-area entry. While it has so far focused on budgetary surveillance. There is. But there is scope to provide stronger policy guidance and closer surveillance of economic developments in particular for the countries participating in the Exchange Rate Mechanism (ERM) II framework. are still hampering efficient adaptation to changing economic circumstances in the euro area and are 1 COM(2007) 316 9 . The Lisbon Strategy for Growth and Jobs.1 to support the achievement of sustainable budgetary policies and address broader issues which may affect the macroeconomic stability of a country and the overall functioning of EMU. The key instruments for fiscal policy surveillance and economic policy coordination are clearly anchored in the Treaty and the SGP. improved market responses will pay a double dividend – by boosting growth in living standards over the longer haul while allowing better adjustment to shocks and fostering macroeconomic stability. 6 on the euro area and the euro-area-specific recommendations. which has been instrumental in putting structural reform on the policy agenda. as endorsed by the ECOFIN Council. which is both an element of the euro adoption criteria and an instrument to foster sustainable nominal and real convergence. Better integrating structural policies in the co-ordination process The euro area has a special interest in the success of structural reform. scope to improve the way such instruments are used. The SGP provides for the definition and assessment of medium-term budgetary strategies through Council opinions on national Stability Programmes. Many future euro-area members are experiencing large capital inflows (reflecting expectations of continued fast income growth) and rapidly developing financial sectors. In a partnership approach between the Commission and the Member States. Removing remaining barriers to product market integration is essential for a well-functioning euro area. The enforcement of the corrective arm of the SGP will remain a key pillar in dissuading non-compliance with the Treaty. Article 99 of the Treaty states that "Member States shall regard their economic policies as a matter of common concern” and “shall coordinate them within the Council". however. Finally.

European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union keeping up pressure on prices. the euro area should take a strong role in fostering the EU agenda for financial integration and in enhancing EU financial stability arrangements. there is therefore a need to strengthen the incentives to pursue reform in the euro area. This would facilitate economic adjustment through risk sharing and promote a more uniform transmission of the single monetary policy across the euro area. (b) The reform of the SGP in 2005 created the possibility. However. Numerous reforms to raise labour utilisation have been undertaken in the framework of the Lisbon Strategy – and have paid off. The market monitoring system proposed in the Single Market Review should be used to specifically target these shortcomings. progress has been uneven across countries and should therefore remain at the core of reform strategies in the next decade. increased effort is required to promote the cross-border provision of retail financial services. a peer review mechanism could be established based on the analytical framework developed under the Lisbon Strategy and ex ante information provided by Member States. but would also help boost the incentives for other structural reforms to follow by bringing forward their longer-term benefits and allowing capital to flow to the new investment opportunities generated by these structural reforms. and investment in human capital are instrumental in boosting competitiveness and allowing the smooth reallocation of resources in the event of shocks. The euro area can draw comparatively large benefits from promoting EU financial integration. Greater wage flexibility and differentiation across industries. It helps develop the financial industry in Europe. To reap the full potential of EMU. In particular. important elements for enhancing both competition and productivity. Significant progress has been made in integrating EU financial markets but further efforts are required to enhance the efficiency and liquidity of euro area financial markets. THE EXTERNAL POLICY AGENDA: ENHANCING THE EURO AREA'S INTERNATIONAL ROLE The international status of the euro brings advantages. particular priority should be given to improving the functioning of financial markets. But the sheer size of the euro area means that policy decisions and economic developments within EMU are 10 . occupations and regions. Integrating structural policies in the euro area coordination process can provide support via three avenues: (a) The recommendations to the euro area as a whole together with the country-specific recommendations made within the Integrated Guidelines of the Lisbon Strategy provide the backbone for the coordination of structural reforms. responsibilities and risks. there is a growing need for stronger cross-border cooperation in arrangements for crisis prevention. In light of these specific efficiency and stability considerations and taking on board the lessons of the current financial turmoil. a closer monitoring of their implementation needs to be organised. To ensure compliance with the commitments enshrined in the SGP. This would not only have favourable effects on growth and adjustment. Better-functioning labour markets are needed in the euro area to underpin adjustment in a globalised economy and raise growth potential in the face of ageing populations. to improve the efficiency of corporate and government bond financing and ease regulatory and supervisory costs for financial intermediaries operating in a multi- jurisdictional environment. when assessing progress towards the medium-term budgetary objectives. Reforms of social expenditure programmes and active labour market policies should aim to offer better income protection while strengthening incentives to work. II. management and resolution as financial integration proceeds. to take account of structural reforms that are fiscally costly in the short run but yield longer-term gains in terms of growth and fiscal sustainability. Given the shared responsibility of the Eurosystem and participating Member States to safeguard financial stability in the euro area as a whole. (c) To achieve a better sequencing of reforms. yields seignorage gains from the use of the euro as a reserve currency and reduces exposure to exchange rate volatility as pricing and invoicing in euros develops. Innovation and technology diffusion. are lagging behind in euro-area member states.

ultimately obtaining a single seat in the relevant international financial institutions and fora. 11 . while the new Lisbon Treaty. That said. It has to play a more active and assertive role both in multilateral fora and through its bilateral dialogues with strategic partners. From the outset the ECOFIN Council has been the forum for economic policy decision-making in the EU and. The most effective way for the euro area to align its influence with its economic weight is by developing common positions and by consolidating its representation. in view of the evolving overlap between the euro area and the EU. PROMOTING EFFECTIVE GOVERNANCE OF EMU EMU's system of economic governance must rise to the challenges facing the euro area. all discussions on these issues will take place within the ECOFIN Council. The current Treaty provides ample scope for more comprehensive coordination and surveillance along these lines across the whole EU. once ratified. the euro area. Moreover. And there are risks. macroeconomic policy. is now called upon to develop a clear and all encompassing strategy on international economic and financial affairs. financial markets and taxation – so as to ensure positive synergies between them. it could push for a more consistent approach within its own fields of competence – i. ex ante coordination of budgetary policy through the Mid-Term Budgetary Review should be geared to guiding fiscal behaviour over the cycle as a means to address any pro-cyclical bias. It has to speak with a single voice on exchange rate policies and assume its responsibilities in financial stability and macroeconomic surveillance issues. In particular. It has to improve coordination and define common positions and – when appropriate – common terms of reference on all these issues. All in all. there is a clear need to adapt institutions and practices to tackle the emerging policy challenges. III. Nevertheless. the euro area still punches below its economic weight in international fora. This is an ambitious aim and progress on the external agenda will depend first and foremost on a more effective system of euro area governance. will strengthen the role of euro area finance ministers on questions affecting the functioning of EMU.e. which already provides a stability anchor for its neighbours. In view of the ageing challenge. It would also free up much needed space for emerging market countries to increase their participation in international financial institutions. The risk that the unwinding of global imbalances disproportionately harms the competitiveness of the euro area and its members is adding to these needs. Communication from the Commission felt elsewhere. Following a successful first decade. as the growing international status of the euro exposes the euro area to disruptive portfolio shifts between key international currencies and asset classes. the growth of the euro as an international currency and the combined strength of the euro-area economy have changed the rules of the game for the members of EMU and for their international partners. the current division of responsibility between the institutions and instruments that govern the conduct of economic policy in EMU is sound overall. The Eurogroup should continue to serve as a platform for the deepening and broadening of policy coordination and surveillance in EMU. not least because global financial markets are acting as an ever-stronger international transmission channel. both for the euro area and for its key partners. it should remain centre stage in EMU's system of economic governance by integrating EMU issues more thoroughly in its work. A strong involvement of all EU Member States within the ECOFIN Council is key to ensuring that EMU functions effectively. Consolidating the euro area’s representation would strengthen its international negotiating power and reduce the costs of international coordination. In terms of fiscal surveillance. Even though the EU and euro area are often seen by other countries as over-represented in international organisations (in terms of both seats and voting power). The euro area must therefore build an international strategy commensurate with the international status of its currency.

European Commission
EMU@10: successes and challenges after 10 years of Economic and Monetary Union

a major task is to increase the effectiveness of the preventive arm of the SGP in fostering the
achievement of ambitious medium term objectives. To avoid the build-up of imbalances and excessive
divergences between euro area countries, the Eurogroup should exchange views, develop policy
guidelines and monitor Member States' compliance in areas that foster adjustment capacity and
macroeconomic stability. “Peer reviews” – multilateral discussions on relevant developments in one
or several countries – should be strengthened to encourage ministers of finance to consider national
issues and policies within a euro-area perspective. Moreover, the Eurogroup should devote greater
attention to monitoring the euro-area Lisbon recommendations in order to increase potential growth
and strengthen competitiveness through structural reforms.

The Commission should play a strong, supportive role to ensure the effective functioning of EMU.
It is called upon to foster the coordination of policies while internalising the EMU dimension in its
policy proposals. It should step up its fiscal and macroeconomic surveillance and promote further
economic and financial integration. In its surveillance role, it should deepen the assessment of
economic and financial developments of the euro area, focusing in particular on the spillovers of
national policy measures. Work to improve the accuracy of cyclical and structural fiscal indicators
should continue, in cooperation with the Member States. As to the international agenda, the
Commission needs to enhance its role in international dialogues and fora. In sum, the Commission
must support efforts to improve the functioning of EMU both domestically and internationally by
assuming the responsibilities assigned to it by the Treaty as the guardian of sound economic policies.
To this end it should endeavour to better exploit the instruments provided by the Treaty.

The new Treaty, once ratified, will provide scope to strengthen coordination and surveillance of
economic policies within the euro area. Article 136 of the resulting Treaty on the functioning of the
European Union would offer the possibility to "adopt measures specific to euro-area Member States:
to strengthen the coordination and surveillance of their budgetary discipline; and to set out economic
policy guidelines for them, while ensuring that they are compatible with those adopted for the whole
of the Union and are kept under surveillance". Furthermore, the Treaty would enhance the
Commission's role as an independent “referee” in the context of multilateral surveillance, with Article
121 giving the Commission the possibility to issue direct warnings to a Member State when its
economic policies are not consistent with the broad guidelines or risk jeopardising the proper
functioning of EMU.

EMU's governance system must ensure that euro-area enlargement continues smoothly. Over the
next decade, the euro area is set to expand to encompass most current EU Member States and ensuring
that this process proceeds appropriately will safeguard the effective functioning of the euro-area
economy in the future. During participation in ERM II, countries should capitalise on the environment
of enhanced macroeconomic stability to adopt sound macroeconomic and structural policies. As
specified in the Treaty, the Commission should provide a regular, fair assessment of sustainable
progress in the convergence process. The Eurogroup and ECOFIN in turn have a special responsibility
to build trust, survey economic developments and provide the necessary guidance in terms of the
policies and reforms necessary for prospective euro-area members' nominal and real convergence.

There is also a need to improve the dialogue concerning EMU among the EU institutions and
with the public at large. The Commission should develop its dialogue and consultation with the
European Parliament in particular, as well as other European and national stakeholders. In a similar
vein, the Eurogroup should pursue dialogues with the ECB, the European Parliament and the social
partners in the euro area. All these institutions, starting with the Commission, should improve
communication on EMU issues to the wider public. In particular, there is a need to better explain the
euro's significant macro- and microeconomic advantages, such as its role as a protective shield during
the recent financial turmoil, and the significant, beneficial contribution of economic policies in EMU.

12

Communication from the Commission

CONCLUSION

EMU is a resounding success. Ten years into its existence, it has ensured macroeconomic stability,
spurred the economic integration of Europe – not least through its successive enlargements –,
increased its resilience to adverse shocks, and become a regional and global pole of stability. Now
more than ever, the single currency and the policy framework that underpins it are proving to be a
major asset. Nevertheless, there is potential to reap further benefits from EMU. This -- coupled with
the pressing challenges of globalisation, scarce natural resources, climate change and population
ageing, -- calls for improved co-ordination of economic policies, further progress with structural
reforms, a stronger global role for the euro area and an unwavering commitment by Member States to
achieving these goals. The fact that the effects of these global trends are already being felt in high
energy, food and commodity prices, financial turbulence and global exchange rate adjustment only
underscores the importance of timely action.

Achieving the domestic and external policy agenda and improving governance as set out here will go
a long way towards meeting the challenges that the euro area and the global economy are facing. It
will also bring important positive benefits for all EU members:

• EMU remains a milestone of EU integration. Although its objectives and achievements are
predominantly economic, EMU has never been solely an economic project. From the outset EMU
was conceived as a crucial step in the process of EU integration. This role has become even
stronger since the EU’s enlargement from 15 to 27 Member States since 2004, with all newly
acceded EU member countries preparing for euro adoption. The prospect of euro-area accession
has been one of the main drivers of those countries’ convergence with the EU’s standard of living.

• A well-functioning EMU is a major asset for the EU as a whole, not least since the
overwhelming majority, if not all, of EU countries will eventually become members of EMU. A
thriving euro-area economy will contribute to the wealth and dynamism of the whole EU,
reinforcing public support for EU integration both within and outside the euro area.

• A strong EMU will also foster the EU's leadership in the global economy. A well-functioning
euro area lays the foundations for EMU to play a strong role externally, both in the
macroeconomic sphere and in the area of global financial supervision and regulation. Proving its
ability to strengthen the euro area’s external role and assume its global responsibilities will have
positive spin-offs for other policy areas where the EU aspires to global leadership, e.g. sustainable
development, development aid, trade policy, competition and human rights.
Political will and determination is required to implement this comprehensive agenda. The very success
of EMU shows that political initiative and ambition can generate considerable economic, social and
political benefits. But to fully deliver these benefits, the continued involvement of all parties is crucial.
Hence the Commission will encourage a wide discussion on these topics in the second half of 2008
and promote a broad consensus on the building blocks of this agenda with other EU institutions as
well as a range of relevant bodies and stakeholders. Drawing on this discussion, the Commission will
come forward with appropriate operational proposals.

13

Part I
Assessing the first 10 years

SUMMARY OF MAIN FINDINGS

mentioned above qualified for participation in
A leap forward
the first wave.
On 1 January 1999 eleven EU Member States –
Belgium, Germany, Spain, France, Ireland, Italy,
Initial expectations, goals and challenges
Luxembourg, the Netherlands, Austria, Portugal
and Finland – adopted the European Union's Before it was created there was a lively academic
single currency, the euro, in what may be and political debate on the viability or
considered to be the world’s most radical desirability of a monetary union for Europe.
monetary reform since Bretton Woods. This There was a very broad spectrum of views on the
move established the second largest single subject: some predicted a bumpy start or even
currency area in the world (after the United collapse, while others were more sanguine.
States), which now produces two thirds of the However, many tended towards a pessimistic
EU’s GDP and one fifth of the world’s. Four view and this may have adversely affected
other EU Member States have joined the euro perceptions of the euro area's performance in its
area since its inception: Greece in 2001, Slovenia early years. The assessments were coloured also
in 2007 and Cyprus and Malta in 2008. The area by the global economic downturn in the early
is set to expand further as most EU Member 2000s and the depreciation of the euro against
States currently outside the euro area are the US dollar in the period 1999-2002, both
preparing to join at some point in the future. (2) roughly coinciding with the run-up to and
introduction of euro coins and notes in 2002.
The establishment of a single currency for This is in contrast with the assessment in Part I
Europe has been a leap forward in the process of of this Report, from which emerges a
European economic integration. Although the predominantly favourable picture of the first ten
origins of the single currency go back to the years of the euro – even if weaknesses,
1970s, the process accelerated in the early 1990s shortcomings and unfinished business are also
when the lifting of the Iron Curtain and the highlighted.
ensuing political uncertainties prompted the
perception that stronger common goal setting in Aside from the political motivations for the
Europe was needed. Among the related political creation of a single currency for Europe, the euro
events of the early 1990s was the reunification of was intended to serve a number of economic
Germany, which had serious macroeconomic goals, which can be grouped under the following
ramifications and contributed to tensions and three headings:
turbulence in the European Exchange Rate
Mechanism (ERM). This eventually led to the • Macroeconomic stability. As noted, the single
go-ahead for monetary union in Europe, as laid currency was a response to the episode of
down in the Maastricht Treaty signed in 1992. financial turbulence in the early 1990s. The
From then onwards EU Members willing to join use of the exchange rate and monetary policy
the euro area in the first wave engaged in a instruments had lost much of their efficacy,
process of convergence towards the reference especially in smaller countries. The
values enshrined in the Treaty regarding price underutilisation of resources stemming from
stability, exchange rate stability, interest rates, this source of volatility was deemed to be
government net borrowing and government costly in terms of both efficiency and equity
indebtedness.(3) Eventually the eleven countries – and hence its removal beneficial.

(2) The following countries are committed to join the euro long-term interest rate must be less than 2 percentage
area once they fulfil the convergence criteria established points above the average for those three countries, the
in the Treaty: Bulgaria, the Czech Republic, Estonia, general government deficit must be below 3% of GDP
Latvia, Lithuania, Hungary, Poland, Romania, Slovakia and public debt below or trending towards 60% of GDP
and Sweden. Denmark and the United Kingdom have and the exchange rate have been within the bands of the
opted out of the single currency. ERM II system of exchange rates for a continuous period
(3) Specifically, in order to qualify a country needed to of two years. Often the term "nominal convergence" is
satisfy the following criteria: inflation must be equal to used to indicate fulfilment of these criteria (as opposed to
less than the average of the three countries with the "real convergence" which usually refers to convergence
lowest inflation rates plus 1½ percentage points, the of per capita GDP).

17

Moreover. Indeed. The reduction in possibility of exchange rate adjustment could transaction costs and risk premiums prove costly and the effectiveness of the associated with the single currency were single monetary policy – which by its nature expected to boost intra-area trade and could only be geared towards the needs of the finance. a better use of scarce resources The use of fiscal policies to stabilise the national could be achieved. Low labour mobility annually a Stability Programme which contains a within and across borders. In completion of the European single market such an environment the loss of the established in 1992. are breached. which were enshrined in the 1992 participating Member States. interest rates and public deficits and within a common framework – by its debt. the absence of cross-border fiscal transfers – were considered to create a risk of tensions The concerns over the weak adjustment capacity of the countries participating in the euro area also 18 . as premiums. and the limited degree of the competent EU authorities (the European integration of financial markets – along with Commission and the European Council) is based. The single currency was between participating countries building up if deemed to be a decisive move towards the their economies failed to move in sync. they risked spilling over. the European Economic and Monetary Union (EMU) is unique in that it comprises a These concerns led to the development of the single currency in combination with fiscal convergence criteria for inflation. but the experience of previous decades had given rise to growing scepticism. countries are required enabling fiscal transfers to automatically flow to move towards and sustain a fiscal position from booming to slumping states. by running budget deficits while economies would become more similar. the fiscal deficit exceeds 3% of GDP and/or if public debt fails to converge towards or below • Second. As the exchange rate risks and area as a whole – questionable. alternative mechanisms of 60% of GDP. unless 'special circumstances' can adjustment in the euro area were deemed to be demonstrated. not least because greater economies was seen as possible to some extent. thus inflicting instability onto the area and squeezing But even its fiercest proponents saw the creation productive capital formation in other and management of the single currency in participating countries. like the United comply with to qualify for euro-area accession States. This is unlike Maastricht Treaty. whereas 'close to balance or in surplus' over the medium the euro area has no such transfer term and will be subject to corrective measures if mechanism. currency transaction cost would diminish or disappear. It would also hinder the Europe as a major challenge. weak record of current and expected fiscal outcomes responsiveness of prices and wages to the and on which the assessment of compliance by business cycle. exchange rate policies conducted at national level – albeit stability. The US rules for fiscal policy and penalties if those rules federal budget acts as a powerful stabiliser. It also led to the adoption of the endowed with sovereignty to tax and to Stability and Growth Pact in 1997 which fixes provide common public goods.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union • Growth and jobs. It was hoped that outset it was recognised that countries would be by fostering integration real economic tempted to "free ride" in the absence of the convergence towards the best-performers disciplining effect of exchange-rate risk would receive a boost. The adverse effects of fiscal as the importance of national desiderata profligacy would be all the more damaging as diminished. where a federal government is (see above). and which countries must federal monetary unions. essentially for the newly created European Central Bank (ECB) in following two reasons: doing its job of maintaining price (and by extension macroeconomic) stability. transparency would foster competition. Participating countries submit be comparatively weak. from the • Cohesion and convergence. • First. Concretely. neglecting longer-term considerations of fiscal policies would become easier to co-ordinate sustainability.

the global economy has begun to move A promising start away from a unipolar dollar-based financial It is against this backdrop that Part I of this system and as such the euro has become a Report will take stock of the performance of the valuable public good. jobs and growth dotcom bust. UK United States 1989-1998 1999-2008 1989-1998 1999-2008 1989-1998 1999-2008 Real GDP % rate of change 2.1 4.8 1. Sweden. both inside and outside the euro area during its first ten years.0 2. also in comparison with comparable instrumental to enhancing the adjustment economies. but designed to boost growth and jobs over the were still grappling with past economic longer haul in the whole EU.3 -2.3 2. as opposed to cyclical.1 4.6 4.7 3.7 3. create opportunities for risk sharing and employment growth has been strong.6 68.4 4.2 3.1 0. and this has been accompanied by developments.5 1. As a result. the euro very quickly established its role in foreign exchange and international security markets and has become an important reserve currency. the upshot of the analysis is that in economic adjustment capacity of the countries many respects the euro area has performed better participating in the euro area. thus easing the performance has improved and real interest and stabilisation role of macroeconomic policies. For example. As well.7 Long term interest rate % 8. The economy euro area.4 1.6 48. cycle.5 1. decades. the first ten years of the euro area has been 19 . there has been disturbances.8 60. Moreover.6 1.1 2. fiscal consumption smoothing.0 67.9 5. Structural reform since the creation of the single currency than within the Lisbon Strategy therefore became before.3 7.1) As well.2 5.6 Real GDP per capita index.2 3. followed by a – first slow and then decisive – recovery. the integration and growth has been around 2% since the creation of development of financial markets is seen to the single currency.6 0.9 1.8 Real long term interest rate % 4.7 2. The bulk of is complicated by the fact that many of the the disinflation in the euro area actually occurred changes in governance structures and policy in the 1990s as a result of the efforts to meet the orientations prompted by the single currency Maastricht inflation criteria.6 -0.8 1. while economic present and future.9 7.3 2.7 2.3 -1. This makes it easier to avoid The inflation performance of the euro area has wrongly attributing observed economic decisively improved in comparison with previous tendencies to permanent.3 2. labour participating countries were clearly not entering and financial markets.2 2.8 Fiscal balance % of GDP -4.6 Real GDP per capita % rate of change 1.7 43.9 1. Average inflation in were already ongoing in the run-up phase.7 -3.4 8. moving from the peak of the cycle at the advent of the euro to its trough in the wake of the Macroeconomic stability.9 -3. The sections below discuss these has gone through approximately a full business findings in somewhat more detail. even if that performance has varied capacity of the euro-area Member States – both across countries. At the same time the assessment greater stability also of GDP growth. many orchestrate structural reform in product. which was adopted in 2000 to Maastricht convergence criteria.0 Inflation % 3.0 2. similar to its prior level. mounting evidence that structural policies also have favourable knock-on effects on the Even so. inflation rates have fallen (Table I.9 1.0 Labour productivity % rate of change 1.6 Unemployment % of labour force 9. While the Strategy was the euro area under 'steady state' conditions.3 8. US = 100 73 72 74 76 100 100 Employment % rate of change 0.2 1.6 1. OECD led to a growing role for the EU's Lisbon including – importantly – the pursuit of the Strategy.3 0.1 Macroeconomic performance indicators Period averages Euro area Denmark.4 Source : European Commission. Part I Assessing the first 10 years Table I.3 4.8 1.5 Gross public debt % of GDP 68.8 5.

the institutional changes that have indeed emerge if faster employment growth leads accompanied the creation of the single currency to a lower capital use per worker and if greater – such as the establishment of an independent numbers of low-skilled workers are employed. with adopted by the euro area itself has undoubtedly growth in output per worker halving from 1½ % helped. Even so. And and specialise. with low skills or limited cycles. in the period 1989-1998 to an estimated ¾ % in 1999-2008. slow development and diffusion of new technologies and best work practices. showing that labour market than the United States. the same area economy and the widening interest as in the preceding decade – despite a much differential between euro-area and US short-term faster growth in labour utilisation. labour productivity even if inflation is currently well above this mark would have been even weaker in the euro area due to hikes in energy and food prices. This is partly a reflection of a tendency job histories). A number Another tangible economic achievement in the of euro-area countries are not yet fully reaping first ten years of the euro area has been massive the benefits of the information technology growth in employment – with the creation of revolution and the spurt in the global division of 16 million jobs and the unemployment rate labour. The long-term decline in inflation is tempting to assume the recent jobs 'miracle' itself observed also in other developed countries. and has caused the productivity slowdown. the euro area gauges of long-term inflation expectations continued to lag behind US living standards. the euro area's record on generated by the single currency. there interest rates. – have been instrumental in anchoring price indeed tiny in comparison with the impact of the developments in the euro area. and there is this score has improved over the recent cycle. Indeed. It largely well beyond its fundamental value. various than it has been. It would be inappropriate to attribute this adjustment of supply and demand towards achievement solely to the economic conditions equilibrium. off between more jobs and productivity may Even so. plummeting from 9% in 1999 to an estimated 7% in 2008. The basis. While this explains why the euro area has seen its growth partly reflects the relative strength of the euro- rate stalling at around 2% per annum. in particular the currency has favoured productivity as it has large deficit on the US current account (see Part 20 . central bank with a clear price stability mandate But this combined effect is found to be small. A trade- hence the euro area is not unique in this respect. the flipside of this development has oriented macroeconomic policy framework been a significant productivity slowdown. job growth has by far outpaced that in main culprit behind this lack of resilience is the other mature economies with generally more comparatively greater rigidity of prices and favourable demographics. including the United wages in the euro area which inhibit a rapid States. Without it. indeed evidence that labour market reforms have with the 2001-2003 downturn having been facilitated the labour market participation of shallower than comparable episodes in previous 'marginal' workers (e. This is in sharp contrast with the A growing concern is that the exchange rate of rapid pace of productivity growth observed in the the euro vis-à-vis key currencies has appreciated United States over the same period. But the stability- However. international that used to prevail under the previous system. Nevertheless. risk sharing and consumption smoothing across the industrialised world. However. Obviously it is credible.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union broadly on a par with the ECB's benchmark of offered firms even greater opportunities to trade price stability of close to but below 2%. with the underutilisation participation has soared. on a per capita of resources typically being more protracted. with remain consistent with the price stability goal.g. This has occurred in spite of growing The euro area has historically been characterised numbers of people approaching or exceeding by slower recoveries from economic downturns retirement age. this is also being driven by the is evidence that the introduction of the single unwinding of global imbalances. But it is unlikely that job gains towards smoother business cycles globally – the would have been as impressive under the more so-called "great moderation" – possibly owing to volatile monetary conditions and fiscal instability better macroeconomic management. per capita income having stalled at 70% of the suggesting that this goal is well anchored and US level ever since the 1970s.

however. In absence of exchange rates. while the fourth (Portugal) has establishment of the Single Market in 1992 disappointed. but is not uniformly effective public capital formation. Two of the three largest countries in the that competitiveness realignment is doing its job euro area (Germany and Italy) have posted as an instrument of intra-area adjustment in the considerably weaker growth than the average. It finds that: EU-average living standards that was seen as a precondition for a well-functioning monetary • Business cycles have become more union. at the time of the admission to the buoyant economies and too tight for the others. with the single currency and the • The analysis also provides evidence that integration of financial markets acting as a intra-area synchronisation is particularly catalyst. involving major shifts in intra-euro-area currency was created. not all inflation a more differentiated behaviour over the medium differentials are harmful. Overall. Portugal has been the comparatively poor fiscal but remains weak in the recovery. spurred by capital the euro. Key to the much weaker performance of strong when the business cycle turns down. the divergences in growth and inflation • Interestingly there have been no major further among the euro-area countries have been long- synchronisation gains since the single lasting. inflows attracted by comparatively high rates of return. By contrast. with the tax burden increasing suggests that the single monetary policy may while public expenditure has been growth- be effective in choking off activity in the face unfriendly – i. which in some synchronisation between the euro area and cases have gone beyond their longer-term the rest of the world has clearly accelerated. diverted away from productive of overheating. the one-size-fits-all monetary policy would be less effective – i. Italy's sluggish performance of the effective exchange rates of the euro-area has been due to continued losses in member economies has been relatively muted by competitiveness associated with weak historical standards. In contrast. sync.e. Some. This has been reflected in This suggests that the euro area as a whole divergent current-account positions across has been moving more in step with an countries. real effective exchange rates. in boosting countries out of the slump. in the euro-area Cohesion and convergence periphery a strong growth momentum had been One precondition for the favourable effects of building up prior to the introduction of the euro. growth and external positions can be attributed to structural Despite the greater synchronisation of business convergence in living standards (real cycles at higher frequencies. euro area. Overall. The performance of three of the four synchronised between participating countries "cohesion countries" (Spain. This management. Otherwise. too loose for Moreover. productivity growth and an industrial structure that is particularly prone to competition from low-wage countries. some are merely a sign term. several participating countries had not This Report examines the euro area's record on yet fully completed the catching-up towards this score. The strong performers have been and the joint policy efforts in the run-up to thriving on investment booms. Ireland and Greece) during the decade preceding the creation of have since shown a satisfactory development the single currency – possibly driven by the overall. Better functioning the case of Germany this reflects the fact that it labour and product markets have helped still had to work off the consequences of strengthen this channel while the integration and unification and the associated real appreciation development of financial markets have also helped smooth divergences by spreading their 21 . monetary union to materialise was always owing to sharp declines in real interest rates considered to be that the business cycles of the along with successful structural reform and an participant countries must be more or less in associated strong growth potential. differences in inflation.e. Even so. Part I Assessing the first 10 years II of this Report). elements of these emerging global business cycle. but not all. the volatility of its exchange rate. there is evidence of convergence). equilibrium values.

The authorities. which are deemed to be powerful in from a short spell of pro-cyclical fiscal policies the euro area owing to the extensive public social during the ICT boom.g. after its 2005 reform integration of financial markets in the euro area. already As noted. unbalanced policy mixes. there is strong evidence that the and difficulties in enforcing the Stability and creation of the single currency has spurred the Growth Pact. According to countries. However. In theory a Macroeconomic policies succession of unbalanced policy mixes. but conditions were weak and removing it as the it is clear that on balance the single currency has economy recovered – even though monetary had little discernible effect on the pace of activism has generally been less pronounced in structural reform. which invalidates the TINA the euro area than in e. albeit subject to rules.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union impact on broader groups of consumers and The early debates highlighted the risk of investors. which was unsustainable the main culprit. progress in the cross-border Notwithstanding recurrent difficulties in integration of services has been more muted than enforcing the fiscal rules. which in turn has led to be quite complex. with participating countries' fiscal policies working against. monetary policy. as was reformed in 2005. safety nets and progressive taxes. argued that the been positive. continued to be somewhat pro-cyclical in 'good This has been recognised by the European times'. budget deficits have expected. which reconfirmed and this was seen as the only way to enhance the strengthened its "corrective arm" after difficulties market-based adjustment capacity so as to offset were experienced with its enforcement during the the loss of the exchange rate instrument of intra- economic downturn of 2001-2003. governments to undertake structural reform. the movement of cross-border capital towards its best uses. with fiscal and attributed a strong role to automatic fiscal monetary policies supporting each other. The Stability and Growth Pact. Meanwhile discretionary fiscal policy should be geared to Structural policies and financial integration the 'close to balance or in surplus' target over the medium run. This initially led revamped in 2005. area adjustment – so that the so-called TINA (There Is No Alternative) hypothesis would The experience with this policy framework has apply. The fiscal rules proved to be largely unfounded. It is declined significantly in comparison with notably in this area that price rigidities persist. Notably. but less so than previously. The evidence is not very conclusive. also risks implied a radical change in the macroeconomic triggering volatile movements in the external policy framework. It previous cycles – and in the euro area more so appears that the political incentives to pursue than in non-euro EU members. Monetary policy has been largely disappearance of the exchange rate risk would successful in broadly maintaining price stability rather weaken the incentives for structural and providing stimulus to activity when cyclical reform. Fiscal policy has rigorous reform in EMU are relatively weak. with the relatively long lags intensified surveillance of national structural before boom conditions and the associated fiscal policies in the euro area in the framework of the windfall gains are recognised as being Lisbon Strategy for Growth and Jobs. by diminishing the risk of local credit 22 . to breaches of the 3% of GDP deficit ceiling in some countries when the economy turned down Meanwhile. hypothesis. surveillance and the analysis in this report these fears have in fact co-ordination at the EU level. the United States. Some. the adoption of the single currency undesirable on its own account. rather than supporting. Monetary policy was value of the currency – with strong appreciations henceforth centralised whereas fiscal policy during upswings if monetary policy tightening is remained in the remit of the participating not supported by fiscal restraint. which is particularly problematic. member countries regained ownership of the This has supported the financial sector’s fiscal rules and enforcement has since adjustment role in several ways: by encouraging considerably improved. The single currency was expected to spur arguably the core of EMU's fiscal framework. however. aside stabilisers. such as the Eurogroup and the mechanisms underlying this behaviour appear to European Commission.

resilience to adverse shocks. More paths of the fiscal position and attempts to generally. which leaves policy responsibilities to the Member States wherever possible. financial integration remains a work in progress. the euro quickly emerged as the second Even so. However. It has clearly helped promote a The international role of the euro common understanding among euro-area policy At the outset there was a consensus that the euro makers of the importance of sound public would be well received internationally but would finances and flexible product. Even so. It plays an taken in 2005. labour and capital not match the US dollar's dominant position. euro-area) countries hold in them. anticipated. In reducing the actual influence of the euro area March 2005 a reform of the Stability and Growth despite the large number of seats that EU (and Pact was adopted by the ECOFIN Council. suggests that there is considerable scope for the euro to continue expanding its role as a global The dissuasive effect of the fiscal governance currency. Bilateral Concerning the "preventive arm" of the Pact it dialogues are held with strategic partners. practice. the appointment of 40 countries. While it has progressed substantially since – and Governance issues partly owing to – the introduction of the euro. the US dollar remains the a President of the Eurogroup – the informal first global currency in many areas. depending on a country's 23 . in part due to gathering of euro-area Finance Ministers that incumbency effects. preoccupation with cosmetic improvements. and the euro's international traditionally precedes the meetings of the role remains relatively concentrated in the Council of Economics and Finance Ministers regions neighbouring the euro area. set-up embodied in the Stability and Growth Pact initially turned out not to be as effective as Despite the growing global role of the euro. Affairs). "subsidiarity". several markets are still fragmented and the pace The governance structure in EMU has helped of integration varies from one country to another. This (ECOFIN) – for a term of two years. and by promoting risk diversification Commissioner for Economic and Financial and associated cyclical smoothing. EMU’s governance arrangements have most important international currency alongside also suffered from a deficit of political and the US dollar and continues to consolidate this national ownership. the revamping of the Lisbon in the managed exchange rate regimes of about Strategy for Growth and Jobs. markets and its role as an invoicing and reserve Decisive steps to improve this situation were currency has been growing as well. In markets for the smooth functioning of EMU. There of the euro area on financial and monetary were sizeable deviations from agreed adjustment matters have not made much progress. The euro has become a prominent reluctant to translate a common understanding of currency of denomination in international debt policy challenges into policy-making at home. Underlying budgetary imbalances attempts to improve the external representation where still built up during good times. and better fiscal but also to improve its capacity to adjust to behaviour. Part I Assessing the first 10 years crunches. It builds on a strong tradition of country-specific shocks. but introduced a focus on structural balances and the this involves the EU as a whole rather than the possibility of adopting medium-term budgetary euro area as an entity in its own right – with one objectives that are better tailored to a country’s exception represented by the dialogue with China specific circumstances along with some (where the Presidents of the ECB and the flexibility in the pace at which this objective Eurogroup are involved together with the should be achieved. with some Member States position. Europe's external representation in comply with the 3% of GDP reference value for international financial fora – such as the Bretton budget deficits in some cases led to a Woods institutions – remains fragmented. notably a reform of the Stability important role as an anchor or reference currency and Growth Pact. major efficiency which needs a high degree of financial gains associated with strong integration in integration not only to raise productive potential financial and product markets. deliver macroeconomic stability in many The remaining fragmentation represents an dimensions: low and stable inflation. greater opportunity cost for the euro-area economy.

the BEPGs now help to internalise frequency statistics. This boosted the development of high- Importantly. holds the economic circumstances that could lead to a euro area's foreign exchange reserves and has waiver of the excessive deficit procedure were sole responsibility for exchange rate intervention. although more can be done euro-area priorities – notably the need for to increase the timeliness and scope of EMU flexible and effective adjustment of prices and statistics. wages in the absence of internal exchange rates – into Member States' reform priorities. For with the use of Terms of reference on this topic example. 24 . Formal or informal agreements on exchange rates with partners outside the euro area require a decision by the Council. but the need for Eurogroup President for a term of two years and enhanced structural reforms in the euro area has his expanded participation in G7 meetings along been widely accepted from the outset. The a comprehensive information system to provide importance of structural reform for the the statistical data on which to base surveillance. proposals However. smoothly. although further progress concerning the preventive arm would be desirable. reinterpreted and clarified. The implementation In practice the conduct of exchange rate policy of the corrective arm now runs much more has not encountered major problems. the National Central Banks and the ECB).European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union structural reform efforts (notably pension The Eurosystem (the system of euro-area reform). An action references to the euro-area dimension in the plan on EMU statistics was endorsed by the Broad Economic Policy Guidelines (BEPGs) to ECOFIN Council in September 2000 which which the Treaty has assigned a central role in identified the statistical areas where progress was the coordination of economic policies. Another important area of EMU governance concerns the conduct of exchange rate policy. Article 99 of the EC Treaty requires has improved the situation in this regard. urgent. Concerning the "corrective arm". Eurogroup do not always converge and this has occasionally led to inconsistencies in public Structural reform has remained largely under the statements. The 2005 decision to appoint the remit of the Member States. Member States to "regard their economic policies as a matter of common concern and shall Finally. functioning of the euro area has led to including coordination and policy decisions. the views of Ministers in the to this effect are made in Part III of this Report. the proper functioning of EMU requires coordinate them within the Council".

Jacques Delors. Slovenia. Over time. with the most rates and coordinating monetary policies recent one prior to the launch of the single between the Member States. and for the whole recession in the United States could spill over European economy to perform better. but the period 1989-1998. which set out a against which the performance is valued. if inflation is project of a single currency could not be on average lower in the period 1999-2008 completed in the 1970s and only fully revived at than in the period 1989-1998. proposed the outside it (United States). on modeling or econometric techniques. submitted in 1989. Germany. arguably Greece. The committee's (United Kingdom. Italy. cooperation was needed for the internal market A new turning point may be nearing as the to develop and flourish further. the Netherlands. Austria. a fresh wave of currency instability on area's performance against a combination of the international markets squashed any hopes of following three benchmarks. Portugal and Finland. this provides the end of the 1980s. but rather the impact euro became the official currency of assessment against this counterfactual based 11 countries: Belgium. an attempt is made to measure the euro However. reconstructions of the would have a single currency for the 21st century. after a decade of preparations. European Union (the Maastricht Treaty). The origins of EMU can be traced back more clearly to 1970 with the publication of the Any assessment has to consider a benchmark Werner Report (Werner 1970). decisions constitute the euro area had there not been the on the move to the final stage of EMU were single currency. Ireland. either inside the EU economic and monetary union.1. possible evolution of the economies that now Finally. although the economic development for 25 . coming from a cyclical peak in single currency.e. Bretton Woods. dependent on the success. Sweden and Denmark) or report. In this process to achieve EMU within ten years. to study stage of development. although it mentioned the need 1999-2000. As a result. This assessment is Treaty of Rome in 1957. into weaker activity globally and hence also in the euro area. INTRODUCTION Economic and Monetary Union (EMU). First. France. Luxembourg. Similarly. Report. the time framework that would foster growth and seems ripe for a first comprehensive assessment employment. it became 2001-2003 and a – initially hesitant but clearer that closer economic and monetary subsequently firm – recovery in 2004-2008. followed by a downturn in for economic coordination. For example. In June 1988 the European Council set up a committee chaired by the then President of the • Control groups of economies at a comparable European Commission. which included these three stages. The objective is not the taken in May 1998 and on 1 January 1999 the counterfactual itself. i. the Member States greatly facilitated by the fact that the euro area concentrated on building a 'common market' for has now gone through a virtually complete trade and the Treaty contained no provisions on a business cycle. a introduction of economic and monetary union in negative inflation differential over the period three successive stages (Delors 1989). Subsequently Two other methodological remarks are in order. In 1991. When the EU was founded by the of its functioning to date. deciding that Europe • Counterfactuals. 1999-2008 between the euro area and its the Member States approved the Treaty on peers points to a better inflation performance. Spain. an indication that the inflation performance has structurally improved. This system currency roughly coinciding with the ten-year operated successfully for over a decade. has been a recurring ambition for the European Union because it promised Ten years after the decisions that led to the stability and an appropriate macroeconomic introduction of the single currency. in 1979. restricting the fluctuation of intra-EU exchange • Previous business cycles. the European availability of information: Monetary System (EMS) was launched. Malta and Cyprus have the most important monetary innovation since adopted the euro.

so in order to financial markets and the associated achieve comparable data sets over time decisions opportunities for risk sharing and consumption had to be taken to include the bulk but not all of smoothing.9) and the development of down as inflation rises in cyclical upturns and EMU's governance structure (Chapter I. euro-area aggregates always refer to clearly developed in that direction. including the point that the majority of the ex ante assessments incentives to implement structural reform and of EMU prior to its launch have been rather boost the growth potential of the economy in sceptical (Buti and Sapir 1998 and 2002). With the loss of the exchange rate mechanism which starts off with a discussion of the overall the adjustment to country-specific macroeconomic performance of the euro area disturbances would be sub-optimal.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union the whole year of 2008 is unknown at this stage. while adjustment the available projections should be converging to problems definitively exist. Second. it has otherwise. This is followed by an examination of the degree of synchronisation • Fiscal policies.7) and structural catching up of lagging countries (Chapter I. the creation of the euro impinges on many more features of the Finally. chapters examine the growing global role of the cyclically at the country level as well. Third. Therefore any numbers for cushioned by offsetting developments triggered 2008 are estimates based on the latest available by the single currency and monetary policy. This would exacerbate the allegedly weak The policy mix issue is addressed (Chapter I.5) adjustment capacity at the country level and as well as the development of structural policies produce a suboptimal mix between monetary (Chapter I.10). (Chapter I. Even if the euro area may not have the current euro-area countries.6). 26 . The diversity of the euro area the euro in the global financial system. the structural convergence of including the following: per capita income levels. any including the greater synchronisation of business euro-area aggregates reported for the period prior cycles across countries. the eleven countries that joined the euro area in the first wave plus Greece. as noted euro-area membership environment overall as well as the integration of has been expanding over time. Unless indicated started off as an optimal currency area. the more stable macroeconomic purposes.3). it is also useful to underscore at this economy it has helped shaping. most recently in the 2006 issue of the EU Economy Review (European Commission 2006a). since its advent (Chapter I. which remained in the hands of business cycles across the participating of the member countries. interaction with the EU Lisbon Strategy for A number of prior concerns have been advanced. European Commission forecast. The relevance of these ex ante concerns – which as presented here are far from exhaustive – have been extensively studied as EMU evolved. The Review concluded that. going euro (Chapter I. they have also been the actual outcomes. reflected in the structure of Part I of this Report. Growth and Jobs. Aside from the adjustment issue.2). financial market integration and fiscal policies at the aggregate level. the better anchoring of to the launch of the single currency are obviously inflation expectations (and perceived real interest ex post constructs used only for illustrative rates). the adjustment experience (Chapter I.8). the challenge of economic governance and co-ordination in a • The euro area risked being not an 'Optimal multi-jurisdictional framework and the role of Currency Area'.4). would risk being countries and its development over time pro-cyclical due to the 3% of GDP fiscal (Chapter I. This is was deemed to result in cyclical divergences. The final • Real interest rates would tend to behave pro. complemented by an analysis of deficit ceiling imposed by the EU fiscal rules. vice versa and again exacerbate the adjustment gap (the Walters critique).

27 . The following section will look at the growth and employment performance in the euro area and its • Inflation volatility leads to greater volatility main determinants. the macroeconomic policy framework in the euro (4) The European Commission's Quarterly Report on the area is geared to maintain price stability. The subsequent section and underutilisation of resources is costly. including the adoption of the in output and employment. Commission 2008a). disturbances. This was hoped to act as a lever for the single market by High inflation is potentially costly. as the analysis in later chapters bears adversely affect the growth prospects of the out. established a low inflation environment amid financial stability and also brought lower 2. It was. Not surprisingly. not assesses the cyclical variability of activity in the least since resources may be withdrawn for euro area and its resilience against adverse good (hysteresis effects). • Greater inflation uncertainty makes it more difficult to disentangle relative and absolute Against this backdrop. They contributed to growth and resilience of economy. by acting as a catalyst for financial rates. This increases the real cost of capital market integration and development. with the Euro Area N°1 provides an assessment of the reduced volatility of output growth in the euro area (European European Central Bank to deliver on this goal.2.1 which shows a strong What was less appreciated at the outset was that positive correlation between the level and the removal of the exchange rate risk and the standard deviation of inflation). moreover. MACROECONOMIC PERFORMANCE The inflation performance of the area thus 2. Three sources of associated reduction in macroeconomic volatility costs of inflation volatility are generally might produce additional growth effects by advanced: reducing the cost of capital alongside with the lower transaction cost of trade. this chapter will start off price changes. could and lowers the equilibrium stock of capital. Greater variability in the price with a discussion of the inflation performance in level thus tends to blur the price signals to the euro area in comparison with the pre-euro consumers and producers. The final section looks at the development of the exchange rate of the euro in Inflation volatility has sharply declined since the comparison with its legacy currencies. Such forces have nevertheless been productivity. hence lower disturbances. jeopardising the history and that in other advanced economies. produce opportunities for risk sharing and Lower capital means lower output for a given consumption smoothing in the face of economic level of labour input. Recurrent slack single currency itself.2.1. (4) From a period of low growth volatility in One of these criteria refers to countries' inflation performance.2. inflation is associated with high inflation volatility (see Graph I.2. the US and the been required to fulfil the Maastricht criteria. UK. turbulent 1970s.2. efficient allocation of resources. 1980s and early-1990s and this has been accompanied by a similar decline in the volatility and the volatility of GDP growth. INFLATION PERFORMANCE example Graph I. INTRODUCTION naturally provides prima facie evidence on the effectiveness of the institutional setup in terms of The creation of the single currency in 1999 delivering on one of its key objectives. For 2. This is the case because high competition. The benefits of low inflation transactions cost for cross border trade. and its creating economies of scale and stimulating removal beneficial. the euro-area economy. along with lower and more stable inflation. • Inflation uncertainty gives rise to an inflation not obvious initially that the creation of a single risk premium embedded in long-term interest currency.1.2 shows the familiar moderating pattern for the standard deviation of All participating countries in the euro area have GDP growth in the euro area. Inflation volatility can thus at work.

