Mr. Heikensten examines EMU and economic policy in Europe  (Central Bank Articles and Speeches, 29 May 98)
Central bank: riksbank | Type: speech | Date: 1998-05-29

Mr. Heikensten examines EMU and economic policy in Europe Speech by the Deputy Governor of the Bank of Sweden, Mr. Lars Heikensten, at JP Bank's Conferenc the World Trade Center, on 29/5/98.This is not the end.

It is not even the beginning of the end.

But it is, perhaps, the end of the beginning.Winston Churchill's declaration in November 1942, after the victory El Alamein, is, I think, applicable - in rather different circumstances - to EMU's co for economic policy in Europe after the weekend at the beginning of May.Several years of intensive preparations for monetary union now lie behind us work, steeped in economic policy premises as well as technicalities, has been carried o different European settings.

Many of the EU Member States have also worked hard both ready on time for EMU by fulfilling the Maastricht criteria and to complete the more and technical arrangements.

It is now roughly a month since these processes were crown the historic decisions in Brussels to initiate European monetary union with eleven co couple of days from now, the new European Central Bank will be holding its first meetinSo there are good reasons to shift our attention and look ahead.

The conve process has been successful in many respects and monetary union is to start in little mo months time.

But once it has started, what challenges will EU's economic policy have What are the rules for this policy?

How are the dialogue and decisions likely to deve next few years?

These are some of the questions that I shall be considering today.

## 1.

ConvergenceA natural starting-point for a discussion of the current economic situa Europe is the convergence reports that the Commission and the European Monetary Inst (EMI) presented at the end of March.- The price trend for the EU area in recent years is impressive.

The dispa the rate of price increases have diminished and in January this year i was below 2 per cent in all the Member States except Greece.

Th development is fundamentally a consequence of the monetary policy focus price stability, backed up by economic policy in general.

Other factor been increased international competition and low oil prices.- The picture of government finances in the EU countries has also bright Progress has been made in the process of financial consolidation.

Howev number of countries are only just below or at 3 per cent and have qua thanks to measures of a temporary nature.- A high degree of exchange rate stability now prevails in most EU count and tensions in the exchange rate mechanism (ERM) have been moderate.- The notable convergence of long-term interest rates is another indicat the stable situation and EMU expectations.All in all, the reports from the Commission and the EMI show that convergen the Maastricht sense has come a long way.

This is important because the chances of the union functioning properly are better if rates of inflation are much the same in government finances are under control.Besides the matters behind the Maastricht criteria, with monetary union imm there are somewhat different issues that need to be considered.

Even when the Treaty w drafted, many economists pointed out that the criteria by no means constituted the onl not even the most important, requirements for an efficient monetary union.There are now two other matters that seem to be particularly important an will no doubt receive more attention, both in the European economic debate and in decision-making processes in economic policy:- One has to do with the degree of uniformity in cyclical activity an possibility of using judicious fiscal stances in different parts of the monetary union to make up for the absence of national discretion in monetary polic- The other concerns the participant countries' economic structures, not how their labour markets function and to what extent they are sufficiently flexible both to cope with any shocks to stability and to bring unemplo down to more acceptable levels.If the various political systems fail to prevent large imbalances in gov finances, internally as well as between countries in the monetary union, then the EC under strong pressure to consider other objectives than average European inflation. applies if unemployment were to remain high or become even higher.I shall be returning to these questions in my final section and try to pain of how they will be handled in the European Union in the coming years.

Before doi however, it may be in place to look in somewhat more detail at the structure for econom decisions in EU/EMU.

## 2.

FunctionsEMU is a historically unique construction, with a common central bank that conduct monetary policy across national boundaries.

At the same time, however, eleven governments are to conduct fiscal policies with eleven different budgets, besides mak other decisions that affect the functioning of their national economies, not least markets.

## Monetary policyIn

a monetary union, monetary and exchange rate policy is, by definiti common concern.

The monetary policy objective is price stability; without prejudice objective, monetary policy is to support the general economic policies in the Communi more budget policies focus on stability - and wages stay in line with productivity will be the room to manoeuvre in monetary policy.The ECB's basic tasks will be to define and implement the single monet policy, conduct foreign exchange transactions, hold and manage the official foreign re the Member States, and promote the smooth operation of payment systems.

The national c banks (NCBs) will be able to have an active influence on policy, participate in it implementation and, perhaps not least, communicate it in their respective countries analysis of the euro area will be undertaken centrally to a large extent and the leve rates will be decided by the ECB Governing Council, which consists of the members o ECB's Executive Board and the NCB Governors of the, initially eleven, participating counThe European System of Central Banks (ESCB) has been given a highly independent status so as to be in a position to conduct a monetary policy for pric without short-run political considerations.

But its independence does not relieve the duty to inform and communicate.

On the contrary, it accentuates the need for a dial exchange of information.