2. The inflation record to date with further declines in the past decade. as a consequence 2 of the two oil price shocks and the policy 1 responses to them. Growth volatility has since subsided.Dev . which turned out the reasons behind the observed marked decline to be a powerful incentive for making in growth volatility.8 1981 2.8 13. 6 the euro area registered a gradual improvement St.4 2001 *Corresponds to the period since the start of Stage III of EMU.one of the lowest on record in post- 1960s 1970s 1980s 1990s 2000s war history.9 5. 0. Table I. % currency -.2. As can be seen in the first column.5 1960s 3.2.0 1990 1.8 12.2 5.2: Volatility of GDP growth Standard Date of Average Maximum (St. An overall characterisation of inflation Graph I. it is clear that which involved the granting of independence to there is a strong positive correlation between the national central banks. been reached on the deeper causes. with a nearly that have reduced the volatility of inflation and trebling of the standard deviation in the euro area growth.1 1963 3.3 2. This was achieved in spite of a have contributed to the decline in the volatility of series of inflationary shocks that hit the euro-area both inflation and growth (Blanchard and Simon economy.0 1965 1970 1975 1980 1985 1990 1995 2000 2005 Euro area UK US SE The bulk of the disinflation occurred in the Source: European Commission. 2. While this intensity of production. This was largely the result of the efforts consented by euro-area candidates There is a growing body of literature examining to meet the Maastricht criteria. 0.2. however.8 1. Subsequently. 0 average inflation declined from above 9% in the 0 5 10 15 20 1970s to 2% in the first ten years of the single Inflation.5-yr rolling 5 in terms of the level of inflation over the last four 4 decades. 1990s. UK and SE) area and the preceding decades is shown in 7 Table I. These include the reduced energy and doubling in the US and UK. of which 1.5 3.6 1974 2. This suggests that the Average inflation in the first ten years of the move away from irregular discretionary policy single currency has been broadly on par with the responses to economic events towards regimes ECB's benchmark for price stability of (close to targeting a clear inflation objective is likely to but below) 2%. particularly in the US.3 2. Key among the efforts of the time was (Bernanke 2004).7 0. was a resurgence of volatility in the first half of the 1990s. Although no consensus has yet an improvement in monetary policy making. inflation inflation 4.0 1990s 2. when average inflation dropped by some 4½ percentage points. Source: European Commission.0 1970s 9.5 Source: European Commission. there financial markets and smaller disturbances. But obviously there are also other factors rise in output growth volatility. Inflation more than doubled in the 3 1970s compared to the 1960s.Dev .1.1: Inflation: level and volatility performance during the first ten years of the euro (Euro area. increased risk sharing via development was reversed in the 1980s. paths of inflation volatility and growth volatility over the last 50 years. annual data) deviation of max.1: Inflation performance in the euro area Graph I. US. which considerable progress towards low and stable is often labelled the “Great Moderation” inflation.5-yr rolling.2. the following decade saw a marked 2001). annual average.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union the 1960s.0 inflation inflation 3.0 the last 2 years are forecast values.5 2000s* 2.2. In the first two years this included a 28 .0 0.5 1980s 7.

wage growth volatility As shown in Table I.2. Many of the half of the 1980s.5 11.6 13. Greece. it convinced the public Spain.2.3 1979 significantly across the participating countries in 1980s 5.9 2. which are likely pronounced. inflation inflation Even more striking than the reduced level is the inflation inflation reduced volatility of inflation.6 0.3.4 2000 *Corresponds to the period since the start of Stage III of EMU. but in Belgium. with the most substantial declines last 2 years are forecast values. which now play Table I.6 1. the US and non-euro. Accordingly.4 2007 Table I. the Netherlands and Finland. As shown in 2000s* 2.6 9. Part I Assessing the first 10 years hike in oil and food prices. the standard deviation of inflation SE peaked in the 1980s at close to 4 percentage 1960s 3.0 5.4 1969 1970s 7.5 5.2. gradually edged up in the US.2 1975 1980s 7. except for Source: European Commission. As shown in Graph I.2: a dominant role in short-term inflation dynamics Inflation performance by decade: UK.6 10.7 1. expectations and the credibility of monetary inflation rates in the range of 10-20% were policy.2. Germany. to have responded to the improvements in the macroeconomic policy framework and the 2. Italy and Portugal inflation rates in excess that the authorities will act to prevent inflation. better understanding of the importance of Luxembourg.3). of which the 1970s.2. while it patterns as those described for the euro area.7 2.0 1980 inflation than in any other period of comparable 1990s 3. France. This stemmed from a beyond 10%. low inflation objective. geopolitical policy objective – also took place elsewhere. giving the euro and strong increases in indirect taxes it a explicit and clear mandate for achieving price and administered prices in several euro-area stability.4 1. In 1990s 3. In conscious and systematic move to stability- Germany and Austria inflation never went oriented frameworks.4 1977 points. countries in the latter group registered the most the public will not change their expected pronounced disinflation since.5 1990 further progress has been achieved since. Obviously With a credible commitment to price stability. tensions and supply concerns have led to further sharp increases in energy prices. the depreciation of granting independence to the central bank.1.5 5.1 5. It declined to nearly one fourth of that 1980s 7.6 1980 during the run-up to the single currency and still 1990s 3. and wide recognition by policy makers countries associated with fiscal consolidation and the public at large that price stability is a key efforts. registered mainly in the 1990s.5 1990 duration in post-war history. on average three inflation in the face of an upward price shock.9 3. An international comparison corresponding changes in expectations as well. Austria and the Netherlands where this took place already in the 1980s.6 3. the period 1960s 3. of 20% have been no exception. the cross-country convergence of This is not only reflected in price developments. inflation volatility has also been very but also in wage developments. In the 1980s and 1990s environment of low and stable inflation – such as 29 .1 1. to peak in the first which is therefore not unique. The initial Over the last two decades there has been a dispersion of inflation rates was very large.5 2.4 4.8 11. SE and US (Graph I.4 1990 most euro-area countries inflation peaked in the 2000s* 2.5 3.3 6. times that recorded in the other countries. Using the standard UK deviation to gauge inflation volatility.5 18.1 13.2.3 1966 1970s 8.1 2. Further down the road.3 24.4 1969 since the launch of the euro displays more stable 1970s 12.8 1. By committing credibly to achieving a occasionally reached and in Ireland.5 3.2. at roughly twice the standard institutional changes that matter for achieving an deviation of the 1960s. tripled in the 1970s in the euro area and Sweden area EU countries feature the same overall and rose by a factor of eight in the UK.4.7 2001 US It is also striking that inflation has converged 1960s 2.5 1980 the run-up period to the launch of the euro.4 0.7 0. Standard Date of Average Maximum deviation of max. 2000s* 1.

Jul. Jul.4: Volatility of wage growth higher than in the 1960s.Dev . In the 1970s.2. Jan. Jul.2. Jan. Jul.5 0. Jan. Jan. Jan. Jan- 99 99 00 00 01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 Unprocessed food Energy HICP Source: European Commission. the volatility of import price inflation surged. Jan.5 1.0 -0. Jul. Jul.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union y-o-y % change Graph I. Import Euro area UK US SE price inflation volatility was very low in the Source: European Commission.5 Jan. a pattern prolonged into the.0 0. Jan. annual data 9 changed in the 1990s and 2000s. 3 2 Graph I.0 2. 30 . Jul.0 € cash changeover 3. mostly below 2 percentage points. but remained considerably Graph I. In the 2000s break-up of Bretton Woods and the oil price further reductions in volatility were recorded.5 2.2. In the next decade the volatility of import price inflation went back to single standard deviations.0 1. 2 Graph I. 12 10 It is also fair to acknowledge that the favourable 8 inflation performance of the euro area has clearly 6 benefited from the better inflation record 4 elsewhere via developments in import prices. The pattern visibly St.5 3.2.3: Contributions to euro area overall HICP inflation 4. shocks.5-yr rolling.5 yr rolling annual data 0 18 1965 1975 1985 1995 2005 16 Euro area UK US SE 14 Source: European Commission. with the points.5 shows that the volatility of import 0 1965 1970 1975 1980 1985 1990 1995 2000 2005 prices declined markedly in the last three decades across industrialised countries. when import 8 price inflation volatility reverted to levels unseen 7 since the 1960s.5: Volatility of import price changes 1 St Dev . This suggests that reduced 6 volatility in global price impulses also 5 contributed to the decline in the volatility of 4 inflation. Jul. 1960s. wage growth volatility returned to standard reflecting the predominance of fixed exchange deviations mostly between 1 and 2 percentage rate regimes at the time. reaching double-digit standard deviations. Jan. Jul.

(2008). (5) A number of generally risen while those of less frequently stylised facts can be inferred from these graphs. These inception of the euro than before it. being matched by equivalent wage moderation. JOBS AND PRODUCTIVITY Second. see Pisani-Ferry et al. as its introduction roughly coincided both periods – i. the relative ones.1. A number of explanations have been advanced. these favourable effects it may be somewhat Adjustment was clearly not completed when puzzling that a sizable a gap in living standards Germany entered the euro area. Despite of the Deutschemark in the early-1990s. the arithmetic average will exceed the prices of frequent expenses of local services have weighted one and vice versa. In addition. over and above the effects of lower inflation Germany has had to work off the consequences volatility.6 and I. The record so far evidence to suggest that the pass-trough of import prices onto domestic inflation may have Graphs I. if small countries grow faster than large often well perceived. (5) For a similar approach. It has been rapidly losing international market shares as a result.e.1). Countries that are inflation. This in turn feeds back onto global 1989-1998 and 1999-2008. which led to between the euro area and the most advanced protracted wage moderation and weak domestic economy in the world – the United States – has demand. Part I Assessing the first 10 years In addition. stalling at around 30% despite a attributable to unabated losses in competitiveness welcome surge in the number of people at associated with weak productivity growth not working age participating in the labour market. impact of the single currency itself on growth. the literature provides ample 2. and Faruquee comparator group of economies in the periods 2006). owing to the (per capita) growth rates in the euro area and its increased use of pricing-to-market strategies participating countries alongside with those of a (see Taylor 2000.7 show the average annual declined in advanced countries. Notably include structural policies (which will be Germany slowed down from the 2½ to 3% range discussed in later chapters) alongside with in the decade preceding the creation of the single secular trends such as economic integration and currency to a mere 1½ % while Italian growth ageing populations. There has also been an remained weak all along at around 1½ %. Italy's sluggish performance is remained. GROWTH.2. In particular. 31 . Italy's industrial structure is more strongly exposed to competition with low-wage emerging economies. the area has been growing by slightly over may help explain the rather negative public 2% per annum in both periods. purchased big-ticket consumer durables and services that are globally traded steeply fell. This section will give some clues. McCarthy 2000. But the arithmetic perceptions of the euro in many participating average growth rate amounted to almost 3% in countries.2. indicates that smaller countries have on average been growing faster than the larger ones in both periods. For the euro area both the weighted (EA) and arithmetic averages Meanwhile. For rather radical shifts in relative prices that are not example.3. the drive towards lower global (AV) are shown to provide an impression of the inflation did not come without a cost in terms of contribution of country-composition effects. via stronger competition and of unification and the ensuing real appreciation economies of scale as markets integrate. thus creating a virtuous circle of low located above the 45° line have seen growth and stable inflation across the world. accelerating and vice versa.2. two of the three largest countries have Inflation is one among many other factors that posted considerably weaker growth after the impinge on overall growth performance. close to the US record – which with this change in relative prices (Box I. This First.3. 2.

the public remains more Source: European Commission.2.1:Public perceptions of inflation in the euro area With the introduction of euro banknotes and with the cash euro introduction. This gap remains groups. support rates are highest in Ireland. regular opinion polls to monitor citizens' attitudes towards the euro (Eurobarometer).0 30 benefits which the euro has brought about. Flash Eurobarometer results.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Box I. see graph).0 60 they adjusted rather rapidly to the euro. Germany. popular support for the euro is 0% correlated with inflation. low increases in disposable euro to be "a good thing for Europe". education and higher incomes more than those with lower education levels or lower 5% 70 income levels (Jonung and Conflitti 2008). two thirds of Luxembourg. less than half consider it to be a "good thing The perception gap has also to be seen for their country". at 1. More specifically.0 -15 reduction of transaction costs. many coins in January 2002. energy. Euro area Actual HICP inflation (lhs) On the other hand. but income and various psychological factors."out-of-the-pocket" (lhs) determinant of people's perception of the HICP . which could explain the perception gap in the euro area countries. as measured by the European integration for European citizens European Commission’s Consumer Surveys. the steep increase in house prices in many Around two-thirds of citizens consider the countries. Since the euro cash introduction. the euro has become citizens seem to hold a different view. According to the latest country. Belgium and Slovenia and the respondents in the euro area either had a lowest in Greece. These include the The Eurobarometer show that citizens are relatively price increases for frequently more positive on the usefulness of the euro purchased goods (food. 3. who use it. In terms of socio-economic or admitted not to know it. men are on average more positive a challenge for researchers to interpret than women. y-o-y % change Euro area percentage balance These polls show that people are overall 5.0 15 least the microeconomic benefits such as the 0 0.0 Euro cash changeover → 75 supportive for the single currency and that 4. younger people more than although it is expected to diminish over older ones and citizens with higher time. -1% -10 1996 1998 2000 2002 2004 2006 price perceptions seem to be an important HICP . When citizens are asked against the rather low awareness of the about the usefulness of the euro for their actual inflation rate. aside 1% from the socio-economic factors discussed 10 above. for Europe than for their individual country. increased significantly with the euro cash the European Commission has conducted changeover in 2002 (graph below). Although there were on Source: European Commission. Italy and too high estimate of the actual inflation rate Portugal. Euro area Inflation perceptions (rhs) sceptical about the euros' positive impact on growth and employment and sound public A number of factors have been identified finances. 4% 50 3% Recent research carried out by the 2% 30 Commission services suggest that. Inflation perceptions (rhs) average no major price increases associated 32 . the ease of 1996 1998 2000 2002 2004 2006 2008 travel and the increase in price transparency.0 45 They also show that citizens are aware of the 2.low frequency purchases (lhs) single currency. one of the most tangible symbols of Inflation perceptions.

% per annum 6 IE 5 This overall picture is broadly similar in per LU 4 EL capita terms (see Graph I.2. The boost to job growth in Spain has been particularly impressive. detects a structural break in aggregate Portugal's performance has been weak as employment in the euro area in the late-1990s. the UK and Sweden since the (see Chapter I.7: Output growth per capita insight in the approximate causes of these developments. less strict 33 .8). 1989-1998. These countries have all from over 9% in 1998 to 7% at present outpaced the US. Greece as a whole. A recent study (Mourre 2006) launch of the euro. including the US. Among the smaller countries. within the group of smaller countries approximately half of the jobs surge in the area there have also been striking differences. macroeconomic imbalances built up in the 1990s and explains this by lower tax rates. Part I Assessing the first 10 years boom – which saw current account deficits. an easing of SE IT FR EAEL 1 US NL credit constraints on households and strong FI UK BE AT PT migration inflows.8 reveals that job 6 creation in the euro area has overall been buoyant since the launch of the single currency.2.2. The jobs boost owes mostly to and Finland sharply accelerated while Ireland has growing numbers of female workers as well as been growing rapidly in both periods. % per annum 1999-2008. but it did not show any acceleration in US 2 FR EA AT NL its per capita GDP.6). Graph I. A decomposition of GDP growth into changes in employment and labour productivity gives some Graph I.8: Employment growth 0 1 2 3 4 5 6 7 5 1989-1998. explaining Fourth. ES FI Spain has performed well on this measure in both AV 3 SE BE UK periods.7). ES 4 IE Third. 1999-2008. Graph I.3 1989-1998.6: Output growth household indebtedness and underlying fiscal 7 deficits soaring – had to be worked off (see Chapter I.2. as rapid population growth IT DK DE PT (mostly on account of immigration) rather than 1 productivity growth has become the main growth 1 2 3 4 5 6 7 engine. % per annum and I. FR EA AT PT 1 IT DE 0 Graph I. % per annum 5 IE and slightly more so than in countries outside the 4 EL LU area. The pick-up in job SE BE UK AV growth has been widespread. some stage as the economy is cooling down sharply. % per annum Source: European Commission. Growth thus relied heavily on 0 DK DE the non-tradable sector. % per annum Source: European Commission. except for Spain. even if falls in the structural rate of unemployment – slowing down slightly. with only the 2 DK US NL Netherlands backsliding. 1999-2008. the comparatively rapid growth in Spain – 3 the fourth-biggest economy in the euro area – has 2 LU been driven by a boom in residential construction AV spurred by declining interest rates. accelerating from ½ to 3 FI ES around 1¼ % per annum.7) – a situation that may be reversed at Source: European Commission. and the current account -1 0 1 2 3 4 deficit widened progressively (see Chapters I.2.

Regulatory issues. Although firms can trade. The main culprits of the entails a lower capital use per worker and if slowdown have been the sluggish performances greater numbers of low-skilled workers are of Italy – which has been showing no employed. This compares rather poorly higher productivity may emerge under some with the US record of 1¾ % productivity growth conditions. real estate and other business services and hedge themselves against currency risk.2. A trade-off between more jobs and ¾ % (Graph I. wage while the weak productivity performance of moderation during the 1990s. wholesale and retail associated currency risk. notably if faster employment growth in both periods. reveal that the differential stems mainly from the information and communication technology • Elimination of exchange-rate volatility and (ICT) equipment industry.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union employment protection legislation (EPL) and a especially entry and exit rules. Portugal also and best work practices. 34 . posted weak labour productivity growth.3. % per annum 3 IE FI LU Openness to trade and investment enables a 2 UK country to specialise in more efficient production US SE AT processes. the elimination of exchange rate uncertainty may be expected to boost EL productivity through a number of channels. appear to be shift in the production structure towards more playing a role in business and financial services. banking fees sluggish developments in only a handful of and in-company resources for currency industries. with the Maastricht convergence criteria. the evidence points in the opposite productivity growth slowed down from 1½ to direction. The thrust of the findings is • Elimination of transaction costs associated that the bulk of the productivity slowdown with operating in multiple currencies like (relative to the US performance) is attributable to currency conversion charges. The impact of the euro Graph I. It is also plausible that increases in FR EA PT competition brought about by the removal of IT 0 barriers to trade and cross-border investment 0 1 ES 2 3 4 5 raise productivity. and thus raise the level of output per NL BE AV DK 1 DE unit of input. % per annum is generally found to have been instrumental in this regard. As well. have provided further impetus. 1999-2008. The low level of private ICT hedging is costly and never complete and R&D expenditure in comparison with the US (Döhring 2008).2. possibly in Europe's retail and wholesale industries is in part response to trade integration in the wake of the explained by constraints to the use of scale internal market initiative and efforts to comply economies. labour intensive services. but participation in the euro area may Source: European Commission. may have contributed. Detailed sector-by-sector analyses management.9). financial services. 2.2. It forces less productive is mostly due to the smaller size of high tech industries in Europe. The deeper causes of the productivity slowdown Trade effects of the single currency are expected have been studied extensively – most recently in to materialise via three main channels: the EU Economy 2007 Review (European Commission 2007a). While it is tempting to assume that the recent jobs surge has caused the productivity The flipside is that area-average labour slowdown. But this combined effect is small and productivity growth at all since 1999 – and Spain dwarfed by the impact of skill formation and the – where output per worker has even declined development and diffusion of new technologies since the inception of the euro.9: Labour productivity growth Even if productivity growth in the euro area has 4 been weak. The single market programme -1 1989-1998.

Additionally. which would increase goods arbitrage between countries. this is Other studies find a diversion of FDI away from confirmed in most econometric studies and they non-euro-area EU countries into the euro area generally attribute this to the euro.2. both in range of 5 to 15% so far and there may be more terms of FDI flows into the euro area and of to come (Baldwin 2006b.g. the better allocation of production across euro-area countries made euro-area goods more 35 . SE. It triggered companies direct investment (FDI) is less straightforward. enhances Graph I. and other countries. 24 euro-area trade and it is difficult to discern a euro 22 effect. On the other hand. Taglioni 2005). pointing to a genuine trade creation effect. According to (Taylor 2007). in transport and communication costs generated the development of new forms of trade and A priori the effect of monetary union on foreign production management. The fall the unbundling of production process enlargement of the EU created similar becomes more profitable. Trade in intermediate products will also area in their proximity. UK.10). a secular fall Source: European Commission. the euro-area firms' investment abroad (Petroulas increase in trade flows between euro-area 2006. Yi 2003. exceptions (e. Skudelny. 28 increased rapidly (Graph I. whether on balance FDI A positive euro effect on trade is easier will be positively or negatively affected by the observable when restricting the analysis to EU single currency is a purely empirical issue.10). Berger and Nitsch 2005). both within the euro area and with the rest of the world. to stay on their competitive and resulted in increased extra-euro- domestic market.2. Extra-area trade 26 has increased slightly more rapidly than intra. however. trade within the euro area has clearly expanded Most studies find a positive euro effect on intra- more rapidly than trade between euro-area euro-area FDI flows in the range of 14% and countries and other EU countries. • Price transparency. Barring a few 36% (Petroulas 2006. Emerging economies like China. thus raising "vertical" opportunities for companies based in the euro FDI. to break up the production process There are also complex interactions between FDI internationally and 'offshore' production stages to and trade. Sum of exports and imports as a % of GDP 32 In the run-up to the launch of the single currency. India 1995 1997 1999 2001 2003 2005 or Brazil have been rapidly integrating into the intra-euro-area extra-euro-area global economy. This so called "unbundling" of the production facilities in destination countries. boosting trade between them euro-area trade with DK. Comparisons between intra. So.2. A priori this will to boost trade between advanced and emerging entail a concomitant increase in trade of final economies and to reduce the relative size of products. the euro has positive effect of the euro on FDI flows between increased trade between euro-area countries in a the euro area and the rest of the world.10: Real trade in goods competition and. be interpreted 20 with care. increase as a result and this will be largely intra- sector or intra-firm. Available studies also find a recent reviews of the literature. raise trade flows. mainly small ones.and extra- euro-area trade should. countries (Graph I. if transaction costs intra-area flows in total euro-area trade. If cross-border transaction costs fall. countries has not been at the expense of trade with non-euro-area countries. Sousa and Lochard 2006). area trade (Flam and Nordstrom 2003. 30 euro-area countries' trade flows. it make a better use of countries' competitive may be less urgent or profitable to set up advantage. 2008). Part I Assessing the first 10 years firms. Foad 2006). in turn. and Baldwin. Indeed. Since the late 1990s. production process (Baldwin 2006a) has tended reducing "horizontal" FDI. Importantly.

in the long run. over and above the volatility of output growth). This raises labour 80% of the euro area). the component of labour of inflation. with the Research and Development (R&D) and Foreign strongest effects found in the smaller countries. AT). This is done in a two-step approach. NL and BE. for participation in the European single market (or Concerning the controls. 2008). these factors.e. The effects of R&D vary across countries and only reduced transaction costs and smaller exchange in FR and BE are significant effects of FDI found. countries DE. Direct Investment (FDI) are included as This confirms that there may be indirect effects of explanatory variable in the equation along with the the euro on the level of productivity via the user cost of capital and a measure for risk (the volatility channel. This may significant impact of the euro on productivity be somewhat surprising in view of the relatively 36 . SE. owing to better price transparency. is EUKLEMS. It suggests that the most integrated part of barriers may raise productivity further through the euro area has drawn most benefits from euro faster diffusion of technology. The direct and indirect (volatility) single-currency The key finding of the estimates is that EMU effects on productivity are estimated to be 3% and effects are positive and significant in five ‘core’ 2%. This is (BE. suggesting that integration and associated scale economies and the euro has had a positive impact on M&A competition pressure. volatility and an associated decline in risk premiums built into capital cost. Single Economic Research (NIESR) has tested the market effects are significant and positive in BE. Econometric volatility of output have a significant positive research carried out by National Institute for effect on productivity in all countries. three EMU-out tested with an equation for output volatility in countries in the EU (UK. notably (i) via economic (European Commission 2007b). EU entry inflation volatility are positive and significant in and adoption of the single currency. and (ii) via reduced output activity. over and intra-euro-area mergers and acquisitions (M&A) above the impact of the single market in total M&A by euro-area companies was programme. IT. The study distinguishes two types of reversed after the introduction of the euro single currency effects. stems from a rigorous productivity and in addition increases in process of elimination and checking and is quite competition brought about by the removal of trade robust. hypothesis if EMU membership has a positive DE. DE. both inflation and NAFTA in the case of the United States). respectively. France and Italy) as preparation of this Report provides evidence of a well as the Netherlands and Belgium. A proxy for all countries and the EU entry dummy is trade openness is also included. i. NE and SE. which a single currency dummy in included The dependent variable is output per hour worked alongside with controls for the volatility and levels adjusted for skills. DK) and the US. FI. GE. Dummies are included specialisation and competition channels. EU entry dummies have a impact on labour productivity over and above significant impact on productivity in SE and AT. rate and related risks (Barrell et al.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Box I. Moreover. The productivity that can be attributed to other factors single currency effect on volatility turns out than the quality of human capital. EU membership introduction in terms of its productivity. Both stocks of significantly negative in most countries. In a second step it is tested if there are additional indirect effects of the single currency on In a first step a panel error correction model is productivity through reduced output volatility estimated on a sample of seven EMU countries feeding into the risk premium on capital.2: The impact of the single currency on labour productivity The ability to trade enables countries to specialise The finding that the single currency effect is in production that is better attuned to their constrained to only five countries (which comprise comparative advantages.2) in largest countries (Germany. NL.2. FR. IT. The first A study carried out by the National Institute of channel appears to be strongest in the three Economic and Social Research (see Box I. The database used significant in FI and AT with a negative sign. FR. decreases in the user cost of capital and potentially powerful growth boosters. EU entry and the single market.2. In and the single market programme are thus addition. a downward trend in the share of growth via the trade and FDI channels.

Table I. altogether. 2000s against 6-7½ % in the two previous cycles. 1991Q4 and 2000Q4. cyclical peak for a period of 24 quarters.2.11 compares the the two economies. the analysis controls for R&D and the exception of the recession of the mid-1970s. developments in the output gap following the (6) Caution should be exercised in comparing cycles over time for the euro area as a whole since it only existed as an economic entity during the most recent cycle. 1980Q1.2. the in product markets onto wage bargaining. Sum of consecutive negative output gaps (in % of GDP) 2003. while benefiting from faster Source: European Commission. the trough of -1 the cycle was reached earlier in the US and was -2 followed by a stronger recovery and the US cycle -3 was not subject to 'false dawns'. Graph I. with the trough less deep and the on this. the study does not find any evidence shallow. US -8. it does find evidence of a negative gap absorbed faster (Table I.(6) With However.1 -3.12 shows that the fall in the output gap 1 was sharper and significantly more rapid in the 0 US than in the euro area.2. All these appear to more than offset the positive were characterised by a long period of output gap EMU effect.4 be examined in some detail. Moreover.0 -6.2. has seen deeper cyclical troughs.7 -5. Graph I. The main While the most recent cycle is similar to its two channel would be the effect of stiffer competition predecessors on a number of counts.3 shows a convergence of the These downturns followed cyclical peaks in. this issue can EA -7. Comparing The euro-area economy has experienced four previous cycles along with the present one. With EMU having been EA 26 26 16 23 place for a full economic cycle (going from a US 11 27 15 18 peak in 1999-2000.3: Two indicators of the severity of downturns (1) economy can dampen the initial impact of a 1980s 1990s 2000s Average shock and the speed with which it rebounds to Number of consecutive quarters with a negative gap trend after the shock.2. which appear to 0 Q2 Q4 Q6 Q8 Q10 Q12 Q14 Q16 Q18 Q20 Q22 Q24 be a typical feature of the euro-area cycle. 'false dawns' and delayed recoveries and. It could indicate that the negative shocks hitting the euro-area economy have been milder in the 2. As a moderating effect of trade integration onto wage result. the cumulated output gaps totalled less formation. human capital effects on productivity growth and these downturns share strong similarities. downturn of the early 2000s was comparatively However. This concept covers two dimensions: the degree to which the Table I.2. Meanwhile. respectively. and stronger recoveries than the euro area. developments from peaks 3 2 Graph I. A priori it is possible that the single currency has had effects on employment as well. protracted periods of output below potential.5 -7. Part I Assessing the first 10 years poor productivity performance of notably Italy. to recovery in 2004-2008). 37 . RESILIENCE IN THE FACE OF SHOCKS early 2000s than in the past or it could be evidence that the economy's resilience has Observers have expressed concerns that the euro improved. The second channel turns out to be falls. area may lack "resilience". 1991Q4 and consecutive quarters with a negative gap between 2000Q4.6 -5. cumulated output losses as well as the number of respectively. via a downturn in 2001.11: Euro-area output gap Source: European Commission.8 -2. relevant for all euro-area countries.2 (1) Downturns following peaks in. major downturns over the past four decades. but this is attributable to the single than 3% of GDP in the downturn of the early market rather than the single currency. This 1973Q4 1980Q1 1991Q4 2000Q4 reflects that the US.4.3). 1973Q4. 1980Q1.

A striking feature of the latest downturn in the Graph I. euro area (index 100 at cyclical cyclical peak) 109 peak) 111 107 105 106 103 101 101 99 97 96 95 Q0 Q4 Q8 Q12 Q16 Q20 Q24 0 Q4 Q8 Q12 Q16 Q20 Q24 1980Q1 1991Q4 2000Q4 1980Q1 1991Q4 2000Q4 Source: European Commission. cycle (see above) and the associated buoyancy of with short-term real interest rates about 2 to household disposable income (Graph I.15: Consumption after cyclical cyclical peak.2. income were offset by a pro-cyclical rise in the households' savings ratio. euro area peaks. However.15).14).2. The ECB's success in anchoring inflation This is striking in view of the comparatively expectations has allowed the stance of monetary strong growth in employment over the latest policy to be more expansionary in the downturn.2.2. average consumption looks more supportive macroeconomic policy stance. 3 percentage points lower than in previous However. euro area (index 100 at peaks. This apparent resilience 108 (index 100 at cyclical peak) 106 of domestic demand can be largely traced back to 104 the behaviour of investment. 38 .13). euro area affected (Graph I.12: Output gap developments Graph I. Growth in 1980Q1 1991Q4 2000Q4 household spending was slightly stronger during Source: European Commission. Consumption 94 also behaved somewhat differently during the 0 Q4 Q8 Q12 Q16 Q20 latest cycle in the euro area. six years after losses in the euro area in the recent cycle is the the cyclical peak.2.16: Household real disposable euro area was that domestic demand was less income after cyclical peaks.17).2.2. very similar for the three cycles (Graph I. the One element which has helped dampen output opposite holds for the upturn and. euro area (index 100 and US (in % of trend) at cyclical peak) 3 110 2 105 1 100 0 -1 95 -2 90 -3 85 0 Q3 Q6 Q9 Q12 Q15 Q18 Q21 Q24 0 Q4 Q8 Q12 Q16 Q20 Q24 Euro area US 1980Q1 1991Q4 2000Q4 Source: European Commission. Source: European Commission.2.2. Source: European Commission. which was less hit 102 in the contraction phase of the cycle than in 100 similar stages of previous cycles and it also 98 96 recovered faster (Graph I.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I.16). the early stages of the downturn than during similar stages of previous cycles. positive developments in disposable recessions (Graph I.2. Graph I.14: Investment after cyclical after the cyclical peak of 2000.13: Domestic demand after the Graph I.

euro (cyclically adjusted Box I. the seeming lack of resilience of the euro area should be viewed in a historical perspective. while the euro in comparison with previous such episodes. area and the US have differed in the pace of their Many participating countries went into earlier recoveries from major downturns.18 suggests that the discretionary inflation expectations. euro area initial impact on consumption while delaying the 9 (in %) necessary adjustment process (Duval et al. This product markets dampen the initial impact of a combination of factors may help explain the shock but lengthen the ensuing adjustment comparative resilience of investment. Part I Assessing the first 10 years This stimulus was reinforced by the more benign the associated tax windfalls amid an financial market conditions. In contrast. it is generally does not find Source: European Commission. which may be the fruit of the in view also of turbulent conditions in exchange improved macroeconomic policy framework markets. low real interest rates and component of fiscal policy was pro-cyclical stable nominal intra-area exchange rates have during the recessions of the early 1980s and early supported domestic demand. However. Anchored Graph I. in gap. notably investment. 1990s in the euro area as a whole (see in the latest downturn. the trough would be less pronounced 7 than in a more flexible economy and the period 5 of negative output gaps would be longer and the 3 cumulated loss in output larger 1 -1 Q0 Q3 Q6 Q9 Q12 Q15 Q18 Q21 Q24 While these findings fit the stylised euro-area 2000Q4 1991Q4 1980Q4 cycle pretty well. For example. 39 . fiscal policy was cyclical in downturns. in part owing to the exceptionally busy election calendar. There is also some Chapter I. Meanwhile. following the inception of EMU.2. the resilience of the euro area order to contain the deficit and debt snowball and has increased. strong support in model simulations.the response of activity to (adverse) productivity shocks (see Graph I. In this case.2.18: Discretionary fiscal policy in major downturns. Moreover. fiscal policy in the euro area volatility of growth and this results in milder was also more supportive in the latest downturn downturns globally.5 for further evidence and a country-by evidence that fiscal policy has become less pro- country analysis). 2007). Summing up. but its effect on private consumption -2 muted by offsetting developments in the savings -3 ratio. In that case an economy with more 3 primary balance in %) rigid prices shows a lower degree of resilience: 2 output growth returns to trend more slowly and 1 cumulated deviations of output from trend are 0 bigger. there is an important exception -.5 this was potential. single currency. with comparatively low long- term interest rates and the absence of swings in It is usually assumed that rigidities in labour and intra-area nominal exchange rates. thereby mitigating its rates during major downturns. they typically recessions with high (sometimes two-digit) suffered similar cumulated losses in the output budget deficits as a share of GDP. Employment is relatively resilient as real -1 wages stall.2. There has been a secular decline in To a lesser degree.2. Hence. fiscal policy was forced to tighten. Market rigidities are still mildly counter-cyclical in the latest downturn – clearly weighing on the economy's production although as explained in Chapter I. Y-1 Y0 Y1 Y2 Y3 Y4 Y5 Y6 Y7 Yo = 2000 Y0 = 1991 Y0 = 1979 Source: European Commission.3). phase.17: Real short-term interest employment to a shock. but their impact on the economy's largely fortuitous in the sense that the easing was resilience seems to depend both on the nature of a lagged response to the previous upswing and the shocks and the type of rigidities considered. strict employment protection may delay the response of Graph I.

A rapid fall in prices leads to a faster disposable income and consumption is similar and increase in real wages which in turn supports an there is no significant difference in the GDP increase in aggregate demand. Also real wages will be higher shortfall of aggregate demand over the transition with lower adjustment costs. real wages increase more with the supply shock to be more expansionary on lower adjustment costs. (ii) differences in labour supply because the smaller increase in real wages leads to responsiveness (e. the adjustment of employment is trade. With stiffer price response. reduces employment temporarily. For instance. however. why the US economy returned to potential faster than the euro area after the downturn of the early 2000s. price rigidities may reduce Differences in price rigidities in the face of economic resilience in the face of supply shocks diverging productivity developments (faster in but this is not necessarily the case for other the US. marginal tax rates on labour).3:How do structural rigidities affect adjustment to shocks? Grenouilleau et al. In the US-type economy. On initial employment response and therefore allow the other hand. simulation experiments effect on GDP is negligible. This delayed since it takes longer for prices to decline effect will be stronger with lower labour to their new equilibrium level. responding less strongly to the boost in employment. its adjustment to shocks. Both effects lead to a period. differences in labour adjustment models for the euro area and the US to analyse costs only entail only modest differences in the how differences in rigidities in the euro area affect impact of world demand shocks on GDP. The net played by these rigidities. However. In the case of a positive shock to world rigidities. In order to illustrate the role compensates the shortfall in consumption. Employment A fast price reaction can cushion the negative falls more when adjustment costs are smaller. differences in price rigidity can little impact on the size and speed of adjustment of explain significant differences in the adjustment GDP. slightly stronger rise in domestic demand when labour demand is less rigid and therefore to slightly higher GDP. employment decreases more in the (e. slower in the euro area) may help explain rigidities and shocks.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Box I.g. and (iii) differences lower real wage growth increases investment and in price rigidity. In the case of a are conducted for stylised shocks to total factor positive global demand shock. However.g. This is done by simulating the response of the euro-area to shocks Differences in labour supply responsiveness and comparing these simulations with those have also little effect on the size and speed of resulting from a modified model where structural adjustment of GDP. associated with employment protection case of the stronger labour supply responsiveness legislation). due to difference in effective a more muted increase in consumption. real parameters are set sequentially to their (less rigid) wages respond less to a productivity shock US values. (2007) use estimated DSGE Overall. For example a positive productivity shock pattern of GDP in the case of productivity shocks. leading to a adjustment costs. the higher labour productivity (supply shock) and global demand supply elasticity results in wage inflation (demand shock). in labour adjustment costs mainly affect the response of employment and real wages but have By contrast.2. Therefore the net effect on impact. the effect is small and The simulation experiments show that differences does not show up in the GDP response. The exercise focuses on three main because labour supply acts less as a constraint. 40 . rigidities: (i) differences in labour adjustment costs Meanwhile. employment will be affected positively.

sustained fast output growth at low inflation it reached a low in June 2001.20). and the euro policy-makers which culminated in foreign depreciated again against the US dollar. Corsetti 2004. Actual GDP growth and the estimated growth 41 . interest rate differential and annual 2002) in line with the received wisdom that percentage change in the EUR USD interventions have the best chance of succeeding exchange rate 20 300 if they are i) done when there is evidence – 15 200 shared by market participants – that exchange 10 rates are clearly misaligned with fundamentals.85 dollar per (Corsetti and Pesenti 1999. with a temporary high reached of of the dotcom bubble and with growing concern close to 1.2.2. Jan 1999=100) 130 120 110 100 90 80 70 60 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Source: European Commission. 1999 2001 2003 2005 2007 change in USD (left scale) 3-month interest rate differential (right scale) With hindsight. index. suggesting higher returns on investment more generally. Part I Assessing the first 10 years Graph I. To this added the "New After the launch of the euro on 1 January 1999 Economy" paradigm with the expectation that the exchange rate quickly fell against other major strong productivity growth would allow currencies (Graph I. Against the US dollar. 0 0 iii) undertaken in a coordinated manner. US short-term rates had again started to The initial depreciation triggered reactions from exceed those in the euro area. When the interest 2002 and even if the appreciation came to a rate differential was reversed and the New temporary halt in 2005 it quickly resumed its Economy lost much of its shine with the bursting upward trend. the exchange rate of the euro started its ascent. at 0.19). and -5 -100 -10 iv) in line with the stance of monetary and fiscal -200 -15 policies (Taylor 2004. The exchange rate started to recover in mid European Commission 2004). THE EURO EXCHANGE RATE area.2.2. Sarno -20 -300 and Taylor 2001).20: Euro area-US short-term way risk in the euro exchange rate (Begg et al. 5 100 ii) accompanied by clear communication. During the episode of euro depreciation.19: Euro-USD and effective exchange rates against 41 countries (monthly data. but less so in others (Nautz and Ruth 2005. Graph I.5. interest rate differentials explain Source: European Commission. the movements of the dollar-euro exchange rate fairly well in certain periods. Dominguez 2003. EUR NEER EUR REER EUR-USD potential in the US also exceeded that of the euro 2. exchange market interventions. euro. These interventions successfully reintroduced a two. By 2005. Graph I.60 against the US dollar in March about the widening US current account deficit 2008. short-term interest rates were higher in the US than in the euro area.

The entering recession. it had reached the lowest level in 0. all euro-area Member States Over the same period.5 4. fundamentals such as interest rate and growth differentials.2.21: Daily exchange rate volatillity non-euro-area EU countries.5 2.3 1. the euro area's trade balance has geographical orientation of their exports.7 0. Moreover.9 3.4 1.5 1.9 1.6 90-98 2.4 20 years.7 1.8 2. 0. by 1997. As well.7 Before 1999. The daily volatility against the USD (st'dev in %) of most currencies against the US dollar has also 1.9 5.4) (7) A decrease of similar magnitude is also visible in the effective exchange rates of Graph I.0 4.0 1.9 2.9 3.9 1.4 3. 42 . but thereafter the volatility 0. euro refers to synthetic euro. which enters the calculation of the effective exchange rate.1 1.7 99-07(q2) 1.2 1. after the adoption of the euro.0 99-07(q2) 2.8 3.3 2.2 2.6 1. current account deficit were becoming more acute. The strong euro appreciation since 2006 set in been slightly positive every year since the while the interest rate differential in favour of the inception of the euro in 1999. given the different 2007c).9 2. recovery.0 1.0 3.5 1.2 3.21).3 2.4 3.2 90-98 3.2 1.8 1.0 2.6 9.0 1.4 0.5 1.3 2.2. However.8 0.2 2.5 2. by definition.8 among the euro legacy currencies quickly abated 0. The sharp acceleration of the amplitude of quarterly swings in the nominal appreciation of the euro in recent months can be effective exchange rate (NEER) of the countries explained by this development along with a participating in the euro area decreased from the reversal of the interest rate differential as 1980s to the 1990s.1 Non euro area GBP USD JPY CHF SEK DKK NOK TRY CAD MEX AUD NZD 80-89 3.1 0.4 1.1 1.2 8.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Table I.6 2. (Table I.4 1.7 2.4 saw a jolt of volatility in 1992 (the time of the 1. The 1990s 1.7 1. On average in the 2001-2006 period.1 2.2 1999 has broadly matched this record.0 the development of the euro exchange rate 1967 1972 1977 1982 1987 1992 1997 2002 2007 appears to have been broadly in line with the DEM FRF ITL EUR Source: European Commission.8 1.2.9 1. 0. The sustainability of this imbalance Occasionally there have concerns over excessive became more questionable and its unwinding volatility of the euro exchange rate. In sum.6 been trending down (Graph I.9 1.1 0.9 5. strong world demand experience the same bilateral exchange rate movements contributed 6 percentage points to annual euro.6 6.8 2.6 1. (7) While.1 1. and with the introduction of monetary policy in the US was significantly the euro it decreased further for all of them eased.2 1.9 3.5 1. Source: European Commission. but this is may now have started with the US economy not born out by the actual developments.4: Volatility of quarterly nominal effective exchange rates against 24 industrial countries (Standard deviation in %) Euro area and Member States EUR BLF DEM GRD ESP FRF IEP ITL NLG ATS PTE FIM 80-89 3.2 1. by that time the conjunction of further euro appreciation and a euro area had finally emerged from the slowdown of the global economy could weigh protracted period of sluggish growth and more heavily on euro-area exports in the near concerns about the persistent and rising US term. The daily volatility of the euro since 0.5 6.6 and.2.7 6. their effective exchange area export growth (European Commission rate movements can still differ. But obviously a US was narrowing. to date the volatility of the exchange rate has not been atypical and has Econometric analysis suggests that the euro even been relatively muted by historical appreciation has not acted as a major drag on the standards.6 1.0 last EMS crisis).8 percentage point was shaved off euro-area exports each year by the appreciation of the euro.6 2.

following the dominant Engel and Rose (2002) identify a direct causal effect of currency unions on cross-country business cycle synchronisation. this approach also depends on some correlated business cycles. see Box I. cyclical and irregular components.1. performance. They present empirical evidence that higher bilateral trade is associated with more correlated 3. A similar theoretical ambiguity The cyclical component as the deviation of the emerges for the effects of financial integration on smoothed series from its trend is then referred to business cycle synchronisation. 43 . sectoral shocks. the launch of the euro still represents a relatively recent regime In terms of the theory of Optimum Currency shift. and thus to higher EMU calls for a sufficient degree of business cross-country synchronisation. focusing on the effects of increased trade globalisation in general.3. The consumption. Therefore. The first question is how to measure the business cycle in the first place. the so-called "endogeneity of optimum currency liberalisation of international capital markets or areas". over time. launch of the single currency pertains to the effects of the euro on economic structures and Close to ten years after the launch of the euro. such that a multitude of different Rose and Szapáry (2005) conclude that countries growth cycles can result empirically. particularly the censoring rule stipulating the minimum duration of the business cycle convergence in macroeconomic policies entailed phases. (8) However. several caveats apply. Hence. However. BUSINESS CYCLE SYNCHRONISATION by the Maastricht criteria and the Stability and 3. there may cycle synchronisation of economies. whose effects may not yet have fully Areas (OCA. Second. Frankel and Rose important developments such as the Internal (1998) have kick-started a rich literature on the Market Programme.2. Corsetti (2008) shows that convergence in consumption (and Various methods have been proposed in the spending) patterns reduce the costs of literature to investigate the issue of business participating in a currency area. MEASURING BUSINESS CYCLE business cycles through the cross-border SYNCHRONISATION transmission of demand shocks. denoting states of contraction allowing countries to specialise without being and expansion. disentangle the effects of the euro from other area countries has improved. the parameters to be chosen. there is no consensus on how to estimate the trend from the data. trade integration may foster prominent view rests on the assumption that inter-industry trade specialisation and therefore economic time series can be decomposed into the increase the probability of country-specific sum of trend. A On the other hand. (8) An alternative view integration encourages cross-border portfolio rejects the decomposition into trend and cycle diversification and thus promotes area-wide and defines the business cycle in terms of the synchronisation of aggregate demand through turning points of the original time series. 2004).1) this translates into unfolded. it is very difficult to the question whether the OCA rating of euro. respectively. based on growth cycles. While financial as the "growth cycle". A theme be more sources of endogeneity of OCA at work that has received considerable attention since the than trade and financial integration. the IT revolution. First. it may also have an important resulting "classical cycle" is thus a binary series causal effect on industrial specialisation by of zeros and ones. cycle synchronisation. INTRODUCTION Growth Pact as the coordination framework of EMU might have led to a reduction of policy- The conduct of a common monetary policy in driven asymmetric shocks. with similar budget positions tend to have more (9) Empirically. The question is whether the euro one can start taking stock of the effects the has fostered some virtuous processes that have common currency has had on business cycle brought its participating countries closer together synchronisation in the euro area. integration once a currency union is created. (9) The analysis of subject to higher income volatility (Kalemli. euro-area synchronisation in this chapter will be Ozcan et al.3. while Darvas.

which measures the percent deviation of phases. their subsequent On the other hand. see Corsetti (2008) and Mongelli (2008). 1999).1: The Optimum Currency Area theory and its implications for business cycle synchronisation The theory of Optimum Currency Areas The degree of economic integration and (OCA. Massmann and Mitchell production (IP) will be used. are highly integrated. Here. The second question is how to measure (10) See e. Countries sharing a high structural reforms. More specifically. the greater exposure of trade- examination of convergence of euro-area business cycles intensive manufacturing to external shocks might points to substantial similarities across alternative be a source of bias towards de-synchronisation measures of the cycle. the design cannot effectively accommodate existence of the monetary union and its diverging cyclical positions across the coordination framework might foster ongoing economies involved. The benefits of monetary integration among countries forming a currency union. aggregate output. 44 . approach in the literature. defines its OCA-rating. both GDP and industrial Inklaar and de Haan (2001).European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Box I. consist first and foremost in reduced there is disagreement as to the effects on transaction and information costs and business cycle synchronisation. and the classical cycle. wages and factor mobility) propagation of shocks across countries might will find it beneficial ceteris paribus to share become more symmetrical. (10) One attraction of budgetary surveillance. While it is quite undisputed costs of abandoning independent monetary that economic integration is likely to increase policy. the terms of prices. Massmann and monthly frequency and the fact that the industry Mitchell (2004). As far as the latter cycle synchronisation or overall flexibility (in help to absorb shocks more rapidly. These benefits Rose (1998) predicts higher synchronisation (efficiency gains) are higher when the due to increased trade acting as a conduit for countries willing to join the currency union the transmission of common demand shocks. a continuous the decomposition approach is that the implied measure of the cycle invariably incorporates growth cycle is conceptually close to the "output more information than a binary series of cycle gap". While the increased price transparency. (*) For a re-assessment of the debate on OCA. Synchronisation measures based on the aggregate output from its potential and which growth cycle should therefore encompass results plays an important role in monetary and derived from the classical cycle. increasing the costs are mainly macroeconomic in nature flexibility of the economies involved in the and arise as the common monetary policy currency union. business labour market reforms. Given its (2002. Finally there may be adjustment to asymmetric shocks. the studies by Artis and Zhang (1997. the the alternative Krugman (1993) view argues costs increase the more asymmetric the in favour of less synchronisation due to countries' business cycles are. cycles display different properties depending on the identification approach used. The position of the group another potential source of endogeneity of of countries along these three dimensions OCA. flexible the economies are in terms of sector-specific shocks.g. constituting a single currency. 2004). find that euro-area countries' most studies use the cyclical component of IP. On the other hand. boosting trade endogeneous OCA theory due to Frankel and and fostering competition.3. and the less higher specialisation promoting asymmetric. Confirming Canova’s historically close correlation with GDP. including product and level of either economic integration. its (1998) conclusion that the properties of the business cycle depend on how it is measured. Kaiser (2005). examining measures of both the growth sector accounts for the bulk of cyclical variation. Mundell 1961)* weighs the benefits cyclical synchronisation in a monetary union of adopting a common currency against the evolve over time. Besides. These institutional forces at play. However.

the correlation measure Source: European Commission. whether the cycles display a common factor driving individual business common periodicity and phase. the the turning points of the cycle. 45 . together.3. dispersion of output gaps in the euro area has narrowed considerably since the early nineties and has been standing at historically low levels since around 2002. small phase shifts between countries will rise (fall) proportionally with a rise otherwise identical cycles can lead to systematic.2% 0. the closer the individual cycles cluster medium-term changes in synchronisation. However.4% 0.3. The latter 1.8% correlation may then be considered as evidence 0. Suggestions include analysing depend on the scale of the series under scrutiny the dispersion between individual business and is thus better suited to measure the genuine cycles or their correlation over time. too. then Var(aX)=a²Var(X) ²Var(x) a²Var(y))1/2 = cov(x. see e.0% the mean can be computed. Given its importance for common Correlations based on shorter windows tend to be monetary policy. European Commission evolution of the standard deviation between (2006a). (13) Bilateral correlation coefficients can be computed over a Graph I. However. small number of sub-periods or over a series of area output gaps rolling windows of a fixed length. Part I Assessing the first 10 years across countries compared to the broader. (fall) in the magnitude of the individual but artificial. For a given level of association if the window is shorter than the mean length of of cyclical series. the standard deviation across the cycle itself. this observation seems (12) For a recent analysis of the reduced volatility of output growth in the euro area see European Commission (2007d).ay)=cov(ax. allow for an important to note.4% over time. disregarding cycles.1: Standard deviation of euro. to reflect a general decrease in the amplitude of services-dominated GDP. cyclical fluctuations across industrialised countries rather than a continued increase in The third question is how to gauge the degree of business cycle synchronisation in the euro synchronisation.y)=r and a is a constant variance. It is closer to the end of the data sample. between area.ay)/(Var(ax)Var(ay))1/2=a²cov(x.0% This correlation based approach is a standard set- 1980 1985 1990 1995 2000 2005 up in the literature to investigate the issue of standard deviation smoothed series (13-term MA) business cycle synchronisation. in the euro area and elsewhere. While longer windows tend to be more euro-area countries' output gaps over time. smaller the standard deviation at a given point in there is the danger of smoothing out important time. drops in the association measure at cycles. i. (11) As shown by Graph I. since they can be computed cyclical convergence in the euro area. scale-dependent. (11) This follows directly from the mathematical properties of 13 ( ) This follows directly from the definition of the the standard deviation as the positive square root of the correlation coefficient.2% correlation coefficients of a group of countries. that the measure is analysis of very recent developments. possible changes in amplitude. then (output gaps) at time t and a denotes a constant scaling cor(ax. Yet. Others look synchronisation dimension of business cycle for evidence of an increase in importance of a convergence. The results can be rather sensitive to the length of the rolling The analysis of dispersion entails looking at the window chosen. the closeness of output gaps is more sensitive to short.g.e. (12) The correlation coefficient does not business cycles. 1. If cor(x.6% provides a continuous track of developments 1.1.y)/(Var(x)Var(y)) = r and thus stdev(aX)= a·stdev(X). suffers from drawbacks. however. A rise in mean 0.6% of increased synchronisation.and medium-term a very relevant measure to gauge the degree of deviations and. 0. The reliable since they are based on more data points. or comovement. If X contains the cross-section observations inflating the series' amplitude. To summarise all possible bilateral 1.y)/(a factor inflating their magnitude.

the focus will be asymmetric effects of the second oil price shock. and heterogeneous responses to 0 common shocks. The area countries' output and price fluctuations. They interpret this as evidence of countries having become more Graph I.3. the last common euro-area cyclical component to have a midpoint of the six-year window characterises higher correlation with growth cycles in euro-area synchronisation around mid-2004.3. the importance provide a timely impression of synchronisation of common factors seems to be high but rather developments readily attributable to specific stable across the whole sample.2 exogenous sources of variation. structural models may be used to decompose cross-country heterogeneity into 0. the fall in cross-country correlation could be more directly attributed to the In the remainder of this chapter. country- specific shocks. bivariate correlation between euro-area IP cycles national databases and used to assess computed over rolling windows of four and six comovements with national developments.e.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union A third approach to the study of business cycle 3. period of falling correlation in the early eighties while persistent country-specific shocks are until 1986 can be characterised as a period where mainly responsible for remaining cross-country the EMS was rather unstable. A band-pass version of the Hodrick/Prescott filter is used to extract the business cycle-related fluctuations from the logarithms of the series. To aggregate euro-area GDP growth. Using different modelling strategies. Germany. the last window estimates cyclical explaining national GDP growth between 1981 synchronisation in the period 2003:7-2007:7 and 2003 are mixed between countries. The asymmetric transmission of exchange rate re-alignments taking place. Giannone and Reichlin (2006) and Eickmeier Reading the graph. on the descriptive analysis of correlation developments within the euro area and between the area and outside countries. (14) The initial four-year window covers Eickmeier's (2005) results regarding changes in the period 1975:7-1979:7 (1981:7 for the six- importance of common euro-area factors in year window). years. it is interesting to relate the (2006) consistently conclude that common developments in correlation to the policy shocks are most important in explaining euro. IP sensitive to common euro-area shocks. 0. Common euro-area Graph I. The relative importance of the 1977 1984 1991 1998 2005 different types of shocks can be monitored using 4-year 6-year Source: European Commission.2 shows the evolution of mean trends and cycles are estimated from large multi. RECENT CORRELATION DEVELOPMENTS synchronisation that has gained some AND STYLISED BUSINESS CYCLE FACTS prominence in recent years is built around dynamic factor models.6 To have a closer look at the sources of desynchronisation between euro-area business 0. variance decomposition and impulse response analysis. consistent 0.2: Mean euro-area correlation. same time. with a number of heterogeneity. In case of (2001:7-2007:7 for the six-year window). 1992-2003 than in 1980-1991. 46 . de events.8 with the convergence process occurring in the 1990s. (14) Monthly IP data is available from 1975m7 to 2007m7 for eleven euro-area countries (excluding Luxembourg and Slovenia). i. framework and/or specific economic events.3. the correlations are centred on the Bandt and Flageollet (2006) find their estimated midpoints of these windows. At the common shocks seems to play a minor role.4 cycles. Thus. France and Italy in the period while it is mid-2005 for the shorter window. Bruneau.

47 . Furthermore.3. recovery was relatively stable and credible. the decrease reflects the beginning of a phase of severe divergence between Greece and the rest of the euro area. (16) See Gayer (2007) for details.3. 1975m7-2007m7) the moving correlations of Graph I. The more sensitive and evolve in (mini-) cycles.3. Part I Assessing the first 10 years The marked increase in mean correlation in the It emerges that.3: Euro-area business cycle Against this background.4 reconsiders phases (IP. see below for a country-wise analysis of synchronisation developments. phases tend to stretch out over a longer period alignments taking place.4: Mean euro-area correlation and explanation for the subsequent drop in recession phases (IP data) synchronisation around 2003. with no re. EMU as well as closer macroeconomic policy coordination in the euro area. (15) Furthermore. The extent of this 0. structural rigidities can lower the speed of when a sudden decline in business-cycle adjustment to shocks. hand. However. the three recession phases 1% seem to be characterised by a higher degree of 0% cross-country correlation. argue that smaller and emerging markets crisis. and thus higher -1% synchronisation of business cycles.3 displays the euro-area business cycle 1976 1980 1984 1988 1992 1996 2000 2004 phases. (15) The subsequent Stage 3 accommodation via endogenous changes in of EMU is characterised by a rather steady competitiveness and external trade. Graph I.3 0. small association sets in. While the rise in correlation countries are on average found to undertake since the late nineties might be due to the effects more and faster structural reforms. while slower of enhanced trade and financial integration in the reforms in larger countries may restrict their wake of the Internal Market programme and adjustment mechanisms. cross-country correlations typically -3% 03:06 decline.8 0.2 by cross- 4% 80:01 3% 91:11 00:11 plotting them against the recession phases from 2% Graph I. 0 Graph I. The next significant decrease in countries during cyclical recoveries. Graph I.6 the four-year correlation window. Given different four-year window indicates temporary phases of adjustment speeds across countries following a de-synchronisation following German re. the graph clearly points to a 0.g. (16) recession phases 6-year 4-year Source: European Commission.7 de-synchronisation is considerable according to 0.4 rebound in euro-area synchronisation 0. -4% 82:12 93:07 -5% 1975 1980 1985 1990 1995 2000 2005 recovery recession Source: European Commission. and reflects the open economies are more flexible and recover differentiated effects the crisis had on individual faster from recession through spontaneous euro-area countries. one can argue the case of a general unification in 1990 and around the ERM turmoil pattern of higher cyclical dispersion across in 1992-93. On the other increase in cyclical synchronisation until 2003.3.2 In order to possibly link the evolution of 0.3.1 synchronisation to stylised business cycle facts. Duval and correlation around 1997 coincides with the Asian Elmeskov (2006) e. 0. After a -2% recession.3. recession.3.5 from 2004 onwards. there is no obvious Graph I. while euro-area business cycle later eighties occurs in a period when the EMS recessions are typically short and steep. identified using a HP bandpass filter. Indeed.

3.g. though based on three euro-area cycles only.8 ensuing downswing.5: Mean euro-area correlation cross-country correlations should be expected in and recession phases (GDP data) the further course of the recovery and the 0.5 displays the mean of pair. (17) A marked increase in mean Commission's Spring 2007 forecast.1: correlation is observable from the mid-eighties to Mean euro-area business cycle correlation in the early nineties followed by a stabilisation recoveries and recessions correlation window thereafter. spurred by peculiar developments Complementing the so far industry-related in some periphery countries (Greece. based on the decline in business cycle synchronisation after turning points of the cyclical component of euro- the latest turnaround in mid 2003 can be partly area GDP. Ireland and Portugal a partial analysis is carried series (peaks in 80:1. has been passed. troughs in 82:4. and the Netherlands. despite some signs of transitory de- 0 synchronisation in the case of France and Spain. the picture of a recession phases 6-years 4-years relatively widespread but temporary de- Source: European Commission. In relative terms.6 A country-specific analysis of correlation 0. i. this corresponds to that set in already around 2000/2001. Germany. while it is 2006q4 for eight euro-area countries: Belgium. Graph I.1 quantifies the extent of this pattern by level around 50% since 2004/2005. Spain.3. Finland. wise country correlations of quarterly GDP series.50 0. Greece. France. 0. after the trough adjustment to common shocks. There is thus some evidence. Ireland). 93:3 out using shorter series. If this pattern was to persist in the current business cycle.5 again suggests a ascribed to a recurrent pattern of temporary de- general pattern of decreasing mean euro-area synchronisation in cyclical recoveries. In 2003-2004.3.44 short-run divergence (e.3. for all components including during recoveries by slightly more than 20% exports and imports (but not net exports) the compared to the level during (the previous) partial recovery of cyclical synchronisation recession. All quarterly GDP series are and 03:2) are fully congruent with those derived from the augmented by six forecasts for 2007q2-2008q4 from the correspondingly filtered monthly IP series. 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Looking across all countries. starting around 2004 is reproduced in the respective correlations. 92:1 and 00:4.57 in 1990).European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Table I. overall 0. owed to correlation just after the recession phases of the cross country differences in the speed of cycle have come to an end.3. then an increase in Graph I. Again.47 synchronisation increases again until 2003. synchronisation of cyclical forces across the euro area emerges. German re-unification in recession 0. the correlations computed over Mean correlation 6-years 4-years the four-year window are more responsive to in recovery 0.e.2 seem to continue to stick reasonably well together.4 developments shows that the larger countries 0. Finland and analysis. a reduction of business cycle synchronisation Importantly.59 0. that the observed Looking at the recession phases. It emerges cross-country correlation is led by decreases in that mean euro-area correlation is on average 13 correlation of private consumption and percentage points lower in recoveries than it is in investment and by a de-coupling of net exports recessions. Italy. An analysis showing the mean levels of area-wide correlation of GDP components shows that the decrease in during recession and recovery phases. The last midpoint of the six-year window characterises euro-area 17 ( ) Quarterly GDP is available from 1980q1-2007q2 for synchronisation around 2005q4. 48 . After diminishing until around 1997. business-cycle association declines rather sharply but recovers and stabilises at a Table I. (18) Graph I. For (18) The turning points of the HP-filtered quarterly GDP Austria. the shorter window.46 0.

period around the previous trough in mid-1993 Since the launch of Stage 3 of EMU in 1999.3. As Table I. HAS THE COMMON CURRENCY excluded from the computations.48 0.2 shows. runs from 1989 to 1998. Artis (2005) finds 49 . before the cycle reached its trough in 1982:12. Chapter I. the level of synchronisation within the earlier reference period starting in mid-1978.5. Over the past decade.56 0. one can go back one more cycle prior to and after the introduction of the euro. which end in 2007m7. countries have experienced a marked cyclical 2008:4) are still based on GDP forecasts. correlation between euro- The first question is thus whether the area countries' IP cycles has risen considerably synchronisation of business cycles in the euro from the first period 1978-1986 (0.1 for comparing the first ten years of The apparent stabilisation at a high level might EMU with the ten preceding years. economic rationale that has been given in albeit at a significantly reduced pace. trough in 2003q2. one may Even though correlation results may depend compare mean intra-euro-area correlation in the crucially on the chosen periods. euro area can be compared to that of important This again corresponds to four and a half years outside countries. Mean correlation between euro-area Turning to the comparison of euro-area with countries has increased from 0. fully in line with the cross-country synchronisation has risen further. be it through specialisation effects or divergent effects Table I. when cycles started to diverge. reflect the circumstance that the stimulating effect of lower trade barriers has already largely Table I.48) to the area has been higher over the period following second period 1989-1997 (0. and has 1 January 1999 in comparison with a relevant increased somewhat further to 0. and calculate mean euro-area correlation over the Second. it is difficult to Mean intra-euro-area correlation in consecutive cycles disentangle the euro-specific effects from . OECD six data points of the post-euro period (2007:3. no reliable forecasts are The question of whether the launch of the available for the remainder of 2007 and 2008.59). 0. Portugal and Ireland had to be financial integration as well as forceful common shocks. the comparisons are based on the cycle synchronisation in the euro area can be slightly truncated periods 1999:1-2007:7 and approached from two angles.4.60 Internal Market programme. specific euro-area and to 0. In any case. given the earlier start synchronisation within the area can be compared of the IP data.61 common currency might have promoted Source: European Commission. since the last global trends. As discernible from Graph I. However. cross-country synchronisation in of the euro in 1999 occurred approximately four the euro area seems to have risen considerably and a half years ahead of the latest cyclical between the late eighties and the late nineties. Overall. correlations computed over the two ten-year periods. of recurrent ups and downs in synchronisation in the course of the business cycle.59 0.56 in 1989-1998 outside developments. Part I Assessing the first 10 years 3. Based on the identified pattern euro-period 1999-2007. common currency has had an impact on business Therefore. First. some caution is needed. the appropriate reference programme on trade and financial integration. European trends have to be disentangled from However. In line with the corresponding ten-year period of the previous previous results based on continuous correlation cycle. the start developments. As to the IP-based country cycles. pointing to the effects of the Internal Market Correspondingly. Correspondingly. persistent asymmetries between countries. since quarterly SPURRED SYNCHRONISATION IN THE GDP data is not available before the mid- EURO AREA? nineties.3. the general period 1999–2008 with mean correlation in the picture is quite unambiguous.60 in 1999-2008 based on GDP cycles. 1989-1998 1999-2008 underlying integration effects related to the GDP .2 compares the mean of cross-country of common monetary impulses.3.3.2: played itself out. 1989:1-1997:7. the 1978-1986 1989-1997 1999-2007 analysis does not support the view that the IP 0.61 in the post reference period. convergence on the back of rising trade and Furthermore.

the UK and At the same time. mirror similar developments at the world level.56 1983 1986 1989 1992 1995 1998 2001 2004 1999-2008 0. the rapid convergence of world Japan in the two ten-year sub-periods before and cycles since the mid-nineties and the ensuing after the launch of the euro. Table I.6 displays the mean of rolling territory until the end of the sample.3. EMU. the euro attained around 2000 suggest that area can be seen to be significantly closer aligned synchronisation within the euro area might have to the US.2 Table I.4 0. business cycle between intra. 0. The correlations between the euro area on the one observation of a transitory but rather pronounced hand and important outside countries on the decline in synchronisation of euro-area business other (EA-World) along with intra-euro-area cycles thus has to be partly qualified by a much correlations (Within-EA). While world-cycle synchronisation rose steeply from the mid-nineties to match euro- Graph I. euro area and the US. and extra-euro-area association was as high on average between the synchronisation has narrowed significantly.65 0.60 EA-World Within EA Source: European Commission. UK and Japan as it was within the euro area.6.18 0. The ensuing decline of both intra-euro-area and implying that where increased business cycle euro-area-world correlation since 2003 shows synchronisation is found.6: Rolling correlations area synchronisation later in the decade.2 1989-1998 0. it is not clear whether that the temporary de-coupling of business cycles this is due to area-specific forces or global in the currency union is accompanied by a trends. et al.56 0. and early euro area being a mere side-product of stages of. UK and Japan Source: European Commission.52 0. (2004) this increase in the symmetry of business cycles in the euro area during the 1990s The empirical evidence does thus not support the might reflect the closer economic integration and hypothesis of increased synchronisation in the policy coordination in the run-up to.6 on the world level. However.35 0. The gap between the more pronounced decline in synchronisation two curves from the late eighties to the late between the area and the rest of the world. Euro-area cycles hold together relatively more closely again than cycles 0. 6-year window) 1 recent experience points to the temporary nature 0.3. As monetary union points to a sustained distinct suggested by Mélitz (2004) and Kalemli-Ozcan euro-area business cycle affiliation. but far more pronounced de-coupling of synchronisation in the euro area could simply the euro aggregate from the rest of the world. 1 EA-world is based on correlations with the US.3. raising its correlation with the currency zone 50 . As expected from high level of euro-area-world synchronisation the rolling correlations in Graph I.3. the finding of a recent dip in parallel.3: EA-correlation with outside countries 0 EA-JP EA-UK EA-US Average Intra-EA -0.11 0. the gap attacks. driven by forceful common shocks already very high level of intra-euro-area such as the universal IT boom of the late nineties synchronisation prior to 1999 and the relatively and the ensuing dotcom bust and 9/11 terror minor further increase thereafter. globalisation. the more (GDP. Likewise. Between 1997 and 2002.3.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union evidence of an emerging "world business cycle".3 compares the level of correlation between the euro area and the US.8 of this development. Mean euro-area-world correlation temporarily falls to below zero and remains in insignificant Graph I. Given the world level.46 0. a large part of this development is due to a markedly closer euro-area affiliation of the UK. The nineties points to a euro-area specific process of implied relative closeness of cycles within the cyclical synchronisation during that period.06 -0. the UK and Japan since 1999 than benefited from synchronisation tendencies at the during the previous ten-year period.

3. both compared to previous common currency has had on business cycle periods and to outside countries. synchronisation in the euro area. the separation of euro-area specific and EU-wide 3. distinct euro-area specific as opposed to a global process of business cycle synchronisation. While the analysis is supportive of a largely forthcoming. 51 . The dip in point to further "Europeanization" rather than synchronisation appears to be a transitory globalisation of business cycles since the phenomenon. the difficulty lies in disentangling synchronisation effects due to the monetary euro-specific effects from EU-wide union's policy coordination framework and its developments on the one hand and global trends impact on structural reforms might still be on the other. on the other hand.3 would therefore indicated from around 2004 onwards. Given the historically low levels since around 2002. with a rebound and partial recovery area. it is very decrease in the amplitude of cyclical fluctuations difficult to determine whether. The results of Table I.65 Around 2003. the mean level of synchronisation of actual launch of the euro. Since then. Using cross-country area synchronisation can be attributed to the correlations. Yet. That being said. to what extent and rather than a continued increase in business cycle since when the observed developments in euro- synchronisation. interdependence of EU-wide integration and the this observation seems to reflect a general (perspective of a) common currency. the euro area might still have as much to do with the EU's Internal Market programme as with the As to the question whether the launch of the euro specific effects of the euro on product and has spurred the synchronisation of cycles in the financial market integration. synchronisation experienced a quite abrupt are still markedly less synchronised with the euro decrease. highly synchronised at the time the euro was one can start taking stock of the effects the launched in 1999. synchronisation between participating countries. though not currency might have led to increased de- much higher than in the previous ten-year period.5. the level of cross-country thereafter. Additional currency zone. The dispersion mean correlation between Member States has of output gaps across Member States has reached edged up a little further. Business cycles in the euro area were already Looking back on ten years of EMU experience. Part I Assessing the first 10 years from practically zero prior to 1999 to 0. the national cycles within the currency union since analysis clearly rejects the view that the common 1999 is found to be overall high. The US and Japan. CONCLUDING REMARKS effects on synchronisation remains an open issue. This supports the view of falling business cycle synchronisation in early that the high level of synchronisation reached in recovery phases. partly rooted in a recurrent pattern introduction of the euro.

INTRODUCTION remain of a less efficient adjustment to disturbances. compliance with the medium term objectives For example. limitations of discretionary budgetary policy as an instrument for stabilisation are well • The experience in the early years of EMU known. However. has been achieved. EMU can be said to be in a steady Against this backdrop this chapter takes stock of state where constraints on macroeconomic the adjustment experience in the first (almost) stabilisation in the participating countries are ten years of the euro area. several have been long-lasting. some countries would be countries at high (quarterly) frequencies. the burden complicate the adjustment. inflation and current account adjustment needs – including the sharp fall in positions to diverge across countries and these interest rates in some countries and the divergences prove to be rather persistent. In this context. This adoption of conversion rates of national issue was addressed in detail in the 2006 issue of currencies to the euro that in several cases the EU Economy Review (European Commission were either too high or too low from a 2006a). a concern is that pro-cyclical behaviour of real interest • As the participating countries are no longer rates (falling if buoyant activity boosts able to adjust the stance of monetary policy expected inflation and vice versa) may to steer non-inflationary growth. 4. Some economies henceforth depends crucially on elements of these differences in inflation. However. adjustment in the participating countries' and entailed current account deficits. it was The findings in the previous chapter suggest that recognised from the outset that. risks 4. medium-term point of view. not least since the so. coverage since the 2006 Review by another year and a half or so. domestic demand has adjustment mechanisms. Once these policies definitely not all of it (see Chapter I. The chapter starts with a brief 52 . the overtake the real interest rate channel. which in the dynamics of structural convergence in turn depends on the conduct of appropriate living standards ("real convergence"). which in some cases probably went their room for manoeuvre until such time as beyond their longer-term equilibrium values.1. The divergences in growth and biases linked to the political cycle (see inflation among the participating countries Chapter I. notably the tendency toward pro. but microeconomic policies. Germany has relied primarily enshrined in the Stability and Growth Pact on the external sector as a driver of growth. however. In the long run the impact of these disturbances will peter out The main findings of the Review can be briefly as real exchange rates tend towards their new summarised as follows: equilibrium values. over longer time horizons there has been a launch of EMU itself has given rise to tendency of growth.5 of this Report). confirmed that these are indeed main cyclicality due to long response lags and/or challenges. supported by a continuation of disinflation and increases in cost competitiveness. Moreover. Conversely. involving major shifts countries entered EMU with budget deficits in intra-euro-area real effective exchange of close to the 3% upper limit which confined rates. The • The constraints imposed by the EMU adjustment may have gone too far as macroeconomic policy framework along with domestic demand failed to take over the helm the disappearance of intra-area exchange of growth and a large current account surplus rates highlights the need for compensating built up. during the business cycles have converged across euro-area early years of EMU. the adjustment of intra-area real exchange growth and external positions can be traced to rates and factor (labour) mobility.8). have delivered the necessary degree of flexibility. even if ultimately of macroeconomic adjustment in principle the competitiveness channel will inevitably shifts to fiscal policy. Even vulnerable to imbalances. thus extending the no longer a major concern. The smooth been the key growth factor in other countries. THE ADJUSTMENT EXPERIENCE • During a transitional period.

When the euro was introduced. 10 0 -10 • There is a third group of countries that have IE EL LU FI ES BE AT NL FR DE PT IT also portrayed higher inflation rates than the average. including house prices. residential investment and real average.2: Cumulated consumer price where both fiscal and structural policies were inflation relative to aggregate 1999-2007 less well managed and which. been rather sluggish (Italy and Portugal are the prime examples).4. 1990s. Part I Assessing the first 10 years discussion of the stylised developments. episode Germany had built up a current the real exchange rate and real interest rate account deficit and this has now turned into a channels. Greece) and where inflation and cost German economy was still grappling with the developments have been above average. In these countries strong growth house prices in the participating countries. where Source: European Commission. Greece and Spain. go when the euro conversion rates were fixed followed by an analysis of the key mechanisms and the only way by which this could be behind these developments.2 to I.8) have seen Graphs I. • At the other extreme.4. The shifting back of ones that show roughly a mirror image resources from the construction industry to (Germany) and there are ones that have the tradable industries still had a long way to combined comparatively high and persistent 53 .4. IE EL ES PT LU NL IT BE FR AT DE FI this is not the case in e. -5 While in Spain this loss in competitiveness -10 may be seen as benign up to a certain degree.8).7 depict the accumulated price output grow rapidly (although in the case of increase and unit labour cost (relative to the Spain less so on a per capita basis) while aggregate) and the current account positions. but whose activity has on average Source: European Commission. The final two achieved was via further competitiveness sections examine in some depth the determinants gains and associated disinflation. there are countries that have seen of Germany's reunification boom in the early tendencies towards excess demand (Ireland.2.1: Cumulated real per capita GDP residential construction. its decline in cost- • At one extreme. see Chapter I. there are unwinding of the boom. This is a legacy In sum. STYLISED DEVELOPMENTS "cohesion countries" countries (Ireland. These are countries Graph I. along with 20 Spain.e. Not surprisingly. 40 the relative unit labour cost has shown a 30 secular increase and so have their current 20 % account deficits. three of the four 4. the Spain. have shown weak growth in labour 15 and total factor productivity (see Chapter I. In the boom of the main transmission channels involved – i. the inflation persistently exceeded the euro-area real interest rates. rapid growth in growth relative to aggregate 1999-2007 labour supply and powerful "catching-up" dynamics (see Chapter I. From momentum had been building up prior to the this the following stylised developments can be introduction of the euro – owing to sharp inferred: declines in real interest rates and an associated surge in real housing prices and Graph I.2).4. has portrayed a sharp demand-pull nature. Apparently. the largest economy in the competitiveness is more of a cost-push than a euro area. Italy. fall in its relative unit labour cost and price level.g. Germany. large surplus. domestic demand has also stayed weak. 10 As a result they have seen their cost % 5 0 competitiveness and external positions erode.

2 0 IE ES NL FR FI DE IT Graph I. residential construction sector is building up.0 80 ES PT EL LU BE IT NL IE FR AT FI DE 60 Source: European Commission.5 house prices % 1.0 Graph I. 8 39 141 9 6 13 4 10 Graph I. 20 but here the conditions for adjustment look more 15 favourable owing to the much faster rate of 10 growth of labour and total factor productivity.6: Residential investment as 2 a share of GDP % of GDP 0 2005 -2 -26 -43 16 -4 14 -6 Numbers indicate the -9 absolute position.4. But the overall picture is relatively become overstretched and excess supply in the clear-cut.4.5 2.0 1999-2006 120 0. % 40 20 0 In the majority of countries the ongoing -20 adjustment may be characterised as benign – i.4: Current account positions 2007 baton.5: Real interest rates Source: OECD.4.7: Cumulated change in real 1. competitiveness losses and current Spain may not be sustainable. 12 -8 billions of euros 10 -10 -15 -97 % 8 -12 -25 6 NL DE FI AT BE IT FR IE PT ES EL 4 Source: European Commission. with resources Graph I. A growing concern though is that Source: OECD. -40 pushing real exchange rates towards their new ES FR IE IT NL FI DE equilibrium. 5 % 0 Conversely. a correction appears to be in store. The counterpart of account deficits with sluggish growth (Italy. Other countries have shown less households due to the ongoing residential pronounced tendencies.4. sluggish household Source: European Commission. So.4.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union inflation. reflecting a persistent imbalance IE PT EL ES IT NL FR BE FI AT DE between booming exports. First signs of 1999-2007 such a correction are also emerging in Ireland. 2006 2.3: Cumulated change in possibly shifted back to exporting industries relative unit labour cost away from residential construction.e. this deficit is a rapidly growing indebtedness of Portugal). and the construction industry being in a protracted slump. the current account surplus in -5 -10 Germany may have overshot in the other -15 direction.5 100 0. there may be a risk of overshooting in some countries. The large current account deficit in 54 . This boom now seems to be one or several of the above positive and negative cooling as household balance sheets have features. in some cases combining investment boom. So far there have been scant signs of domestic demand taking over the growth Graph I.

as countries that have been hit by some permanent noted in the previous section. (19) As a result domestic demand will be Measuring the strength of the competitiveness boosted and the external imbalance will channel is not as straightforward as it might overshoot. the relative price level will competitiveness deteriorate due to weak converge to a new equilibrium and the inflation productivity along with upward price adjustment. spurred by upward "real convergence" towards the best performers) pressure on public wages.1). However. it also identified by adverse spill-over effects of persistent high scope for a better balance between the two inflation in other countries via a tighter stance of channels so as to smooth adjustment. if the responsiveness of inflation to that it spills over into the area wide interest rate the buoyancy of economic activity and/or of the (see Box I.1 assume that actual inflation is only to a limited extent built into the perceived real interest rate – i. A particular problem associated dependent upon the empirical sensitivities. Part I Assessing the first 10 years 4. Importantly.3. composition and level of output to changes in competitiveness (which together form the so. households are forward- looking. differences in exercises. 55 .4. with supply driven inflation in some countries is Specifically. For example. monetary policy.4.e. There is a plethora of indicators available.e. THE CORE MECHANISMS AT WORK In a monetary union the cyclically most advanced countries experience. Even so. may therefore not "shock" in the run-up to the euro need a period of always be benign. unavoidable to some extent.4. Economy Review suggest that adjustment via the adjustment will be lengthy. as reported in Box I. The cyclical position are just one of the explanatory simulations suggest that indeed most euro-area variables of inflation differentials which. there is a potential source of short. Empirical investigations reported in the 2006 EU called competitiveness channel) is weak. The adjustment is concern that several countries see their cost inherently stable. This is particularly competitiveness channel is strong enough to costly for countries whose real exchange rate is offset such possible destabilising effects overvalued.g. strongly to the country-specific past inflation record (inflation persistence). it risks overshooting due to its about international price and cost interaction with asset (notably housing) markets. and indeed The broad tendencies identified in the previous should experience. The real interest rate channel is seem. GAUGING THE COMPETITIVENESS an upward adjustment of its price level (be it CHANNEL after a positive demand shock or adverse supply shock). indexation between countries will eventually disappear. above-average inflation rates section can largely be replicated by modelling – and vice versa. since their cumulative output loss stemming from pro-cyclical real interest rates will be large – and may be further exacerbated over the longer haul. This mechanisms or malfunctioning labour and process can be shorter or more drawn out product markets. but if it is too strong each providing different types of information and persistent. there is a five to ten years to adjust.4. the perceived real interest rate will fall if a country is going through 4. In this context it is useful to revisit in expectations are weakly anchored in the area. i.1. competitiveness: • The most straightforward indicator is the effective exchange rate deflated by export (19) The model simulations reported in Box I. rate channel will produce persistent inflation and run instability stemming from what has been growth differentials along with short-run cyclical dubbed the real interest rate channel. more detail the overall strength of these channels wide price stability goal and hence respond and their determinants. If inflation instability. a combination of a weak competitiveness channel and strong real interest In addition. e. and growth differentials (other than those This is particularly damaging if the source of resulting from different initial conditions and inflation is structural.

4. respectively – and 100 points to the following developments which are 95 largely in line with the stylised assessment in the 90 previous sections: 85 80 • A first group of euro-area countries – 1995 1998 2001 2004 2007 Germany and to a lesser extent Finland – has BLEU DE AT FR FI steadily improved its competitiveness Source: European Commission.11 plot the development of two 115 1999 = 100 broader competitiveness indicators – the real 110 effective exchange rate deflated by the GDP 105 deflator and unit labour cost. labour cost indicates a profit squeeze in a country's economy relative to partner Graph I.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union prices. also in currency suffers less from the 'law of one terms of the unit labour cost indicator. France and Belgium – maintained their competitiveness positions vis-à-vis the rest of • An effective exchange rate measuring the the euro area in terms of the GDP indicator comparative unit labour cost in a common and. 56 .9: Real effective exchange rate based on GDP deflator Graphs I. The price' bias and its interpretation is rather latter suggest a modest loss in the cost straightforward too. potential to cut or service its external liabilities. In the case of Finland the the extent that the prices of internationally improvement is only significant in terms of tradable goods are subject to the "law of one the GDP indicator.e. price" (i. for each traded good there is only one global price). An increase in the competitiveness of the French exporting effective exchange rate using relative unit industries. 90 an increase in a country's comparative GDP 85 deflator would indicate a relative price 80 increase in non-traded output.4. Chapter 6. (21) However. in order to make a proper assessment the real effective exchange rate based on the GDP deflator should be adjusted for differences in the rate of productivity growth between the tradable and the non tradable sectors. In the case of Germany. Hence it points 1995 1998 2001 2004 2007 to resources being attracted towards non. However. If the law of one price holds. this indicator may be • A second group of countries – Austria. thus reducing a country's Source: European Commission.4. BLEU DE AT FR FI traded industries. to come to an end. see European Commission 2006a). (21) Graph I. 105 • A third approach is to use the relative GDP 100 deflator to compute a country's real effective 95 exchange rate.4. position vis-à-vis the rest of the euro area (20) For a detailed description of the information content of the various price and costs' competitiveness indicators.8. (20) This directly measures the since 1999. somewhat misleading.8: Real effective exchange rate countries and vice versa which is not based on unit labour costs 115 necessarily picked up by the competitiveness 1999 = 100 110 indicator based on export prices. with the exception of France. the real international relative price of a country's depreciation trend does not yet seem to have exports in a common currency.I.

experiences the shock) partly offsets the adverse interest rate effect. 57 . because the into deficit. the increase in the as competitiveness is restored. because the demand shifts from tradeables to Samuelson effect: wages accelerate in the non-tradeables in the country experiencing tradables sector and this subsequently spills the shock. The difference is though and the associated fall in interest rates is that now competitiveness suffers. This initially comparatively large negative spillover effects boosts inflation owing to the Balassa. The current • An easing of credit constraints for households account deficit deteriorates. housing investment and an associated increase in house price inflation.e. • Some countries experienced a favourable shock to total factor productivity (TFP) in the • An increase in housing demand has tradeables sector (Ireland). which overshoots and then falls back. strong initial adverse effect on housing investment and GDP growth and produces • A positive TFP shock to tradeables produces disinflation. Part I Assessing the first 10 years Box I. low real interest rates and a housing • The disappearance of the exchange rate boom.g. which induces a persistent current effect on the demand for non-tradeables and account deficit. The an overvalued exchange rate – Germany central bank is forced to raise interest rates.1: Standard adjustment channels and cross-country spillover effects The 2006 EU Economy Review discusses a series • Conversely.4. • In some countries occurred an immigration Consumption remains at a higher level all shock (Spain. akin to a positive TFP shock in the premium in e. The real interest rate falls and spill-over effect. This creation of the euro area: produces higher prices in the non-tradeable sector. along with real GDP growth. Spain. • A negative TFP shock to the non-tradeable sector has a relatively strong spillover effect • Several countries entered the euro area with due to the monetary policy response. Housing investment is strongly onto the economies of the other participating affected initially as house prices inflate. growth predicted to produce a boom in housing slows and the current account deficit widens. which has a powerful along. The current account first turns smaller negative spillovers. housing demand picks up strongly. which further fuels the housing The simulations also suggest spill-over effects boom. Spain and Portugal). some countries experienced an of simulations to capture the "shocks" that adverse shock to TFP in the non-tradeables accompanied (and were partly triggered by) the sector (Italy. investment. being the most prominent case. Aside from the implied variations in the interest rates fall further which sustains the real exchange rate. boosts the demand for owner-occupied housing. The which dampens aggregate demand and associated sustained increase in the terms of inflation in the other countries of the area trade and real interest rates is found to have a country. Economic demand for tradeables in the country that growth than also picks up. Therefore import demand is over to wages and prices in the non-tradable weakened. Real countries. but this is subsequently reversed positive income effect (i. Ireland). which exacerbates the interest rate sector. Excess and interest rate channels: supply then triggers a downturn in housing investment. Portugal and Ireland tradeables sector. there are effects via the income housing boom until it overshoots. The current account is little affected as the strong demand for non-tradables produces only small import leakages.

3 effective exchange rate (%) average change in the real ES GR 2 IE NL • The maximum competitiveness loss recorded 1 EL PT DE NL IE IT BE LU amounts to about 15% (Spain. Graph competitiveness position vis-à-vis the rest of I.12: Real effective exchange rates and of Spain this is true only for the GDP-based the trade contribution to growth indicator. A critical issue is to what extent these Italy.0 1991-1998 average contributions of net exports 1999-2007 to GDP growth (%) Graph I. The negative Source: European Commission. -1 FI These do not point to dramatic gains and IT DE -2 ES losses on average per annum. but the striking PT -3 feature is their persistence.4. although in the case Graph I. Ireland) and 0 ATBE FR AT FR the maximum gain 15% as well (Germany). while in Portugal the net 100 trade contribution to growth has been practically 95 nil as imports slumped along with weak domestic 90 demand. Portugal. 120 1999 = 100 115 A related and even more crucial issue is how 110 sensitive the area's internal real effective 105 exchange rates are to the relative cyclical 100 95 positions of the participating countries.4. the adjustment process. Ireland.10: Real effective exchange rate Source: European Commission. and 90 whether this has changed with the introduction of 85 the single currency. where the situation has also portrayed a negative net export contribution improved somewhat (or at least stabilised) to growth – and vice versa for countries whose since 2003. of 2007.4. As highlighted in the 80 previous section a weak responsiveness of real 1995 1998 2001 2004 2007 effective exchange rates to comparative excess IE EL ES IT NL PT supply or demand conditions will tend to prolong Source: European Commission. Ireland managed to sustain export- 85 driven growth despite a loss in cost 80 competitiveness. 58 . the former group includes 105 Spain. and the slope based on GDP deflator does not seem to have changed much. Greece and Italy.4.0 1.12 shows that generally countries that have the euro area. Spain and Ireland portray the biggest competitiveness losses. -2.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union • A third group of countries – Greece.0 2. based on Unit labour costs 120 1999 = 100 115 110 As may be expected.0 0.11: Real effective exchange rate creation of the single currency.0 -1. possibly due strong 1995 1998 2001 2004 2007 comparative advantages in a number of specific IE EL ES IT NL PT (mostly hi-tech) industries. With the exception of the seen their real effective exchange rate appreciate Netherlands. all countries in this group were real effective exchange rate has been still on an appreciation trajectory at the end appreciating. correlation between the real exchange rate and net trade also holds for the decade prior to the Graph I. the Netherlands and Spain – competitiveness developments have been experienced a significant decline in their reflected in international market shares.0 3.

205 0. from 1999 onwards). The absolute value of z statistics is reported in parentheses.57)*** (2. rate reacts positively to differences between the domestic and rest-of-area output gap.093 -0.61) (1. estimation methods and variables as in the previous table. indicating that competitiveness provides an effective channel of adjustment.667 0.162 "Pure" price competitiveness and cyclical divergence: (4.238 -0.182 displayed) and allows for heteroskedasticity and auto (20.4. The response to method the relative output gap is also stronger but the Explanatory (1) (2) (3) (4) difference is not statistically significant.78)*** constructed as the difference between the national and Rel.054 -0.23)*** (4.556 gap(-1) (6. The real exchange significant at 5%.222 0.265 0.18)** correlated standard errors. *** significant at 1%.77)* variable: ∆log P Relative output 0. percentage point per year.58)*** Estimation GLS GMM GLS GMM Observations 385 374 99 99 method Explanatory (1) (2) (3) (4) Notes: Sample includes 11 countries (the first wave plus variables: EL less LU). * significant at 10%.162 -0. * significant at 10%. owing to the negative In a first step the year-on-year change in the real and significant coefficient on the lagged REER.063 -0.714 0. The relative output gap is (7. effective exchange rate (REER) was regressed on However. Notes: Same sample. econometric tests were carried out to test (lower) by one percentage point compared with whether the responsiveness of the real effective the rest of the euro area implies a REER exchange rate has changed after the introduction appreciating (depreciating) by about half a of the euro. ** significant at 5%.386 0.87)*** (3.11 0.01)*** (2.11)*** (5.458 0.122 -0. Part I Assessing the first 10 years Box I.094 (4.58) evidence from panel regressions logREER(-1) -0. The REER is calculated logP(-1) -0. relative output gap considered as Observations 385 374 99 88 predetermined.87)*** (5.22) (2.049 -0. its lagged level and the lagged output fallen. 59 .2: Competitiveness as an adjustment mechanism in the euro area Building on earlier work by Honohan and Lane The effect is non-negligible: an output gap higher (2003).20)*** (5. GLS estimation includes fixed effects (not ∆logP(-1) 0.92)*** (5. A control for while the change in the intra-area nominal differences in income per-capita (low income effective exchange rate (NEER) is included as an countries should exhibit appreciating REERs) explanatory variable (which is obviously zero appeared insignificant (see table below).03)*** (2. The real exchange rate is stable in the long run. except logP computed as Separate estimations are reported for the periods logREER–logNEER.2006 variable: (less inertia and stronger mean reversal). ** 1970-2006 and 1999-2006. The first two explanatory variables capture inertia and mean reversal In a second step the regression was re-run on the effects.019 -0.546 0. GMM are estimates obtained with Arellano. *** significant at 1%.358 the GDP-weighted output gap of the remaining gap(-1) (5. variables: ∆logREER(-1) 0. This evidence from panel regressions appears to be the case across two dimensions Dependent 1970 . The regressions are based on annual data relative GDP deflator (P) in stead of the REER. output 0. and include country fixed effects.69)*** (8.53)*** (3.2006 1999 .91)*** (9. ∆logNEER(-1) -0. The purpose is to examine if the responsiveness of the relative GDP deflator Real effective exchange rates and cyclical divergence: increased with the launch of the euro.017 -0.42)** (1. gap differential.62)*** (1.72)*** (0.1 using the GDP deflator.75)*** Bond) procedure.54)*** (2.037 Dependent 1970-2006 1999-2006 (6.40)*** (6. ∆logREER indicating that relative prices have assumed a Estimation GLS GMM GLS GMM stronger role in the adjustment.626 0. after 1999 the speed of adjustment has its own lag.65)*** countries.

13 :Determinants of cost aggregate slack larger. it also produces adverse exchange rates.4.2 tackles There are at least three other main reasons for this question and yields the following stylised concern: findings: • First. costly also since it implies that to achieve price stability of the euro area as a whole. it responding more strongly to loss of adjustment capacity through the more excess demand than to excess supply. this mechanism is still blurred in DE AT FI BE FR NL ES EL IT PT IE the euro area as prices in services are sticky. This is potentially costly as it have tended to become more persistent. 60 .European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Econometric work reported in Box I. as noted above. several countries that • The first-round responsiveness of real have been experiencing a persistent effective exchange rates to output gap deterioration in their competitiveness also differentials has remained largely intact (even saw their comparative productivity decline if having fallen slightly) after the introduction along with an increase in relative wages of the single currency. the non-tradable sector potentially plays an important role in the 0 competitiveness channel. This implies that inflation adverse competitiveness developments in and output differentials in response to shocks these countries. the experience over the past decade competitiveness channel has become stronger has shown that the response of the real after the introduction of the single currency.4. looking at the 'pure' price effect rates. the speed of (Graph I. As noted. (thus abstracting from the nominal effective exchange rate effect) suggests that the • Second. effective exchange rate to cross-country While encouraging. A country which -1 experiences overheating and an external -2 deficit needs to shift resources from non- -3 tradable to tradable industries and vice versa. This has notably been the adjustment of real effective exchange rates case in Italy and Spain.4. this greater sensitivity of differences in cyclical positions is prices does not yet suffice to fully offset the asymmetric. -4 However. 4 3 • Third. Relative productivity Relative compensation per employee Relative unit labour costs Source: European Commission.13). than it would competitiveness. while the analysis of competitiveness Average annual growth (%) 2 developments naturally focuses on tradable 1 industries. This confirms that towards their equilibrium has slowed down adverse supply shocks impinging on with the irrevocable fixing of nominal productivity have been a main driver of the exchange rates. However. This weighs on structural profitability and may is obviously not surprising in view of the depress potential growth for sustained disappearance of the nominal internal periods. monetary policy needs to be tighter and Graph I. spill-overs onto economic activity in other euro-area countries via the area-wide interest • By contrast. This is flexible nominal exchange rates. 1999-2006 otherwise need to be.

This yields a so-called and price regulations put upward pressure on ex ante real interest rate.5. In addition. zoning restrictions real interest rates yields valuable information on and restrictive labour regulation put a brake on the extent of anchoring of inflation expectations. ex post real interest rate. related to real convergence and to policy unavoidably produces economic changes in lifestyles (particularly evident in divergence across countries in the euro area. It also disregards the fact that measuring to be influenced by changes in administered real interest rates. Not surprisingly. the more destabilising will the real interest competitive. sometimes linked to policy (for instance interest rate channel. where entry barriers (the method applied here). already occurred during the run-up to the single currency as exchange rate risk premiums In sum. retail This has been identified as crucial for the degree financial services. Meanwhile. competition) that call for policy responses. Beyond these factors. a secular price Walters critique which predicted that countries increase in services relative to goods is to an with buoyant economic activity and higher than extent to be expected due to the higher labour average inflation rates would enjoy further intensity in production (and typically lower stimulus by below average real interest rates. An alternative is to use prices. however. Looking at both types of such as shop-opening hours. and traditionally regulated sectors. Prominent among them is shortcomings in market functioning (notably that the expected inflation rate which is used to inefficiencies in regulation and lack of 'deflate' the nominal interest rate is unobservable. with the standard deviation falling factor. where EU integration is less of pro-cyclicality of the real interest rate channel advanced than in the wholesale financial sector (the less forward looking inflation expectations and some domestic markets appear insufficiently are. By recreational services). pushing real and liquid and inflation rates converged in the effective exchange rates towards equilibrium. This term demand shifts towards services would seem to imply that the single monetary consumption. wholesale and retail trade. productivity growth) and limited international while weaker economies with a lower than competition. Some examples such as those reported by Consensus Economics are: professional services. Part I Assessing the first 10 years With regard to the third concern. the CHANNEL spread between the country with the highest and the lowest real interest rate fell both in ex ante At the outset there were fears that the real and ex post terms from around 10% in 1994 to interest rate channel would act as a destabilising 7½ % in 1998. GAUGING THE REAL INTEREST RATE inertia in inflation expectations. the early 1990s to below 3% in 1998. productivity growth and competition. is not as straightforward as healthcare reforms). Balassa-Samuelson effects are likely disregards the operation of the competitiveness to have contributed and services prices also tend channel. high and Measuring real interest rates raises a number of persistent services price rises also reflects methodological issues. On ex ante basis the decline was somewhat more pronounced from 7% to 2½ %. such as railway transport or Most convergence in real interest rates had postal services. Ex post real there is considerable scope for it to be interest rates declined from an average of 6% in strengthened. it may seem. In some now it should be clear that this line of argument countries. but pursuit of the Maastricht criteria. where factors observed actual inflation. and by extension the real prices. In The two main approaches are to use inflation most participating countries there are services premiums built into the rate of return on financial sectors that operate in a regulatory environment assets such as indexed bonds or to use surveys not conducive to low inflation. where the scope for liberalisation has not yet been exploited. the sharpest falls 61 . reflecting a low degree of average inflation rates are further weakened by tradability. markets became more integrated operational in the euro area. of many services. the "competitiveness channel" has been disappeared. indicating some 4. higher than average real interest rates. long. which results in an partly related to non-economic considerations. This was based on the well-known from 3 to 2%. rate channel be). may play a role.

monetary policy can be another source of divergences via the real interest rate channel.3). Finland. asymmetric transmission of economic growth. regulatory in markets structure (concentration with Portugal. Ireland and Italy at and size) systems (Sander and Kleimeier 2004. adjustment faster and smoother and limit the Inflation differentials are not an exclusive feature risk of the real interest rate channel to kick in of the euro area and observed in other monetary as a source of short-run macroeconomic unions as well. CONCLUDING REMARKS currency in Greece. Importantly. the bulk of the dispersion in real competitiveness channel. microeconomic reforms in product and labour according to calculations by Angeloni and markets even stronger. Again. This would make interest rates reflects inflation differentials. recoding mostly below-average real interest there is some reason for concern that the real rates. for the years 1999-2002 the impact of money market rates on bank lending and deposit rates (within one month) varied between 0. empirical studies concerning interest rate channel and. several countries and this may entail some short- indicating that the dispersion of expected run macroeconomic instability as real exchange inflation rates is less pronounced than that of rates overshoot.6. Inflation persistence exacerbates the real 2003). two groups of countries can be Summing up. with the current the interest rate pass-through into bank interest account constraint being removed. and Belgium registering above-average real even if further progress towards enhancing this interest rates since 1999 and the other countries channel is possible and desirable. Ireland and Spain. Meanwhile ex post real interest rates show interest rate channel is still rather prominent in more dispersion than ex ante real interest rates. Van Els et al. what is specific to the euro economic growth potential. The main challenges arising in observed inflation – although the difference is this context can be summarised as follows: small. area is the rather strong persistence of these differentials across countries (Altissimo et al. Ehrmann (2003). Maudes and Fernández de Guevara 2004). a combination of integrated Studies covering the early years of monetary financial markets and inflation persistence union did not find strong evidence of such risks sustaining divergences across countries. For example. Spain. This makes the call for adjustment towards equilibrium.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union in real interest rates were observed in countries The main culprits are differences in the legal and that had previously had high real interest rates -. 62 . France appears to be rather powerful in the euro area. • A better functioning of labour and product Given that nominal interest rates have largely markets would help strengthen the converged. It is indeed quite similar across instability. • The integration and development of financial 2006). the competitiveness channel distinguished – with Germany. it can rates do point to asymmetries – both in terms of result in asset booms which will have to the equilibrium interest margin and the speed of unwind at some stage. this favourable effect likely to be one of the main culprits. Meanwhile.621 in France. More generally. asymmetries (Peersman 2004.4. it would pay a double metropolitan areas in the United States (see dividend by also helping to raise the Box I. Such inertia in inflation differentials is markets could help smooth adjustment and damaging since it heightens the pro-cyclicality of ease divergences further by spreading their the real interest rate channel. However. the top of the league. • However. However.387 in Germany and 0. would come on top of the positive impact integrated financial markets potentially have Aside from the persistence in real interest rate on the allocation of capital and longer-term differentials. Austria. As mentioned impact across a broader group of investors earlier sticky prices in services industries is and consumers. Further sharp declines in real interest rates were observed after the introduction of the single 4.

persistence of inflation differentials in the euro- like that of Arnold and Kool (2004). the US Bureau of 1. a main difference between euro-area substantial degree (e.0 five years are published. countries have accumulated a substantial positive Most studies find that the diversity of inflation inflation differential (e. but for a total of 26 14 US MSAs Euro area metropolitan areas. other studies have 0. Others studies. ECB 2003a). For three MSAs monthly data are published and for another 0.4.g. with most of the difference difference is less striking when all US due to Ireland. Ireland. Observations support this view as some of gross output per state. Greece. areas the ECB (2003a) concluded that persistence while standard deviations have remained slightly is indeed weaker in the United States.g. but the higher in the euro area. Spreads between maximum and comparison with a sample of 14 US metropolitan minimum inflation rates have been quite similar. Part I Assessing the first 10 years Box I. metropolitan areas are taken into consideration. Asdrubali.0 price movements through the competitiveness All US MSAs (26) channel: it would take three to four years for the 1.0 changes in real interest rates due to movements in 4.5 Economic Analysis (BEA) publishes consumer price inflation data for metropolitan statistical areas (MSAs). However. Sørensen and countries and US regions is the stronger Yosha 1996). annual CPI data for at least 0. four in All US MSAs (26) odd months) are available.0 14 US MSAs competitiveness channel to dominate the real Euro area interest rate channel. This effect 3.0 would initially outweigh the offsetting effect of 2.g. use deflators area. Spain rates in the euro area has become more or less and Portugal) while others have accumulated a similar to that among metropolitan areas in the negative differential (e. Therefore many existing 1997 1999 2001 2003 2005 studies derive conclusions on the basis of just 14 of the 27 MSAs (e. Based on a United States. 63 . but not for the states. Maximum inflation rate spreads Arnold and Kool (2004) have found evidence that 5.g.0 state inflation rates do affect differences in activity across states in the United States.0 data which are available for the states. In this case. the accumulated differentials on both sides of the Atlantic appear to be quite similar.3: Real interest rate differentials: a comparison with the United States The analysis of real interest rate differentials in the Standard deviation of inflation rates United States suffers from limited availability of data. unlike output 1.5 11 bimonthly data (seven in even months.0 shown that risk sharing provides an offset by 1997 1999 2001 2003 2005 smoothing the impact of state-specific shocks to a However. For the United States. Germany).

For example. As may be concluded from the The analysis in this chapter indeed finds analyses in Chapters I. Notably fiscal the role of removing these rigidities. with a policy would be working against rather than majority of observers expressing scepticism. rather policy has remained a national responsibility. national stabilisation this may be less the case in economic "good policy would be stifled and economic activity times". This EMU. sluggish growth) by fiscal activism. and also confirms the findings reported in the account positions. Chapter I. alternative insurance policy was still responding to recession fears in mechanisms to stem the risk of recurrent the wake of the Asian crisis. during the Moreover. a high policies became more clearly less procyclical. would entail a systematic aggregate deficit bias and force monetary policy to be tighter than it From the outset this assignment of policy otherwise would be – i. It thus failed to stem income loss due to cyclical fluctuations in the upswing and – despite extremely favourable economic activity have been emerging. and with fiscal policy constrained by asymmetry (e. and while with hindsight this • The macroeconomic imbalances that have built up in the euro area in its first ten years – (22) This is in line with the seminal work of Gali and Perotti with wide-ranging disparities in current (2003). In particular. as updated in Turrini (2008).g. ceilings for deficits and debt) rules and commitments. Von Hagen and Wyplosz (2008) also find evidence that fiscal rather than cyclical roots. One support each other. and hence the complex. due to attempts to maintaining price stability. INTRODUCTION persistence) along with real rigidities in labour and product markets appears to have EMU assigned monetary policy to a single contributed to overshoots and undershoots in independent central bank but left the the real effective exchange rates. albeit within certain bounds.10 of this alleviate some of the symptoms of structural Report contains a detailed account of the rigidities in product and labour markets experience with fiscal policy co-ordination in (i. It would be participating countries a large degree of political more appropriate to assign structural policies sovereignty in most other areas. position of the economy. 5. The complicating factor is that fiscal need for national stabilisation policies over policy has severely suffered from long and above the stabilising impact of the single recognition lags regarding the actual cyclical monetary policy has been diminishing. 64 . spillover effects and is consistent with the goals One risk that has been repeatedly evoked is that of ensuring sustainability of public finances and of an unbalanced policy mix. than burdening fiscal policies with addressing which allows participating countries to pursue their symptoms.2 and I. In the as the opportunities of risk sharing and subsequent downturn fiscal policy was eased on consumption smoothing offered by the the back of windfall gains stemming from the rapidly integrating financial markets. evidence of an asymmetric response of fiscal this fear now looks misplaced to the extent that: policy in good times – although less so in EMU than in previous economic upswings.e. MACROECONOMIC POLICIES AND THE POLICY MIX degree of nominal rigidities (inflation 5. but given their inherent policy. real interest rates and 2006 issue of the Public Finance Report. European housing markets – largely have structural Commission (2006c). The fiscal rules in place stem fear was that with the loss of national monetary this risk to some extent.3 of this Report. domestic stabilisation goals. fiscal and monetary responsibilities has given rise to debate. Specifically. dotcom boom.e. as will be discussed in some detail dotcom bubble in the early years of EMU fiscal in Part II of this Report. such conditions – to consolidate budgets. (22) But the • Business cycles are increasingly mechanisms underlying it turn out to be rather synchronised across countries. the participating countries Another fear that popped up regularly in the have committed to conduct their fiscal policies in debate is that of an imperfect co-ordination of a manner that takes account of cross-border macroeconomic policies at the European level.1. would be left at the mercy of the vagaries of the business cycle.

1. definition of price stability of less than 2% HICP Since then. its as perceived with hindsight. The final section of interpretation as a "ceiling without a floor" came the chapter then provides an assessment of the under intense scrutiny in view of the economic policy mix. while more emphasis is Consumer Prices (HICP) (close to. De facto this quantitative definition of price stability – i. The assessment will be both against "real acquisitions. published a review of its strategy. as arguably had been its strategy all along. respectively in the first ten years of coins. this chapter assesses the Meanwhile. (25) Issing et al. Concerning the the time – and the actual "ex post" developments quantitative definition of price stability. THE CONDUCT OF MONETARY POLICY quantitative definition of price stability. the data as perceived at credibility of the reference value. Achieving the price stability goal consisting of: (i) a "first pillar" assigning a prominent role to broad money (M3) for which a As discussed in Chapter I. The ECB does not pursue an explicit findings stemming from the analysis of short- inflation target. Against this backdrop. (24) ECB (2003b). but it highlighted that the ECB would aim to keep the 5. and (ii) a "second pillar" referring to achieved when the euro was launched in 1999. (23) growth (26).2. but" was as for example derived from French inflation introduced in a review of the monetary policy framework in 2003 – see below.5. (25) narrow range around the ECB's gauge of price stability and it has been below this mark in 42 out of 110 months (Graph I. geared towards a quantitative qualify for euro accession in the "first wave".g. non-resident use of euro notes and policies. The policy framework inflation rate close to 2% over the medium term. a means that less prominence is given to the rate of change of the Harmonised Index of analysis of M3 per se. weakening activity. (24) Initially the ECB pursued a two-pronged strategy 5. The review reiterated the aforementioned 5. In the event. a broadly-based evaluation of risks to price mainly as a result of the nominal convergence stability. in reality this was largely Since the advent of the single currency the year- unintentional. the move towards reference value of 4½ % annual growth was low and stable inflation was already largely formulated.e. evolved over time as experience was these decisions have been widely interpreted as a accumulating. (26) Beyer and Reichlin (2008). It fixes its analysis of money aggregates. Part I Assessing the first 10 years looks like a countercyclical response to Both benchmarks have been subject to criticism. Even though the ECB stressed the continuity of its strategy and stated that the The implementation of the policy framework has decisions taken were merely about clarification. but it has put forward a term economic developments. (2001). which was main policy rates in the pursuit of price stability henceforth focussed on long term price in the euro area as a whole over the medium developments and aimed to "cross-check" the run. portfolio shifts and mergers and EMU. 65 . A Monetary policy is conducted independently by somewhat different role was attributed also to the the European Central Bank (ECB). downturn and the Japanese deflation experience.2. including credit 2% per annum. non- inflationary expansion of the money stock. Notably.e. but) below put on its counterparts.2. in May 2003 the ECB downgrading of the (previous) first pillar. (23) Scheller (2006). The qualification "close to. using a wide array of economic and process in the 1990s motivated by the desire to financial variables.2. Financial market-based measures of inflation expectations. This threatened to undermine the time" developments – i. fiscal positions on-year growth rate of M3 had persistently deteriorated and a long and painful consolidation exceeded the reference value of 4½ % which the ensued.2. M3 was severely distorted by the evolution of the stances of monetary and fiscal impact of e. ECB used as the benchmark for a prudent. inflation has been hovering in a inflation per annum.1).

0 4. In the 1990s. disruptive As also discussed in Chapter I. geopolitical strains associated volatility has been greatly reduced as well.0 5.0 Launch of the euro 0. which with the Afghan and Iraqi wars. The ECB interest rates. inflation terrorist attacks. These included the committed to maintaining price stability. The volatility of quarterly changes of monetary policy again faces difficult times. episodes can be distinguished since the launch of term Consensus inflation expectations has also the euro: declined substantially. with HICP inflation in the euro area (measured as its inflation accelerating due to soaring oil and food standard deviation) fell from around prices associated with rapid growth in demand 0.0 2.2). markets and private to respond to an unusual string of adverse agents perceive the ECB as being fully economic disturbances.1 percentage point in recent years.3 percentage point in the 1990s.0 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Source: HICP HICP excluding unprocessed food and energy Break even inflation rate indexed bonds European Commission index-linked bonds. as measured for example by Consensus Economics 5. the explained this decision as a response to the standard deviation of long-term interest rates (on reduced inflation risk implied by 66 .0 3.3. and soaring food is of particular importance for the risk premiums prices due to hostile weather conditions and built into bond yields and hence investment and animal diseases. Apparently.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union % Graph I.0 1.6 percentage point during the 1980s to around from emerging Asia. Long-term inflation expectations. While volatility of actual and expected inflation has maintaining this rate unchanged until April contributed to the lower volatility of long-term 1999. inflation to financial stability. in the past seven years. aftermath of the Asian and Russian crises. volatility has only been 0. Monetary policy in action forecasts or the ECB Survey of Professional Forecasters. the unwinding of the dotcom bubble. in spite of major (food and energy) price shocks With the benefit of hindsight. for example. At the current juncture growth.2. four policy during this period. energy. The average volatility of long. This lower policy rate at 3% (Graph I. from almost half a percentage point in the 1990s to less than • At the start of EMU. again mainly turbulence stemming from the subprime crisis as a result of the nominal convergence process in entails downside risks to activity along with risks the 1990s.7 percentage following sharp price increases of food and point.1: Inflation in the euro area 6. the ECB fixed its main 0. have also been continuously at a The early years after the launch of the euro were level broadly consistent with the ECB's gauge for a turbulent episode in which monetary policy had price stability. while financial market 0.2. have consistently been close the basis of monthly data) was around to (even if mostly slightly above) 2% and have 2 percentage points.5.5. this hardly responded to the recent pick-up inflation measure has fallen to around 0.2 percentage point. it then cut the rate to 2½ %. Since the launch of the euro.

The ECB cut rates cuts financing by the ECB have contained the between May 2001 and June 2003 by a spread to some extent. after economic prospects are very uncertain in increasing from 1 percent. % 6 4 • From then onwards. enterprises from declining by a comparable However. this risk did not materialise and amount. Although credit growth slowed 6 down appreciably in this period. The ECB left interest rates on accelerated in step as economic prospects hold at 4¾ % until May 2001.5. This aimed to stem 1999 2001 2003 2005 2007 upside risks to price stability amid a buoyant Domestic credit M3 economy.2: Official and short-term interest real long-term interest rates were at historical rates lows as well. but it has remained cumulative 275 basis points to 2% -. The inflationary impact of higher Source: European Central Bank. December 2005. the key official interest rate was kept at 2%. Part I Assessing the first 10 years deteriorating growth prospects in the wake of premiums prevented capital costs for the Asian and Russian currency crises. triggered a series of interest rate cuts in the Frontloading and lengthening the maturity of major economies.2) emerged as • As the economy gradually recovered. rising risk shocks since 1999. although monetary policy in the euro impact of the ECB’s interest rate cuts on area has had to face a number of (external) economic activity. lowest rate ever adopted by a national central bank in the euro area. against the recovered. Meanwhile. From June 2003 until level in November 1999. Moreover. slightly above view of the downturn in the US. M3 initially 5 accelerated as increased uncertainty led to greater risk aversion. Next policy moves accelerating rates of consumer price inflation are difficult to predict as inflation has been -.3). 2 percent.1 % in May 2001. the euro appreciated from official rates were restored to their initial its end-2000 lows. the the main sources of concern. inflation and inflation 67 . as ECB raised its policy rate by a total of 200 noted.the sizeable.5. Secondly. 4 % 3 Graph I. In this period nominal and Graph I. Firstly. weakening economic growth and area being a main driver. oil prices and the depreciation of the exchange rate (see Chapter I.5. Two factors muted the All in all.which peaked at 3. with mortgage lending associated background of the bursting of the dotcom with soaring house prices across most of the bubble. thus making credit dearer.3: Money and credit growth 2 1 14 12 0 1999 2001 2003 2005 2007 10 3-month euribor ECB REFI rate 8 Source: European Central Bank. the ECB gradually 2 4 1/2 % reference for M3 moved its official interest rate up to a peak of 0 4¾ % in October 2000. the deteriorating spread between the three-month interbank economic outlook in the world economy and official rates. Money and credit (Graph I. picking up to well above the 2% mark Measures of core inflation (HICP excluding (exceeding 3½ % in March 2008) while unprocessed food and energy) remained. liquidity hoarding by banks sparked by the subprime crisis has significantly widened the • Starting in early 2001. broad money growth persistently basis points from December 2005 to its breached the 4½ % reference value in line current 4% in a drive for interest rate with a rapid expansion of credit "normalisation".

The ones used here are the monetary an estimated equation describing actual average conditions index. monetary conditions Another way to assess the monetary stance is to benchmark it against the so-called "neutral" real interest rate. which market participants for better transparency and more than offset the fall in the real interest rate. which would be clearly at odds with the GDP. the overall time % profile of the stance development is broadly -1 similar. initially driven by normalisation the ECB also earned credit by the appreciation of the real exchange rate. 0 neutral (Graph I. in the long run.2.4. Even so.4).5.5) However. with the Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 weights reflecting the effects of these variables Source: European Commission.4: Monetary conditions index a long stint of easy policy in the period 2002 to 2 2006.5. which roughly corresponds to the 1½ to price stability goal. a tight stance in the next year and half and Graph I. (27) According to the MCI. loosened between 1999 and the beginning of While initially the ECB has been criticised for a 2002. according to a positive Taylor rule monetary policy has been 1 mostly within a reasonable range of the rule. i. The stance of monetary policy not). Since then monetary conditions time.e. During the recent period of interest rate have gradually become tighter.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union expectations have been kept reasonably low. Since there are pros and cons tightening or easing of monetary policy. Taylor to each measure it is best to look at a range of rules can be "normative" or "positive" (based on indicators. the neutral interest and hence the index.6). For example. the impulse it provides to based policy rate could be interpreted as a economic activity. central bank might conduct monetary policy if it was to follow such a rule (which the ECB does 5. -2 -3 Graph I. Deviations from the rules- of monetary policy. interest rate decisions four times a year and the language that is consistently used in the monthly Taylor rules can be interpreted as a response rule press releases following the policy decision is for the policy rate.5: Short term interest rate in the 1999 2001 2003 2005 2007 euro area: actual and implied by a Index normative Taylor rule Contribution of real exchange rate 7 7 Contribution of real short-term interest rate 6 6 Source: European Commission. A rule of thumb – going back to an (27) Obviously there are many caveats to be borne in mind 1898 paper by the Swedish economist Wicksell – when interpreting indicators of monetary conditions. (Graph I. 5 5 4 4 The Commission's Monetary Conditions Index 3 3 (MCI) is a composite of the real short-term 2 2 interest rate and the real effective exchange rate 1 1 relative to their value in a base period. it built up a rate and subsequently driven by the fall in real reputation for the policy of a “steady hand” over interest rates. 68 .5. it now and subsequently also by the pick-up in the real publishes its staff projections underpinning the interest rate. monetary policy ease in 1999 and the first half of 2000.e. initially on account of the falling exchange policy of a “wobbling hand”. The normative rule suggests "neutral" rate approach. on aggregate demand (Graph I.5. helping to understand how a now well-understood in financial markets.5. The arguments in the rule are typically the deviation of inflation from the "target" and the There is no single best way to examine the stance real-time output gap. it would signal a need to ease rate should be at around the growth rate of real monetary policy. i. the Taylor rule and the behaviour). if high inflation boosts the real exchange rate suggests that. For example. clearer communication.

which runs counter to the goal of sustainable public finances in the face of the ageing challenge (see Part II of this Report).5. this failure was masked by the favourable economic conditions EMU's fiscal policy framework has contributed prevailing at the time. except for LU stints in 2000-2001 and in 2007. as adjustments were needed to realisations became increasingly evident. THE CONDUCT OF FISCAL POLICIES medium-term budgetary objective of "close to 5. progress in the immediate aftermath of by a discord over the enforcement of the the launch of the euro disappointed. Progress has been qualified for the single currency. 5.3. In 1992 virtually none Unsuccessful attempts to enforce the provisions of the eleven countries that joined the euro area of the preventive arm of the Stability and Growth in the "first wave" qualified for the deficit Pact (SGP) – the main coordination mechanism criterion (3% of GDP) enshrined in the Treaty for fiscal policy in EMU (see Chapter I.6: Short term interest rate in the ES euro area: actual and implied by a positive NL Taylor rule 7 7 FR 6 6 PT 5 5 FI 4 4 3 3 BE 2 2 IT 1 1 EL Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Source: European Commission.1. qualify for EMU in 1998. Even so.3. economic slowdown in 2001-2003 when the gap Most of the improvement materialised in the run between the budgetary plans and their up to the euro. which is AT consistent with the findings on the basis of the normative Taylor rules.5. -12 -9 -6 -3 0 3 % of GDP 1992 1998 2007 Source: European Commission. see and debt records have been biased in a the various issues of the annual Public Finance Report of favourable direction by the inclusion of 'one-off' the Commission published since 2000. After having corrective arm of the SGP. some countries still portrayed sizeable deficits in 2007. in turn.7). about 1½ to 2%. 69 . some countries debt to GDP ratios also moved up Studies on the euro area (Giammarioli and Valla 2003 and Crespo-Cuaresma. However. Gnan and Ritzberger-Gruenwald and only a minority of countries now post ratios 2004) suggest that since the mid-1990s the neutral rate below 60% (Graph I.8) – the other main has come down. Progress with fiscal consolidation (29) balance or in surplus". several more impressive recently. despite the favourable cyclical conditions overall.10) – while by 1998 all of them did (Graph I. but it surfaced during the to a marked improvement of fiscal positions.7: Development of fiscal terms). in some countries the 'headline' deficit policies and the budgetary coordination framework. short term positions interest rates in the euro area were almost constantly below this benchmark. spurred by the countries failed to make progress towards the correction of excessive deficits. Part I Assessing the first 10 years 2% gauge (or a 3½ % to 4% range in nominal Graph I. (29) For thorough analysis of the developments of fiscal Moreover. DE IE Graph I. In (28) The neutral rate varies over time and across countries. to around 2¾ per cent by 2000 and to reference value enshrined in the Treaty.5.5. (28) Since January 1999. were followed by the breach of the 3% of GDP threshold by a number of countries and. Initially.

5.5.5. -5 -10 Graph I.8: Development of gross public -15 debt IE NL FI AT DE LU EA ES IT BE PT FR EL 1992-1998 1998-2007 1992-2007 LU Source: European Commission. countries saw their expenditure ratios to GDP fall.9: Change in revenue ratio to GDP These evident difficulties eventually led to the aforementioned revision of the EU fiscal 10 surveillance framework in 2005.10).10. FR FI Graph I. the bulk of the fiscal consolidation Since 1992 fiscal consolidation in most would preferably come from expenditure participating countries has indeed been restraint. Belgium and Greece) was largely based on lower interest expenditure. distortions they entail amid stiffening international competition and greater factor mobility. it is nonetheless useful to examine this. 70 . with the exception of France and Portugal (Graph I. Percentage points 5 0 Although the EU fiscal framework contains no -5 explicit provisions on the composition of the -10 fiscal adjustment (in terms of tax and spending). Nogueira Martins (2007). Fiscal consolidation that is based on expenditure based.5. (30) Graph I. However.11: Change in primary expenditure ratio to GDP 1992 1998 2007 10 Source: European Commission.5. Most (see European Commission 2006c).5. Ireland and Finland being commitment to adhere to an "expenditure rule" prominent examples (Graph I. 0 20 40 60 80 100 120 % of GDP Graph I.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union windfall gains and 'creative accounting'. Some countries that pursued expenditure restraint (as opposed to tax successful fiscal consolidation even managed to increases) is also more likely to be sustained – orchestrate a fall in the tax burden -.9). As the -15 FI NL AT ES DE IE LU EA IT BE FR EL PT tax burdens in most EMU members are widely 1992-1998 1998-2007 1992-2007 considered to be too high in view of the Source: European Commission.the especially if it is supported by a government Netherlands. expenditure consolidation in countries where debt burdens are high (Italy.10: Change in expenditure ratio to DE GDP ES 5 Percentage points PT 0 -5 AT -10 NL -15 EL -20 IE FI IE NL IT BE ES AT EA DE EL LU FR PT IT 1992-1998 1998-2007 1992-2007 BE Source: European Commission. A more detailed 5 Percentage points account of the revised Pact is provided in 0 Chapter I. owing to falling interest rates in the run-up to the euro and (30) Koen and van den Noord (2006) and Gordo and the low interest rates since then.

0 4.0 output gap in 1999-2000.1: Assessing the cycle by country This section examines the development of the Graph 2: The output gap by country.0 2.0 LU EL AT DE LU FR NL sharp downturn and a drawn-out recovery -5.0 2.0 -2.0 ES PT aggregate pattern quite well. with output gaps -9.0 pronounced short-lived boom followed by a -3. contracting (and turning negative) in the downturns of 1991-1993 and 2001-2003 and then closing again in the recoveries of 1994-1998 and Graph 3: The output gap by country. most countries failed -1.0 -4.0 DE ES EL FR 3 AT IT AT PTNL Level of the output gap (%) LU FI 1.0 6.0 0. Part I Assessing the first 10 years Box I. 1999-2008 For the assessment of the stance of fiscal policy it is important to consider also the output gaps in real time (Graph 4).0 IT FR ES ES IT FR 1 Recovery Recovery -3.0 NL ES AT LU DE ES FR BE As noted. the two last euro area business 1. More specifically.0 IT BE (see Graph 1).0 NL DE EL FI EL BE 2 PT -1.0 DE is common to virtually all participating NL LU PT IT BE AT EL ES IE 1. 1999-2008 2004-2008 (see Graphs 2 and 3).0 LU -1 Downturn -9.0 4.0 ATFIFR NLEL EL FI countries.0 IE DEBE AT PT IE -5.0 -2. a phenomenon that 5.0 -2 Change of the output gap (%) Level (%) -3 Downturn 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 Graph 4: The output gap by country in real time.0 Level (%) 1989-1990 and 1999-2000. 71 .0 IE positive and expanding in the booms of -4.5.0 countries did not recognise the positive -7.0 -2. and they were also Level (%) largely unaware of the extent of the 2001-2003 downturn.0 4. 5.0 2. It suggests 1999-2000 2001-2003 2004-2008 a much smaller variation of the level and Change (%) changes of the output gap. 1989-1998 levels and changes of the output gaps on a 1989-1990 1991-1993 1994-1998 country-by-country basis following the Change (%) methodology discussed in the main text.0 EL FRIT BE AT DE EL IT FI cycle have portrayed similar patterns.0 -4.0 values and saw much smaller increases of the -9.0 0.0 3.0 IE Graph 1: Gauging the euro area business cycle BE 3. many -5. Apparently.0 IE PT NL PT 3. 1999-2000 2001-2003 2004-2008 Change (%) 5. with a -1.0 6.0 6. Virtually all countries fit this -7.0 0.0 IT DE FR LU DE BE ES BE IT PT AT FR LU to perceive the relatively volatile swings -3.0 PT IE NL ES FI IE going on at the time.0 FINL 0 Boom Boom -7.

More 3 specifically.5. convention is also followed here.5.12 compares the actual (ex post) closing.1 there is a evolution of the output gap in the euro area with strong resemblance with the previous cycle. (31) As shown in Box I. that is common to virtually all participating countries.11). The record of euro- -2 area countries with respect to the errors in -3 assessing the cyclical position of the economy 1996 1998 2000 2002 2004 2006 2008 over this period compares unfavourably with that Ex post Real time of the United States where revisions of the output gap have been relatively small since Source: European Commission. that observed in real time. it is important to consider that governments may A boom is defined here as an episode in which have been led by quite different perceptions of the gap is positive and increasing. 2000 (Graph I. 72 .1. The stance of fiscal policies 0 Assessing the stance of fiscal policies is -1 complicated since the cyclical position of the -2 economy is not always clear. this decline was comparatively small and in bugger share of the expansion in the second half of the terms of changes in the output gap the trough had clearly 1990s to stronger potential growth as opposed to the been attained in 2003. This reflects that forecasters ex post attributed a However. many countries did not recognise 2 the positive values and saw much smaller % of pot. and 0 they were also largely unaware of the extent of -1 the 2001-2003 downturn.5. and this Source: European Commission. a phenomenon similar time profile for the output gap.5. Apparently. as analysed in Box I.5. From the point of view of fiscal policy the most common measure -3 1996 1998 2000 2002 2004 2006 2008 of the cyclical position of the economy has Ex post Real time traditionally been the output gap. Graph I. The first ten years of EMU then roughly coincides with a full cycle.13). GDP 1 increases of the output gap in 1999-2000. consisting of three phases.5. (32) (32) On the other hand. dubbed “boom” For the assessment of the stance of fiscal policy (or "good times").13: Output gap estimates for the US on public debt) has been considerably less 3 impressive in these countries (Graph I. It suggests a much which according to the same criteria also smaller variation of the level and changes of the spanned ten years (1989-1998) and portrayed a output gap ex ante than ex post.3.2. cycle (which led to smaller output gaps). GDP 1 5. “downturn” and “recovery”. 2 % of pot.12: Output gap estimates for the most countries did not perceive the relatively euro area hefty cyclical swings going on at the time.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Primary expenditure restraint (excluding interest Graph I. A downturn is the cyclical position of the economy than called if the gap is falling and turning negative suggested by the output gaps as estimated ex and a recovery is called when the negative gap is post. Graph I. there is a substantial difference between real-time and ex-post estimates for the US prior (31) The output gap showed another decline in 2005. to 2000.5.

with some countries tightening and some easing.0 2. the pattern is different and -4.0 3.0 easing bias in the downturn. the overall ex ante stance was contractionary.0 0.0 During the 1999-2008 cycle the fiscal stance EL FR BE was mostly close to neutral in the boom.e.0 2.0 Next the elasticities of tax proceeds or 1 Accumulated change in the cyclically-adjusted fiscal balance (% of potential GDP). 73 . There was a -6. -2.0 6.0 LU DE relevant items on the government account which DE NL AT ES NL IE FRES EA BE FR FI would be obtained if output were at its potential 0.0 1.0 4. -6.0 5.0 4.0 -3.0 ES PT However. First.0 FI NL IE economic activity.0 1 Accumulated change in the cyclically-adjusted fiscal balance (% of potential Output gap (%) • During the 1989-1998 cycle the fiscal stance was mostly stimulatory in the boom (but Italy Graph 3: Fiscal stance over the cycle.0 -1.0 IT PT IT AT BE PT EL ES IE PT level (i.0 adjusted primary balance (a measure of the stance 4.0 4.0 EL LU BEDE AT NL IE The method proceeds in three steps.0 LU IT EA FR AT FI EL EL BE DE NL -4.0 1. 1999-2008 nominal budget numbers and the output gap is based on the officially accepted methodology Fiscal stance 1 1999-2000 2001-2003 2004-2008 developed at the OECD (van den Noord 2000 and (%) 6.0 NL overall less clear-cut (Graph 3). which in turn 2. 6. These two sets of elasticities are combined into reduced-form elasticities that link Fiscal stance1 1999-2000 2001-2003 2004-2008 the cyclical components of taxes and (%) expenditures to the output gap.0 -4. Output gap (%) clear for the recovery period.0 -3.0 -3. PT IT ES AT IE FI ES LU 0. The approach starts of from the observation that economic activity influences tax 4. EL have been estimated through regression analysis.0 IE AT NL BE IT PT DE AT FI the recovery (Graph 2). 2. 1999-2008 estimated.0 2.0 bases and unemployment.0 -2.0 6.0 FI 2002).0 0.0 ES IE EA DE ES IT EA BE stimulatory in the downturn and tightening in 0. The pattern is less 1 Accumulated change in the cyclically-adjusted fiscal balance (% of potential GDP).0 BE DE LU FR PT unemployment with respect to (cyclical) -4.0 slight tightening bias in the boom years and some -4. the BE AT IT EA FR EA IT elasticities of the relevant tax bases and -2.5. Output gap (%) expenditure with respect to the relevant tax bases are extracted from the tax code or otherwise Graph 2: Fiscal stance over the cycle in real time.0 -1.0 0. the output gap is zero). 1989-1998 and Belgium are outliers).0 -4.0 -2.0 EL LU NL • 4.0 1. The cyclically.0 -2.0 3.0 6. gauged by the output gap. in real time.0 3. Since three of the four largest countries tightened fiscal policy (Italy being the exception). Part I Assessing the first 10 years Box I. tightening in the downturn and again tightening in the Fiscal stance1 (%) 1989-1990 1991-1993 1994-1998 recovery (Graph 1).2: The fiscal stance by country The approach to derive the fiscal stance from Graph 1: Fiscal stance over the cycle.0 -1.0 FR NL DE PT EL EA ES determine tax proceeds and public expenditure.0 Based on this methodology the following can be IE LU inferred: -6.0 5. PT FR AT EL EA IE LU DE FR LU -2.0 5.0 FI of fiscal policy) is derived by re-calculating the 2. 6.

The ex ante stance also suggests adjusted in the face of lower than projected counter-cyclical fiscal stimulus in this economic growth and the associated lower than episode. on aggregate the stance was slightly confirmed by the real time measure.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Political economy factors play a role in countries – with the notable exceptions of explaining why official macroeconomic forecasts Italy and Belgium where high debt levels and in EMU display systematic optimism about an associated surge in debt servicing forced medium-term economic growth and – by fiscal consolidation upon them. but this was prompted more by the fiscal consolidation needs imposed by • In an ex post sense. this reflects the of large euro-area countries the macroeconomic underestimation of the extent of the boom scenarios underpinning budget plans exhibited a and hence the cyclical component of fiscal rather persistent upward bias (see Jonung and gains. during the cycle.2 and Tables I. it causes budgetary slippages as larger countries (Buti and van den Noord expenditure levels are typically not immediately 2004).e. but it is more likely to have output is "convenient" in the sense that it puts a been driven by the mechanism described favourable gloss on the annual stability above: governments were responding as if programmes by easing the move towards the there had been a structural improvement in close to balance or surplus requirement over the the fiscal position. Differences between the two largely reflect the • In the 2004-2008 recovery governments were assessment of the output gaps as revisions in the forced to correct the past excesses. Ex post.5. The fiscal more detail (see Box I. This may have result of the incentives generated by the SGP been motivated by stabilisation itself. with the real While most forecasters – private sector and time measure suggesting that on average the government alike – had a tendency to overstate fiscal stance was tightening – i. However. counter- growth prospects in the early 2000s. Indeed. Larch 2006). the following can be inferred: of the recovery. when fiscal policy was procyclical manner in the vast majority of tightened in the recovery phase in a vast majority of countries (France is a notable exception). This does not compare also indicates a tightening stance of fiscal unfavourably with the boom of 1989-1990.5. 74 . ex post observed neutrality was not in the plans in most countries ex ante. as tightened their budgets.10.2 tightening eventually leaned against the wind and I. counter-cyclical. with nominal budget numbers themselves have been several countries facing Excessive Deficit comparatively minor. These optimistic growth projections biased the estimated trend growth upward and as • In the 2001-2003 downturn the fiscal stance a result potential output was overestimated and was stimulatory in most countries (except for the real time output gap accordingly Spain. behaved market turbulence. This drive to consolidate budgets is boom. This behaviour is quite similar to the when fiscal policy was clearly eased in a previous cycle.10). although procyclicality the SGP than by a desire to choke off the has not been widespread in the 1999-2000 upswing.5. in a number cyclical.3). but again this was probably projected revenues. both in real time and ex post. which stimulatory.5. This bias may be partly the sense – i. possibly in response gauged by the change in the cyclically-adjusted to sustainability concerns and financial primary balance as a share of GDP. the extension – of potential output during upswings. accidental. This reflected the measures taken (33) This is with the exception of cases where accounting to qualify for euro adoption subsequent to the issues gave rise to major revisions – see Chapter I. electoral calendar at the time – notably in the however. It is in contrast with the 1991-1993 downturns when many countries The issue then becomes how fiscal policy. I. This tendency may have medium term (since a bigger share of fiscal been reinforced by the unusually busy deficits will be labelled "cyclical"). Portugal and Austria) in an ex post underestimated. policy. an overestimation of potential considerations.(33) Looking at the record in Procedures (see Chapter I.e. As noted.1.

Contr. Contr. Spain Stim. Stim. Contr. Stim. Part I Assessing the first 10 years Maastricht Treaty. Stim. Stim. Contr. Stim. France Stim. Stim. Euro area Stim. Contr. Euro area Contr. Italy Contr. Stim. projections and this may be reflected again in Note : Pro-cyclical stance is bolded.4). Stim. Contr. the Finland Stim. Contr. Contr. Stim. Contr. Source: European Commission. 1999-2008 Austria Contr. Contr. Contr. Stim. Stim. Contr. Stim. in which case the output gaps may well turn out higher (and the structural Table I. Boom Downturn Recovery Belgium Contr. Stim. Germany Contr. Italy Stim. Contr. Contr. Contr. Stim. budgetary plans seem to have become more Ireland Stim. Note : Pro-cyclical stance is bolded. Stim. Stim. Contr. Stim. which in turn may Chapter I. Contr. Stim. France Contr. Germany Stim. at this stage Italy Contr. Finland Contr. Electoral considerations Table I. Contr. cautious in recent years. which lead to a temporary comparatively tax-rich. Contr. Contr.8) – In addition. 1999-2000 2001-2003 2004-2008 Germany Contr. Stim. Contr. Contr. Luxembourg Contr. Stim. 1999-2008 Boom Downturn Recovery Table I. Note : Pro-cyclical stance is bolded. Stim. Contr. Contr. Contr. 1989-1998 Boom Downturn Recovery the single currency was seen to raise the odds 1989-1990 1991-1993 1994-1998 of re-election unlike in normal times when Austria Stim. Contr. However.1: 1999-2000 2001-2003 2004-2008 Fiscal policy stance ex post.2: may have played a role as well: qualifying for Fiscal policy stance ex post. (ii) via capital gains on taxes on (see Eschenbach and Schuknecht 2004). the election campaign (Von Hagen 2002). governments tend to ease fiscal policy during Belgium Contr. Contr. Contr. 75 . Contr. Ireland Contr. Stim. Finland Contr. Contr. Portugal Stim. the structural fiscal positions may be the convergence towards the euro unleashed a set biased upward due to the (now maturing) of events that is likely to have led to higher than housing booms in many countries (see normal government revenues. Contr. Stim. Stim. This along with buoyant inflows of tax revenues risk is further heightened by the fact that during going well beyond the expansion of aggregate the upswing the composition of output itself is economic activity. Contr. Stim. In several countries – notably those that have been in a catching up phase (see Chapter I.3: fiscal positions worse) than initially thought. downward revisions of the macroeconomic Euro area Stim. Contr. macroeconomic projections underpinning France Stim.5. Luxembourg Stim. Austria Contr. Luxembourg Stim. Contr. Spain Stim. Stim. Portugal Stim. lower potential output. (iii) via transactions on assets on turnover taxes on indirect taxes.5.(34) VAT-exempt exports and boosting VAT-liable imports. Stim. Contr. Stim. Belgium Stim. Ireland Contr. Stim. Stim. Stim. there is still considerably uncertainty around the Netherlands Stim. Building on the past experience. Greece Stim. Contr.5. Spain Contr. with home pressure of increase in implicit tax elasticities with respect to demand and competitiveness effects squeezing the output gap. Contr. Contr. Contr. Contr. Source: European Commission. Contr. Fiscal policy stance ex ante. During the 1999-2000 boom these types of mechanisms led to the conclusion that the high tax content of growth was likely to be permanent. Netherlands Contr. Contr. Contr. Contr. size of the output gap. Stim. There have recently been Portugal Stim. Greece Stim. and the policy response was to (34) The increase in the stock of wealth had a beneficial effect on government revenues through a number of channels: (i) via the wealth effect and high consumption income. Netherlands Contr. Stim. Greece Contr. Source: European Commission. The experience of the end of the mislead fiscal policy makers to believe in a 1990s has shown that upswings in asset prices go structural increase in available resources. Contr.

As regards the US. The same behaviour is been consistent in terms of their direction -.5 2002 Monetary easing 2006 2007 Fiscal/Monetary 2005 -4. significantly more than plus/minus 1 percentage point. since then both have been countercyclical.5. but economic activity. As regards Fiscal/Monetary easing tightening the fiscal stance.0 -2.i.5.e.0 0. since 2001. being observed most recently. 2002 2001 2000 -1.5 1999 Source: European Commission. THE MACROECONOMIC POLICY MIX pronounced shifts. In the euro area the fiscal stance was rationale for the recent stimulus package must be never tightened or expanded by significantly seen against the background of an economy in 76 . As a result.0 0. By contrast.5 Fiscal 2001 easing/ Monetary Graph I. the move resulted from (i) becomes evident from inspecting Graph I. never changed by juncture.5. Both monetary and fiscal policies were eased during Graph I.5 -4. the macroeconomic policy stances in the US recorded much more 5. and in crisis and the associated growing risk of slowing 2000 fiscal policy was again pro-cyclical. a striking feature of macroeconomic of the 2000s was not solely a response to the policies in the euro area.4.15 overseas military engagements and the ensuing below. which sets out clear restrictions for -4. % GDP 2003 2008 -0. budgetary policy making in the -3.5 Fiscal tightening/ tightening (especially in the large countries) in the recovery Monetary easing 2006 so as to comply with the provisions of the 0.5 easing Fiscal tightening/ -3.5 Monetary different degrees of policy activism. as measured by the annual change in the above potential.14: Fiscal and monetary stance in -2. Rather. the quick and sharp shift in fiscal policy towards an expansionary stance at the beginning Even so.0 2. As in 2001.5 euro area is constrained by the provisions of the SGP.5 2004 tightening Change in real short-term interest rate Change in CAPB.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union reduce taxes or to increase expenditure plans at a more than 1% of GDP per year and the monetary time when the economy was de facto operating stance. with a sharp cut in they were either both tightening or easing (see official interest rates accompanied by a fiscal Graph I.0 -2. compared to the US. Both the fiscal and the monetary stance loosened sharply and in tandem After the launch of the euro the stances of fiscal during the 2001-2003 downturn and tightened and monetary policies have most of the time forcefully afterwards.15: Fiscal and monetary stance the economic downturn following the dotcom in the US Fiscal/Monetary bust in 2001. % GDP corrective arm of the SGP and so was monetary 2004 2007 policy. is economic slowdown following the dotcom bust that it has been significantly less prominent. discretionary fiscal policy making.0 discretionary measures.5 tightening the euro area Fiscal/Monetary 1.14). -1. The Atlantic. In 1999 fiscal and monetary stimulus package in response to the subprime policies were both mildly pro-cyclical.5 Fiscal There are several rationales for the observed easing/ -2.0 0.5. the thrust of fiscal -0.0 2. This is rooted in a growing scepticism towards the effectiveness of Change in real short-term interest rate Source: European Commission.5 2008 1999 and monetary policy have been well aligned 2003 overall. both the fiscal and the monetary stance increase in defence spending and (ii) tax cuts produced markedly smaller impulses to with primarily an electoral motive rather than aggregate demand than on the other side of the aimed to serve the output stabilisation goal. Fiscal policies were tightened 1.5 2000 2005 Change in CAPB. The same type of errors may real short-term interest rate (deflated by the well turn out to have been repeated at the current annual price increase of GDP).

However. the the macroeconomic outcomes. (2007). rather than an alleged of the subprime crisis clearly being located in the imbalance in the policy mix. When assessing the policy mix it may be worthwhile to recall also that not only are perceptions of the cycle changing over time. the recent US experience also suggests that a stronger housing channel may contribute to a housing bubble and associated financial turbulence. apparently the Fed was to some extent accidental in the case of attaches a lower implicit cost to strong fiscal policy. (2007). while in diverging economic assessments. In a way. However. Sahuc et al. Moreover. It also reflected a sharper serious concern is that the underlying fiscal deterioration of activity and a more benign positions in many participating countries are still inflation environment in the US at the time than not consistent with the goal of sustainable public in the euro area. Whenever fiscal and monetary wages responding more strongly to slack. with the epicentre sustainability risk. as noted. However. (35) The same may hold true finances in the face of ageing (see Part II). (2007) arguing that that role. but also fiscal and monetary authorities may not always share the same real-time assessment of the prevailing cyclical conditions. This point was Europe stronger automatic stabilisers mostly play raised by Balboni et al. (2006) and Christiano et al. the more aggressive monetary policy So. Part I Assessing the first 10 years which automatic stabilisers play a relatively There is indeed frequent anecdotal evidence in minor role. this affected them both and. albeit that this an upturn). 77 . provide stimulus in a downturn (and vice versa in both moved in concert in practice. the initial fears that fiscal and response in the US in the 2001-2003 downturn monetary policies would work against each other cannot only be attributed to a presumed different in EMU turn out to be unfounded. Monetary reaction functions are found to be broadly similar. (35) See Grenouilleau et al. but there is some evidence that US monetary policy has benefited from a more powerful housing transmission channel. with hindsight. thus authorities were misled by wrong perceptions of creating greater leeway for monetary policy to the cycle. different views about the position in the cycle would lead to conflicting policy steps affecting As regards the monetary policy stance. this stronger activism in the US may reflect the does not seem to have been the case in the early greater flexibility of its economy. is the true cost of United States. fluctuations in interest rates than the ECB does. A more reaction pattern. with prices and years if EMU. This again at the current juncture. part of the stimulus the financial press that in the euro area fiscal and package is a surrogate to cope with weak social monetary policy decisions are based on such safety nets during a marked slowdown. The comparative strength of housing investment and private consumption in the US in the latest upswing lends support to this conclusion. the fiscal profligacy in the early years of EMU.

product market competition research.2. This persistent income gap points to final section of this chapter. (37) See Arjona et al.2. structural impediments. (2002) and OECD (2005. INTRODUCTION the need for and progress with structural reform in. 78 . However.2. • If unemployment compensation systems offer Populations are aging fast in the euro area too high benefits and. The role of labour markets in EMU trade. Nominal rigidities institutions and social safety nets that are too (lack of wage and price adjustment) are found to closely knitted. output and productivity in the euro area. As has been discussed in Chapter I. This may in part explain the employment rates and GDP per capita. the euro-area Member States to adjust to The findings suggest that some labour market country-specific disturbances. in particular. comparatively sluggish per capita income growth Specifically: of the area highlighted in Chapter I. reducing job-search intensity and lowering Therefore progress with structural reform is of particular importance for the euro area – as has been acknowledged in the Lisbon Strategy for Growth and Jobs. it appears natural to examine if the actual persisted since the 1970s. the United States.7. respectively. (Chapter II.2 as well as the adjustment worries discussed in Chapter I. up as innovations spread and economic structures what might explain this. This is the focus of the converge. these favourable effects have been The impact of labour market institutions on overshadowed by lack of progress with structural unemployment and employment performance in reform on other fronts such as innovation. thus defying economic pace of progress with structural reforms has theories predicting that lagging economies catch actually increased in EMU. It has had sizeable favourable effects on 6. this chapter first examines 6. thus weighing on the capacity of wages changing labour market conditions by to adjust and public finances to be sustainable. mid-1990s has made use of aggregate indicators of the strictness of labour market arrangements The structural policies that determine the developed by inter alia the OECD and. economies in the world. Arpaia and Mourre (2005). LABOUR MARKET REFORM the single currency has been a major structural change. labour markets and social The euro area is among the most advanced security systems as well and product markets. REFORMS OF SOCIAL SYSTEMS AND LABOUR AND PRODUCT MARKETS Against this backdrop.(37) destabilising “real interest rate channel” (Chapter I. 6. and if it has not. Ten years after the launch of the economy. 2006a).1.1. (36) Most analysis carried out since the and labour market participation.2) and social security systems entitlement of long or indefinite duration.4.10). including structural policy stances in product and labour markets.4). This gap has euro. while pursuing important social slow down the equilibrating “competitiveness objectives. more potential growth rate of the economy largely recently. human Europe has been subject to vast academic capital formation. (including pensions and health care) become they impede the adjustment of real wages to costlier. the creation of 6. the overarching co-ordination framework for structural policies in the EU (see (36) The main results of this research are summarised in Chapter I. yet its per capita income leaving the discussion of financial markets to is around 30% below that of the leading Chapter I. Real rigidities (lack of response of Labour market institutions are often found to production factors such as labour to changing have a negative impact on the adjustment economic conditions) reinforce these nominal capacity of euro-area countries along with their rigidities. can create obstacles to labour market channel” and to reinforce the potentially participation and job creation. incorporated in the Commission's overlap with those that improve the capacity of database on Labour market reforms (LABREF).

These need to be financed and econometric research • Disability programmes offer early labour provides evidence that high labour tax market exit routes. Blanchard and Wolfers levels and cut down the employment (2000). (38) If structural unemployment is high social well designed. (2006).e. the high wedges further reduce labour resource numbers of disabled in several countries have use. and Elmeskov et al. may not sufficiently internalise the spillover effects of wage bargains onto the macroeconomic or the individual firm level. A drawback is that those already in work may reduce their work efforts at pay levels in the phase-out range of the benefits (38) See for instance Bassanini and Duval (2006). prospects for low skilled workers. See Duval (2003). the pace of adjustment in EMU will be across industries and professions. Similarly. hit some countries but not transmission of human capital and innovation others. In-work benefits and tax relief may help to unlock these traps and promote participation for low-paid work. Nunziata (2003). (2005). i. notably if set up (see Chapter I. replacement rates. wake of an adverse shock. These results have the correlation is likely to reflect political economy been confirmed in recent reassessments and updates linkages in the opposite direction. notably for low-productivity workers exit of older workers in the pursuit of low who qualify for social benefits and have very unemployment. Jimeno and wedge between productivity and real pay Rodriguez-Palanzuela (2002). see Immervoll et al. offset these adverse incentives to some extent. underpinned by powerful labour can create unemployment or inactivity financial incentives. Moreover. The Retirement systems also offer early exit interaction of social benefits and taxes on routes to workers. ( ) Blanchard and Wolfers (2000) find that higher Palanzuela (2002) and Elmeskov et al. Rather. (43) If such shocks are Low job turnover also slows down the asymmetric. by reducing job turnover and hiring.(42) workers typically goes along with high unemployment. (1998). Promoting labour market traps. on an industry-by-industry basis (as opposed to nation-wide or company-based bargaining). Part I Assessing the first 10 years the opportunity costs of not working. reported by Bassanini and Duval (2006) and Duval Bassanini and Duval (2006) and OECD (2006b). (41) Euro-area countries also exhibit less to do with their health situation than with higher marginal tax rates on labour and fewer their disability benefit coverage. by an adverse shock. As a result. while expensive. and employment protection legislation (EPL) therefore complicate the trade-offs between such as firing laws both for regular and equity and efficiency policy makers are facing. stricter EPL and a higher tax wedge (39) For cross-country empirical evidence see OECD (2003) lead to significantly persistent high unemployment in the and Bonato and Lusinyan (2004). a fortiori of the below-par activity after an economy has been hit young. Jimeno and Rodriguez. (40) Econometric panel studies generally confirm that tight labour market regulation and extensive • Notably the southern euro-area countries are social safety nets potentially result in high characterised by comparatively strict unemployment and low labour resource use. affected as cross-country differentials in capacity utilisation and inflation rates will tend to persist • Collective wage bargaining. is likely to little financial incentives to enter be ineffective: low participation of older employment. 79 . Nickell or relief. unemployment benefit rates and EPL. Strict EPL They also confirm that these features produce a is deemed to worsen the job prospects of new strong persistence of high unemployment and labour market entrants and. (2005).4). tend to boost public expenditures. 43 et al. temporary employment contracts. minimum wages can drive a (41) See for example Bassanini and Duval (2006). activation policies may help to exclusion entrenched. Daveri and Tabellini (2000). Scarpetta (1996) (40) This finding does not imply causality running from finds a statistically significant effect on persistence from participation of older workers to unemployment. (1998). (42) See OECD (2006c). As a result.(39) hours worked than other countries. as suggested by the experience in the • Some features of labour market institutions Nordic economies.

e. flexible working hours has been eased in most countries. Moreover. low estimated 7. Dismissal just before the launch of the euro in all cases. (2001) and Mourre (2006).2 of this Report. which suggests that • The average tax wedge has fallen in most these groups – rather than prime-age male euro-area countries over the period under workers – have been most affected by labour review. (46) the field of unemployment and other benefits. Most of the labour market flexibility and mobility: increase is attributable to greater participation of female and older workers. adjustment of in-work benefits and 9 means-tested benefits in Germany in 2004). 80 . Unemployment rate NAWRU • Legislation concerning part-time jobs and Source: European Commission. Apparently.2 %. the euro-area countries in the1990s. The impact of labour market reforms Labour market reform has been widespread in As highlighted in Chapter I. the liberalised employment protection legislation employment rate is currently higher than it was for temporary contracts. stricter work availability criteria. Several countries have Looking at the individual Member States. These were geared to increasing activation Graph I.2. NAWRU in the euro area sanctions for repeated non-compliance and 11 control mechanisms) and improving the 10 incentives for labour market participation (e.6. compensation cost has been cut and The increases have generally been stronger than converting temporary into permanent contracts has become easier in some countries.g.1: The unemployment rate and the (e. (44) Tax cuts were mostly targeted on market reform. young and older workers. % 8 Efforts have been undertaken in almost all countries to reinforce the role and means of 7 the public employment services and to boost 6 activation measures.5.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union 6. the lower incomes or specific disadvantaged unemployment rate fell from 10% to an groups such as long-term unemployed. the The main initiatives since the launch of the euro employment rate has risen from 62% in 1998 to have been in the areas of labour taxation. only a whisker away unemployment benefits. being of a structural nature as reflected in an equivalent fall in the estimated NAWRU (Graph • Almost all countries have taken measures in I. annually in terms of hours worked).(45) Accordingly. the rate of unemployment below which wages accelerate. The initiatives to reform labour markets have been numbers of persons employed has increased on more piecemeal or targeted onto relatively small average by almost 1% per year (over ½ % groups of (potential) labour market participants. suggesting that labour market creation.2. econometric studies identifying a structural break in the mid-1990s. improvements 1997 1999 2001 2003 2005 2007 in training have been piecemeal. Labour market reforms since 1999 6. (44) See Chapter I. with budgetary costs justified the benefits. it has not always been clear that the the job-intensity of growth has increased.1). an estimated 68% in 2008. (46) European Commission (2006d) The NAWRU (Non- Accelerating Wage inflation Rate of Unemployment) provides a rough gauge of structural unemployment – i. and this employment growth in the euro area has been appears to have had a noticeable impact on job relatively buoyant.g.3. Over the same period.10). (45) Decressin et al. However. with the bulk of the decline paid.2.6. since the launch of the euro reforms have been delivering results. However. public employment from the official Lisbon target of 70% for the EU services and measures that aim at increasing as a whole (see Chapter I.

0 0. The indicator is calculated as the sum of normalised OECD indicators in four fields (unemployment benefits.6. Part I Assessing the first 10 years those recorded by the EU-15 Member States that Graph I.3 -0. 81 .6. rate stance. Sweden and Denmark). rate falling Empl. Graph I.6. a few countries have bugged this trend. (47) The structural reform indicators shown in these graphs are taken from Duval (2006). Tightening ES and 2008. % seen increasing flexibility of labour markets Source: European Commission.3) – with only Portugal 2008.2: Employment rate by country SE 5 UK IE AT US 80 DK NL DK 3 SE 3 5 7 9 11 13 15 75 DE PT 1998. % 65 IT BE FR As illustrated by Graphs I.3: NAWRU by country do not participate in the euro area (UK. rate 10 IE FI IT NL DE EA 5 BE EL DK AT SE UK FR PT 0 Easing stance. Portugal and Austria scoring unfavourably on some or all of these counts. DE EL FR ES 7 PT BE EA IT FI Graph I. which in most participating countries has shown a sizeable 11 decline (Graph I.6. while the US saw a fall in the 15 employment rate (Graph I. falling Empl. more EL rigidity) is generally associated with rising (or 55 smaller declines of) structural unemployment as 50 well as falling (or smaller increases in) the 50 55 60 65 70 75 80 employment rate.3 Policy stance. US Tightening stance.5.2 -0. employment protection legislation and early retirement incentives). change between averages of 1999-2003 and 1990-1998 Source: European Commission and OECD. A broadly similar 13 picture emerges for the NAWRU. rising Empl.2).4 and I. % 9 registering a sharp increase. combined with rising employment rates and falling structural unemployment rates. % rising Empl.4: Labour market reform and the change in the employment rate Employment rate.1 0.2 0. tax wedges.6. change 15 in the level between 1998 Easing stance. (47) While most countries have 1998.1 0.e.6. % US FI AT UK 70 IE Source: European Commission. rate -5 -0. ES EA 2008.6. with France. a tight 60 stance of labour market policies (i.

0 0. changes in the pension population. sustainability of public finances has become a with the more recent reforms being less far. percentage points 2 NAWRU PT 1 DE AT 0 NL US -1 BE UK EL SE FR -2 EA DK -3 Easing IE Tightening stance. 6. well before the launch of the that reform efforts have slowed down since the single currency. AGEING-RELATED REFORM A majority of euro-area countries have 6.6. Obviously these overall positive outcomes are no aggravate the economic burden on active reason for complacency: employment rates and workers. including low through a number of changes in the pension fertility rates.1. ranging from smaller changes to far-reaching reforms that have changed the entire structure of the pension system (OECD 2007a). rising NAWRU 2008.5: Labour market reform and the change in the NAWRU NAWRU.3 Policy stance. constrain potential growth and living accrual rate. falling IT falling NAWRU -5 NAWRU FI -6 -0. Such reforms have been undertaken including their growth potential. needed. the impose dramatic changes in the size and age pensionable earnings measure and the indexation structure of the population. Since the launch of improvements in labour market performance to the single currency the need to achieve long-term the implementation of reforms during the 1990s.3 -0. expenditure. labour and financial markets preserving the basic structure of the pension functioning. Pensions introduced reforms that reduce the long-term pension promise for individuals and thereby The ageing of populations will have wide. fiscal in existing public pension schemes while sustainability. Econometric pursuit of the Maastricht criteria being the main studies (Mourre 2006) attribute the bulk of the driving force (OECD 2000). Pension promises have been altered wealth. with fiscal consolidation in the launch of the single currency. change between averages of 1999-2003 and 1990-1998 Source: European Commission and OECD. reaching and piecemeal.3.2 0. Common features include increases in the will result in a fall of the working-age statutory retirement age.3. structural unemployment rates still look worse in most euro-area countries than in those of the Reform of pension systems in the euro area comparator group of countries. -4 stance.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I. change in the 4 Tightening Easing stance. and the distribution of income and scheme. changes in the way how the standards and boost future pension expenditure. pensionable wage is calculated (as lifetime Past patterns of early retirement further earnings instead of the last or best years' earnings) and valorised (indexed on overall wage 82 . rising level between 1998 and 3 stance. Demographic trends. These developments rules. increases in life expectancy and the parameters – so-called parametric reforms – such nearing retirement of the baby-boom generation as the retirement age. the replacement rate. contain the increase in future pension ranging effects on euro-area economies. There is evidence started in the 1990s. More progress is The reforms have taken a variety of forms.1 0.2 -0. major motivation for further reform efforts.1 0.

R. In addition. A recent innovation. (48) Notional defined-contribution schemes provide benefits that are based on actual contributions augmented by a notional rate of return. The age beyond the current common 65 years. contribution schemes (Italy in the euro area and Sweden outside the euro area) have introduced These reforms have prompted a sizeable increase built-in mechanism of adjusting the pension level in the employment rate of older workers (aged 55 to the expected period in retirement. Moreover. schemes increased. Germany. but less so in the regarding the statutory retirement age. in most tightened eligibility rules for early retirement. Recent projections completed in rates. Countries with (notional) defined.7 % in the EU- 15 Member States in 1994. (48) to 64). Italy (along with Sweden). Part I Assessing the first 10 years developments) and changes in the indexation of Netherlands. Germany has taken steps in this direction. France will adjust undertaken in Sweden and most new Member the number of the contribution years required for States. aimed at Sweden). As well. pension spending. expenditure. the projected increase in mid-1990s. Many countries have taken measures line with the longer life expectancy. Also Spain and Ireland have pension provisions to statutory fully-funded introduced flexible retirement ages and reward private schemes. several European countries have established particular pension The focus of many reforms has been on scaling reserve funds with the aim of accumulating down early retirement provisions through: (i) reserves for future needs. and (iii) the introduction of actuarially more Rebalancing pension provisions between public neutral adjustment of early or deferred pensions. The scheme and rate of return are notional because the contributions are not actually (49) These simulations were not conducted for the euro area. Such reforms have been for additional years in work. have raised the statutory retirement reduce pressure on public pension provision. However. Partial pre-funding is an essential prices). invested but are used for the funding of current pension Results are expected to be comparable for the euro area. 83 . particular those based on labour market reasons. as well as the United Kingdom and pensions in payment (moving from wage Denmark. and private sectors has also featured prominently More recent reforms have introduced flexibility in pension reforms in the EU. the projected increase in public pension introduced the actuarial principle of matching the expenditure remains substantial in most lifetime contributions to lifetime benefits in their European countries (see Chapter II. the balance between lifetime contributions early 2006 indicated a much smaller increase in and lifetime pensions has become more public spending on pensions compared with transparent and prefunding in public pension similar projections made in 2001. While there has considerable progress towards the Lisbon goal of been some overall increase in the contribution a 50% by 2010. (ii) countries such funds are still small in size phasing out early retirement schemes. to encourage occupational or private Germany. After reaching a low of 35. only a full pension. is the adjustment of the pension index notably in Finland and Luxemburg (as well as in to changes in the dependency ratio. countries with substantial employment rates of older workers will not be occupational pension schemes such as the sufficient to compensate for the increase in life expectancy (Carone et al. while most notable shift has occurred in countries Finland and Portugal have abolished a fixed which have switched a part of their public retirement age. (49) However. This represents method of pension schemes. in relative to future expenditure increases. exceeding 45% in 2006. 2006). These countries have accumulated ensuring a balanced evolution between wages substantial assets to meet the future increased and pensions. The pension reform agenda is clearly unfinished business. Among the euro-area countries. have introduced defined-contribution indexation towards a partial or full indexation of elements. (2005). Muenz. the employment rate Projected increases in pension expenditure have of older workers has shown an unabated forced to review more closely the financing increase. For instance. to bring it euro area. along with Denmark and the United supplementary pension schemes in order to Kingdom. introduced by feature only in a few public pension schemes.4 of this public notional defined-contribution schemes in Report).

factor so far. voluntary health insurance and activity-related This will drive up the demand for long-term care. organising the provision of services better. Accordingly. more user charges. care and some also on public provision of Although the health status of populations has services while others rely on contracted services. the right balance of public and private provision increasing competition among service providers or funding (50). The fastest growing segment of the population is Since the mid-1990s. supply of these services in order to meet the 84 . and Oliveira introduction of performance-related payment Martins 2006).European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union 6. However. Ageing populations has not been a main driving doctor and service fees. is linked to the final years of life rather than to including budget ceilings and target budgets for the age itself (Oxley and MacFarlan 1995. As a result. payments. such as controls of drug prices. 80 years old will have almost tripled by 2050. areas: the improvement of health care systems. Batljan and Lagergreen 2004. although this contribution is likely to be in capital and technology.2. shifts care services via public insurance. although towards greater reliance upon community-based care and a tendency to separate the financing of long-term care from health care and to link it to (50) Comas-Herrera and Wittenberg (eds. but will bring about increases in the hospital beds and facilities as well as investments future. In future. e. the primary concern in Council (2007). macro-economic efficiency and microeconomic Recent measures regarding long-term care efficiency (51). systems and increases in patient's co-payments. to need to consider the right mix of services. Mossialos and LeGrand (1999). there is also budgetary pressures. including in the EU as whole. Reforms factors. spurred by rising living major concern since the mid-1970s and a variety standards and technological developments of reforms have been undertaken aimed at (Häkkinen and Joumard 2007). as well as improving contracting and payment systems. residential and community services. all EU Member States services have included applications of needs- have now achieved universal access to health based eligibility rules. spending on health care per capita has increased faster than GDP per The growth in health expenditure has been a capita in most countries.in to out-of-hospital care. Docteur and most EU countries has been to increase the Oxley (2004). In the mid-1980s the moderate since a large share of health spending emphasis shifted to budget setting mechanisms. These reforms aim i. (51) See. such as a broad and universal coverage between the mid-1970s and mid-1980s of health insurances have facilitated the increase emphasised direct and indirect control in demand for services while costs increased. the focus in particular the increase in female employment -. Many governments are appropriate incentives into the payment and already now confronted with an inadequate services provision system aims at producing supply of long-term care services.e. Building members to formal care. separate public purchasers and providers while including informal. socioeconomic developments -.g. the share of persons over user charges and restrictions for reimbursements. recent health care reforms has been to achieve will shift demand from care provided by family better cost efficiency and effectiveness.) (2003). along with a shift from hospital care In addition. Institutional containing health care expenditure. mechanisms.3. public health care and its sub-sectors. controls of manpower. home and institutional care. and insurers and introducing benchmarking practices as well as modifying financing Health care reforms over the past two to three arrangements to better align the incentives of decades have addressed mainly three broad services providers and patients. improved over past decades. European social services. more value for money while helping to ease while services need to be increased. Health and long-term care disparities remain regarding the coverage of public services and insurance as well as Health and long-term care are particularly regarding the quality of services. reforms have attributed a the group of very old people: in the euro area and greater role to market mechanisms. EU Member important for EMU since its participating States rely heavily on public financing of health countries are generally aging comparatively fast.

even done in view the mediocre productivity though the evidence suggests that the most performance of the euro area. amounting approximately to 1. activity is expanded and employment rates rise – even if employment (52) For a recent analysis of the economic effects of the is adversely affected initially to the extent that Internal Market. especially those that institutions but this is still at an early stage in liberalise entry. indicators of product market functioning.6).4. when the Research suggests that easier regulation of entry euro was launched the agenda of unfinished into product markets has statistically positive business was still vast and more reform was effects on employment (Haefke and Ebell 2004. A mix of services demanded 2003). (2007). underway. forces in product markets may stifle market Accordingly. Progress towards the completion of the single Market contestability puts pressure on firms to market for goods and services has helped boost innovate and favours the turnover of firms by competitive pressures and scale advantages prompting competitive businesses to enter the arising from cross border activities. However. spur investment (Alesina et al. are introduction of the euro led to an increased relatively few and in early phases. Initiatives to introduce cost-sharing changed over the 1990s. as was highlighted innovative firm in a market is usually the in the 2007 issue of the EU Economy Review dominant one.2) as well as to a greater firms from innovating because pressure on profit synchronisation of business cycles across margins would make it difficult to generate the countries (Chapter I. (52) The estimated macroeconomic 6. a hard core of Innovation and technology diffusion have been regulations persists concerning barriers to entry shown to be a particularly important element of in services. resource allocation and productive regulation point to a fall in regulatory efficiency.6. which is a major determinant of competitive pressure on product markets. PRODUCT MARKET REFORM gains from the internal market are sizable. Empirical studies have also found that supporting longer living at home instead in regulatory reforms. Gust and Marquez 2002). and have been found to have adverse impediments to product market competition effects on productivity and growth (Nicoletti and since the late-1990s – with the most regulated Scarpetta 2003). including public or private insurance. Competitive conditions in product markets in the term care should be covered in a special euro-area Member States have considerably insurance. The importance of product market and 1. see Ilzkovitz et al. with more care than cure-intensive services has also raised the question whether the risk of long. countries moving towards the more liberal countries (Graph I. public interventions and technology eased and competition increases. Still more remains to be required funds appear to be unfounded.3). (European Commission 2007a) Regulatory impediments to product market competition have Enhanced product market competition can also been reduced since the mid-1990s in network affect GDP per capita via its impact on labour industries. the link between competition and productivity (Aghion et al. However. evidence that this has contributed to economic Concerns that intense competition would deter growth (Chapter I. growth of those industries. firms earn lower product market rents. and this is reflected in productivity resource use (Blanchard and Giavazzi 2003). Globalisation reform in EMU and the diffusion of information and communication technologies have added to the Regulations that limit the role of competitive competitive pressure on product markets.8 % of EU GDP 6.4. The Single Market mechanisms along the tax financing of long-term Programme and the preparation for the care. and there is market and less competitive ones to exit. openness of economies. 85 .1. mostly in the areas of competition Nicoletti and Scarpetta 2004).4 % of total employment. many countries. 2001. As restrictions are policy. Part I Assessing the first 10 years growing demand for a variety of services needed previous regulations were conducive to over at old age. The trend is to develop services manning.

4. Gains in the euro area can be expected to be in a comparable order of magnitude. (2007) for the results of the latest and transport services. to strengthen competitive pressures in poorly Moreover. although the implementation at the legislation. postal (53) See Ilzkovitz et al. currently no simulation available for the euro area. but account for over 70% of authorities and regulatory bodies have been value added and employment. gains from the single market could be contested markets have led to a multitude of substantially larger if the services market were structural reforms.2. gas.6: Indicators of product market regulation 3 2 1 0 -1 1993 1998 2003 -2 EL IE FR PT IT AT FI EA BE ES SE DE DK NL US UK Source: OECD. There is under way. Competition policies and distribution sector. necessary powers and The impact of opening up competition in the resources to carry out their functions. Ambitions and implementation of Internal Market rules. the adoption of the expanded. including: fully opened up to cross-border competition. Major steps have been taken in the areas of electricity. creation and diffusion. Competitive pressure towards both opening market access and is translating into price falls: since 1996. Further measures are calculations made with the Quest model in the framework of the Internal Market exercise. 86 .6. or prepare to reform certain professional services and trades as well as the retailing 6. In view place in the telecoms sector has increased the of large market shares of incumbent number of market players and reduced the operators. network industries have competitive European regulatory framework in been liberalised since the mid-1990s. regulatory authorities have gained independence. The pro- • As noted earlier. National competition and country level is not completed. Competition policy is crucial for a well- functioning EMU as it helps to make prices more There still remains unfinished business regarding responsive to demand and supply conditions and the deepening of the single market.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I. Many thus facilitates the adjustment to shocks in the countries still have a backlog in the transposition absence of intra-area exchange rates. network industries since the 1990's may serve as an example of what may be achieved. Most countries amended their Services Directive in 2006 represented a notable competition law to align it with European progress. There have been initiatives to reform since. telecommunication. the improving competitive conditions. (53) Since services are responsible for less than 20% • Competences and resources of competition of intra-area trade. including extensions of shop opening hours. reforms have been directed dominance of incumbents. The sections below • Barriers to competition in services have been review the reform initiatives that have been taken eased.

up to carry out more productive activities. state aid and undertaken in several countries. a reduction of 56 ( ) European Commission (2005a). allowed. business.5%. this respect. (59) Simulations with the Worldscan Model yielded an (55) Martin.4. the establishment of focus rightly has been on policy measures to (54) The Copenhagen Economics (2005) study suggests that (58) Progress has been made in Slovenia in 2006 following prices have been 8% lower in 2001 compared to the level the adoption of a programme aiming at introducing better they would have been at without the market opening that drafting of regulations and decision. it 6.6% if it is period at 1. Statutory law. which mainly results from compliance. (54) Airline launched a simplification programme. increase of 1. administrative costs increases GDP by 0.4. According to model increasing spread of on-line government simulations this would yield an increase of GDP services can be considered a useful device in of another 0. some countries have yet to • Corporate tax reforms have aimed at transpose the European rules into national removing or easing distortions.3%.4. (56) Further regulatory reforms in the EU • Efforts have been made to improve the electricity sector are estimated to lead to price efficiency of public administration. Roma and Vansteenkiste (2005). energy institutional body dedicated to better deregulation helped cut the real price of regulation has been created and several have electricity in the euro area by 8%). (59) While the decline in the share of state aids in GDP has been slower than in the 1990s. including taxation.3. in the industry by 19% between 1996 and 2002. For example the long-run public) service provision has been removed effect of a reduction of the administrative in some cases. Similar burden of regulation imposed on experiences have been recorded for other sectors.5 % after five years. 6. boosting labour efficiency as workers undertaking such administrative tasks are freed • Cuts in state aid have been implemented. Research and knowledge building continued to fall in the majority of euro-area countries. including a cut in the Chapter I. 87 . (58) In some countries an For example. The concern for EMU since it inter alia complicates majority of countries pursue a "better the competitiveness channel of adjustment (see regulation" strategy.4) and weighs on potential growth. A number of countries have burdens for businesses by 25% is estimated at taken measures to simplify corporate tax over 1% of GDP. Part I Assessing the first 10 years price of communication services in the euro area systematic impact assessments measuring the has fallen by around 40% in real terms. Impact deregulation not only cut real prices over the assessment of all relevant aspects of new period (the price of promotional fares is legislation is now compulsory in several estimated to have fallen by 30% between 1992 countries and independent bodies have been and 2000 (55) -. Improved public intervention • Public procurement markets have been opened up.but also increased employment set up for this purpose in some cases. With Quest. Public regulation: procurement contracts now represent 16% of GDP. (57) The observed trend decline in productivity growth in Europe has been a matter of policy • Regulatory burdens have been reduced. Measures to simplify rules and A number of reforms have been aimed at increase transparency and thereby reducing market distortions caused by public competition in public procurement have been interventions. between 1996 and 2005. occurred over the 1990-2001 period. The number of laws. The reductions of about 20%. rates of corporate tax have been cut and the tax base broadened. Tax discrimination of There is evidence to suggest large gains from corporate ownership or private (as opposed to these types of actions. However.9 if no (57) It remained approximately constant in Slovenia over this additional market entry is assumed and 1.

(62) Again simulations are only available for EU-15. Most euro-area countries have introduced programmes to facilitate access to risk capital and reduce the bureaucratic and legal obstacles for setting-up new firms. the evidence on the benefits stemming from these reforms is still scant. Almost all Member 6. A databank on product market reforms expenditure have been implemented or (MICREF) is currently under construction. model simulations suggest that higher knowledge via public-private partnerships. THE DETERMINANTS OF STRUCTURAL States achieved to increase the number of REFORM IN EMU scientists and engineers.g.9 %. notably in labour markets (see e. by 2½ to 4½ % even on conservative assumptions. countries aim at improving the diffusion of though. In ex ante terms. but this is been tightened. Some countries have made it easier from the current level of 1. R&D expenditure can lead to a marked for example trough the creation and improvement in economic performance. broadband internet infrastructure. what is the evidence on this • Support for young and small enterprises has issue ten years down the road? been strengthened. National Reform Programmes are supported by Cohesion • Financial incentives for R&D have been Policy Programmes that channel about € 86 created or expanded in all euro-area billion for improving the above mentioned policy countries.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union target investment in research and new Policy Guidelines. (61) If these for smaller companies to access the patent targets are achieved. Some promoted targeted aid to centres of excellence in The single currency was hoped to produce academia or created tax incentives to attract incentives for governments to undertake high-skilled workers from abroad.5. (62) • Measures to upgrade general education have been undertaken in the majority of participating countries. 2002 is available by the Commission at http://ec. Almost all participating mostly of a cyclical character.eu/enterprise/enterprise_policy/charter_d including via the European Commission's irectory/index. single currency itself is likely to have been a Measures included the promotion of ICT use driver of efficiency gains. Implementation Reports of the Broad Economic (61) So far statistics do not show an increase in private R&D. structural reform in the pursuit of market flexibility (see e. But on the other hand in education and training.g. Overall. online government the disappearance of the exchange risk may have services and e-commerce and the build-up of tended to weaken the incentives for reform.htm. As highlighted in Chapter I. (60) strengthened. On balance. Labour • Links between research and business have productivity rebounded in 2006. (60) Comprehensive information on European measures in Product market reforms are closely monitored favour of entrepreneurship and competitiveness until documented by the European authorities. moreover. Calmfors 2001). 88 .8 % of euro-area GDP by 2010 spin-offs. the experiences in the Nordic countries. In development of innovation poles and spring 2006.2.europa. notably in the southern European countries. following the Alternative'). Since 2005. This argument • The use of information and communication has become known as TINA ('There Is No technology (ICT) is stimulated. member countries committed to networks or improvement of innovation country-specific targets for R&D expenditure support services or facilitation of university amounting to 2. Bean 1998). the National Reform Programmes and the promotion of risk capital and education and Commission's Annual Progress Report keep training have been the main policy levers: track of reform efforts in the EU. Support for business start ups. Tax incentives to stimulate R&D lever. the technologies. GDP would be boosted system.

Findings in the literature Elmeskov (2006) see no acceleration of reforms in EMU and Duval (2005) even a slowdown in A number of institutions. but appropriate controls can However. who finds reform pace might have changed over time that euro-area countries implemented more independent from EMU. who note stronger information due to their aggregate nature. since the launch frequency of product market reforms and pension of the Lisbon Strategy. (64) Duval and (63) For a critical evaluation of reform indicators. which may distort the reforms than other OECD countries in both picture unless relevant controls are introduced to 1994-1998 and 1999-2004. of countries. A weakness of these indicators is that and migration. NL.5. i. This differs from the assessment in those that establish them and the loss of Debrun and Annett (2004). to their dependence on the theoretical priors of IT. when the euro was introduced. 2007). composite indicators can be derived. 2005) and of labour market reforms compared to (66) The IMF WEO indicators for product and labour market 1971-1993 (Buti et al.e. there was an increase in the concentrate on the years 2000-2002. 89 .e. (65) Two approaches have been used in the economic literature to assess the impact of EMU on the Assessing the euro area against a control group pace of structural reforms based on these of other OECD countries. see Campos and Horváth (2006). Debrun and Annett compares the pace of reforms in euro-area (2004) for a panel of 17 OECD countries over countries with a control group of countries the period 1975-1998 find that EU Membership outside the euro area. specific on indicators of (65) The difference is likely due to a different method in labour market institutions.6. This may give a biased fostered reforms. (66) has had no statistically significant impact on the pace of overall reforms. which they interpret in that EU picture if the reform needs are different across helped to overcome domestic reform resistance. Part I Assessing the first 10 years 6. they euro (phase III) in 1999. Van Poeck and aggregate indicators. Moreover. have assembled data on reform Bertola and Boeri (2002) detect stronger reform measures (Table I. ES and IT). Commission. country groups. but not in the area of pensions. the weights used to aggregate the rankings of European Commission (2006e) found reform various features of institutions are ad hoc and intensity to have been higher in six countries in uniform across countries. The most commonly used was higher in 1999-2002 than in 1994-1998 in datasets ore the ones constructed by the IMF and the areas of income replacement benefits. EMU comparing the amount of reforms before and countries undertook fewer labour market reforms after 1999. PT). A more nuanced The problem with this approach is that the picture emerges from Duval (2005). compared to the sample reforms compared to 1990-93 (Deroose and Turrini 1999-2002 in European Commission (2006e). than non-EMU countries. numbers of both marginal and substantial reforms. see Ochel (2005) and Arpaia combining marginal and structural reforms in both and Mourre (2005) and Crafts (2006) and Schiantarelli studies. and the Their result is confirmed in ECFIN (2006) using changes in these indicators can be interpreted as the same data source. Most studies combine both statistically significant positive effect on approaches by pooling time series over a sample incentives to conduct labour market reforms. (63) reform effort in only three euro-area countries (DE. but fewer than non- capture these other factors. The first consists in Borghijs (2001) find that in the 1990s. be it positive or negative. including the European reforms in 1999-2004 relative to 1994-1998. reforms were used in this exercise. while EU Membership had a again be introduced. The number of reforms reform activity. Annet (64) When EMU is considered to have begun with the start of and Debrun (2004) weigh substantial reforms three times phase II in 1994. From these sources efforts for non-employment benefits and EPL. rather than with the introduction of the higher than marginal reforms. The second approach euro-area EU countries. being in the ERM with narrow fluctuation bands had a statistically significant negative effect on From the available studies emerges that EMU labour market reforms.1). ES. although with results varying across reform areas and countries. Other criticisms relate the period after 1999 than before (DE. i. EPL the OECD. European Commission (2006e) reports the (2005) of product market indicators.1. FR.

NRPs) address reform EU recommendations to Capital markets priorities MS (partly) Index of product 7 networks 21 OECD contries 1985-2003 market regulation OECD regulation indicators Index of labour 7 policy areas OECD countries 1994-2004 market regulation 5 yr intervals Assessment of 165 countries (123 Frazer indicators of economic 10 policy areas with 1970-2000. pensions. 6. and social Analysis from research Description and Bertelsmann foundation security health care. 2005 backcast to 1995) regulation vintages 2007 Employment Indicators of labour Nickell Nunziata data base protection.4 9.7 1.3 4.6 the policy areas of product markets and labour Implementation score* 1. 2 (in progress) and 3 (complete) (67) Other policy areas covered by the BEPGs were fiscal Source: European Commission. to issue approaches are pursued.1: Reform data Coverage Source Record Special features Areas geographic time EPL.Product market 1.3 6. EU Implementation reports measures that measures that address labour markets. A crosscheck The first approach is to analyse whether euro- area countries fared better or worse than non- The overall picture seems to be that being in or euro-area countries in terms of respecting the out of EMU. .5 1 = limited. From 2000 onwards.2: Every year the European Commission has Recommendations and implementation scores in the Broad Economic Policy Guidelines 2000-2005 assessed progress in the Member countries with EA12 Non-EA Top 3 EA stan.10 for a discussion).5. countries concerned.3 .2 markets coded. countries data trade Source: European Commission. Two proposal by the European Commission.6 1.4 1. 14 EU countries 1985-2005 and structural and foundation reform data base reform events migration direction of reform Pensions.6 0. has not been a stimulus for structural under the Broad Economic Policy Guidelines reform – which is a concern in view of the (BEPGs) – a Treaty-based tool for policy co- stronger reform needs of the euro area. Recommendations on social security. All EU countries 2000-2005 (BEPGs. (Change in methodology tightness of countries for older liberty various sub-indicators annual 1995. upon alternative sets of reform indicators. including pension reforms were included in this exercise as labour-market 90 . Scores are computed in . 0 = none).7 1.6. 20 industrial 1975-20000 structural reforms Nickell/Nunziata product market. Table I. limited). 2 = in progress/partial. Labour 20 OECD countries 1960-1995 market institutions union density Summarises OECD Financial sector.8 15 14.6 0.Labour market 1. the BEPGs therefore useful to crosscheck this finding with provide the basis for the European Council. the implementation of policies to address these control per.5 0.4 1. dard recommendations.Product market 12. policy and in some years capital markets.3 1. tion mainly of qualitative nature.6.7 10 2. recommendations for economic reform in the EU countries (see Chapter I.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Table I.Labour market 10. Though the assessment is group formers devia- (DK. Assessment of Reports on policy product markets. (67) The data set comprises the .7 categories (3 = complete.2 * score encompasses 0 (no measures) via 1 (partial. reforms industrial relations Discontinued.3 4.2. IMW WEO indicators of and labour market.3 5. Description of accessible on DG ECFIN LABREF 8 labour market areas 25 EU countries 2000-2006 reform events ECFIN website Description of 7 product market will be made public in ECFIN MICREF 27 EU countries 2004-2006 reform events areas summer 2008 Public finances. tax. progress with each UK) EU15 recommendation has been classified in four Number of recommendations 22. employment Distinguishes marginal Rodolfo De Benedetti Description of benfits. It appears ordination. institutes located in assessment of 10 EU countries 1997-2004 International reform monitor labour market. SE. or the launch of the single currency recommendations addressed to them by the EU itself.

6. yield a reforms and those on the knowledge-based economy as significantly positive impact of a "small-country product-market reforms.2 compares the that the size of the economy has a positive average scores of the 12 euro-area Member impact on reform scores. to 2002 and multi-annual recommendations however. This yields with membership in EMU remains negative even four observations per country. it is well possible that this effect summarises the results of estimations from is driven by a negative correlation between the number of recommendations and the policy effort devoted to each recommendation. The noted. 69 ( ) Duval and Elmeskov (2006).3 show. which is contradicting States with those of the three countries that have the widely held belief that small countries in the not joined the euro area. 3.005)*** (0.if (68) However. The estimates in Table I.16)*** (0. respectively.12) EMU countries was about one standard deviation 2 R = 0. 1% level. The average score for all 2. that the correlation of structural reform available for the 2003-2005 period. OLS estimate. the analysis does not cover the period BEPGs now form part of the Integrated since the re-launch of the Lisbon Strategy. (68) It needs to be born in mind that.03)** (0. The Guidelines which brings together policy Commission in its recent Strategic Report of recommendations in the areas of December 2007 concluded that considerable macroeconomic.in(GDP in PPS. for example. dummy" on the probability of reforms. the EMU effect is no longer significant in the third estimate.76 Obs. EMU . Individual years with year (0.6. with visible progress "partnership" approach between the Commission made with reforms in key priority areas. The result reported in Table I.4 reform efforts.07 -0.09 -0.6.3 also suggest The upper panel in Table I.03)** (0. Part I Assessing the first 10 years period 2000-2005. The second approach is to check progress with While the latter findings point to a negative reforms based on reform data for a larger impact of EMU Membership on the structural group of industrialised countries. The analysis if controls are introduced for the number of reported in Table I.3: Determinants of structural reform scores based on BEPGs comparison with the three best countries in the euro area in terms of number of Constant No Size EMU 1. higher reform needs.23 Obs.22)*** (0. Average 2000-2003/05 (0. 5. No systematic difference emerges for the three out-countries in Table I.2.22 worse than for the three out countries.02 0. only a slightly smaller score than the three out Source: European Commission.20 recommendations issued. Individual years (0. Moreover. suggesting that to the relatively low scores in the assessment for EMU Member States were considered to have Ireland and Luxembourg.02)*** (0. when it was revised significantly. (69) reviewed.dummy for EMU Member States. size .6.43 -0.*** significance at 10.6. = 60 No .07 0. *.20 panel of Table I.03)** (0. there were more recommendations However.56 -0. For example.**. and is based on a the Lisbon strategy in 2005.Number of recommendations. Over the period euro area are more active reformers. standard errors in brackets.46 -0. the small number of observations and governments have limited political capital and especially the fact that only three countries outside the euro area are included in the panel warrants caution in administrative capacity to reform. their average interpreting the results.08 -0.11)** the score in each of the three out countries is fixed effects 2 higher than the euro-area average.6.2 does not cover the period recommendations and the size of the since the re-launch of the Lisbon Strategy in economy.25)*** (0. = 60 1.6. Table I. countries. = 15 and non-EMU countries are shown in the lower 1. with annual recommendations achievement will decline with the number of and implementation reports available from 2000 targets. Differences in the 1. and national authorities. average 1999- the three best performers in the euro area had 2005). when Greece is considered a non-EMU country before 2002. Such a negative correlation is plausible -.42 Obs. although again R = 0. more detailed analysis suggests that addressed to the average euro-area Member State the significance of the positive coefficient is due than to the average other country.08)** follow up to the recommendations between EMU 2 R = 0. 91 .05 0. microeconomic and progress has been made since the re-launch of employment polices. as 2005.04)** (0.

There is no evidence that this has suggesting that membership in the euro area has occurred. (2005). That is.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union different time periods and indicators established States progressed more in some areas and less in by the Fraser institute. When both CEEC countries and other currency led to less or more progress with OECD countries are included. these disincentives. OECD and Eurostat data do not countries are expected to portray a different replicate the negative impact of the single reform pace than other countries. the estimate does co-ordination may be necessary to overcome not provide evidence of convergence. the OECD and Eurostat. different areas. Euro-area membership has a positive impact on This has been recognised by the European structural reform. Although it is statistically authorities. 92 . which shows a positive correlation between changes in the Fraser index and a fixed exchange rate regime. policy constraints and government changes. In contrast to other weak. and liberty as the aggregate of sub-indicators in 10 no sweeping conclusions can be drawn. the assessment of whether the single dummy. the euro area. Structural reform is largely in the remit of the individual member states of According to the estimates on the basis of the the European Union and. others. the starting with the EU playing a co-ordinating role (see position of regulation has a statistically Part III of this Report). of the cross-country variation in changes of "economic freedom" explained through this Apparently the political incentives to pursue estimate is in some cases very small. is crucial. mechanisms. a further dummy structural reforms depends largely on the data is introduced for the former as transition source used. For all indicators. with varying compositions of control groups. reported in Panel C. OECD regulatory indices (Panel B). is no overwhelming evidence of the "TINA" While the indicator is available for 122 countries. currency emerging from the BEPGs and Fraser indicators. such as the Eurogroup and the insignificant in most cases. see Beach and Kane (2007). the change in the indicator is regressed on its starting position and a euro-area To sum up. show that euro-area Member (70) For a description of the construction of the Index of Economic Freedom. This implies that the significant impact on the pace of product market surveillance of structural reform at the EU level deregulation with the expected negative sign. Obviously. argument that giving up of the exchange rate and the panel was restricted to 36 industrial interest rate instruments in EMU would countries. However. The results in the framework of the Lisbon Strategy. For the aggregate Fraser indicator as spontaneously produce incentives for structural well as for most of the subcomponents shown reform so as to heighten the flexibility of markets below. the share reform needs. (71) The initial level is for example significantly negative in the estimates in Belke et al. especially rigorous reform in EMU are comparatively in the sub-period 2000-2004. and motivated intensified other findings that membership in the euro area surveillance of national policies in the euro area slowed down progress with reforms. openness. (71) the starting position is not participating countries produces adverse spill- significantly (in a statistical sense) negative in over effects onto the area as a whole. this result dismisses European Commission. otherwise the co-ordination would fail. the euro-area variable shows up in the pursuit of alternative adjustment significantly in a statistical sense and negatively. a fortiori. Even so. To the extent that sluggish adjustment in studies. stronger any of the estimates. (70) A high level of the indicator from the findings can be safely inferred that there signals a more lenient stance of structural policy. which is of concern given the sizable slowed down liberalisation. controlling for the starting level. growth. the small size of the Fraser indices describe the degree of economic control groups constitutes a severe handicap. inflation. Their panel consists of 178 countries over the period 1970-2000.

USA. Change in Eurostat structural indicators Period Coverage Euro CEEC Level R2 Tax wedge on low wage earners 2000-2005 REU+6 +* .68 .35 Unemployment trap 2001-2005 REU+5 +* + 0.44 + . Japan. Iceland.17 .Gas + +* 0. Norway.38 . 0. Norway.Post + +* 0.Road . LTU . + 0. the non-EMU group consists of the remaining EU countries plus Australia.Electricity + +* 0.38 Life-long learning 2001-2005 REU+4 .22 GRR -* +* 0.48 + +* 0.Telecom +* +* 0. Switzerland. Part I Assessing the first 10 years Table I. respectively. 0.56 + +* 0.61 .47 -* + . + 0. For the OECD product market indicators. -* + . 0.47 .17 + +* 0.09 EPL (1998-2003) + .02 .19 . Life-long learning is share of participants.40 + +* 0. + 0. South Korea.15 Low wage trap 2001-2005 REU+5 + + 0. Periods are determined by data availability. Japan. 0.04 .Legal system . .Airlines + + 0.23 Level is the initial level in 1995 and 2000. GRR .50 -* +* 0.91 + +* 0. + .39 C. 0. Canada. + +* 0.69 -* +* + 0. Source: European Commission. New Zealand.47 . +* 0. +* 0.means that the factor has a positive/negative impact on deregulation. 0.6. summary measure of benefit entitlements. 93 . 0. Switzerland and the USA.Business regulation -* . i. + 0. 0. EPL .42 LTU (2001-2004) .Labour market regul.net replacement rate of long-term unemployed. Canada.31 + + 0. A +/.4: Determinants of structural reform scores based on alternative sources A. . Mexico.35 -* . For the Fraser indicators. A * indicates significance at 5% level.Government size -* + . 0.30 Average exit age 2001-2005 REU+3 -* . .22 + . +* 0. REU+X means all other countries of the EU-25 plus x non-EU countries.05 . Changes in OECD deregulation indices 1995-2003 2000-2003 Euro CEEC Level R2 Euro CEEC Level R2 Product market. 0.gross replacement rates.79 .01 . the control group are the non-EMU EU-15 countries plus Australia.53 B.28 .employment protection legislation index. .e.12 Spending on education 1995-2001 REU+5 -* -* 0. 0.Rail . New Zealand. Changes in Fraser indicators of economic freedom 1995-2004 2000-2004 Euro CEEC Level R2 Euro CEEC Level R2 Fraser index -* +* .

while quantity-based of the euro eliminated currency risk on the bulk indicators offer more varied evidence. Third. 7. which needs a high degree of financial participants and was facilitated by the integration not only to raise productive potential availability of interconnected systems for real- but also to improve its capacity to adjust in the time settlement of large-value payments in the event of asymmetric shocks. First. cyclical trends in many of the powerful catalyst for financial integration. the Euro Interbank Offered Rate) is a in terms of price and quantity variables. with an emphasis financial integration and development. focusing on the specific role of EMU where appropriate. price-based EMU and the process of financial integration indicators generally suggest that substantial enjoy a symbiotic relationship. the euro has source of much of the progress in financial stimulated both the supply of and the demand for integration over this period. FINANCIAL MARKET INTEGRATION infrastructures and convergence in the regulatory 7. see e. With these shocks. THE IMPACT OF EMU ON FINANCIAL integration. This assessment covers both the progress achieved in 7. to.1). The main finding is that financial The most immediate and extensive impact of integration remains a work in progress for the EMU on financial integration has been felt on the EU and the euro area.(72) While of intra-EU capital flows and on all capital flows EMU and the euro have undoubtedly been at the within the euro area. European Progress in financial integration can be measured Commission (2007e) and ECB (2007e). the impact of EMU on and so raises the efficiency of the EU economy.g. many markets are interest rates on inter-bank deposits and still fragmented and the pace of integration derivative contracts across the euro area varies among Member States. INTRODUCTION and supervisory environment. and in part owing derivatives.(73) This rapid an opportunity cost for the EU economy. advances in technology and currency environment provides scope for deeper innovation. relevant variables may obscure or distort Meanwhile. Almost from the outset of EMU. several caveats cross-border financial services and so acted as a apply. as well as the remaining priorities for MARKETS action in moving the process of integration forward. The remaining converged fully on the benchmark Euribor and fragmentation in EU financial markets represents Eonia rates (Graph I. SOME MEASUREMENT CAVEATS integration is notably performed by the European Commission and the ECB.1. competition and Overnight Index Average) is an effective overnight rate computed as a weighted average of all overnight consolidation among intermediaries and unsecured lending transactions in the interbank market. 73 ( ) Euribor (i. caveats in mind. intermediaries This chapter assesses the impact of EMU on and infrastructures in the EU. even more so because a single. This convergence reflected early acceptance of the opportunity cost is even greater for the euro-area single monetary policy among market economy. The introduction progress has been made. 94 . Second. which composite of interest rates provided by about 50 reflect inter alia the effects of diversification in European and international banks. integration cannot be easily isolated from global The euro-area economy benefits from these factors such as liberalisation of capital flows.2. efficiency gains. the integration of Member-State evidence of underlying structural changes linked financial markets fosters financial development to integration. deregulation. In considering EU financial integration since 1999. the integration of product markets and economy benefits from integrated financial competition policy) may also have played a role markets as a channel for managing asymmetric in promoting financial integration. (72) Regular analysis on the progress of European financial 7. In addition.3. progress in financial integration is reviewed for the main markets. While integration has euro-area markets for unsecured money and progressed substantially since.e. the euro-area (e. other EU-specific factors financial integration. on trends in the main markets and among the main intermediaries and infrastructures.g.7. Eonia (Euro investor portfolios. In this way. the introduction of the euro.

while a more extensive Source: European Commission. there was a underlying cash securities (see discussion of process of sustained convergence in yields on euro-area government bond markets below). while smaller banks exchange deposits for further efforts in integrating these markets. such as the increasingly Asia. the markets for euro. single. the euro-area interbank ongoing international financial turmoil have market has acquired a two-tier structure in which highlighted the importance of access to efficient larger banks exchange deposits on a cross-border collateralised money markets and suggest a need basis.7. significantly beyond the size implied by the which are important not only as a source of legacy currencies. This convergence in yields denominated derivatives markets takes place reflected the elimination of currency risk implied outside of the euro area in London. by the introduction of the euro. segmentation in these markets was platform) TARGET2.1: Evolution of 3-months interbank and liquidity risk. Over time. which has recently been national borders. annual data) of a substantially homogenous euro-denominated 26 government bond market in 1999. 95 . as well as the private repo the integrated government bond market. Quantity-based 1990 1992 1994 1996 1998 2000 2002 2004 2006 indicators of the distribution of government BE DE GR ES FR IR IT bonds confirm significant cross-border holdings NL AT PT FN LU SI within the euro area. Favero and Missale (2003) and Favero and settlement Express Transfer system. commercial paper and outside of the euro area have also benefited from certificates of deposit. Part I Assessing the first 10 years form of TARGET (74). so issuance denominated in euro.7. the vast bulk of activity in euro. level but also the absence of liquidity in Well ahead of the launch of EMU. so that residual yield spreads progressively reflected only credit Graph I. bonds issued by the euro-area Member States Interestingly.e. Government debt issuers from markets for T-bills. Meanwhile. notably to the United States and money markets within the euro area. (Graph I. the recently acceded Member States frameworks and continued fragmentation in have been able to exploit a broader investor base national clearing and settlement infrastructures and comparably low financing costs by (see discussion below) hinders the cross-border complementing their domestic issuance with movement of collateral within these markets. However. National differences in legal and tax particular. The successful integration not considered to be a major opportunity cost for of these unsecured markets was crucial to the euro-area economy so long as the interbank establishing ECB credibility in the very early market functioned smoothly. inefficiency.2). Although a source of replaced by the more integrated (i. the period of EMU and has provided the basis for a liquidity problems experienced in the euro-area smooth-functioning single monetary policy inter-bank market since August 2007 amid the thereafter. EMU also had a very substantial impact on the denominated derivatives have expanded integration of the market for government bonds. with these larger banks within national boundaries.(75) The result was the creation rates (in %. that they have remained more segmented along (74) The Trans-European Automated Real-time Gross (75) See Codogno. This 10 market is now comparable in size – both in terms of issuance flows and outstanding amounts – to 6 the other major government bond markets in the 2 United States and Japan. In market. partly reflecting an explosive government financing but also in providing growth trend in such instruments on a global reference pricing for other financial instruments. where the 22 various national issues of similar maturity now 18 trade as close substitutes with yield spreads 14 typically below 50 basis points in all cases. Giavazzi (2008). participation of large international banks as primary dealers has facilitated global Integration has been less complete in secured distribution.

The availability of an integrated cash market for The impact of EMU on integration of equity government bonds in the euro area has spurred markets has been less pronounced than in other the development of markets for other related markets. The number and type of issuers of opportunities for portfolio diversification and a non-government bonds in the euro area have shift from county selection to sector selection in gradually expanded. in the period 1999-2006 (Graph I.(77) Price-based evidence issuers. global participation since the mid-1990s (despite the episodes of M&A. 2008). the non-government volatility in equity markets within the euro area segments remain relatively under-developed. a number of EU directives removing currency risk and more indirectly via higher barriers to international equity investment.(78) (76) See De Bondt and Lichtenberger(2003) and Biais et al. Empirical analysis (76) suggests developments. several (Graph I. While the amount of their greater heterogeneity as an asset class and gross issuance of government bonds in the euro the fact that they are issued under often very area has not changed significantly since 1999.7. (2006) (78) See ECB (2007a.200 14 1.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I. Source: European Commission.3: Gross issuance of euro denominated yields (in percent. asset-backed securities and a range of risk – to cross-border trading in equities.7. 96 . which facilitate equity-market that the expansion in these market segments can integration. This reduced impact reflects the asset classes.g. particularly since the introduction of the euro.3).600 1.7. This when compared to the corresponding segments in evolution suggests that equity-market integration the US market. in the euro area has proceeded faster than at the global level. securitisation trends etc). due to derivative instruments.2: Evolution of 10-year government bond Graph I.800 22 1. have been identified. (2004).4). but correction of 2000).7. These obstacles issuance of these non-government bonds has are even more evident in market for post-trading expanded significantly over the period services (see below). annual data) bonds since 1999 (in EUR bn) 26 1. such as corporate bonds. covered significance of obstacles – other than currency bonds. The typical size of issuance has also of an EMU effect on integration can be found in increased.000 800 10 600 6 400 200 2 0 1990 1992 1994 1996 1998 2000 2002 2004 2006 1999 2000 2001 2002 2003 2004 2005 2006 Agencies Supranationals BE DE IE GR ES FR IT Central Government Local Government NL AT PT FN LU SI Financials Pfandbriefe/ Covered Bonds Asset-Backed Securities Corporates Source: European Commission. a reallocation of investment the euro is found to have affected corporate-bond toward equity markets as interest rates converged issuance both directly through the elimination of downward.400 18 1. economic growth. (77) See Baele et al. Nevertheless. different national company laws. including a be attributed to a range of economic and substantial increase in equity-market technical factors (e. the financing needs due to euro-related corporate growth in investment funds offering enhanced restructuring. including a small but international asset allocation linked to the growing cohort of below-investment grade introduction of the euro. confirming the growing maturity of a significantly higher weight of euro-area shocks these market segments in terms of liquidity and relative to global shocks in explaining price depth Nevertheless.

Evidence on equity 15 retail payment systems but only one of these market holdings between 2001 and 2004 operates on a cross-border basis (Graph I. Currently. Consolidation in financial-market infrastructure since 1999 has been driven both directly and On the trading side. The most obvious direct integration/consolidation has been the merger of impact of EMU has been on payments systems.30 0. with cross-border will be phased into operation between 2008 and listings still relatively unusual in the EU. already indicated.5). consolidation in securities-market infrastructure MARKET INFRASTRUCTURES in the EU since 1999. There has been considerable integration and 7.4: Euro area and US shock spillover intensity in the equity market value payment systems of the participating Member States and has now been replaced by the 0. which linked the large- Graph I. The project the behaviour of issuers.10 France. (80) See ECB (2007a.(81) suggests that home bias in EU Member States Efforts to integrate these systems have been declined from 80% to 60% on average over the concentrated in the SEPA (Single European period. the Paris. large volume securities transactions and the foreign-exchange markets in the euro The impact of EMU on equity market behaviour area. retail payment systems (which cater bias” and a re-orientation of asset managers’ only for small value payments) in the euro area investment strategies towards a more euro-based remain much less integrated.40 single TARGET2 platform.7. 97 . which is a global system in which the 0. Brussels and Amsterdam stock where the introduction of the euro necessitated exchanges to become Euronext in 2000 (Graph integrated systems with area-wide coverage. PNS operated by the Banque de 0. In addition to 0. operations. POPS operated by the Bank of Finland 0.7. THE IMPACT OF EMU ON FINANCIAL.2006 These large value payments systems are crucial Euro area shocks US shocks to the smooth functioning of monetary policy Source: ECB integration indicators. SEPA will allow residents almost doubled their holdings of equity customers to make non-cash euro payments to issued in another euro-area country (as a share of any beneficiary located anywhere in the euro their total portfolio of shares issued in their own area using a single bank account and a single set country and elsewhere in the euro area) to reach of payment instruments. 2010.7.15 Association. SEPA is run by the euro-area and increased only slightly. the rapid integration of unsecured money markets in the euro area was facilitated by the prior establishment of the (79) See Delgado (2006). whereas the share of euro area equity assets in euro will become essentially domestic held outside the euro area remains much lower transactions. operated by the European Banking Association. there are or EU-based approach.6). there is less evidence of a euro impact on consultation with other stakeholders. with some overall reduction in “home In contrast. several other large-value payments 0.35 TARGET. (81) The only cross-border retail payments system is STEP2. appears to have been strongest at the level of the investor.(79) Between 1997 and 2006. Part I Assessing the first 10 years ECB’s TARGET system. 1973-1985 1986-1991 1992-1998 1999. As I.00 ECB acts as operating agent for euro payments. euro-area Payments Area) project. including 0. so that retail payments 29%.25 systems now operate in the euro area.20 EURO 1 operated by the European Banking 0.4. but there is no discernible pattern linked specifically to EMU. the most notable example of indirectly by EMU.(80) On the other banking industry and is being implemented in hand. 2008).05 and CLS.

Other examples Number of Central Counterparties (CCPs) of integration/consolidation have also involved Source: ECB integration indicators. the merger attempt consolidation in securities trading infrastructure 98 . while the most notable 2% Euronext Other Europe example of horizontal integration/consolidation 6% 2% is Euroclear. Euronext soon expanded to include the 0 London-based Liffe derivatives exchange in 1998 2000 2002 2004 2006 2001 before expanding once more to include the Number of Central Securities Depositories (CSDs) Lisbon stock exchange in 2002. However.7. horizontal integration of Source: ECB integration indicators. which was formed in 2003 and integration/consolidation that has. In outside of the euro area altogether (the creation this way. exchange in 2005). 15 10 There has also been integration/consolidation in post-trading infrastructure in the EU. Belgium. the link between the Milan directly linked to EMU. been combines seven stock exchanges across mainly driven by attempts to exploit economies Scandinavia and the Baltic countries and the of scale amid more global phenomena such as failed OMX takeover of the London stock increased capital flows. however. but again 5 no EMU-related pattern is discernible (Graph 0 I.7. EMU can be seen as a catalyst for of OMX.7: Consolidation of post-trading 3% Africa-Middle Nasdaq East infrastructures in the euro area 17% NYSE 1% 32% 25 20 Source: World Federation of Exchanges 2007. The prospect of a mega stock more intense competition among traditional and exchange for the euro area emerged briefly in non-traditional service providers etc. it is clear that the and London stock exchanges and the failed creation of a single-currency environment in the merger attempt between the London stock euro area triggered a critical mass of demand for exchange and Deutsche Boerse) or have occurred cross-border trading in equities (see above). the links between the Vienna stock While the pattern of integration/consolidation in exchange and various exchanges in central and EU securities market infrastructure cannot be south-eastern Europe.6: Market share of global stock trading.5: Number of payment systems in failed when Euronext shareholders opted to the euro area merge with the New York stock exchange 20 instead.7. clearing and settlement functionalities respectively and the vertical integration of Graph I. which is constructing a single LSE settlement platform for France.7. Progress in integration/consolidation has 1998 2000 2002 2004 2006 been impeded by the existence of competing Retail Payment Systems models. the Tokyo 11% 8% Netherlands and the United Kingdom.g.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I. clearing and settlement functionalities in exchanges in 2006 (by turnover) silos.7). The most notable examples of vertical Deutsche Spanish Exchanges Borsa Italiana consolidation are Deutsche Boerse and Börse 4% 3% 2% OMX Clearstream Frankfurt. both euro-area and non-euro-area infrastructures (e. reflecting a growing trend toward global integration in equity trading. 15 10 5 While each of these exchanges was located in the euro area. technological advances. including the multilateral linkage of Large-value payment systems existing national CSDs. Other Asia Other 9% Americas Graph I. This global 2006 with the proposed merger of Euronext and aspect is confirmed by similar integration/ Deutsche Boerse.

euro-area banks. Among the more notable may have been tacit support among national examples is the merger of UK-based Abbey authorities for the idea of creating national National with Banco Santander of Spain in 2005.7. First. 99 . concentration ratios 40% within the domestic banking systems of euro- 20% area Member States have mostly slightly 0% increased over recent years (Graphs I.9: Value of M&A deals performed exclusively within national borders. it has been Second. the 2002 2006 outcome was not as expected. Scandinavia and the Baltic countries. Banco Santander and Belgian- all of these factors played a significant role in the based Fortis Bank in 2007. reached levels that might impinge on competition. as a means to limit the possibility the acquisition of the Netherlands-based ABN that substantial parts of their domestic banking AMRO by a consortium of the UK-based Royal systems could become foreign-owned. as 80% a number of bancassurance groups came into 60% existence. the Benelux currency risk and relating to regulation. Whether Bank of Scotland.g.7. there has been desire to acquire sufficient size at the domestic renewed merger and acquisition activity level before venturing into mergers and/or involving banks from the more established EU acquisitions at the euro-area level. Accordingly. Finally. Annual share of cross-border M&A in non-EU countries Annual share of cross-border M&A within the EU Various factors have been cited in explaining the Annual share of domestic M&A preference for domestic consolidation among Source: Zephyr. but their cumulative effect consolidation reflects the extent to which was to limit integration/consolidation among concentration in domestic banking systems has euro-area banks.7. there by EU banks were more examples of cross-sector 100% consolidation than cross-border consolidation. Indeed.8: Concentration in the euro area States. countries) or has crossed euro-area boundaries labour laws and cultural factors – made the (e. Cross-border retail Source: ECB Report on EU banking structures (2007b). been evident among euro-area banks. business case for cross-border consolidation Austria and the countries of central and south- relatively less convincing. there Member States. the existence of barriers – other than concentrated in specific regions (e. taxation.7. It has been suggested nature of banking consolidation in the early years that this more recent pick-up in cross-border of EMU is unclear. Part I Assessing the first 10 years outside of the euro area and notably in the United Graph I. see ECB (2007c). Bureau van Dijk and ECB calculations.8 and Average 2000-2004 Average 2005-2007H1 I. banking remains rather limited within the euro area. the desired scale and scope economies could be exploited at lower cost To the extent that integration/consolidation has and lower risk within domestic banking systems.9). Meanwhile the initial wave of consolidation in the euro-area banking sector occurred almost Graph I. More recently. there was a eastern Europe). THE IMPACT OF EMU ON THE BANKING 70 60 SECTOR 50 40 One of the more anticipated effects of EMU on 30 the euro-area financial sector was a rapid growth 20 in cross-border retail banking and a wave of 10 0 cross-border consolidation among banks at both BE DE GR ES FR IE IT LU NL AT PT SI FI EU12 wholesale and retail levels. champions.5. However.g. Third. banking sector (CR5 ratio) 90 80 7.

the average share 0% 2001 2006 2001 2006 2001 2006 of branches and subsidiaries from other EU-15 NMS EU-25 EU countries in total domestic banking assets has Domestic credit institutions increased from 20.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union A growing cross-border presence among euro. Graph I. 100 .7. 100% area banks on cross-border basis remains 80% relatively low. the inadequacies in the prudential framework and results support the dominance of the transaction crisis management procedures at the EU level. States. present in at least 25% (i. Between 2001 and 2006. While the share of assets held by euro. recent analysis of the bilateral foreign than 68% of the total assets of the EU banking assets and liabilities of banks suggest a clear sector. The next survey with 2007 figures is forthcoming.10: Average share of foreign area banks is also evident in the evolution of establishments (in total domestic banking their branch and subsidiary structures (Graph assets) I.4 % to 62.7. which was conducted for the years 2001. The result is less robust for bank foreign from pan EU financial markets in which they liabilities. particularly if inconsistencies in foreign liabilities.(83) Using BIS data for banks multi-jurisdictional environment and often on a in the OECD countries during the periods 1995– basis where their operational and legal structures 1998 and 1999–2005. while the respective figure Source: ECB (2007c). 16 groups could be labelled the “key cross-border players” in the EU: they hold at least 25% of their EU assets outside their home country and were (82) See ECB (2007c). The result for bank foreign national prudential frameworks imply assets is found to be robust against the inclusion duplication in reporting or inefficient use of of different sets of explanatory variables.(85) These cross-border banks operate in a euro-related effect. (82) There are now 46 EU banking groups – from a total of 8. After a slow start. This effect is stronger and more important deadweight costs for these cross- robust for banks' foreign assets than for their border banks. See ECB (2007c).6 % for the "old" Branches from other EU countries Subsidiaries from other EU countries EU Member States. (84) These figures refer to the ESCB Banking Supervision Committee’s (BSC) biannual survey of banking groups with significant cross-border activity.5 % to 26. In terms of the potentially offsetting operate.10).000 banks – with significant holdings While there is no discernible pattern related to of cross-border assets and liabilities. Given the potential for inefficiency and effects of lower transaction costs and reduced systemic stability risk relating to any diversification potential inside the euro area. Moreover. (85) Of these banks. 2003 and 2005.4 %. Branches and subsidaries from other countries for the "new" Member States increased from 50. capital. The need to interact with impact of the euro on bilateral financial linkages multiple national supervisors can create has been found. it has been rising in recent years with more assets held in their subsidiaries than in 60% their branches. six) of the other 24 Member (83) See Blank and Buch (2007).(84) EMU in the merger and acquisition activity of However. in particular for banks' foreign there is a crucial need to ensure adequate co- assets. a positive and significant diverge significantly. management and resolution. operation among national supervisors in crisis prevention.e. the pace of 40% cross-border integration and consolidation in the 20% EU banking system has accelerated in recent years. these cross-border banks hold more banks. costs effect. the cross-border banks have although it is smaller – but still significant – corresponding cross-border exposures and are when restricting the sample to the EU countries likely to share common exposures to shocks only.

Part I Assessing the first 10 years 7. A greater concern is the protection laws that have proven very difficult to number of national discretions that have been harmonise even in minor respects.europa.(86) While the focus of the FSAP may resulted in a degree of “regulatory fatigue”. (87) progress in market integration at the wholesale level.htm the latter spurs growth and investment. the legislation agreed at EU level become excessive in the process of national transposition. and how ndex_en. barriers linked either to national differences in promoting investor confidence and market regulation. where there is a need States are now in the process of transposing the to transfer ownership of securities across national legislative measures into national law. The wholesale market segments most The FSAP was almost fully implemented at EU affected by such barriers are those involving level by the 2005 deadline and the Member collateralised transactions.6.1). establishing common rules for integrated In reviewing progress in financial integration securities and derivatives markets (the Market in since 1999. ensuring legal the existence of common definitions. In appear somewhat scattered. more fundamental barriers transposition vary by measure and by Member can explain the generally slow pace of State. The original financial services policy (see section 4. the elimination of currency Collateral Arrangements). taxation and legal frameworks or to integrity (Directive on Market Manipulation) and more fundamental factors such as distance. applying to a wide range of Implementation of the FSAP has implied a major financial activities at both wholesale and retail effort from financial-market participants and has levels. For this reason. it is evident that integration is more Financial Instruments Directive). Meanwhile. certainty in the cross-border use of collateral (the conventions and infrastructures. In the other Directives on Settlement Finality and Financial market segments. but it is clear that substantial progress has integration in retail market segments. PROMOTING FURTHER FINANCIAL national clearing and settlement systems INTEGRATION IN EMU (Communications on clearing and settlement). these tendency for Member States to over-implement remaining barriers have become the priority for measures (i. facilitating the advanced in those market segments where the raising of capital on an EU-wide basis (the impact of the euro has been accommodated by Directive on Prospectuses). The launch of the FSAP integrated EU financial market. promoting the creation of a Single Payments culture and language. If deviations from action at both the EU and national levels. the main measures following on from the FSAP. gold-plating). 101 . With the retained within the legislative measures and the impact of the euro now largely exhausted. the Commission can clearly be aligned with the main functions of White Paper on Financial services policy 2005- a modern and developed financial system – for 2010 has avoided another a large-scale example by improving the inter-operability of regulatory programme and focuses on implementation and enforcement of existing (86) For further information on the FSAP. The first set of barriers is Market Capital (the Directive on Payments more relevant in explaining differential rates of services in the internal market). setting common risk implied by the euro has spurred integration standards for financial reporting (the Regulation but has also revealed the significance of other on International Accounting Standards).eu/internal_market/finances/actionplan/i regulatory reform led to financial integration. Rates of borders.e. The main blueprint for creating a common there is an obvious risk that the common regulatory framework for the EU financial sector regulatory framework provided by the FSAP will has been the Financial Services Action Plan not be sufficiently effective in promoting an (FSAP) 1999-2005. where been made in putting a common regulatory national preferences are reflected in consumer framework in place. coincided with the third stage of EMU and the timely and consistent implementation of the launch of the euro and so reinforced the impetus FSAP has become a main priority in EU for financial integration in the EU. including a full list of measures and their transposition by Member States see: (87) See Jappelli and Pagano (2008) for a discussion of how http://ec. FSAP comprises 42 legislative and non- legislative measures.

2). while firms based in late- environment. 102 . to risk management. personal dealing have transposed the MiFID by early 2008. 2) clients. Some effects related to the • Implementation of the Market in Financial MiFID are already evident. integrity. A range of new Instruments Directive (MiFID) trading venues and services have already been announced. border competition among service providers significant progress in integration in this market based on high levels of market transparency and segment is essential to the success of MiFID. more in line with the functioning of a modern financial which advises the European Commission on matters system. outsourcing and conflicts of the Commission will need to monitor this interest. despite the threat of litigation in elements of the MiFID are strengthened rights the European Court of Justice and “name-and- for investment firms in providing services across shame” efforts by the Commission. (89) The MiFID replaces the Investment Services Directive of (90) The Giovannini Group is a group of capital-market 1993. relating to financial integration. A set of conduct-of-business rules will situation in the context of broader efforts to also apply to investment firms. and to the provision of inducements among firms • Integration of clearing and settlement and transaction reporting. relating mainly to ensure timely and consistent implementation of the provision of information and advice to the FSAP measures (see Chapter III. In these ways. The MiFID will also act significant cost differentials between the clearing as a catalyst for innovation and structural change and settlement of cross-border and domestic (88) See European Commission (2005b). All Member States are expected to inter alia.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union regulation and on delivering targeted in EU securities markets. the quality of existing services is The MiFID. under the chairmanship of Alberto Giovannini. the MiFID will increase a focus of policy with the publication of two trading volumes and information flows and so reports by the Giovannini Group in 2001 and facilitates the emergence of larger and more 2003 respectively.(88) The targeted the MiFID will further promote financial improvements in the existing frameworks are integration. notably by making full improvements in the existing regulatory and electronic trading more attractive. Accordingly. to the (best) execution of client orders. Securities exchanges industry and equivalent service providers are required to provide greater price transparency.e. competition between securities exchanges and CESR has stated that investment firms must be other non-exchange providers of equivalent allowed to operate freely in late-transposing services. not only raising the efficiency of designed to help in closing the remaining gaps in securities markets but also increasing the the process of financial integration. Fragmentation in the EU market for post-trading services (i.(90) These reports highlighted liquid capital markets. but by employees. supervisory frameworks. Within this new more competitive Member States. investment firms must comply with transposing Member States will have transitional a range of organisational requirements relating. extending its coverage and bringing its provisions experts. is a cornerstone of the EU consolidation among exchanges is underway. not all of the the EU (based on a single authorisation process Member States have managed to meet the and high levels of home-state control) and free deadline of 1 November 2007.1 and 3. By lowering costs for issuers of and The EU clearing and settlement industry became investor in securities. Among the possibilities for portfolio diversification and risk priority areas identified in the White Paper that sharing in the relevant markets – both of which are particularly relevant for EMU are: effects are specifically relevant for EMU (see sections 3. particularly the market for equities.(89) The key challenge and. which came into effect on being improved and a further wave of 1 November 2007. clearing and settlement) limits The MiFID is expected to transform the structure progress in integrating securities markets and of EU securities markets by encouraging cross. arrangements. With this in mind. financial integration process and establishes a common regulatory framework for financial Implementation of the MiFID is a significant trading and intermediation in the EU.

7. Efficient and integrated mortgage MiFID at the trading level. Outstanding (91) European Commission (2007f) 103 . housing equity withdrawal. The removal of the so-called Netherlands. A further driver credit. the EU clearing and settlement industry that although there are wide variations across relate to national differences in technical Member States (ranging from less than 20% of specifications.2).11). see Graph I. access/ opportunities for income smoothing and interoperability and unbundling of services/ improvements in monetary policy transmission segregation of accounts) and by the (possible) (see Chapter III. by agreement on markets can also be expected to support a industry-sponsored code of conduct (covering smoother functioning of EMU via wider price transparency/comparability. financial system at both the wholesale and the retail level and impact positively on Progress in integrating/consolidating the EU macroeconomic performance via implications for clearing and settlement infrastructure is also re-financing. market practices. Efficient Giovannini barriers is seen as a prerequisite for mortgage markets are central to a modern efficient integration/consolidation. the main rationale for the project is to stakeholders and based on cost-benefit provide a more efficient settlement infrastructure analysis. Part I Assessing the first 10 years Graph I. is the creation of TARGET2-Securities mortgage credit markets.7. • Integration of retail markets for mortgages EU mortgage markets have been identified as another priority for action. increasing diversity. In December 2007. the adoption of common regulatory standards Commission's White Paper on Mortgage Credit proposed by the European system of central Markets highlighted importance of facilitating to banks (ESCB) and the Committee of European cross-border funding and supply of mortgage Securities Regulators (CESR).(91) for the euro area. securities transactions. These cost differentials residential mortgage credits represented close to were linked to a set of barriers to integration in 50% of GDP in both the EU and the euro area. presented a range of policy options that will be While the platform will provide multi-currency further developed in close cooperation with all services. improving consumer of integration/consolidation in the EU clearing confidence. reverse being driven by the implementation of the mortgages etc. which is more euro-area for the competitiveness and efficiency of EU specific. taxation and GDP in Italy to nearly 120% of GDP in the legal frameworks. and facilitating customer mobility and settlement industry.11: Residential mortgage credit outstanding in 2005 (in % of GDP) 140% 120% 100% 80% 60% 40% 20% 0% EE MA ES IE HU GR FR PL EU25 MU12 CZ LT IT PT SI SK CY LV BE DE SE UK DK LU NL AT FI Source: European Mortgage Federation (EMF). The White Paper (T2S) as single settlement platform by the ECB.

which will eliminate differences in Member State is responsible for the management the euro area between national and cross-border of its own public finances. 104 .European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union • Creation of a Single Market for Payments bond market. On the basis of both economic and market measures. and secure as domestic payments within a Member State Fragmentation in the supply of euro- payments to become more quickly and easily denominated government bonds reflects the throughout the whole EU. efficient. Recent starting 1 January 2008. However. The SEPA is a natural and management of public debt. which are recently (Graph I. On integrated payment market which would enable closer inspection. (2006) and Persaud (2006). As the functioning of the even though the spread of euro-area sovereign internal market is still impeded by fragmented issuers over German bonds has again increased nationally based payment systems. Graph I. complement to the use of the euro as a single fragmentation in supply has meant that the euro- currency and is strongly supported by the denominated government bond market cannot Eurosystem. to become as easy. It is expected that banks will be able compete with the corresponding US and to make the first SEPA products available Japanese markets in terms of liquidity. direct debit and card payments – particularly from the supply side.12: Euro area government bond spread over Bunds BE 10-year yield spreads in basis points ES 50 FR 40 IE 30 IT 20 NL 10 AT PT 0 FI -10 GR Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Source: Bloomberg. relevance to EMU. These studies have argued for One area of importance for EMU. and are aiming to make studies (92) have highlighted the inefficiency SEPA a reality for everyone by the end of 2010. where there is a directive provides the legal foundation to make single monetary policy but responsibility for the Single Euro Payments Area (SEPA) possible. this market can be classified as Improving the efficiency of retail payments is a highly integrated. it is clear that the electronic payment within the EU – in particular market could be more efficiently integrated – credit transfer. Each The SEPA. implied by this market fragmentation. The national issues are well diversified across euro- Directive on payment services in the internal area investors and this large euro-area investor market establishes the modern and harmonised base allows national issues to be bought and sold legal framework necessary for the creation of an without significantly interfering with price. is improved functioning of the euro-denominated government (92) See Dunne et al. citing as evidence relatively low levels of turnover in the • Improved functioning of euro-denominated cash market and the migration of liquidity to the government bond markets derivatives markets based predominantly on the German bund. In doing so. which was not identified in the White Paper.7. Holdings of different estimated to cost around 2–3 % of GDP.7. this unique construction of EMU. including the issuance retail payments. fiscal policy remains at the national level.12). The price of the various further priority in delivering the benefits of different national issues has been highly financial integration and is of particular convergent since the introduction of the euro. however.

for pricing other higher risk assets. Part I Assessing the first 10 years further reforms to improve the functioning of the An efficient and liquid government bond market market via changes in trading arrangements and is also important in making the euro area an issuance practices. efficiency of the euro-area government bond providing a risk-free asset class and a benchmark market (See Chapter III. it is essential to is essential in providing the euro area with a address any remaining shortcomings in the modern and developed financial system. facilitating the financial system in performing its essential functions of allocating resources. For these reasons.2). intermediating savings to investment and managing risks. 105 . In this way. attractive location for investment and in allowing the euro to play the role of international An efficient and liquid government bond market currency. it provides the basis for a diversified financial structure.

84. EMU. have shortened the processes in several of these countries. 106 . At reductions in risk premia. with Portugal the 1999 GDP per capita (GDPpc) levels in being notable exception. of capital. 77. Among the countries the catching-up process in EMU. The successful Greece. Greece and Portugal. elaborate comparison of the cases of Spain and Portugal. and 8. The first capita income levels across countries in the euro section presents some stylised facts pertaining to area differed significantly. The following sections look at the convergence to EU per capita income levels. THE STYLISED FACTS OF CONVERGENCE consolidated within. Greece and Portugal) were still techniques to determine the relative contributions considered to be "cohesion countries". A strong have fared very differently. based on the mobilisation of labour and capital resources and building on earlier nominal convergence prior to. Cyprus fall of risk premia and the role played by fiscal and Slovenia). During the ten first However.e. By contributions of general and country-specific the same token. has contributed to a relatively strong pace of catching-up among the Measured in purchasing parity standards (PPS). labour and technology to the observed countries that qualified for structural support catching-up (and falling-behind) processes in the from EU funds so as to speed up their euro area. although at different since the efficiency of capital allocation speeds. of the euro area average. four section applies standard growth accounting (Spain. respectively (Graph I.8. Greece and Spain. which in spite of their geographical This chapter provides evidence that EMU has proximity and other similarities are found to been a driver of real convergence. 8. INTRODUCTION acceded countries have spent in EMU. are also considered as catching-up policy. Cyprus. i. the per Spain. GDPpc in PPS is still at about 94% of the euro Graph I. Spain. CATCHING-UP WITHIN THE EURO AREA Given the very short time the most recently 8. In none of them the catching-up process associated with it is questionable. this chapter will mostly focus on the experience of When the single currency was launched.1.1: GDP Per Capita in 1999 at purchasing power parity standards 200 180 160 Euro area average = 100 140 120 100 80 60 40 20 0 LU CH NO AT DK NL IE SE BE DE IT UK FI FR ES CY EL MT SI PT CZ HU SK PL EE LT LV BG RO Source: European Commission. The next that joined the euro area in 1999 and 2001. including the effects of the acceded the euro area recently (Malta. 68 and 70% of the harnessing the benefits opened up by the euro area average. In Spain.8. the EU countries that have shocks and policies. Portugal and catching-up countries pursued policies geared to Slovenia were 71. there are risks attached to the years of EMU.1). not least distance with the euro area. 71. process of growth. Malta.2. financial market that stage Ireland's GDPpc already stood at 110% integration and budgetary consolidation. now the richest of the four "cohesion" countries aside from Ireland. majority of catching-up countries. The final section provides a more economies. has been completed. Ireland. along with sustainability of the housing-driven growth Cyprus and Slovenia. Ireland.

such as the fall of risk premia or the 2004. Kneller. area. France or Belgium. which joined in 2007.8. Portugal thus behaved in a similar this respect. while. that predicted by a simple regression (see Therefore. In sharp savings. Hungary. fiscal policy framework conducive to fiscal 107 . y. and fertility. There are similarities with the development of Overall. as and Slovakia. followed by Greece (90%). Slovenia (84%) outside it. at 103%. LU 8 EE 7 LT 6 BG 5 RO SK SI 4 PL HU IE EL SE 3 CZ FI AT NO 2 CY ES FR UK BE NL US MT JP 1 PT DE DK CH IT 0 0 20 40 60 80 100 120 140 GDP per capita in 1999 (index euro area=100) Source: European Commission. In contrast. the Portuguese the initial levels of GDPpc. Ireland saw its income soar to about determinants of y*. respectively. Although. changes in the steady-state income the Recently Acceded Member States (RAMS) to would explain why the catching up process has the European Union. which acceded the EU in specific.8. work. the extended neoclassical growth way as a number of "core" euro area countries framework predicts that growth depends on the that have also been lagging behind the euro area relationship between the initial output of a average.2). Malta and Slovenia this group adjustment in catching-up countries are EMU- includes the Czech Republic. growth may be relatively sluggish Graph I.8. Latvia. Lithuania. in terms by about 30 points in the Baltic countries particular the tax mix and the composition of and by 17 points in the Czech Republic.2: Convergence dynamics1999-2008 10 Growth GDP per capita 1999-2008. Part I Assessing the first 10 years Graph I. In (Graph I. % 9 LV All countries excl. Bleaney and Gemmell 1999. recorded in Italy in 1999 was comparable to that y*. the growth rate varies 133% of the euro area average.2) suggests that catching-up processes even if the initial level of output is low if the have been somewhat slower in EMU than steady-state GDPpc is also comparatively low. Some of the factors that might have raised the steady-state income and/or the speed of (93) Aside from Cyprus. For given contrast. which. even when considering differences in and Cyprus (83%). where convergence is also accelerated in some countries and apparently taking place at different speeds. and Chalk up performance over the past ten years against and Tanzi 2002. But obviously more and Maltese relative income stalled at 66% and sophisticated approaches are required to set 70%. and Bulgaria and Romania. Government policies last ten years or so. and its steady-state or 'target' level. inversely with y (conditional convergence). Estonia. Poland and Slovakia. in turn. and monetary policy. the relative GDPpc country. Slovenia public expenditures. depends on government of Germany. ten years later policies and household behaviour with respect to the figure had gone down to 91%. Benchmarking the performance of the catching. growth varies directly with y*. of the euro area average benchmarks for "appropriate" convergence. and the references therein). given y. Barro and Sala-i-Martin 1992 and 1995.(93) During the reversed in others. income has grown in relative influencing growth include fiscal policies. well as institutional choices (Barro 1990 and 1997.

with a steady deterioration in its underlying growth rate from 3½ % in the early 1990's to an average of only 1½ % over recent A priori EMU is expected to contribute to years. lower potential growth if they take place through trimming productive expenditure. Ireland Greece Spain Expenditure-based fiscal consolidations may Portugal Rest of EA Source: European Commission.7 0.4 1.0 potential growth rates almost doubling from TFP around 2% over 1989-1998 to close to 4% for 1989-1998 1. with both countries recording TFP growth rates which The twenty years from 1989 to 2008 have been were only marginally positive over the last ten marked by strong divergences in potential years.9 3.6 1. Portugal. since 8 inflation expectations have become much lower Per cent 6 and stable. The price.9 0.1 experience of Ireland constitutes a prime 1999-2008 2.2 0.1 0. Ireland experienced a more than doubling in its Table I.0 0. Revenue-based fiscal consolidations are less detrimental for With regard to the sources of growth. The Spanish and Portuguese TFP 8.3 3. The one disappointment came from 1999-2008 0. on Europe. GROWTH ACCOUNTING EVIDENCE performances have been.8. The following sections examine these which only Ireland has consistently growth factors.9 0.8 0. with Greece having done so only over the period 1999-2008.8 1. This is not the case in sustaining the process of convergence in however for total factor productivity (TFP).5 0. outperformed the rest of the euro area. annual % change 1989-1998 2.9 3.3. consistently weak.8 1. which would allow economic agents 4 to take intertemporal decisions over longer planning periods with less uncertainty.8 1. Starting unemployment as a result of a series of labour from potential growth rates of the order of 4%. 2005).8 1.1 1. which and capital compared with the rest of the Euro are more distortionary.1 0.3 1. with a reversal to rates of 4% in EA EA4 EA8 IE EL ES PT the most recent years.1 1.8 6. both have performed Capital well over the period as a whole. all four growth if they entail s shift to indirect taxes away countries had higher contributions from labour from direct taxes on labour and/or capital.6 1.7 cases of Spain and Greece.1: growth performance (to close to 9%) over the Potential growth and its components years to 1999.5 1.3 0.8 0.9 example of the speed with which income Contributions to Potential growth differentials can be closed if the correct Labour 1989-1998 0.1. Without doubt.2 0.6 2. 0 provided it is of the right composition 1989 1993 1997 2001 2005 (see European Commission 2003 and 2007g). especially in 10 traditionally high-inflation countries. rather than on fast TFP growth. In the case of it is based on a greater supply of labour and Ireland.9 2.6 1. the Potential Growth.5 3.8 0. this period has been characterised by a capital.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union consolidation and falling debt ratios.3 1.8.3).4 1999-2008.3 framework conditions are set in place.3 3. if and over time (Graph I.2 3. economic convergence via financial market integration.3 1.0 2. These overall patterns are not necessarily growth both between the four cohesion countries at odds with the expected convergence pattern.8 1. Graph I. Also 2 fiscal consolidation might be growth enhancing.8 0.8 1.3 1. spurred by the elimination of 108 . In the strong upward growth momentum over the first specific case of Spain the large contribution of ten years (1989-1998) and a steady deceleration labour also reflects the fall in structural after the adoption of the single currency.6 0.3: Potential growth rates: stability oriented monetary policy of EMU might 'Catching-up' countries vs rest of euro area have affected long run growth. market reforms (Ayuso et al.5 2.0 0.6 1.8.3 1999-2008 0.1 2. In the 1999-2008 0. These EMU-specific area over the two ten-year periods.2 Source: European Commission.8.7 1. with Greek 1989-1998 0.2 6. which are factors have worked jointly with Cohesion policy reported in Table I.

including the fall in risk premia. 97 ( ) Real capital cost are defined as the sum of real interest rates (nominal long term interest rate minus investment price inflation) plus depreciation multiplied with the ration of investment to GDP prices. the Spain and Portugal from low levels and also fight against inflation during the nineties led to a from the mid 1990s in the case of Greece. Part I Assessing the first 10 years exchange risk premia. which Catch-up x (marginal product of capital - restrict international capital flows.014 5. by more than 800bp between 1998 and 2006. 1999. real interest rates also fell in Greece. the inflation rates in GDP.8. THE RISK PREMIUM SHOCK analysis. concomitantly. respectively. GR. Investment in these countries has indeed soared. (95) In line with the Maastricht criteria. investment regressions 109 . This has indeed been the experience in Greece. PT Therefore.4. especially in catching-up 13%. Ten years later. 7% and most EMU countries. Similarly.(94) As a result. real interest rates fell in Spain by almost EA4 group. by Barro (1997) suggest that.(96) In some point – it being driven largely by one-off parallel with the fall in risk premia.2 *** Martin 1995). which is likely to unwind at significant in high-inflation countries. inflation rates had gone down to 1¾ % in Ireland. 1988-2006. respectively contribution of capital to growth of formerly less Source: European Commission. are regarded user cost of capital) 0. 5.2). Spain and Portugal were 14%.4 ** of investment of the four countries under review Rest OECD x (marginal product of capital .0 *** economies. capital costs factors. compared with 1.641 0. predict a strong and positive reaction of Catching-up countries have traditionally initial output to risk premia followed by a slow recorded large and persistent inflation adjustment towards the new equilibrium.user cost of capital) 0. For instance. 0. although the inflation differentials factors. at households savings falling as percentage of the end of the eighties. (96) For instance. (97) Intertemporal 8.1 % in the euro area. IR.3 *** launch of the euro the difference in the elasticity R-squared 0. in real interest rates (see This has led to an asset boom. A regression analysis reported in Cartch-up x lagged dependent variable 0.2 indeed shows that the responsiveness Catch-up x output gap 0. it is not surprising to see a rising euro = dummy. financially integrated economies when the prospects for EMU became concrete after The reduction in inflation may have had a direct signing the Maastricht treaty at the beginning of impact on growth but it is more likely that the the 1990s.120 7. especially in the Chapter I.4 *** Catch-up x (marginal product of capital - as an important barrier for convergence of open user cost of capital) x euro 0. 16 OECD countries of investment to fundamentals has disappeared.6 *** to economic fundamentals has increased. such as discussed by Fagan and Gaspar (2007).2 *** 5.040 2. in the EA4 have sharply fallen and except in Spain are now below to level in the rest of the euro area (Graph I.4). Catch-up: ES. Indeed the fall was particularly housing market. Albeit with a certain lag. GR.2: Explaining the investment-capital stock ratio convergence literature (see Barro and Sala i Explanatory variable Coefficient t-Statistic Constant term -0.138 10. the inflation rates are overall much 600 basis points (bp) until 1998 and by other 260bp after lower nowadays than in the nineties. The cross border holdings of assets main transmission has been through interest indeed increased considerably in the case of rates. after controlling for other Therefore.6 *** Table I.user cost of capital) -0.960 Note: Panel Least Squares estimates. compared with about 4% in economies. Consequently. IR.8. PT. with differentials with the euro area.8.9 ** capital productivity and capital cost interacted Rest OECD x lagged dependent with a EURO dummy.061 19. as indicated by the positive sign of the gap of Rest OECD x euro x (marginal product of capital . real interest rates fell in Ireland by 460bp during the nineties and by other 100bp to date. with the variable Rest OECD x output gap 0. 0 before 1999 and 1 since 1999 *** and ** denote significance at 1% and 5% level.016 . there is no evidence of a positive relationship with the euro area average have persisted in the between inflation and economic growth. steady reduction of nominal interest rates and. private consumption the euro area (and Ireland). Rest OECD: OECD without ES. 2½ % in Greece and 2¼ % in Spain and (95) A survey carried by Briault (1995) and empirical work Portugal.001 . As stated in the Table I.494 7. This is a standard (94) Dummy variable with zero before 1999 and 1 from 1999 measure for the user cost of capital which is used in onwards. financial constraints.

developments in the interest rates came with a substantial financial indices of the three largest countries in the euro market liberalisation. which also recorded a sizeable contributions. although currently declining.es. France and Italy taken together.(98) activity over most of the EMU period. 1997). as sector. As suggested by developments in the (Barro 1990. in Portugal has persistently been hovering above and Martinez-Mongay.8. albeit Source: European Commission. equity markets 1995. as was the case in Spain. the multiplied by a factor three in both countries. and 260% the conditions easing without precedent in their Italian MIB 30).500 points in 1995. area are much more modest (280% the German with market rates significantly falling and credit DAX 30 and the French CAC 40.(101) long-run growth. The Spanish IBEX be relevant for growth. in Italy. By contrast. Maza and Yaniz (2007). such as social (98) Interestingly. certain have also been buoyant in Greece.(100) composition of expenditures and the tax mix can Equity markets also boomed.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union levels rose on a permanent basis.e. to a lesser extent. In Ireland. respectively. These effects Athens index rose from 100 in 1995 to 480 in were magnified in countries were the fall in 2006. due to an increase in prices in the non-tradable In parallel the size of the public sector. Higher surpluses could be used to the Spanish housing market.4: User cost of capital 220%.5. THE ROLE OF PUBLIC FINANCES 10 8 Since the launch of the single currency public % 6 finances have been on a consolidating path in 4 Spain and. The housing market was particularly measured by the share of total expenditures in affected: a property worth 100 in 1995 would GDP. considered as typically distortionary.8. had human. Barro and Sali-i-Martin 1992 and stock exchange market indices. the corresponding index in Portugal grew by "only" Graph I. 14 12 8. was reduced in Greece and Spain (though have been sold at almost 300 in Spain and mostly due to falling interest payments). that enter the labour-tax wedge are reduction of risk premia since 1989 (by about 500bp). where the taxes would be detrimental -. and Mendoza et al. which was around 3. 1985 1990 1995 2000 2005 ES PT IE EL other EA Meanwhile the Greek budget deficit was cut from 4% in 1998 to below 3% at present. after having peaked at 8% of GDP in 2004. physical and knowledge capital decisions.i. This sharp increase in prices came with a surge in residential construction. 110 . France and Italy. the fiscal surplus fell somewhat. In line with sluggish economic recent economic history. Direct taxes on both labour and capital. unlike the reduction in market rates was much lower 99 ( ) See Yaniz (2005) for a more detailed discussion about indirect taxes. but 500 Ireland in 2006 (99). providing scope for fiscal Analogously. as well as other taxes. which Along with the size of the public sector. In Spain the public deficit posted 2 about 3% of GDP in 1998 and turned into a 0 surplus exceeding 1% of GDP ten years later. Ireland in the recent past is higher than in Germany. 220 expanded in Portugal and remained broadly and 180 in Germany. the demand shock induced by a reduction in the where fiscal consolidation had already started in risk premium has led to an additional stimulus the late eighties. Notably investment in 35. Comparatively. (101) See www. those taxes that affect human. the deficit As discussed in European Commission (2006a).bolsamadrid. the Irish ISEQ index grew by policy to play a role in the catching up process 400%. the number of dwellings built in Spain and productive expenditures at a later stage. in Greece (Table I. knowledge and physical capital affects jumped by about 380% in 2006. finance cuts in distortionary taxes and/or higher (100) As a result. as compared to 90.3). As well. constant in Ireland. 3% for most of the EMU period.

a rising public debt crowds out Ireland 42.6 (4) 46. if the total debt Euro area 50.7 45.3 38.2 3.4 -0. which makes private accumulation Greece 41. In Ireland.1 33.3 First.8. high debt increases public Spain 37.0 3. Third. declined measured in terms of both total which would imply a negative effect on expenditures and GDP. public investment and structural funds however.0 42.2 42. which (2) In % of GDP negatively affects growth.4 45..0 2.3. debt levels as a share of GDP have Ireland -2.8.4 2.5 -1. the share of public investment in associated to shorter debt maturity.6 private debt.7 0. preferential tax Spain 36. investment have been influenced by the Community budget through capital transfers Debt-to-GDP ratios have declined significantly from the regional.5 2.3 1999 as compared with the previous decade.3 3.1 4. public investment has relationship between debt and interest rates.3).2 (1) more distorting tax-mix. (1).6 2. Finally.6 43. Tanzi (2002) indeed find evidence of a positive in the case of Portugal.2 -2.4). which total expenditures has exhibited an upwards trend complicates the working of monetary policy and in Ireland. Second. in contrast.2 Greece -12.2 4. while its share in may lead to an inadequate policy mix. Table I. rose in Portugal during the last decade 111 . Fourth.2 45. part of the tax burden was shifted away Indirect taxes(1) Public Structural funds from tax on income to less distorting indirect investment(3) 1999 2008(2) 1999 2008(2) 89-98(4) 99-05(4) taxes.7 contrast.3 1.4 40.6 (4) 48.3: (4) Annual averages over the period in % of GDP Fiscal consolidation and the size of the public sector Source: European Commission.3 4.9 -2. thus moving towards a Portugal 41.1 2.6 -0.7 1. which reduces private investment and thus Greece 27. EU transfers may less-distorting taxes in the total tax burden have had a significant positive impact on growth.9 38. Portugal 31.(2) Budget balance (3) 1989 1999 2008 Owing to fiscal consolidation and falling interest Euro area -4.6 According to Chalk and Tanzi (2002) debt (2) Revenues (3) affects long-run growth through six channels.4 1.6 Greece 39. and depending on how both expenditure restraint and higher revenues. However. Portugal -2. the relative weight of transfers have been financed.7 -2.0 growth.4 1.8 36.8 (2) which eventually will raise taxes and lower Expenditures 1989 1999 2008 (3) investment and growth.3 -1. functioning of financial markets lowering growth.9 rates.0 deficits through higher interest expenditures.1 than the total tax burden.8.1 and growth to fall. the additional national funds associated to such In parallel (Table I. By Ireland 40.5 42. Fifth.0 41.6 . 1989 1999 2008 Euro area 45. while of public investment carried in the catching-up government receipts fell in terms of GDP.1 generally fallen in most euro area countries since Spain -3.0 0.2 ratio is constant. thus.4 40. on growth.2 2.6 36. Part I Assessing the first 10 years As shown in Table I. - 40% in 1999 to around 41% in 2008. high public debt puts pressure on interest Ireland 35. Chalk and GDP also increased. rising public debt may be Meanwhile. social and cohesion funds in Ireland.4 treatment of public debt would led to a sub- (1) Deficits (-) or surpluses(+) optimal allocation of investment. fiscal consolidation in (Table I.8.9 3.5 34.8 39. by consolidation in Spain has been achieved through raising public investment. the share of which increased from about Euro area 32.0 36. except in Greece.3 rates. remained broadly unaltered in Spain and Portugal between 1999 and 2008.1 40.1 46.4 -3. Greece and Spain. indirect taxes in Greece grew by less Spain 33.7 Portugal 33. Greece and Spain. Developments in public investment and. but. EU transfers from the Ireland (in the nineties) and Greece (in the EMU structural funds have amounted to 25% to 50% decade) took place on the expenditure side.5 32. (2) In % of total tax revenues 2007 Autumn forecasts (3) In % of GDP Table I.8.0 2. compulsory (3) (4) Autumn forecasts 2007 acquisition of public debt would distort the Data from 1995 [to be updated] Source: European Commission.3 41.4: The tax mix. Overall.1 37. Fiscal countries since the early nineties. Therefore.

Spain created jobs at a faster rate than Portugal. these economies exhibited a strikingly savings fell in terms of GDP in both Spain and different performance.7 4. as later.4 0.9 Spain.9 Greece 65.8 3.8. which integration. the fiscal Maastricht criteria by 1998. The reduction of debt levels in financial markets of Spain and Portugal combination with the fall in risk premia led to a underwent rapid and effective international significant reduction of interest payments. but rose to the same figure from a lower Source: European Commission. investment played an lessons for other catching-up EU economies in important role in sustaining domestic demand. Euro area 55.9 7. level in Portugal. As a Spain 40. while.5 1. Household EMU. both economies (about 1½ % of GDP) almost entirely mirrors the implemented strong fiscal consolidation to meet increase in public investment. By Portugal having done even better than Spain.0 26. in Spain. the debt increase recorded in Portugal Portuguese GDP had grown at an annual average practically offset the potential impact of the fall rate of 3¾ % between the late eighties and the in risk premia on interest payments.2 4. the expansion was the Exchange-Rate Mechanism (ERM) of the much faster in Portugal.1. which significantly eased financial countries.7 2. Already Portugal. and. 1/4 of the 2% of GDP reduction was devoted to finance public investment. the bulk of this credit went to finance on a strong disinflation process and recorded a household spending (including housing) in sharp and significant fall of risk premia. the in the euro area.0 2. compared to up to maximum 20% in Spain.7 4. 8. The contrast.5: performance of both countries has radically Public debt and its burden (% of GDP) Debt ratios Interest payments changed since then. being particularly buoyant. slump. consequently.6 3.7 5. in Spain.9 Employment growth has also been much higher Ireland 99. The reductions recorded in those since the late eighties or early nineties. Similar.2 in Spain (3½ %) than in Portugal (¾ %). In both countries output strongly reacted strongly 8. which boosted strongly and Portugal being in a protracted consumption on a permanent basis.6 51. entered magnitude in both countries.5 91.8. In Ireland.4 71.8 65. which compares with about 3½ % remained broadly constant in terms of GDP.5 34. was almost fully saved. Financial integration and causes and/or different policy responses. and in three catching up countries are among the largest line with general international trends. The adjustment path Although Portugal and Spain shared many was largely determined by the adjustment of the institutional and economic features at the start of private sector.1 6. the credit impulse was almost equally shared by households and the 112 . coupled with a decisive domestic was used for different purposes in different liberalisation.9 61. A CLOSER LOOK AT SPAIN AND to the reduction of the risk premia in a context of PORTUGAL financial market integration and liberalisation (Fagan and Gaspar 2007).1 2. yet drifting apart Although the credit impulse was of a comparable Both countries joined the EU in 1986.6. Since such differences in economic growth in both countries was fully driven by performance might be linked to EMU-specific domestic demand. the unemployment rate went below 8% in Portugal 53. Moreover.7 3.5 result. in Greece By the early 2000s. both countries had the substantial reduction of interest payments.4 64. Since the early 1990s both economies embarked Moreover.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union (Table I. compared with 3¾ % in Spain. Similarly. where annual credit European Monetary System (EMS) some years growth attained 30% in the late nineties. a closer domestic liberalisation brought capital costs look at both economies may provide interesting down. the fall in interest payments conditions. Therefore.8 7. outperformed most of their EU partners. Portugal has grown by just 1989 1999 2008 1989 1999 2008 about 1½ %. which late nineties. On the other hand. and especially residential investment. with Spain growing Portugal during the nineties.6. while in Spain. with construction. especially households.5). and adopted the euro on 1 January 1999.2 48. the run up to euro adoption. The relative economic Table I.7 102. with about 4% of GDP.

(iii) the functioning of adjusted primary balance net of one-offs. The fall in remittances from least since the comparative position of the nationals working abroad and the increase in the Spanish current account deteriorated rather than external-debt service are also behind this faster improved since the euro adoption). thus squeezing the interesting to compare their respective corporate sector. the bulk of it took place over implemented substantial changes in the less than one year. conversion rates. Spain had 30%. while its current entering the euro area. where the external exposed to very different exchange rate start-up deficit was close to 10% of GDP already in the shocks associated with euro area entry. Sustained and credible The conversion rates of legacy currencies to the fiscal consolidation in Spain provided room for euro were irrevocably fixed based on the market the private sector to borrow without exchange rate at the last trading day of 1998. while it had been overall neutral in Spain. In contrast. both countries have In addition. In contrast. As might be expected. Interestingly. Portugal has frequently reverted to recorded comparable competitiveness losses. one-offs. euro. Some tentative explanations general government budget posting a surplus of 2% of GDP in 2007. conversion rates at EMU entry. already since the mid-nineties. The parity of the Portuguese escudo fiscal institutions to tackle the deficit bias and a was fixed at about 200. By 1993. but it was higher. account continued worsening to close 10% of GDP due to a combination of dynamic domestic Spain and Portugal both embarked on fiscal demand and deteriorating competitiveness. However. This different fiscal policy behaviour reflects a The parity was fixed at about 166 pesetas per failure to improve fiscal governance in Portugal.6). 128 Spanish pesetas were equivalent to 1 euro. the REER of Spain is at present just at order to keep the deficit below the 3% reference 113 . fiscal consolidation was sustained in Spain. which represents a devaluation of about while.8. Given the similarities between the Spanish and fiscal profligacy in Portugal led to a steady Portuguese economic histories at that point it is increase in public debt. mid-nineties. deficits to close 3% of GDP. between the late 1992 and the budgetary process and put in place the adequate mid-1993. (ii) fiscal policies As measured by the changes in the cyclically- and fiscal institutions. while that of Portugal is more than 20% current account in both countries. the labour and product markets. Since then. Due also to fast wage increases. of their stability programmes. Part I Assessing the first 10 years corporate sector. in However. credit growth decelerated in Portugal to Portuguese fiscal deficit stood at about 7½ % of below 10%. suggest that the two countries did face different Since 1999. both countries had reduced their 10% of GDP. This is reflected by nominal exchange rate of 179 escudos per euro differences in the budgetary planning in the prevailing in 1991. notably: (i) the euro government deficit peaking at 6% in 2005. with the 8.5 and I.2. the medium-term the real effective exchange rate (REER) budgetary plans have remained a moving target appreciated by about 15% in Portugal in the in Portugal whereas the medium-term targets 1990s. in some years by up to 2% of GDP. downturn its current account remained at about By 1998. This suggests that both countries were much faster in Portugal. which compares with the void pro-cyclical behaviour.8. the REER of Spain have been consistently achieved and were even depreciated by a comparable amount until the outperformed in Spain (Graphs I. while the fiscal position A number of elements may help explain this deteriorated in Portugal with the general difference in performance.6. while despite a protracted economic GDP. By the early nineties. Judged by the successive updates of around 12%. between 1998 and 2001. the contrast. In consolidation during the nineties. one percentage point higher than in Spain. and (iv) the fiscal policy stance was pro-cyclical in Portugal adjustment in some key sectors. the the level it posted at the beginning of the domestic expansion led to a worsening of the nineties. it does deterioration of the external account in Portugal. credit growth in Spain accelerated to starting conditions in external trade when an annual rate of 30% by 2006. While late nineties while it remained less than half that this is by itself not a satisfactory explanation (not figure in Spain. and represents a devaluation medium term. overburdening the current account.

higher -3 participation and lower unemployment. This adds to SP/CP 2003 SP/CP 2005 SP/CP 2006 Portugal having one of the most restrictive SP/CP 2007 Actual regulatory frameworks of product markets in the Source: European Commission. of women in the labour market. 1 General government budget balances as projected in Stability Specifically. above. while one-offs have been negligible in downturn by prompting a boom-bust cycle. and the expanding working-age population mainly Graph I. as well potential growth has been negligible in both as a stronger role of the Finances Minister. the contribution of Graph I.6: Fiscal balance projections in reflects massive immigration. % of GDP. 3 2 percentage points in Spain. Even Spain. its Spain and Portugal lie in the growth contribution budgetary process still needs a reform towards of labour. While the rise in SP/CP 2001 SP/CP 2003 SP/CP 2005 participation in Spain is largely due to socio- SP/CP 2006 SP/CP 2007 demographic factors. Spain had made stronger countries in terms of their economic performance progress than Portugal in terms of fiscal in EMU. Even if such simulations may not take governance.although Portugal has SP/CP 1998 SP/CP 1999 SP/CP 2001 been catching up in recent years. so. simulations by Gaspar and St. EPL reforms have -5 been much more far-reaching in Spain than in -6 Portugal. Indeed.5: Fiscal balance projections in Spain capital has increased by just ¼ of a percentage point in Spain and decreased by the same amount 4 General government budget balances as projected in in Portugal. the Spanish or Convergence Programmes (SP/CP). compared with the pre-EMU decade. the most striking differences between term sustainability of public finances. thus largely 1 explaining growth differentials between both 0 countries. but just ¾ of a 2 percentage point in Portugal. especially for temporary contracts -7 1997 1999 2001 2003 2005 2007 2009 2011 (see Scarpetta 2007) -. notably the massive entry Source: European Commission.8. Although Portugal is currently taking steps in the direction of As shown in the growth accounting exercise controlling expenditures and improving the long. the contribution of TFP to more transparent rules and enforcement. the fall in Portugal unemployment is likely policy-induced. on which it also scores significantly worse than Spain (see Scarpetta 2007). as well as deficits on expectations. The growth contribution of labour in -1 Spain is almost equally accounted for by the -2 growing working-age population. Aubyn (2008) suggest that the fiscal mistakes would explain According to the assessment by the European just a small part of the differences between both Commission (2006c). countries in the EMU decade.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union value. while -4 unemployment has contributed negatively in 1997 1999 2001 2003 2005 2007 2009 Portugal and the working-age population did not Actual SP/CP 1998 SP/CP 1999 increase significantly. 0 unemployment rate was reduced thanks to a -1 series of labour market reforms implemented -2 since the late eighties. The The expansionary stance of fiscal policy in combination of a more flexible EPL and a large Portugal is likely to have added fuel the initial positive labour supply shock seem to be behind expansion and also precipitated the subsequent the unprecedented wage moderation recorded in 114 . the results point to the the introduction of a rules-based budgetary need to consider other factors as well. % of GDP.8. process and control. as discussed above. OECD. and. According to the OECD’s -3 synthetic indicators of stringency of employment -4 protection legislation (EPL). including the commitment capacity full account of the negative effects of large and power of the Minister of Finances. labour has contributed Stability or Convergence Programmes (SP/CP). However.

the outturns for Ireland. China and India). the fall in structural unemployment based on successive labour market reforms over the 1990s. CONCLUDING REMARKS concomitantly. and it elimination of the exchange risk premium. over the past potential growth rates now pointing to decade. In remains to be seen how smoothly the economy particular. outset posted potential growth contributions from labour and capital equal to or in excess of the Another supportive feature of EMU was average for the other euro area countries. relative to the worst performing region of the country. real wages efficiency could also be part of the secular have lagged (weak) productivity growth. and productive expenditures) in the run-up phase. significant restructuring following the integration thereby facilitating their structural adjustment of large low wage countries in the world trade within EMU. showed that gains in Debt levels measured in terms of GDP recorded a significant fall in Ireland. where. Finally. the specialisation pattern of the with regard to catching-up have been reinforced Portuguese economy was still largely based on by EU cohesion policy. other structural factors. overall. First. however. These sectors had to undergo investment targeted at growth enhancing factors. most notably Ireland and Spain. in real rates. rather than convergence. strong productivity gains and specialisation pattern of the economy.e. This combination of low real interest rates the catching-up phenomenon heavily geared and easier credit conditions fed directly into towards a greater use of the factors of domestic asset markets. Structural and Cohesion low-skill intensive industries such as textiles. The benefits of EMU decade. inflation expectations in many traditionally high inflation countries and consequently to a steady reduction in nominal interest rates and.g. Inadequate wage In the specific case of Spain. since the Portuguese into the country. towards non-distortionary taxes and Spain and Portugal. to a lesser extent Greece. The big disappointment amongst system (e. as well as by intensive economy is smaller and more open than that of investment in human capital. such as the size With respect to Ireland. labour and capital. could were achieved through the absorption of also help understand the differences between technology brought about by large FDI inflows Spain and Portugal. Whilst undoubtedly the strong incentives for fiscal this pattern of growth was accompanied by consolidation and compositional shifts in the relatively disappointing TFP performances in budget (i. with its macroeconomic effects. Indeed. Greece and Spain. a process that the group was undoubtedly the marked induced significant labour market adjustment deterioration in the outturn for the Portuguese costs and is likely to have had non-negligible economy. as reflected in the production.7. the fight against inflation during the will adjust to this shock in an environment of nineties led to much lower and more stable financial turmoil and soaring commodity prices. Part I Assessing the first 10 years Spain in the 2000s. contrast. Greece also Spain has exposed it more to the less favourable managed to produce strong productivity growth external developments in the beginning of this during the EMU years. with area. Second. All four of the buoyant conditions experienced in housing and catching-up countries in EMU (almost) from the equity markets. real wages per unit of output in Portugal outpaced the euro area average. the North of Portugal has been clearly divergence. the Spanish via financial market integration and the housing sector has been contracting. both the living standards in the rest of the Euro area. 8. More recently. In convergence trend. in terms of output per capita and unemployment dynamics. the large behaviour would partially explain the faster contribution of labour is partially explained by deterioration of competitiveness in Portugal. especially over the last decade. Funds have contributed to the convergence of the footwear and apparel – concentrated in its four catching-up countries by supporting public Northern region. 115 . capital costs fell in the group of catching up countries to The EMU years can be characterised as levels below those seen in the rest of the euro displaying a typical convergence pattern. In parallel. The magnitude of such (unavoidable) One of the direct ways in which a monetary adjustment process has been unparalleled in union can contribute to economic convergence is Spain.

underpinned by solid fiscal institutions and continuous improvements in the regulatory framework of labour and product markets in Spain contrast sharply with pro- cyclical policies. The successful fiscal consolidation.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union leading to significant reductions in the burden of interest payments. high deficit biases and worse regulatory frameworks in Portugal. offsetting the potential impact of the fall in risk premia. with overall interest payments. as a share of GDP. However. 116 . remaining broadly constant over the period as a whole. a closer look at the Spanish and Portuguese cases confirms that implementing right economic policies is paramount for a successful catching up. debt levels increased in Portugal. Overall.

9. its broad. 117 . On balance. Some of the euro in international financial markets. Those who argued that the dominant international currency in many areas – partly role of the dollar would not diminish. there area economy and its important trade links across are close relationships and interactions between the world. the international use of the challenge the role of the US dollar as a global euro is concentrated in countries neighbouring currency.2. and the dollar’s incumbency advantages stemming from the 9. in other countries with special the euro would be well-received internationally economic and political links to the EU. Even so. there was a consensus that the euro area. growth and currency. (102) pointed to the needs and opportunities for portfolio diversification. this chapter reviews the The euro quickly established its role as a store of evolving use of the euro beyond the borders of value in international financial markets and now the euro area. It looks in some detail into the accounts for a substantial share of the trends of the international use of the euro since outstanding stock of international debt securities. provides a US dollar (e. The US dollar remains the first position. the launch of EMU triggered a functions (notably its use as an international vivid debate about the potential for the euro to financial currency). 9. and use would be commensurate to that of the Table I. based on Kenen (1983). along with its official foreign use. emphasised inter alia the size but its dominance has declined. Others instead An international currency can be defined as one predicted that the euro eventually would develop that is used outside its home country as a unit of into an international currency whose importance account. first by function and both in long-term maturities (bonds and notes) then by region. But almost 10 years after its euro. In practice. its introduction in 1999. whereby a THE EURO BY FUNCTION good or service becomes more valuable as more people use it (Frankel 1995). TRENDS IN THE INTERNATIONAL USE OF existence of network externalities. and in but would emerge as international currency only transactions directly involving euro-area gradually and not rival the US dollar’s dominant economic agents. also argued that the euro area would maintain a foreign exchange markets. and strength of the US economy. trade and as a parallel much sounder external position than the US and currency. deeper and more private sector participants and official institutions. INTRODUCTION is characterised by a strong regional and institutional pattern: with the exception of some From the outset.1.2. deep and liquid financial markets. For instance.1. the euro is extensively used in international debt markets and its role as an invoicing and reserve currency has been (102) This chapter draws partly on data and results from the ECB's annual reviews of the international role of the growing gradually. It confirms that the euro quickly and in short-term maturities (money market emerged as the second most important instruments). Bergsten 1997. The prominence of the noticeably in this market segment after the euro extends to most of the different functions launch of EMU. medium of exchange or store of value. and Alogoskoufis simple decomposition of the various functions of and Portes 1997).9. private and public sector usage.g. the euro gained consolidate this position. TRENDS IN THE INTERNATIONAL ROLE OF THE EURO introduction. These predictions were based an international currency. or that the because of inertial forces that create a bias in euro would at most become an important favour of the incumbent international currency – regional currency. reflecting the opportunities that a global currency can play in its use by created by more integrated. Compared to the combined share of international currency and that it continues to the euro’s legacy currencies. from the decomposition can development of euro-area financial markets be inferred that it is useful to distinguish the use while providing for monetary stability. International debt security markets Against this backdrop. the internationalisation of the euro 9. distinguishing among on factors such as the relative size of the euro.1. as well as a conviction that EMU the different functions of an international would stimulate the integration.

loans and deposits have been rather stable since 1999 but the prominence of the euro varies with However. official financial exchange currency flows Store of value Holding of international financial assets. prices. which includes respect to different segments.2: Stock of international debt 1999 to 32% at the end of 2006. Graph I. the euro's share in the stock of international debt securities increased from about 22% in early Graph I.(103) 60 market.2. Official interventions in the foreign Medium of settlement of international financial transactions.9. In cross-border home-currency issuance provided that it targets transactions denominated in a currency that was the international financial market.2). In contrast. The (104) For a discussion of the implications of alternative data at market exchange rates tell a broadly similar story. whenever one of the counterparts to a loan or deposit is located in the (103) The data just mentioned were measured at constant (fourth quarter of 2006) exchange rates to remove valuation effects from changes in exchange rates.1). Box 1. the amount of neither the home currency of the borrower nor outstanding euro-denominated international debt that of the lender. International loan and deposit markets 1999 2000 2001 2002 2003 2004 2005 2006 2007 US dollar Euro Yen The shares of major currencies in international Source: ECB. (104) Since then. securities. at 2006 Q4 exchange rates) 50 20 10 40 0 30 1999 2000 2001 2002 2003 2004 2005 2006 2007 20 Euro US dollar Yen Source: BIS.2.9.1: Stock of international debt securities: narrow definition 40 (excluding home currency issuance. which is still securities: broad definition below the 44% share of the US dollar (see (including home currency issuance if targeted to international Graph I. with the euro accounting in June 2007 for Using a narrow concept of international issuance.9. 10 0 9. parallel currency Vehicle currency in the foreign exchange markets. see ECB (2007d).1: Functions of an international currency Function Private sector Public sector Invoicing of international trade. 118 . liquid capital markets in the euro area as well as in 2004. on a broad measure. at current exchange rates) 50 Graph I. percent of total amount outstanding. percent of total 30 amount outstanding.9. the gap between the portfolio diversification considerations.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Table I. compared to 36% for the dollar (see than the currency in which the borrower resides. 13-14. denomination of international financial exchange rate regimes transactions. 48% of the world's stock of international debt which includes only issuance in a currency other securities. definitions of the international issuance of debt however.9. parallel currency Foreign exchange reserve currency Source: European Commission. the euro’s share at the end of securities actually surpassed that of the US dollar 2006 stood at around 18% in both the international loan and the international deposit markets. quotation of international Anchor or reference currency in Unit of account commodity. parallel exchange markets. pp. euro share and the dollar share has continued to widen.

2.3 36.4.0 Bilateral trades in illiquid currencies often carry 2001 90. in developing and emerging Europe. currency of denomination of loans by euro-area The euro/US dollar currency pair also remained banks to non-bank borrowers outside the euro the most actively traded pair.e.2. markets worldwide. 14% of the reported According to the latest Triennial Survey of the turnover took place in contracts denominated in Bank for International Settlements (BIS). after the US dollar and ahead of the Japanese yen and the pound sterling (see Table I.6 23. The combined market share (compared to 45% for the US dollar). i. a A consequence of the euro area's importance in stabilisation compared to 2004 and a slight world trade is that the euro is used extensively to decrease of about one-half of a percentage point invoice and settle international trade transactions when compared with the 2001 survey. dollar's incumbency advantages are particularly Source: BIS Triennial Central Bank Survey 2007. the shares of the some cases. of the euro in neighbouring countries. other two main currencies – the US dollar and the Japanese yen – continued to fall compared to The role of the euro as a trade invoicing or 2004 and 2001. Table I. The euro was on one side in 9. however.3 30. Within published in late 2007. also between third countries.3 37. The 119 . settlement currency by euro-area countries has risen notably since 2000 (ECB 2007d). International trade 37% of all foreign exchange transactions. During The euro continued to be traded predominantly the period mid-2005 to end 2006. but its dominance has loans.6 1995 83.0 efficient to go via a currency with low Notes: (1) Because two currencies are involved in each transactions costs as a medium of exchange.7 13.2: Currency distribution of foreign exchange market 9. the currency composition the interest rate segment of the OTC derivatives of turnover in traditional foreign exchange market.0 16. and Asia and the Pacific. borrowers. Due between the euro-area and third countries and.1 20. located mainly in the UK. developing Europe is playing a international currency in traditional foreign growing role in attracting euro-denominated exchange markets. as a means to exchange 1992 82. In the market for over-the-counter (OTC) foreign exchange derivatives.3 16. The euro compared with more than 60% for the US was the main currency of denomination of loans dollar). the 2007 BIS Triennial Survey confirms the Middle-East.9. the use of the against the US dollar in global markets.0 39.6 22. in mainly to valuation effects. 1998 87. (2) Before 1999. accounting for 27% area. the euro features prominently. Part I Assessing the first 10 years euro area.3.4 13.3 37.1 24. In transaction. In that the US dollar remains the principal particular.7 37.2 11.9 high transactions costs and it is more cost 2007 86. Africa and Overall. The single currency accounted for 39% three years.2 20. For euro/US dollar currency pair represented 74% of instance. The euro was the second most of global daily average turnover compared to actively traded currency in foreign exchange 32% for the US dollar. confirming the increasingly dominant role declined since 2001.9. the euro was the leading markets has changed only slightly over the past currency. with a share of 36% by end-2006 of global turnover.4 one relatively illiquid currency into another.5 15. it refers to the Deutsche mark. the US currencies totals 200% instead of 100%. suggesting a limited role for the euro as a made by euro-area banks to non-bank borrowers vehicle currency in foreign exchange markets. the sum of the percentage shares of individual the foreign exchange vehicle function.2). Most of of other currency pairs involving the euro these loans are extended to developed country remained small (around 10% of global turnover. since 1999 the euro has been the second foreign exchange turnover involving the euro. strong and so it has the highest turnover in foreign exchange markets.2 2004 88. Foreign exchange markets turnover (1) Percentage shares of average daily turnover in April The most actively traded currencies in foreign US dollar (2) Japanese Pound Euro exchange markets are those that are used as Currency yen sterling vehicle currencies. compared to 80% in US dollars.1 9. euros.

denomination in extra-EU exports and imports is partly explained by the prevalence of the US dollar in the denomination of imports of energy and raw materials.3 63. Turkey. i.4 of trade invoicing. Share in international trade invoicing/settlement (1) Exports of goods Imports of goods In international commodity markets the impact EUR USD EUR USD of the euro has so far been very limited.5 50. goods in other currencies (106).0 90.3 Notes : (1) Simple averages of shares of countries in the group.a homogeneous goods such as oil and other basic US n. the I. declared their intention to denominate their (3) Cyprus.7 44. South Korea. Tunisia the predominant use of the dollar as the (6) Indonesia. Euro invoicing of exports and as well as in EU membership candidate imports of services.9.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union euro for euro-area exports of goods levelled off limited beyond its use in countries with while it declined for euro-area imports of goods.9 57. Poland.3 75. Latvia. Japan.2 55. in late 2007. mostly in the commodity producers have from time to time period 2003-06. and services). (4) Bulgaria. commodities.a 70. importance of the EU as a consumer of Russian Luxembourg. which is not affected by the countries.3 33.2 other key commodities.3). Estonia. The divergence between currency assets. Again. Parallel currency in third countries somewhat lower than its share in trade with EU Residents in several emerging. for example. Spain).e. (5) Algeria. Tille (2005) (106) This tends to happen in particular during periods of while the euro is only beginning to emerge in dollar weakness. institutional links to the EU. Finland and Ireland. Romania. the euro However. McKinnon (1979) and Goldberg and denomination of trade between third parties.9 n. Denmark. South Africa. See Financial Times (19 November 2007). This reflects tradition EU candidate countries (4) 61. transition and countries outside the euro area. as underlined by the theories Africa (5) 23. However.9. Malaysia.7 Non-euro area EU countries (3) 58. the shares range from 35% and 55% (ECB 2007d).1 34. (2) Excluding Austria.3: of the euro.3 and inertia but also. the share of euro-denominated the quotation of gas prices given the more merchandise exports was above 55% (see Table regionally segmented nature of this market.4 25.1 5. exceeding 60% in some cases (Germany. The euro share in the euro area's trade with countries outside the EU is 9. Furthermore.2.a n. the decline this role. continued to show shares of these countries with the euro area (ECB an upward trend. this suggests a strong regional and institutional pattern in the international use Table I. Hungary. with its shares exceeding the trade increase in commodity prices. 120 . which are traditionally quoted settlement in non-euro-area EU Member States in US dollars.0 n. those factors have Lithuania. Indeed. Source: ECB (2007d) and Kamps (2006).8 20. Slovakia. the EU is not an important producer of primary products. the use of the euro in in the dollar led some OPEC producers to consider international trade between third countries is quoting oil in other currencies. supported the maintenance of the status quo. Slovenia.a n.0 35.a 2. The US dollar remains the major currency of (105) See. The US Euro area countries (2) dollar is the established standard currency for the Trade outside euro area 56.a Asia (6) 5. For example. such as cash and bank deposits. Morocco. Some authors see In most of the euro-area countries for which data nonetheless some potential role for the euro in are available. this partly reflected rising energy and is the dominant currency of invoicing and commodity prices. Thailand. For imports (of both goods market (Papaioannou and Portes 2008).7 40. with a few exceptions.5 52. but it is still developing countries hold part of their domestic dominant (about 50% for exports and 35% for financial assets in foreign currency-denominated imports).3 80. Czech Rep. With some exceptions. Croatia. UK. and Northern African gas reserves and EU similarly high euro shares are observed in efforts to create an integrated regional gas exports of services.(105) While oil and other Data for the most recent available year. numéraire for commodities.5.7 31.2 quotation. invoicing and settlement of oil and Trade outside EU 49. 2007d).2 76. the advantages of having a North America single "numéraire" for the quotation of Canada n.

because it has EUR billions significant spillover effects on the use of the 400 same currency in official foreign exchange 200 reserves and in foreign exchange market interventions. including abroad is estimated to be lower for the euro than most non-euro-area EU Member States.2.600) than by US residents (USD 870). euro banknotes circulate in a (107) large number of countries outside the euro area. the share of total cash circulating geographically close to the euro area. which they refer to as "creeping euroisation".4: Currency in circulation. As noted by the ECB.4 for details). Most of these countries are Nevertheless.9. the EU candidate equivalent ratio for the United States (see Graph countries and the Western Balkans (see below). official usage in foreign countries' monetary and exchange rate policies as an anchor currency Graph I. In fact. While difficult to measure special institutional arrangements with the EU.3: Currency in circulation. 0 1999 2000 2001 2002 2003 2004 2005 2006 The euro plays an important role as an anchor or Circulation of EUR Circulation of USD Source: ECB. The credit boom being experienced by many of the Graph I. which also reflect an underestimation of euro cash circulating reflects the fact that banknotes have greater abroad.9. The anchor function is particularly important for the 600 internationalisation of a currency. levels currency (store of value) and intervention 800 (Current exchange rates. which compares to an estimated value of zone. foreign exchange reserve and USD. Part I Assessing the first 10 years Due to the stability and wide acceptance of the US as a means of payment and a store of value. potential candidate circulating abroad is estimated at about USD 450 countries and the countries of the CFA franc billion. euro banknotes held by non-residents of around 100 billion (ECB 2007d). EUR recently acceded EU Member States is being and USD. accurately.3). particularly upward trend and is now higher than the in non-euro-area EU countries.9. the value of euro Recent survey data (ECB 2007d) show that the banknotes in circulation nearly overtook that of share of the euro in the bank assets and liabilities dollar banknotes (Graph I. denomination of domestic bank and deposits in area nominal GDP has followed a continuous some countries outside the euro area. 121 . FRB. single currency. the The euro is also used significantly as currency of ratio of euro banknotes in circulation to euro. Official use of the euro Circulation of euro / GDP of euro area Circulation of USD / GDP of the US The internationalisation of a currency includes its Source: ECB. % of GDP accompanied by a significant increase in the (Current exchange rates. of most of these countries is increasing. end of period) share of foreign currency loans (mostly euro 7% loans) in the banks (Darvas and Szapáry 2008). particularly in its neighbourhood. these estimates imply much higher per capita holdings of cash by euro-area residents (USD (107) The large implied gap between per capita holdings may 1. or have for the dollar. Since 2002. end of period) currency (medium of exchange). (108) 3% 1999 2000 2001 2002 2003 2004 2005 2006 9. in 2006. 6% Some European countries outside the EU (notably Iceland) have also seen a marked 5% increase in the share of domestic bank loans 4% denominated in euros.9. reference currency in the managed exchange rate regimes of about 40 countries (see Table I.4). the amount of US dollar banknotes notably candidate countries. EUR (unit of account). I.6.9. FRB. however. (108) Papaioannou and Portes (2008) discuss the case of importance inside the euro area than inside the Iceland.

total reserve holdings are even higher as an increasing amount is held in The choice of denomination of official foreign sovereign wealth funds (SWF). Libya. however. Botswana. 1989. which raises new exchange reserves depends inter alia on the issues (see Box I. Niger. Morocco. Serbia euro as reference currency Pro memoria: Independent floating Albania. Reserves (COFER) data are the most as with the choice of anchor currency. June 2007. country’s exchange rate regime and anchor. Chad. Denmark.1). exchange reserves since the beginning of this most notably in Asia including China. Russia’s currency is also pegged to a trade. Review of the International Role of the Euro. Latvia. Poland Candidate and Unilateral euroisation Montenegro potential candidate countries Euro-based currency boards Bosnia and Herzegovina Peg arrangements or managed floating with the Croatia. and risk is not available. Saint-Pierre-et- Miquelon.4: Countries and territories with exchange rate regimes linked to the euro (as of 1 January 2007) Region Exchange rate regimes Countries/territories European Union Cyprus. ERM II (non-euro area) Malta. Mali. Guinea-Bissau. euro (share of the euro) Myanmar. Full data on the currency breakdown of reserves the currency denomination of debt.9. the direction of trade flows and invoicing currency. FYR Macedonia. United Kingdom. particularly in emerging market and developing countries.7%). these comprehensive but they are only published at an factors also tend to produce a strong regional aggregate level and only include reserves held by bias in its use as a reserve currency. the stock of reported official foreign exchange reserves stood at USD 5. substantially over the past years. Cape Verde. Lithuania. Russian Federation the SDR and other currency baskets involving the (40%). Senegal and Togo) and CAEMC (Cameroon. By mid-2007. Reserve accumulation. are not decade is well-documented (see e. In weight of the euro. Central African Republic.7 trillion. Turkey Others Republic of San Marino. This The phenomenal accumulation of official foreign means that some major reserve accumulators. De Beaufort included in the COFER data. 2) The euro share in Russia's operational basket was increased to 45% in February 2007. For the euro. Tunisia. Estonia.9.g. Source: ECB. central banks that actually disclose the currency composition of their reserves to the IMF. reality. has increased 122 . Burkina Faso. Vatican City. The IMF's Currency diversification strategies (Dooley et al. Vannatu Notes : 1) WAEMU (Benin. Mayotte Unilateral euroisation Andorra. Republic of Congo. Slovakia Euro-based currency boards Bulgaria Peg arrangements with fluctuation band based on Hungary the euro Managed floating with the euro as reference Czech Republic. while it has weighted basket of currencies with a substantial remained moderate in industrial countries. French overseas Peg arrangements based on the euro territories. Kosovo (1) CFA franc zone . Wijnholds and Søndergaard 2007). Equatorial Guinea. Côte d'Ivoire.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Table I. Euroisation Principality of Monaco. Comoros (2) Peg arrangements and managed floats based on Seychelles (37. Romania currency Pro memoria: Independent floating Sweden. Composition of Official Foreign Exchange Eichengreen and Mathieson 2000). Gabon).

9. by tolerating higher risk in the portfolio. 2007). For some non-commodity exporters. and which manage those assets separately from the official reserves of the monetary authorities. and generating inter- generational saving. 2007). assets denominated in euro accounted for almost 40% of the Fund's total assets whereas the share of US dollar-denominated assets was just above 30%. stabilising fiscal and export revenues. The holdings of SWF currently appear to be fairly concentrated. 123 . By some estimates. inter alia. both with respect to asset class and currency composition. government investment vehicles that are funded by commodity exports or foreign exchange assets. by running a current account surplus. they are. Their objective is often to seek higher expected returns. This compares to roughly USD 5. most SWF do not publish information about their investment strategies. In September 2007. Non-commodity funds are generally established through asset transfers from official foreign exchange reserves. their investments are likely to be more diversified than traditional reserves invested by central banks. than under traditional official reserve management. the Commission put forward a common approach to SWF based on the principles of greater transparency and good governance (European Commission 2008b). the rise in SWF can be seen as a manifestation of the global imbalances that have plagued the international economy in the last several years. more than 20 countries have such funds and others are considering establishing them (see Deutsche Bank. De Beaufort Wijnholds and Søndergaard. An increasing number of countries that have accumulated more reserves.Global. which was endorsed by the European Council in March 2008. the accumulation of official reserves in recent years. the value of assets that SWF manage today amounts to USD 2-3 trillion and could rise to USD 10 trillion within five years. e. 2007). Norway has decided to gradually increase the equity portion of the Government Pension Fund – Global to 60% from the previous 40% benchmark. Today. Public disclosure of investment management objectives and strategies varies widely among SWF. large current account surpluses have permitted transfers of excess foreign exchange reserves into SWF. With a few exceptions. on balance. assets or liabilities. in particular among developing and emerging market economies. Commodity-funds are established through commodity exports and serve a variety of purposes. While there is no universally accepted definition of SWF. and there are ongoing discussions whether to include real estate as a separate asset class. Given their sometimes explicit objective to increase returns. notably Norway's Government Pension Fund . According to IMF estimates (see Johnson. In February 2008. has gone far beyond established benchmarks of reserve adequacy (see e.g. It is generally believed that approximately two-thirds of SWF assets are held by commodity funds while one- third is held by non-commodity funds.7 trillion accumulated in traditional foreign exchange reserves and an estimated USD 2 trillion in private hedge funds. particularly in Asia. As such.g. For instance. let alone the currency composition of their balance sheets. five funds account for around 70% of total assets. Part I Assessing the first 10 years Box I. broadly speaking.1: Sovereign Wealth Funds Partly reflecting undervalued exchange rates. SWF fall into two broad categories. than what is necessary for intervention or balance-of-payments purposes have established separate Sovereign Wealth Funds (SWF) to manage those excess reserves. but is rather limited. based on projected developments of current accounts.

9. international borrowing and reserve currency. As 1999 2000 2001 2002 2003 2004 2005 2006 2007 discussed above. In the with economic and institutional links) diversified same period. in neighbourhood of the euro area and in countries most cases. countries and because they already account for about three fourths of global reserves.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union With these limitations in mind.3. the US dollar is more dominant in reserve currency. Moreover. namely the Western Balkans and Turkey. the aggregate COFER data published by the IMF are more Overall. many of these countries use the USD GBP JPY EUR euro as exchange rate anchor (normally as members of ERM II). There also appears to have been a time. in certain regions neighbouring 40% the euro area or with special links to it. in the pound sterling now stands as the third largest relative terms. the emergence 80% (with a disclosed currency composition) of the euro as an international currency has not been happening to the same degree worldwide 60% but has been more manifest. as the dominant trade Source: IMF COFER. invoicing. the data indicate that "dollar zone" countries diversified out of yen that by mid-2007. the US dollar has comfortably likely to underestimate than to overestimate the retained its position as the main currency of increase in the share of the euro in world denomination of global foreign exchange reserves. the euro is already countries are known to hold on average a higher playing an important reserve currency role in the share of their reserves in euros than industrial neighbourhood of the euro area. Close economic and financial prominent in countries in the geographical links with the euro area. particularly for some functions. (2007d) shows that in most EU neighbouring economies that disclose the currency This section provides an additional regional composition of their reserves. because developing diversification. although well behind the euro. the share of the perspective on the international use of the euro euro ranges from 40% to 85%. the countries The idea that the diversification out of US dollars covered by the EU’s neighbouring policy. while reserves were denominated in euros. while data show that the euro and the US general diversification away from the yen while dollar are dominant within their domains. Lim argues 124 . and official data much higher among developing countries than may underestimate the extent of that among industrial countries. the Americas and countries with dollar pegs finds further support in Lim (2006). As noted by Masson (2007). Sub- and into euros has been more pronounced among Saharan Africa. around 25½% of disclosed (rather than US dollars) into euros. countries with close economic and institutional links to the euro area and less important in Asia. Asia and Latin America.9. The ECB contribute to this.5: Currency shares in global foreign exchange reserves As noted in the previous section. EU membership and. At the same 71% to 65%. the prospect of euro area entry with an institutional link to the EU.5). and as parallel cash and domestic The role of the euro as a reserve currency is most banking currency. therefore. by focusing on five non-EU regions. the "dollar zone" than is the euro within its domain. 9. especially the new Member States. the dollar's share declined from out of US dollars and into euros. This is because the share of countries reserves but there has been a significant that do not report the currency composition is diversification towards the euro. up from countries neighbouring the euro area (or those around 18% in 1999 (see Graph I. The use 20% of the euro is particularly notorious among many of the EU countries that remain outside the 0% euro area. REGIONAL PATTERNS Graph I.

by contrast. the Western Balkans is the region in the A cursory look at the exchange rate world where the euro plays a more important arrangements in the Western Balkans shows that role. (111) Kamps (2006).9. 125 . although officially their exchange rates are mark and. Also. which is partially a legacy of the and Kosovo use the euro as legal tender and hyperinflation and financial crises that they Bosnia and Herzegovina has a euro-based experienced in the 1990's. The Turkish central bank however monitors closely (109) The following Western Balkan countries are covered in developments in a real exchange rate index in this section: Albania. Montenegro external anchor.1. All these economies show a high degree of the euro is widely used as exchange rate or "de facto" euroisation and many use the euro as monetary anchor (see Table I. peg "de facto" their currencies to the use of foreign currency. Data on the share of the euro in Turkey's Montenegro. Available 20 Croatia FYR Montenegro Serbia Turkey data for Croatia. Serbia and Kosovo (UN 1244). (110) The strong inflow of FDI from the EU received by these countries in recent years may have also played a role. as they have both institutional links with the EU and their prospect moved towards an explicit inflation targeting of further integration with the EU all argued in regime. Reflecting the predominance of euro- favour of adopting fixed exchange rate solutions based exchange rate regimes as well as the strong based on the euro. Part I Assessing the first 10 years 9. which the euro and the dollar each carry a 50% the former Yugoslav Republic (FYR) of Macedonia. Albania and Serbia are the only situation. the fact of being small and open countries in the region that have allowed their economies.(110). are likely Graph I.3. Croatia. and there is evidence of a rising use of the 100 euro as trade invoicing and financial currency. (111) After the EU countries that are outside the euro area. The Western Balkans and Turkey (109) about 40% of its imports (with an upward trend detectable in both cases since 2002). 80 With the EU accounting for about 60% or more 60 of foreign trade in the Western Balkans and for about 50% in Turkey. has had since 2001 a for the invoicing of about 50% of its exports and floating exchange rate. the larger size and euro share was 55% in Albania. including the customs union. there is not the same their foreign exchange reserves in euro- history of currency substitution and the use of the denominated assets. 2005) future. ranging from 60% to over 80% (Graph I. the euro accounts Turkey.6: Trade invoicing in euros to encourage a wider use of the euro in the (% of total. initially the Deutsche euro. weight. institutional links with the EU. the euro. FYR of Macedonia. since its introduction. their strong economic and currencies to float more freely.6). Croatia and FYR of Macedonia. central banks of the region hold large shares of In the case of Turkey. Macedonia Montenegro and Serbia show that the share of Exports to the euro area Exports invoiced in euro trade invoiced in euro is even higher than what Imports from the euro area Imports invoiced in euro Source: ECB. migration and tourism. the euro has been lower. and nearly 100% in made it less interested in using the euro as Bosnia-Herzegovina (reflecting its euro-based exchange rate anchor. trade and financial links with the euro-area. 86% in Croatia. These crises currency board that has functioned smoothly undermined confidence in domestic currencies since 1997. are either candidate or potential candidates for EU membership.9. as well as Turkey. for and banks and resulted in a widespread domestic their part. combined since 2006 with a formal inflation targeting regime. All these countries. the use of the euro as 40 trade invoicing currency in all these countries is high and shows an upward trend. In the case of Turkey. the shares of trade with the euro area would suggest. Bosnia and Herzegovina. But its close economic and currency board arrangement).9. 82% in FYR of relatively less open nature of its economy have Macedonia. This managed floats.4). As of the end of 2006.

The results obtained by Feige 80 (2003) pointed to relatively high holdings of the 60 deutsche mark cash in several Western Balkans 40 immediately before the introduction of euro banknotes.9. Also. indexed loans. (2007). or indexed to. but they 61% in FYR of Macedonia and 75% in Serbia in have shown a mild downward trend more 2006. the euro's share has been rising in recent years.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union foreign exchange reserves are not publicly euro's overall role in bank deposits and assets is available. (112) foreign currency deposits and loans in total bank deposits and loans.9. but strong and growing presence of banks from euro. reaching 39% and 33%. was dominated by the dollar. the dollar continues to be the recently. respectively. households in the countries of former UN 1244 Macedonia Yugoslavia have the highest volumes of foreign EUR deposits EUR loans cash holdings among European transition Source: European Commission.7).9. on Regarding the use of the euro as currency of average. In Turkey. the euro’s share in foreign currency foreign currencies as parallel cash has been less deposits and loans has shown an upward trend in widespread and. rather than exchange it directly into new euro banknotes. area countries. (114) See Backé et al. about 60% of total deposits and 70% of total loans. This ratio stood at 45% in Croatia. reflecting progress with macroeconomic deepening and integration between the region stabilisation as well as constraints on foreign and the euro area. economies. sizeable worker remittances from euro area countries and inflows (112) See Erçel (2000). reflecting the lower weight of 50%. the denomination for foreign debt. 2006) Western Balkans. favouring lending in euro over domestic currencies. euro. bank deposits in the total foreign debt of Western Balkan denominated in euros rose markedly in 2001. the authorities had encouraged households replacement of dollar cash by euro cash.7). has continued to rise accounting at the end of 2007 for about 56% of in recent years in several countries. Graph I. In 2006. to deposit the foreign cash kept "under the mattress" into foreign currency accounts. Hard data on the use of the euro as parallel cash outside the euro area are sparse. official declarations in the significantly smaller than in the Western Balkans past have suggested that it tends to exceed (see Graph I. the use of In Turkey. See Padoa-Schioppa (2003). However. by contrast. but also inertia in currency currency lending to households in a context of substitution following the financial crises that rapid household credit growth (ECB 2007d). In fact. 126 . with the share of the euro being well above that of the dollar. The share of euro-denominated and main currency of denomination of foreign debt. were denominated in. However. shook the region in the 1990s. markedly since the financial and currency crisis partly reflecting the process of financial of 2001. from tourism may be favouring some (113) At that time. at the end of 2006.7 : The euro as domestic banking surveys and other studies suggest a relatively currency in the Western Balkans widespread use of the euro as cash in the 100 (% of total. They have been supporting credit reaching about 30% at the end of that year growth in the form of euro denominated lending. In Turkey. In most countries. (Undersecretariat of the Treasury of Turkey also helped by an interest rate differential 2008). reflecting a the central government external debt stock. available data euro in the economies of the region (Graph show a growing share of euro-denominated debt I. the partial and anecdotal evidence suggest that geographical proximity. in countries. the run-up to the cash change-over (113). the share of foreign The use of the euro as domestic financial currency deposits and loans has declined currency is widespread in the Western Balkans. However. according to a survey 20 conducted by the Austrian central bank since 0 Albania Kosovo BiH Croatia FYR MN Serbia Turkey 1997 (114). However. before the introduction of the recent years.

The parallel decline in the dollar increased consistently in recent years (Graph shares over this period is also accounted for by I. Moldova. Graph I.9. the Regarding the use of the euro as financing advantages (in terms of liquidity and transaction currency. So far. while foreign borrowing by the strong trade. Azerbaijan. The euro dollar-denominated (on average over 70%).6% against 91. when its central remittances). both the official and private 300 use of the euro remains minor compared to that of the dollar.2. The same and a possible shift towards euro invoicing for pattern is visible in portfolio investments made gas exports could favour a more important use of abroad by Russian residents. For The reserves held by the Russian central bank foreign liabilities.8). but elsewhere the available bank started targeting a currency basket information suggest that the preference is for including the US dollar and the euros with dollars. geographical proximity to the euro area. By September 2007. Part I Assessing the first 10 years 9. the euro Russia has become the third largest holder of share in the currency composition of foreign international reserves in the world after China assets and liabilities has increased somewhat in and Japan. including from euro-area banks. US dollars. This partly reflects the predominance of oil and gas sector. the euro share is lower but is reserves and the share of them held in euros has also growing. as a legacy of the transition-related instability of the 1990s. which is broadly in line years these countries have sought to diversify with the share of euro area in Russia’s trade. Caucasus. Russia’s outstanding external public costs) of using the dollar and the importance of debt is also mainly (about 80%) denominated in energy exports in many of them. portfolio diversification considerations. and liabilities. Ukraine pegs de facto its currency 200 to the dollar and also in the smaller economies of 100 the region (which have managed floating 0 regimes) the dollar remains the main informal Dec-05 Jan-07 Mar-07 Jun-07 Sep-07 reference for exchange rate policy. and Ukraine. about 86% of Russia's exports are (115) Armenia. In recent neighbourhood policy – the three countries of the gas supply contracts signed with Baltic countries. Regarding the currency of denomination of trade invoicing. Nonetheless. respectively. the beginning of 2004 to 16% in 2007.9. 90% and 10%. and is also likely to be one of the recent years. the EU. euro deposits are as in the formulation of Russia's exchange rate common as dollar deposits (most likely linked to policy since February 2005. In the Russian banking sector. as In the countries covered by the EU's noted. De facto Total reserves (in USD billion) partial dollarisation (of banks' balance sheets and Foreign currency reserves held in euro (in USD billion) of cash) is still prevalent in one form or another Sources: Central Bank of Russia and Commission staff calculations. which. Ukraine. uses the dollar as “numéraire”. where the euro the euro in the future. Gazprom (Russia's main gas Mediterranean countries – and Russia.3. share has been progressively increased to reach Having mostly traded with Russia. Foreign currency denominated bank deposits range from 38% in Ukraine to 69% in The euro has also been playing an increasing role Georgia. financial and migration links with private sector has also been mainly in dollars. Moldova and the Northern however. EU neighbourhood countries invoiced in US dollars. Georgia. External public debt is also largely weights of. In Moldova. from 11% of total foreign assets in largest holders of euro-denominated reserves. the role which might be indicative of a new trend. of the euro has not surpassed that of the dollar.8: Reserves of Central Bank of Russia Elsewhere in the EU's eastern 400 neighbourhood (115). exports towards the EU markets. despite conglomerate) has moved to euro invoicing. in recent 45% in February 2007. the euro accounted the increase in rouble-denominated foreign assets for over 40% of its central bank’s reserves. 127 . This partly reflects historical inertia.6% in dollars at end- 2005. share was 4.

9). Lebanon) or heterogeneous while giving little importance to have adopted floating arrangements (Algeria. remained the main trade partner for SSA countries. targets a stable real exchange rate based on a basket of currencies in which the euro carries 2/3 The use of the euro as reference currency for of the weight. which shipped off 63% of its important trading partner for the region. Tunisia also trades mainly percentage points in the euro area's share in SSA with the EU (74% of its exports in 2006) and trade between 1999 and 2005. This is followed by the EU and therefore also in their relative use of Asia. pegs the dirham to a due to China's rising importance in global trade. Both Libya and Jordan peg to the exchange rate arrangements in SSA varies SDR (which includes the euro). countries of the Central African Economic and Monetary Community (CAEMC) have as The main currencies in the composition of public currency the CFA franc.9. Africa.9: EU share in SSA trade of goods support the use of the euro in SSA. Sub-Saharan Africa (SSA) are backed by the French Treasury within certain limits. The limited anchor currency in western and central Africa. 25% in 1995 1997 1999 2001 2003 2005 South African rand and 17% in euro (Kamps SSA imports from Euro area as % of total SSA imports 2006). available information on trade invoicing also Eight countries of the West African Economic indicates wider use of the euro in the Maghreb and Monetary Union (WAEMU) and six compared to other countries in the region. Europe has for trade invoicing has been reported. countries of the CFA zone. Although being two are the US dollar (44%).5% of total euro-area external trade. But in most (1995-2005) 40 countries. For the whole of SSA.4). they use the same yen (9%). In southern de facto stresses stability against the US dollar. exchange rate arrangements based on the euro.3. the euro is an important Israel and. the euro. These public external debt) followed by Algeria and fifteen countries – with a population of more Egypt (30-40%). Morocco. in the the euro. the shares of euros (40-50% of total outstanding Comores pegs its currency to the euro. However. In addition. Morocco and Tunisia have the largest exchange rate to the euro. the South-African rand plays an Other Mediterranean countries with smaller important role as a reference currency whereas in shares of their trade with the EU either peg their eastern Africa currency arrangements tend to be currency to the US dollar (Jordan. the significant differences between the countries in share of the euro area in SSA's total trade is their trade and other economic relations vis-à-vis about 25% (Graph I. the dollar remains the most commonly used 35 international currency. historical links with the EU and.9. inferred from trade data by assuming that its trade with Europe is largely invoiced in euros. than 120 million – are referred to as the CFA franc zone and their exchange rate arrangements 9. which is pegged to the external debt in Middle East and North Africa euro (see Table I. no major change in the use of the euro Following the colonial period. the euro (31%) and the separate currency unions. although Jordan considerably among subregions. Cape Verde has an exchange Strong trade. Egypt). information on SSA exports to Euro area as % of total SSA exports trade invoicing was not available and can only be Source: European Commission. mainly exports to the EU in 2006. Similarly. 128 .3.9.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union however. which is becoming an increasingly the euro. While trade with SSA represents only In the EU's southern neighbourhood. particularly in Southern Africa. migration and Official rate cooperation agreement with Portugal since Development Assistance (ODA) flows from the July 1998 which ties the Cape Verdian escudo to EU. since July 2007. have tended to Graph I. trade-weighted currency basket in which the euro This latter trend caused a reduction of about 10 has a dominant share. 30 25 Trade invoicing of South African exports of 20 goods in 2003 was 52% in US dollar. there are around 1.

12) and for 35% of its imports from the EU.9. in recent 20% 0% years. ODA from the EU is likely to involve some cash transactions in 129 . the euro area is the origin of about half of the remittances sent to WAEMU. significant receipts from tourism may be 100% supporting a significant circulation of euro 80% banknotes in the region. The role of the euro as financial currency in the role of the euro in Asia is limited.10: Currency breakdown of stocks of invoicing and settlement. the aid provided by the EU to SSA world. 40% 20% 2007) estimated that in 2004. up from US$40 billion and 2. which have a weaker affiliation to the euro. and this is reflected to some extent in below the share of the dollar (58%) (see Graph the use of the euro in the invoicing of Asian trade I.10). Evidence on the use of the euro as parallel currency in SSA is scarce but large remittances Graph I. In this respect. out of the 0% €20 billion remitted by migrants in the EU-27 to Japan Korea Indonesia Thailand their home countries. About half of long-term debt in SSA is (see Graph I. the main tourism destinations for Europeans in SSA are in eastern and southern Africa.11: Import invoicing in some Asian countries (2003 and 2004) and ODA flows and. On the other hand.9.9. However. participating African central banks reported that 9.11).3.2 billion were flowing USD EUR Others into SSA. Travel and tourism is another potential channel for the use of the euro as parallel currency in SSA. even if Africa appears to show an increasing trend. Part I Assessing the first 10 years At the end of 2002. well below its share in trade. data from the 40% Japanese Ministry of Finance show that. Bank of West African States. €3. Its Asia as a whole is an important trading partner of share in the stock of outstanding international Europe. EU (see Graph I. In of all aid received by SSA and for over 5% of a survey of central bank reserve asset SSA's GNI. However. which corresponded to 3. the international bonds and notes (shares EU’s share in Asian trade is gradually catching of total in % ) up with that of the United States and this could 100% 80% encourage Asia to use more frequently the euro 60% in trade invoicing.4. although it remains market). Compared with the regions near the euro area.9. According to data from the Central Source: Kamps (2006). According US$69 billion. the euro has been partly replacing the 1999 2007 1999 2007 1999 2007 1999 2007 dollar and the yen in Japan’s bilateral trade with Non-EU Africa Latin America Asia Pacific the EU and already accounts for the Developing denomination of 55% of Japan's exports to the USD EUR OTHERS Source: BIS. the share of the denominated in US dollar and around 20% in euro as an invoicing currency in Asia remains euro. for some countries.1% of to data from the OECD Development Assistance all estimated foreign reserve holdings in the Committee. Asia an average of 18% of their reserves was in euro.9. management carried out in summer 2002. A study financed by the 60% European Commission (Jiménez-Martín et al. Africa held reserves of euro which may then further circulate. The US dollar remains the main currency of choice for trade Graph I. The EU accounts for about 16% of East- debt securities rose from 6% at the end of 1999 Asian exports (compared with 18% for the US to 35% at the end of 2006.6% between 2003 and 2005 accounted for about 56% respectively at the end of 1998 (ECB 2003c).

Singapore and market participants to monitor both the collective Taiwan) held another 29% of global reserves. a heavy dependence on (see Deutsche Bank 2007). compared with 65% for the dollar). the daily fluctuation in the USD-RMB exchange rate has been limited. In their (116) Myanmar has a dual exchange system in which the search for higher yields. however. given the high significant amounts of euro-denominated debt share of Asian countries in world reserves and securities. 130 . 20% of Japanese the fact that COFER data show that the share of foreign debt securities were held in euro- the euro has been rising in developing countries denominated debt instruments while 44% were but it has remained stable in industrial countries. Asian SWFs might official rate is pegged to the SDR (which includes the follow a more diversified investment strategy. However. The ACU would be a Philippines and Thailand) together held 28% of virtual basket currency defined as a weighted world reserves at the end of the third quarter of average of the currencies of Asia’s key trading 2007. (116) 60 Following the 1997-98 financial crises in East 50 Percent of total 40 Asia. the Source: Ministry of Finance. At the end of 2005. takes inspiration on the ECU composite unit. regime that uses as reference an undisclosed basket of currencies that is thought to include the euro. This could result in some shift in regime from a US-dollar peg into a managed floating their portfolios towards the euro. however. serves as a point of 2001 2002 2003 2004 2005 2006 2007 reference for discussions on the regional Euro JPY USD Pound monetary integration in Asia. The euro. Japan.3. For some time. movement of Asian currencies against major Asian central bank decisions on the currency world currencies and their individual movement composition of reserves could therefore against the ACU. The US dollar remains the dominant At the same time. euro) but the dominant exchange rate used in the both across instruments and currencies. Singapore and China alone manage SWFs with an estimated asset value in the order of USD 700 billion. ASEAN+3 have been discussing the concept of introducing a benchmark currency basket. of Japan in November 2006 surprised observers by showing a larger than expected share of the 9. held in dollars (ECB 2007d). including the euro area. Korea. with Japan composition of official reserves do not cover standing out as the only country holding many Asian countries. In practice. significantly influence the role of the euro as international reserve currency in the future.9. the share it can be inferred that the share of the euro in the of the euro in Asia's issuance of international Asian countries reporting to COFER is probably securities has been rising since 1999 (see Graph rising. predecessor of the euro. However. most of them have flexible or managed 30 regimes in which the dollar remains however the 20 most watched reference. reserve data disclosed by the Bank I. Malaysia. China reformed its exchange rate central banks.5.12: Japanese exports to the EU No Asian country currently uses the euro as anchor for their exchange rate regimes.10). the China and ASEAN-4 (Indonesia. Also. Latin America euro (30%.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I. IMF COFER data on the currency currency in Asia remains limited. albeit rising in East Asia. Some market estimates with some differences within the region. so- East Asian economies account for close to 60% called the Asian Currency Unit (ACU). the importance of SWFs is international currency in Latin America. which of the world's official foreign exchange reserves. China (117) and Kong 10 Kong continue to de facto or de jure peg to the 0 dollar.9. than economy is determined in the parallel market (117) On 21 July 2005. Japan and the newly industrialised partners. As The use of the euro as international financial noted above. It would allow economies (Hong Kong. The suggest that the combined asset value of East geographical proximity and economic links to Asian SWFs could be close to USD 1 trillion the United States.

the euro pegs towards more freely floating exchange quickly and firmly established itself in this rates. the euro was expected to The general trend in Latin America over the last become the second most important international decade has been to move away from currency currency after the US dollar. however. which accounted for only Trade conducted with about 10% of total external debt. Central America and the Andean Arroyo 2003). although they Mexico 72.0 10. reflecting the stronger latter from 67% to 99%. trade invoicing and currency in these countries Available data (ECB 2007) suggest that the share to be relatively low. by contrast. CONCLUDING REMARKS Source: IMF Direction of Trade database.5 displays the shares of trade with the Central America but also some in South US and with the euro area for the main Latin America. Colombia. Chile 13.4. In many key functions. Peru and Uruguay.1 10. BIS data on the stock Andean Community (2) 10. Argentina project under way to allow daily settlement in local announced a plan to modify its currency board currency of all trade transactions between Argentina and arrangement by shifting from a peg to the dollar to a peg Brazil without the involvement of the US dollar. inertia (including hysteresis in dollarisation three countries (Ecuador. notably Bolivia and Peru) exhibit high American subregions. share of the dollar was still eight times higher 2006 (share of total trade) than that of the euro. with the former varying invoicing and settlement could be expected to be from 1% in Uruguay to 26% in Chile and the somewhat higher. based on a sample orientation of their trade towards the euro area.4 16.1 Notes : ( 1) For Mexico. Part I Assessing the first 10 years international commodity exports and historical in the region’s exchange rate policies.5: debt of Latin America show that. (119) Mercosur and Chile. the mechanism is to be expanded it to however. It shows that while rates of de facto dollarisation (see Temprano- Mexico. the euro. refers to trade with its NAFTA partners (Canada and the US). the euro plays a were mostly using the US dollar as an anchor. while several other countries (notably in Table I. covering Chile. in 2005. As previous fixed exchange rate regimes position. the rest of Mercosur.0 of international debt securities issued by Latin Mercosur 15. before this plan was implemented.9 32. If it to a dollar/euro basket. Chile had a crawling band regime defined over a basket of currencies of major trading partners that included first the deutsche mark and. (118) international financial currency. In the case of Mercosur and of the euro in these reserves is small compared to Chile. the use of the euro for that of the US dollar.6 17. (2) Includes Venezuela. 131 . reflecting relatively strong current exports. Panama) have officially dollarised monetary regimes. Given the higher orientation of trade of the former group of countries towards In recent years. between July 1992 and September 1999. Latin American countries have the US. proves successful. regarding the use of the euro as should also contribute to this. The euro. in April 2001. Moreover.9 35. For Chile. is not Community trade much more with the US than currently used as anchor currency in any Latin with the euro area. the Direction of Trade in Main Latin American Regions. that. refers to trade with Mercosur. by contrast. one should expect the euro’s role as account balances and a surge in capital inflows.5 America provide a similar picture.9. El Salvador and processes) help explain this. The substantial FDI inflows received by these South American countries since the early 1990s Finally.1 6.6 19. there Rest of the subregion USA Euro area has been a significant increase in the dollar share (1) over the last two decades. Also. Before its introduction. However. Indeed. and the fact that many of them are also been accumulating substantial foreign exchange heavily dependent on international commodity reserves. the trend towards flexible exchange rates has implied a relative shift away from the US dollar (119) It should be noted.9 69. 9. as its application to join Mercosur has not been ratified yet. The currency board collapsed.9 show a somewhat larger euro share (18%). since (118) It should also be noted that there is currently a pilot January 1999.9. the opposite is true for American country.4 Central America 11. World Bank data on the currency composition of external Table I.5 15.

a relatively weak use in far away regions with however. notably as important trade. progress has been largely limited to weaker economic and institutional links (such as certain regions with specific economic and Asia. This is the case countries and. Finally. (discussed in Chapter II. particularly financial currency. where on some measures it among non-euro-area EU countries. but relatively advantages strongly favour the dollar.7). has been countries and the Western Balkan countries. In between lye other regions regional and institutional pattern in the such as Northern Africa. foreign exchange vehicle and as pricing currency in combination with other factors that may affect for international commodities. 132 . perhaps. much less developed than in the euro area's in certain functions where incumbency immediate neighbourhood. the CIS internationalisation of the euro. and particularly impressive. the CFA zone.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union more important role than the Deutsche mark and A regional analysis of the euro's international the other legacy currencies combined used to role confirms a relatively strong presence in the play. revealing a strong Southern Africa). trade third group of regions the role of the euro is invoicing currency and parallel currency. candidate has already surpassed the US dollar. Northern and Central America and political links to the EU. In other functions. The rise of the euro as international immediate neighbourhood area. In this of its use as exchange rate anchor. the euro's inroad the euro's international currency potential has been very limited. could support a more important use of the euro in the future. financial and institutional links. South America.

Sticking to this rule allows Central Bank. which From the outset the Eurogroup has had an contains a "preventive" and a "corrective" informal status in the sense that it does not arm (121): venture into voting on policy. FISCAL GOVERNANCE of common policies is decided by the European Council (notably the Council of EU Economics The euro area is unique in its kind in that it and Finance Ministers. the ECB. area Member States alongside with the Commissioner of Finance and Economic Affairs The fiscal provisions in the Treaty are detailed in and the President of the European Central Bank. It was further shaped as events countries. ECOFIN) and (iii) many adopted a single currency while preserving other economic policies remain in the hands of national fiscal policies of its participating national actors. consists of the Ministers of Finance of the euro. 121 ( ) For an early account of the rationales and features of the representation and coordination of euro-area Stability and Growth Pact. common rules and co-ordination. (2001).2. (2008). The Treaty defines "excessive deficits": deficits that exceed Since not all EU Member States participate in the 3% of GDP or fail to ensure convergence euro area from the outset. (120) This chapter draws on a more detailed account prepared ordination of structural policies under the Lisbon for this Report published separately – see van den Noord Strategy. the co. (122) EU Member States that have not yet adopted the single currency annually submit "Convergence Programmes" which essentially have the same coverage as the Stability Programmes. and (ii) to initiate policy decisions in the Commission take stock as to how far they form of recommendations or propositions to the have progressed in moving towards close to Council whenever it considers this to be balance or in surplus and provide a policy appropriate and in line with the Treaty rules trajectory in the pursuit of this goal over the (right of initiative).1. medium term.10. where (i) a single monetary policy is entrusted with an independent central bank. The role of the European automatic stabilisers to play unfettered while Commission in this framework is two-pronged: respecting the 3% of GDP deficit ceiling (i) to pursue surveillance of economic policies stipulated in the Treaty. Moreover. the Stability and Growth Pact (SGP). unfolded. within certain bounds. the Eurogroup has governments achieve and maintain budgetary no role in the conduct of monetary policy which positions close to balance or in surplus over is in the remit of the fully independent European the medium term. commits participating countries to fiscal ordination at the euro-area level. albeit within a common framework. The Eurogroup discipline while allowing them to respond. but it does play a useful role in preparing such voting by the • The preventive arm stipulates that ECOFIN Council. exchange rate policy and the et al. INTRODUCTION ordination of financial market integration and development under the Financial Services Action EMU's unique economic governance structure Plan is not covered here since it has been was set up by the Maastricht Treaty to ensure the discussed extensively in Chapter I. The annual updates that are in the remit of the ECOFIN Council and of the "Stability Programmes" submitted by the Eurogroup so as to facilitate its decision the governments to the European making. to the business cycle. (120) The co- 10. 133 . a separate body – the towards gross public debt of 60% of GDP. positions in the international arena and the co. see Brunila et al.7. priorities changed and new challenges Specifically. (ii) a range 10. THE EVOLUTION OF ECONOMIC GOVERNANCE ordination of economic statistics. This Eurogroup – was created to deal with co. proper functioning of the monetary union. (122) Against this backdrop this chapter discusses the co-ordination experience to date in four important areas: fiscal policy co-ordination under the Stability and Growth Pact (SGP). fiscal policies are subject to emerged.

(123) It also details the timetable peaked (see Chapter I. % policy working against rather than supporting of GDP) as projected in Stability Programmes (SPs). and after giving a further SPs 2002 SPs 2003 SPs 2004 notice it may impose measures. its own impact on the area-wide fiscal stance would be small. would improvements. The SGP proved Treaty. another deposit according to the same formula for (125) Koen and van den Noord (2005) review the accounting the variable amount can be required. a member state fails to take sufficient measures actual SPs 1999 SPs 2000 SPs 2001 to correct an excessive deficit. in the opinion of the ECOFIN Council. attempts to comply longer act as a discipline on fiscal policy. to be distributed Turrini (2007) explore the political incentives for a among the other member states according to their share strategic use of stock-flow adjustment under a SGP-type in the area wide gross national product. As a consequence. Each deficit procedure was also put into question by individual country would probably not feel the episodes of large upward deficit revisions of the threat of such monetary policy "sanction" since deficit outcomes. with the 3 percent of GDP deficit reference value Growing deficits in one country.1).1: Slipping fiscal targets optimal policy mix. If the next year shows again an excessive deficit.5% of GDP. financial markets would no (see Box I.5). If. These provisions have been modified in 2005 – see -4 below for details. If after two years tricks and 'fiscal gimmickry' in the context of the SGP the excessive deficit is still found to exist. 124 ( ) The excessive deficit should be corrected in the year following its identification by Eurostat unless there are -5 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 special circumstances. the deposit and their determinants.1). of a deposit with the Commission of initially 0. From the outset it was largely unanticipated protracted economic seen as vital to underpin the single currency. with fiscal and monetary General government budget balances (excluding UMTS. but member states have committed not to invoke -3 this possibility if the drop in GDP is less than ¾ %. notably in the largest ones ceased to exist. 134 . The -2 Ecofin Council could also grant a waiver if GDP has fallen if the downturn is abrupt or large relative to past trends. (124) that the achievement of a budgetary position close-to-balance or in surplus became a moving The Stability and Growth Pact took effect when target (Graph I. Moreover. It downturn that followed. including the obligation Source: European Commission.10. in the the euro was launched.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union • The corrective arm details the "Excessive This dissuasive effect turned out not to be as Deficit Procedure" (EDP) embedded in the effective as foreseen. deficits rose again above was designed to address a key concern.2% of GDP plus one tenth of the difference between the actual deficit and the reference value. vicinity of the 3 percent deficit ceiling often led There was a related concern that widespread to creative accounting – an issue that was left fiscal profligacy could result in tighter monetary unaddressed by the SGP. each other. fiscal rule. rather than led to a preoccupation with cosmetic being reflected in wider yield spreads.10. Persistent sizeable countries should respect towards ending the deviations from planned adjustment paths and a EDP.10. Nogueira Martins and will "as a rule" be converted into a fine.(125) The reliability of policy to neutralise the associated demand EMU’s key fiscal indicators for the excessive impulses to keep inflation in check. It specifies when a waiver due to ineffective in preventing expansionary policies in "exceptional circumstances" may be the years 1999 and 2000 when economic growth granted. This would give rise to a sub- Graph I. and the sanctions to be imposed when a deterioration of the economic climate implied country fails to respect the timetable. namely the 3 percent of GDP reference value in a that once exchange rates within the area had number of countries. Buti. with an upper limit of 0. 1 0 -1 (123) The SGP stipulated that as a rule a deficit above 3% is not excessive if real GDP has fallen by 2% or more. This was already evident in the spill over into area wide interest rates and crowd run-up to EMU when budgetary policies in the out economic activity in other member countries.

October 2007 Council abrogates the EDP for the United Kingdom. Portugal and Slovakia. based on deficit outcome in 2002 and forecasts for 2003. on the basis of deficit outcome in 2001. Council decides that an excessive deficit exists in Italy. European Court of Justice judgement annuls November 2003 Council conclusions on France and Germany. November 2002 EC recommends the Council to address an early warning to France. April 2004 The Commission recommends the Council to address an early warning to Italy. November 2003 Council does not step up excessive deficit procedure (EDP) vis-à-vis France and Germany and decides instead to adopt conclusions addressing recommendations while declaring the EDP in abeyance for the time being. on the basis of the deficit forecast for 2006 in the stability programme. February 2002 Council rejects the EC's recommendation to give an early warning to Portugal and Germany. Part I Assessing the first 10 years Box I. (Continued on the next page) 135 .1: Implementation of the SGP July 1998 Council regulation (EC) 'on the strengthening of the surveillance of budgetary positions and the surveillance and co-ordination of economic policies' (1466/97) enters into force. July 2005 Amended regulations of the Stability and Growth Pact (1055/2005 and 1056/2005) enter into force. on the basis of deficit outcome in 2003. The country's commitment to take measures for the deficit not to breach the 3%-of-GDP threshold is considered to suffice. June 2005 Council abrogates the EDP for the Netherlands. Greece and Germany. June 2007 Council abrogates the EDP for Malta. June 2004 Council decides that an excessive deficit exists in the Netherlands. Slovakia and Poland. March 2006 Council steps up EDP vis-à-vis Germany July 2006 Council abrogates the EDP for Cyprus. Malta. SGP is fully operational. The countries' commitment not to breach the 3% threshold is considered to suffice. May 2008 Commission recommends to abrogate the EDP for Italy. January 1999 Council regulation (EC) 'on speeding up and clarifying the implementation of the excessive deficit procedure' (1467/97) enters into force. Cyprus. Council rejects the Commission's recommendation to give an early warning to Italy.Council decides that an excessive deficit exists in Germany.10. June 2003 Council decides that an excessive deficit exists in France. February 2005 Council steps up EDP vis-à-vis Greece March 2005 Council adopts a report on the revision of the SGP. January 2007 Council abrogates the EDP for France. on the basis of deficit outcomes for financial years 2003/2004 and 2004/2005. May 2004 Council abrogates the EDP for Portugal. January 2003 Council addresses an early warning to France. Council decides that an excessive deficit exists in Portugal. Czech Republic. July 2004 Council decides that an excessive deficit exists in Greece and in the following recently acceded Member States: Hungary. Czech Republic. January 2002 European Commission (EC) recommends the Council to address an early warning to Portugal and Germany. September 2005 Council decides that an excessive deficit exists in Portugal. January 2006 Council decides that an excessive deficit exists in the United Kingdom. on the basis of 2003 and 2004 data. on the basis of deficit outcome in 2002.

The report In March 2003. In adjusted terms and net of one-off measures.e. Based on the Commission's Communication the the Commission pointed to a need to take EU Heads of State and Government endorsed in complementary measures in order to foster March 2005 a report of the ECOFIN Council the overall fiscal and statistical governance. by allowing for small and allowing for more country-specific temporary deviations from the underlying circumstances in defining the medium-term budgetary position of ‘close to balance or in objective of “close to balance or in surplus”.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Box (continued) Number of countries in Excessive Deficit Procedure 8 7 EU enlargement 6 5 4 3 2 1 0 2002 2003 2004 2005 2006 2007 Euro area other EU In 2002 the Commission adopted a five-pronged recommendation to step up the ongoing proposal to improve the implementation of the excessive deficit procedures against France and SGP: Germany (Box I.5% of GDP.2). but also updates that there was no need for legal changes to the and complements the Stability and Growth Pact current EU fiscal rules. be forced to take a decision against its will. yet agreed government deficit and debt. Council decided not to endorse the Commission 136 .10. Franco(2005): (i) placing more focus on debt sustainability in the surveillance of budgetary • to avoid pro-cyclical policies in economically positions. entitled ‘Improving the implementation of the Stability and Growth Pact’. an appropriate adjustment path). However. (ii) introducing the concept of good times. response.10. (iv) next section). and surplus’ or the adjustment path to it. and (v) ensuring earlier actions to correct inadequate budgetary developments. the ECOFIN Council endorsed reconfirmed the Treaty’s reference values for most of the Commission proposals. which ruled that the Council could not objectives that are measured in cyclically. the Commission presented its Communication on “Strengthening economic • for countries that have not yet realised a governance and clarifying the implementation of budgetary position of ‘close to balance or in the Stability and Growth Pact” in September surplus’ to achieve an annual improvement of 2004.1). • to attach greater weight to public debt and the sustainability of public finances. acute along the lines of the Commission difficulties arose in November 2003 when the Communication (see Box I. Moreover. "protracted slowdown" in the exceptional circumstances clause. The Commission considered several the underlying budget position of at least elements for strengthening the SGP (Buti and 0. (iii) allowing for country- • to ensure the consistency between the Pact specific elements in the correction of excessive rules and the goals of the Lisbon strategy (see deficits (i. The Commission challenged this outcome for the European Court • to establish medium-term budgetary of Justice.

whilst enhancing economic rationale and national • Annual structural adjustment of EDP ownership. not achieved their MTO. Special attention is to be substantially and continuously and has come paid to pension reforms introducing a close to the reference value. The Report furthermore highlights the suggests a greater involvement of national importance of national budgetary rules and their parliaments in the EU fiscal surveillance process. countries: the annual adjustment should always be of at least 0. the revised SGP requires an annual improvement of their • Other relevant factors may also be taken into structural balance by 0. whereby the deviation should reflect the net budgetary cost. the MTOs now are consequences on government finances.5% of GDP as a account. downturn may be considered 'severe' in case of a negative growth rate or accumulated loss • Annual structural adjustment: For countries of output during a protracted period of very in the euro area or the ERM II which have low growth relative to potential. economic events with major unfavourable balance or in surplus. Special consideration is again major structural reforms positively affecting given to the implementation of pension long-term sustainability can be invoked to reforms. fully-funded pillar alongside a pay-as-you-go pillar. Budgetary (126) The Treaty also recognises the importance of national institutions should appropriately reflect the country- budgetary institutions and procedures in delivering sound specific institutional set up. the country-specific negative annual growth rate of GDP of at MTOs should be between -1% of GDP and least 0. This adjustment can be deficit remains close to the reference value modulated depending on economic and its excess over the reference value is conditions.(126) In this context the Report budgetary policies when it calls on Member States to ‘ensure that national procedures in the budgetary area enable them to meet their obligations’. mandatory.10. the net cost of the allow a temporary deviation from the reform to the publicly managed pillar is set adjustment path or from the MTO itself against the deficit on a linear degressive basis provided that the deviation remains for a period of five years.75%. In the years. They can be revised when a major structural reform is • Re-definition of a 'severe downturn' which implemented and in any case every four may lead to abrogation of the EDP.5% of GDP in The following changes were introduced to the structural terms. and this is taken temporary and that an appropriate safety into account also for the abrogation of the margin with respect to the deficit reference EDP provided the deficit has declined value is preserved. For euro area and ERM II Member SGP mark I a 'severe downturn' required a States (see Chapter II. 137 . surveillance to complement countries' It also recognises that the credibility and commitments under the SGP so as to strengthen implementation of the fiscal framework rely national ownership and enhance enforcement. Under the revision an economic balance or surplus. differentiated across countries. especially the 3% of GDP deficit and corrective arm of the Pact: 60% of GDP debt thresholds of the Treaty. Specifically. Part I Assessing the first 10 years Box I. but only if the general government benchmark. preventive arm of the Pact: • Revision of deadlines in the EDP can be • Medium-term budgetary objectives (MTOs): granted if there are unexpected adverse Rather than being uniformly set at close-to.2: The 2005 reform of the SGP The revision of the SGP reaffirms the rules-based The following changes were introduced to the framework.6). the implementation of temporary. As well.

wage rigidities. Article 99. 138 .6) A report on progress towards achieving context. setting a precedent and strengthening the older workers). single monetary policy. Initially they remained competitive and dynamic knowledge-driven economy by fairly general. attributes number of proposals to strengthen the mixed progress to " a lack of sense of political implementation within the reformed SGP urgency among the EU Member States". considered excessive. reforms in EMU has been widely accepted from efficiency of financial adjustment and the the outset.1.g. to which the EU Treaty. Over time. But since the detail developments in statistical governance in 2007 Integrated Guidelines specific reform areas EMU. For 10. the euro-area recommendations target the strengthening of adjustment capacity in the Although largely remaining in the remit of the euro area. In this and I. employment rate of 70% (60% for women and 50% for respectively. labour market flexibility and wage improved. success. (4) cutting red tape and (5) a sound credibility of the full set of instruments under the SGP. 2 has assigned a central role in the co. confirming that the SGP effects. financial market implementation of the corrective arm has clearly integration. The actual feared by media and other commentators did not governance of structural reforms in the euro area materialise. the need for enhanced structural manoeuvre. since Council". The BEPGs and the Lisbon Strategy example.10. A weakening of implementation as developments (See Box I. the Treaty. EU governments more visible in the texts of the BEPGs and later signed up to the goal of making Europe "the most Integrated Guidelines. Further proposals to improve the Apparently the "open method of co-ordination" fiscal surveillance are contained in Part III of this adopted by the Lisbon Process has had limited Report. price stickiness. Initially remains an effective rules-based framework. including a Dutch Prime Minister Wim Kok. This is evident in e.3. GOVERNANCE OF STRUCTURAL POLICY there is a euro-area specific structural reform agenda to be pursued for the area as a whole. internal exchange rate adjustment and with a Article 99. Since the 2005 Reform of the SGP the competition in services. 1 reallocation between the tradable and the non- requires Member States to "regard their tradable sector.2 concerns the preventive arm of the Pact. for the first time.3). since the SGP reform. In fact.4 discusses in potential and a lack of resilience. quality of public finances. (127) the progress with structural reform under the However. encompassing the fiscal room for Member States. the references to they deal with mechanisms to adjust more the euro area in the Broad Economic Policy efficiently within the euro-area in the absence of Guidelines (BEPGs). referring to a need to step up 2010". Section I. including completing the internal market. For example. ordination of economic policies.3. triggering the excessive which is mostly oriented towards learning deficit procedure. These are euro-area specific economic policies as a matter of common issues that go beyond the "traditional" Lisbon concern and shall coordinate them within the agenda for higher growth and more jobs. all has remained subject to the "open method of co- deficits in excess of 3 percent of GDP have been ordination" under the Lisbon Strategy (128). drawn up in 2004 by a Communication on 'Ensuring the effectiveness of high-level experts group chaired by the former the preventive arm of the SGP'.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union crucially on the availability of correct and structural reform in view of a low growth reliable fiscal data. (2) faster structural reform.9. framework. The main goals included 1) boosting innovation and research and development (R&D) including setting a target for R&D at 3% of GDP. the situation is less clear for what Lisbon agenda has been mixed (see Chapters I. (3) (127) Moreover. have been mentioned. references to structural reform needs in the euro area have gained importance and have become (128) At a Summit in March 2000 in Lisbon. macroeconomic policy mix. The adoption of recommendations specific to the euro-area Member States to address structural reform gaps made clear that 10. Notices on insufficient modernising the social model (for thorough labour progress in accordance with Treaty Article 104(9) have market reform and tackling exclusion with a goal of an been issued to Greece and Germany in 2005 and 2006. the Commission issued in 2007 a the Lisbon objectives. including the room for fiscal manoeuvre. benchmarking and peer pressure.

unlocking Integrated Guidelines now help to internalise business potential especially for small and euro-area priorities into Member States' domestic medium size business. investing in the four priority areas. The lack of adjustment labour markets and guaranteeing secure and capacity does not naturally emerge as an obvious stable energy supply. euro area" that culminates in a coherent and comprehensive reforms with a recommendation to Member States to "ensure view to enhancing the adaptability and better co-ordination of their economic and efficiency of product. These are next to period (which merged the BEPGs with the fiscal policy. recommendations to the euro area. Member States were asked to draft National Reform Programmes setting out their 139 . At the national co-ordinators. the Council issued four specific However. the more in knowledge and innovation. in its general part. efficiency of existing coordination The BEPGs were introduced as early as 1993. Member States have 2006 Spring European Council Member States submitted reports on the implementation of their indentified four priority areas and agreed upon National Reform Programmes and achievements concrete actions to achieve progress. • The 1999 BEPGs. but does so at the setting. covering both mix. capital and labour budgetary policies". The latter they are based on forging consensus. (2) quality of public finances. Five recommendations were addressed to policy In 2005 the strategy was re-launched and became policy intentions for 2005-08 and to appoint more clearly focussed on growth and jobs. Part I Assessing the first 10 years Box I. budgetary positions. Since then they have evolved as follows: growth potential and resilience to shocks (Council recommendation of 25 June 2003). inflation macroeconomic and structural policies. (3) competition • The BEPGs for the period 2003-2005 in services and financial market integration. this referred only to budgetary recommendations to the euro-area Member policy and not to the recommendations on States. monetary policy and wage Employment Guidelines) includes a specific bargaining "a commitment from the Member chapter on a "dynamic and well functioning States to press ahead with front-loaded. The recommendation markets" (Council recommendation of 12 made four more detailed points of which the July 1999). governance of the strategy was improved euro-area level.3: Evolution of the Broad Economic Policy Guidelines The Broad Economic Policy Guidelines (BEPGs) actors at national level related to the policy- are key policy documents.10. Aside for tighter priority problem at the national level. included for the first time specific (4) labour market flexibility and wages. of 15 June 2001). through a clearer partnership and division of responsibilities at the community and national levels. They concern (1) budgetary consolidation. but procedures in the area of structural reforms country-specific recommendations have only been that aim at strengthening the euro area's included since 1999. third one demands to "press forward with structural reforms" (Council recommendation • The 2001 BEPGs include for the first time a of 28 June 2005). Importantly. describes the policy-mix in the euro area to • The Integrated Guidelines for the 2005-2008 consist of four elements. They aim differences. while relying one asks Member States to "improve the largely on peer pressure for their implementation. grater adaptability of reform priorities. Guidelines. which they should consider together structural policies (Council recommendation with their specific country recommendations. external representation and at fostering consistency across policy areas and governance of structural reforms. reference to the euro area in the country- specific economic policy guidelines • In the 2007 update of the Integrated addressed to each euro-area Member State.

loss evident that measures to improve financial aversion and uncertainty about distributional integration are rarely discussed by the wider consequences have been identified as public other than in emergency situations. Reforms typically involve conclusions of the Spring 2006 European costs to those who benefit from the pre- Council are worth noting: "The European reform policy regime. competence. as a requirement to more effectively deal with asymmetric developments within the • Inefficiencies inherent in policy making.2: Public perception of reform needs 100 90 80 % of respondents 70 60 50 40 30 20 10 0 FI NL LU AT IE BE DE ES SI FR PT EL IT Agreement with need for significant reforms Agree with public expenditures. (129) A recent Similarly.g.10.a. Status quo bias. which applied approaches used in behavioural economics to study psychological reasons behind reform resistance. 140 . important obstacles. enthusiasm for them strongly several years ago. e.10. (130) Eurobarometer (2007). (2007). Moreover.2). In this context. dwindled if they were associated with higher taxes or a downgrading of social transfers or A political consensus has emerged among euro. for example. there is still a rather capacity to pursue reforms also depends on loose link between euro-area reform needs and the level of technical and administrative concrete reform undertakings in Member States. spread thinly across the population. Flash Eurobarometer No 216. a picture emerges to suggest that carrying out desirable or even necessary reforms (129) These issues were identified in Heinemann et al. the interest groups. should be reduced to finance economic reforms Agree that taxes should be increased to finance reforms Source: European Commission. public services (see Graph I.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union Graph I. Clearly. • Lack of public support. social benefits. Public attitudes and perceptions in the euro area. • Reform resistance from well-organised ordinating reforms." Even so. (130) area Member States on both the need for structural reforms and the advantage of co. the benefits of more integrated and Eurobarometer survey in the euro-area more competitive service markets for adjustment suggested that while a large majority of in the euro area have hardly played a role in the respondents considered economic reforms controversy surrounding the Service Directive necessary. The monetary union. i. It is. the fact that the euro-area Observers have identified three main reasons for recommendations are now much more precise reluctance to reform: than in earlier BEPGs may contribute to public awareness of reform needs. These groups can Council recognises the special importance of mobilise and exert pressure against such enhanced structural reforms in Member States of reforms. This pressure has usually no the euro area and stresses the necessity of counterbalance since reform gains tend to be effective policy coordination within this areas.

The exchange rate. either However. The ECB has also occasionally issued written and position taking and external representation statements and press releases on the euro on issues of particular relevance for EMU. In the case of informal agreements. following a proposal by the ECB or the Commission and While some ambiguities remain. under certain conditions the electoral on a recommendation from the ECB or on a cost of structural reform may be limited as voters recommendation from the Commission and after may reward. Exchange rate policy the Eurogroup. discussion on exchange rates at the G7 meetings of Finance Ministers and Central Bank Governors. rather than reject governments that consulting the ECB.4. the Eurogroup formulated its position in The Treaty (Article 111) foresaw procedures its regular communiqué rather than adopting covering exchange rate policy. Part I Assessing the first 10 years are perceived as unpopular by policy makers. strongly redistributive social welfare net may is the sole responsible for carrying out help to overcome the political resistance to interventions. INTERNATIONAL GOVERNANCE the foreign exchange interventions in the autumn of 2000. where – despite informal agreements with partners outside the the euro area itself not being a member of the euro area as well as unilateral position-taking by IMF – IMF staff meets with the ECB. ECOFIN Council was identified as the main policy actor and the Commission was given the The interdependence of exchange rate and other right of initiative. may not 2007). and the Eurogroup President as well as the Commissioner for Economic and The Treaty envisaged the possibility of entering Monetary Affairs are invited as observers to the a system of fixed exchange rates with countries meetings of the ECB's Governing Council. The reported in Chapter II. arrangement whereby the President of the European Central Bank attends the meetings of 10. The instruments provided markets and growth in "permanent income". lengthen households' time horizons (Bertola and in particular general orientations. unanimous decision by the Council. to be shared with the ECB on economic policies has given rise to an exchange rate policy matters. exchange rate policy. income of National Central Banks and the ECB). Financial market development would do so by removing liquidity constraints In practice. has not encountered major problems. which insurance provided by financial markets and/or a holds the euro area's foreign exchange reserves. A outside the EU as well as the formulation of pragmatic approach is also followed for the IMF general orientations for exchange rate policy. the rules governing the conduct of and also by allowing to "front load" future gains euro exchange rate policy have largely evolved stemming from structural reform via capital in an informal manner. by the Treaty have never been used for the Recent work at the European Commission purpose of exchange rate policy so far.4. Notably. the the euro area.1. exchange rate arrangements with third countries. Social insurance does so by offering the jeopardise the primary objective of price "losers" of structural reform generous stability. missions in preparation of the Article IV The latter are generally understood to cover consultations on the euro area. the practical consultation of the ECB and the European conduct of exchange rate policy in the euro area Parliament. As an additional safeguard for the structural reform since both factors tend to independence of the ECB. Eurogroup (based on a decision by the ECOFIN The upshot is that advanced financial market Council in 1997) results in "terms of reference" development and/or the presence of wide social on the exchange rates of the euro against the safety nets indeed diminish the political major currencies and in agreed language for the resistance to structural reform in labour and participation of the Eurogroup President in the product markets. the conclusion of general orientations on the basis of Article 111. Even when preparing the ground for 10.4 provides empirical regular exchange-rate surveillance by the evidence that these channels are indeed active. The 141 . the Council acts with qualified majority. compensation. Formal agreements require a Commission and the Eurogroup Working Group. The Eurosystem (the system carry out structural reforms.

action is possible. Not only do the topics on which coordination takes place remain As highlighted in Part III of the Report. policy. its voting matters have not made much progress. However. without another specific Moreover. a limited. (2008). This fragmented Eurogroup in September).10. They also have 6-8 executive representation.European Commission EMU@10: successes and challenges after 10 years of Economic and Monetary Union coordinated interventions in September and international financial fora unfortunately remains November 2000 to stem the depreciation of the fragmented. and members of both the Eurogroup and the despite the steps in that direction taken since Eurosystem tended to emphasise their own role 1999 (131). The situation at the World imbalances. 132 ( ) Each IMF member country is assigned a quota. by way of leading enlarged participation in G7 meetings has mixed country constituencies. after which the Eurosystem the Bretton Woods institutions remains dispersed carried out the interventions together with G7 among a large number of constituencies (see partners. this approach was repeated at multilateral economic and financial fora such as the highest level. and the amount of financial assistance it can result. The interventions in September 2000 followed an agreement at The representation of euro-area/EU countries in Eurogroup level. views of Ministers in the Eurogroup do not the EU is seen as less influential in them than the always converge.1 for the situation at the IMF). As a share. that is broadly based on its of the EU/euro area on financial and monetary relative position in the world economy. EU countries hold together The decision in 2005 to appoint the Eurogroup about 32. on an additional increased the transparency of euro-area 12% of the votes.5% of the actual quotas (132) of the IMF. See van den Noord et al.2. the follows below. for which exchange rate Bank is similar. insufficiently developed. and to stick to the agreed view in their external communication. reducing the actual influence of the euro (see Chapter I. In the IMF-led multilateral directors (of a total of 24) and 7-9 alternate consultations on global current account executive directors. EU's aggregate quota. appointment every two years of an EU executive Director to represent EU positions at the IMF and the participation of the ECB as an observer at the IMF 10. President of the ECB and Commissioner for Economic and Monetary Affairs representing the euro area. power is well below its aggregate voting share. which has however a quota about half the lack of consistency in their public statements. but there have also been occasional challenge the Eurogroup is facing is to develop a problems to fully translate the common lines common view on exchange rate issues that is the agreed in Brussels into the statements of EU precondition for conducting an exchange rate executive directors in Washington. a different setup coordination means that the EU’s actual voting emerged. Europe’s coordination at the IMF is in preparing the decision to intervene. The lack of All this explains why. This has on occasions led to a US. In their public representation would require a strong statements after the episodes of intervention.4. Quotas determine a member's capital subscription.2) demonstrate that effective euro area in them. A further (131) These include the creation of specialised committees in Brussels and Washington to improve the coordination of discussion of euro-area external representation EU positions at the IMF and World Bank. In a bilateral dialogue with China Concerning the G Groups and other key in November 2007. Attempts to formalise the external representation denominated in SDRs. despite the large aggregate transparency often perceived by third countries' voting share and large number of chairs EU authorities is compounded by the fact that the countries have at the Bretton Woods institutions. where the Presidency of the Eurogroup. insufficient developments also played a role. coordination to be effective. the Eurosystem Table I. the ECB and the Commission jointly represented the euro area. intervened unilaterally. External representation Board. 142 . President for a term of two years and his and exert some influence. some of them are mixed- agreement at Eurogroup level (based on the constituencies that include non-euro area and "green light" to intervene provided by the even non-EU countries. In November 2000. Europe's external representation in obtain from the Fund. with a Troika of the Eurogroup the Financial Stability Forum (FSF) and the President. However.

Part I
Assessing the first 10 years

Table I.10.1:
Constituencies in the IMF (as of 13 February 2008)

Other EU countries in Total voting share Total voting share of EU
Country holding chairs the constituency of constituency (%) countries (%)
Single country constituencies:
United States 16.79
Japan 6.02
Germany 5.88 5.88
France 4.86 4.86
UK 4.86 4.86
China 3.66
Saudi Arabia 3.17
Russia 2.70
Mixed constituencies including EU countries:
Austria, Czech Republic, 5.15 2.15
Belgium Hungary, Luxembourg,
Slovak Republic, Slovenia
The Netherlands Bulgaria, Cyprus, Romania 4.76 0.85
Venezuela (1) Spain 4.45 1.39
Italy Greece, Malta, Portugal 4.11 0.75
Canada Ireland 3.64 0.39
Denmark, Estonia, Finland, 3.44 1.52
Sweden (2)
Latvia, Lithuania
Switzerland Poland 2.79 0.63
Notes:
(1)
Chair rotates between Spain, Mexico and Venezuela
(2)
Chair rotates between Denmark, Finland Sweden and Norway
Source: IMF.

OECD, only a few large euro-area/EU countries prevents them in some cases from having
are represented, while the presence of the more meaningful discussions and reaching
Community or euro-area institutions in them agreements on certain issues as part of the
remains inadequate: relevant players are excluded.

• In the G-7, Community institutions are partly • The representation of the EU and the euro
excluded from the preparatory meetings at area at the OECD is also far from optimal.
Deputy or "Deputy Deputy" level and the Only 19 EU countries are currently members
Commission only participates in certain of the OECD, with three new euro-area
issues of the agenda of the ministerial countries (Cyprus, Malta and Slovenia)
meetings, being often excluded from issues in remaining outside this institution. While the
which it has Community competence and Community, represented by the Commission,
expertise (e.g., trade, financial market issues, enjoys a special status with practically all
development cooperation and global membership rights and obligations, it does
imbalances). not have the right to vote. And, despite the
existence of some coordination infrastructure
• The Commission is also excluded from the in Brussels (mainly through the so-called 133
G-20 ministerial meetings and, despite its Committee, which however deals only with
role in financial regulatory issues, from the some of the issues addressed by the Paris-
FSF. (133) The partial exclusion of based organisation), coordination among the
Community institutions from these fora EU countries that are OECD members often
leaves to be desired.

(133) At their meeting of 28 January 2008 in London, the In recent years, a number of economists and
Prime Ministers of the European G-7 countries reiterated policy makers have argued that the existence of a
their wish to see the Commission participate as observer
in the FSF. However, this proposal has yet to be agreed
single monetary and exchange rate policy
by the other members of the G-7. provides a strong argument for the full

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EMU@10: successes and challenges after 10 years of Economic and Monetary Union

consolidation of euro-area (or EU) representation IMF should remain in the realm of their national
at the IMF through the adoption of a single foreign economic policy.
chair. (134) For some observers (Ahearne and
Eichengreen 2007), the homogeneity of In the case of the G groups, there have also been
preferences on macroeconomic and monetary proposals aimed at reforming them by
issues among EU countries (and not just euro- consolidating European representation while
area countries) is such that it may warrant even a allowing the entry of some systemically
consolidation of the representation in the IMF of important emerging market economies. Thus, for
all EU countries. The argument here is clearly example, Ahearne and Eichengreen (2007)
weaker, however. A full consolidation of propose collapsing the G-7 into either a G-4,
euro-area (or EU) constituencies would probably comprising the United States, China, Japan and
require amending the IMF’s Articles of the euro area, or a G-5 including also the UK.
Agreement since they limit the size of elected Bergsten (2006), for his part, proposes to build
constituencies to 9% of the total votes and do not on the existing G-20 but consolidate EU
foresee the joint membership of a group of participation by dropping the four individual EU
countries. (135) members, creating a G-16 (Bergsten 2006).

Recent research suggests that the euro area could For some economists the G-20 is too large and
increase its actual voting power in the IMF by unwieldy. For others, a core group such as the G-
consolidating representation even if its aggregate 4/G-5 would be too small to be representative.
voting share declines. Thus, by applying voting As Bergsten (2006) stresses, in reforming the G
power analysis authors such as Leech (2004, group structure, an appropriate balance should be
2005) and Bini-Smaghi (2006b) show that the found between legitimacy and relevance (which
actual voting power of the EU/euro area is argues for including more countries) and
significantly below its aggregate voting share efficiency of decision-making (which argues for
while that of the USA exceeds its voting keeping the total membership small). The
share.(136) More recent analysis by the consolidation of European representation would
Commission staff confirms these findings, also help form a G group that is both efficient and has
suggesting that the euro area/EU could gain a wide coverage of relevant players. So far,
actual voting power with a partial regrouping of however, there has not been sufficient support
its constituencies (see Bertoldi, Just and Wichern for this type of reform among either European or
2008). other members of G-7.

The objective of having a single chair at the IMF Finally, in the case of the OECD, the
has so far not received sufficient political support Commission launched in 2007 a reflection
from euro-area countries. In particular, some process to assess the implications of the new
euro countries that find themselves in a strategy adopted by this institution (which has
privileged situation, holding the Chair or the decided to enlarge it membership to some key
Alternate Executive Director position of their emerging market economies and to increase its
constituencies, may fear a loss of influence from involvement on globalisation issues) and the role
a consolidation of chairs. Some feel that, despite the Community should play in it. The objective
the existence of a common monetary and is to ensure that all EU countries are effectively
exchange rate policy, their participation in the represented in the OECD (notably through the
Commission's participation), considering that
some of them will not be able to join for a
(134) See Bini-Smaghi (2004 and 2006a), Truman (2006) and relatively long period, and that the Community's
Pisany-Ferry et al. (2008) voice in this institution is commensurate with its
(135) On the legal implications of adopting a single chair at the economic and regulatory importance. But
IMF, see Mahieu, Ooms and Rottier (2003).
(136) An actual voting power index is defined as the concrete measures to attain these objectives have
probability a shareholder has of being able to change the yet to be adopted.
outcome of a vote by joining or withdrawing from
possible coalitions with other voters. A voter's power is
measured as the fraction of all swing votes that he could Long-term trends in the world economy, and in
cast. particular the rising weight of emerging market

144

Part I
Assessing the first 10 years

economies (notably in Asia) and the declining Brazil, China, India, Japan, Russia, South Africa,
weight of the euro area, are likely to further and the United States. These countries together
weaken the influence of euro-area countries in account for nearly 70% of non-EU world GDP
international financial institutions and fora. (137) measured at purchasing power parities and for
This will add to the problems caused by the 46% of EU trade with third countries. With
fragmentation of their representation. China, India, Japan, and Russia, annual dialogues
on macroeconomic matters are already taking
10.4.3. Bilateral dialogues place, in most cases jointly with financial
regulatory dialogues. Similar dialogues with
Over the last 20 years, the EU has developed Brazil and South Africa are being considered.
regular dialogues on macroeconomic and With the US, priority has been given to the
financial issues with a significant number of financial regulatory cooperation, including in the
countries and regions, both at high level and at context of the new Framework for Advancing
technical level. With the exception of the troika Transatlantic Economic Integration(139), while
dialogue for China, these dialogues are held by discussions on macroeconomic issues have not
the EU rather than the euro area.(138) been formalised and generally take place in the
margins of the multilateral fora.
From the EU's point of view, these dialogues are
not an alternative to those conducted within These bilateral dialogues with strategic countries
multilateral fora but, rather, a useful normally take place, on the Commission side, at
complement. The dialogues cover three main the level of Director General/Deputy Minister
types of issues: i) global issues that are salient in but are in some cases upgraded to ministerial
the discussions taking place in the multilateral level. The ECB is invited to participate in the
financial fora (e.g., global imbalances, dialogues and is often represented by a board
IMF/World Bank reform, financial globalisation, member. In the case China, a bilateral dialogue
energy efficiency and security, development with a euro-area troika including the president of
financing); ii) regional issues of interest to both the Eurogroup, the president of the ECB and the
parties or in which the EU's experience is European Commissioner for Economic and
relevant (e.g., financial and monetary integration Monetary Affairs was, as noted, organised in
among Asian or Gulf Cooperation Council November 2007. It has also been agreed to
partners); and iii) key bilateral issues, including explore ways to enhance the dialogue with China
macroeconomic policy challenges, structural on a more permanent basis. (140)
reform strategies, EIB lending, and the impact of
free trade agreements between the EU and the With all these countries, the EU has also agreed
country or region in question. to establish strategic partnerships, which imply
an intensified cooperation and dialogue on
From a global surveillance point of view, the political and economic matters, including the
focus of the high-level dialogues is being put on regular organisation of Heads of State summits
a limited number of strategic partners, namely, and other high-level meetings.

(137) Thus, for example, long-term growth projections
undertaken by Commission staff (Moreno, Just and
Wichern, 2008) suggest that the aggregate calculated (139) At the EU-US Summit of 30 April 2007, both parties
quota share of the euro area could decline form 23% in agreed to engage into a closer regulatory dialogue on
early 2008 to 21% by 2020 and to 12% by 2050. trade, financial markets, investment and intellectual
Bénassy-Quéré et al. (2007) also project a significant property rights. The Summit established a Transatlantic
decline in the euro area's quota in the period up to 2030. Economic Council at ministerial level to guide and
(138) The discussion below does not cover the dialogues with oversee the implementation of the measures envisaged in
the countries that are formally considered candidate for the Framework agreed at the Summit.
140
EU membership (currently Croatia, the former Yugoslav ( ) The US and China have also decided to strengthen their
Republic of Macedonia and Turkey) or potential bilateral economic dialogue. In 2006, they established a
candidates (Albania, Bosnia and Herzegovina, six-monthly Strategic Economic Dialogue with China at
Montenegro and Serbia, including Kosovo - UN1244), ministerial level, which covers, in addition to
since they have a different institutional and political macroeconomic and financial issues, other areas such as
framework and somewhat different objectives. energy and the environment.

145

European Commission
EMU@10: successes and challenges after 10 years of Economic and Monetary Union

The EU also conducts macroeconomic and macroeconomic statistics, but the quality varied
financial dialogues at high level with certain considerably. Several initiatives had been taken
regions or country groupings. In particular, EU since the adoption of the Maastricht Treaty in
finance ministers meet regularly with their Asian 1992 to promote the co-operation among
partners under the so-called Asia-Europe compilers of macroeconomic data, and improve
Meetings (ASEM) (141), with the EFTA countries statistics. (145) Among the most important
(Iceland, Liechtenstein, Norway and statistical legislation adopted or prepared in the
Switzerland) and with the Mediterranean run-up to the euro were (i) the adoption of the
countries (142). The macroeconomic dialogue European System of National and Regional
with the Latin American countries has been Accounts (ESA95) and its transmission
limited and occasional (for example, ad hoc programme of national accounts data; (146) (ii) a
meetings with ministers of finance of the series of regulations on the compilation of
Mercosur countries (143). With the Gulf harmonised indices on consumer prices (HICP);
Cooperation Council countries, the dialogue on (iii) the regulation governing the reporting of
macroeconomic matters has so far remained government deficit and debt data for the purpose
mostly of a technical and sporadic nature. of the excessive deficit procedure; (iv) the
regulation on short-term economic statistics, and
(v) a regulation on the organisation of a labour
10.5. HIGH-QUALITY STATISTICS FOR EMU force sample survey in the EU. (147)

The proper functioning of EMU, effective However, in the inaugural meeting of the
surveillance and co-ordination of economic Eurogroup (known at the time as the Euro-11
policies and more in general the running of group) on 4 June 1998, Ministers called attention
modern-day democracies requires a to important gaps in the available euro-area
comprehensive information system to provide statistics that needed to be addressed urgently. In
policy-makers with the data on which to base response, the EU's Monetary Committee
their decisions. (144) Timely statistics are a prepar