The European Parliament has displayed a high profile in these and worked to establish a basis for discussing and monitoring monetary policy continuouThe ECB will be obliged to make difficult decisions in various matters. problem may arise from cyclical disparities between euro area countries.

While these d may diminish over time, they are unlikely to disappear completely.

Meanwhile, the ECB set a single instrumental rate for the whole monetary union.

The common interest r normally not be ideal in relation to the economic situation in every country.The national financial structures also differ considerably, which means t instance, interest rate sensitivity varies.

There are countries where a large pr borrowing is arranged at a variable interest rate; the national tax systems differ, f regards tax relief for interest expenditure; and the time required for bank interest ra varies.

All this means that the impact of a change in the monetary union's interest rat from country to country.

In Italy, for instance, lending to households is arranged interest rates to a greater extent than in Germany and the Netherlands.

EMU will probab up the ongoing integration in these respects, too, so the ECB's problems may be greatesMany matters to do with the ECB's working procedures have already bee decided.

The broad structure is in place.

But in many respects, the way in which the EC ESCB will operate and develop in practice is still an open question.

Some observ concerned that national interests will be excessively influential at the expense of a perspective.

They point out, for example, that the NCB Governors make up a larger propo the Governing Council than is the case with the regional FED Governors in the United Another argument is that the ECB has a limited staff at its disposal.

Personally, I do particularly convincing.

The performance of a clearly defined task - maintaining price in a way that is good for the union as a whole will be a heavy responsibility for each the Governing Council; in this sense they are all in the same boat.

There are also many power will gradually shift towards the centre and this in turn will affect recruitment. that the ECB will be able to attract personnel who are qualified, which in contexts more important than their number.

## Fiscal policyFiscal

policy is a national concern but the national room to manoeuv conditioned by various EU regulations.

The Treaty has general provisions to the eff economic policy is to contribute to the achievement of Community objectives in accordanthe principle of an open market economy with free competition.

The Member States are to their economic policies as a matter of common concern and are explicitly required to c them but the decisions are to be made on a national level.Then there are more specific agreements on matters like the scale of ra value-added tax, government subsidies and rules for public procurement.

These agree which are a limited constraint on the construction of taxes and public spending, h concluded mainly for purposes other than stabilisation policy - to promote competit establish a single market for capital, goods, services and labour.The fiscal policy rules that have attracted most attention are those for go budgets and debt.

The Maastricht Treaty stipulates that budget deficits are not 3 per cent and that the government debt-to-GDP ratio ought not to exceed 60 per cent. intended to make monetary union candidates put their public finances in order p participation.The Stability and Growth Pact has clarified what will apply once monetary has begun.

The Pact can be said to consist of two parts: a surveillance mechanism for d an early stage that a country is starting to have budgetary problems and is in danger an excessive deficit, and a mechanism for sanctions on errant countries.

The first m covers all the EU countries and requires them to present a fiscal policy program sanctions mechanism, on the other hand, applies only to countries in the euro area.

Th of the Pact is to strengthen political mechanisms at union level so that budget di permanently maintained.

There has been underlying concern that otherwise a country mi strongly tempted to shift a part of the adjustment costs for consolidating governmen onto the other countries.The Pact requires every Member State to aim for a medium-term budgetar position close to balance or in surplus.

If the 3 per cent limit is exceeded, the Com the Ecofin Council are to follow a specified plan of action: examination, recommendation, publication and, as a last resort, sanctions.

The Pact has been constr a view to generating so much pressure on Member States to put government finances in that sanctions will never be necessary.A knotty problem when constructing the Pact was how to make the requiremen sufficiently strict without placing undue restrictions on national fiscal policies. more important when monetary policy is no longer available at national level, so that adjustment falls more heavily in practice on fiscal policy.

OECD estimates indicate 'normal' economic downturn, the cyclical budget balance in EU countries weakens 1-1.5 per cent of GDP.

Some budgetary discretion is therefore needed so that there is for automatic stabilisers to act when activity is falling.

The conclusion is that the t reasonable but the Pact does make it necessary to achieve a balanced budget or a relatively soon.

Under these circumstances, the Swedish government's ambition to estab annual budget surplus of 2 per cent over the business cycle is commendable.Fiscal policy accordingly faces new challenges and it is not all that easy t what may happen.

When monetary policy ceases to be a national instrument, fiscal poli have to play a greater part in stabilisation policy.

At the same time, the scope for will be curtailed in a sense by the Stability and Growth Pact, though this need not be a restriction in practice as long as the objective of medium-term balance or surplus stronger challenge is to be expected from the ongoing integration in the European UnioEMU may accentuate.

This process can be rather rapid, not least in financial markets.

I for goods, pricing in a single currency may accelerate the existing trend towards differences in consumption taxes, for example.

## Structural and labour-market policyFinally some words about structural and labour-market policy.

This policy f much less clearly defined than the two I have already considered.

It is affected by man rule systems at both national and EU levels, besides belonging to the competence o different ministers and commissioners.

The common agricultural policy and tax harmoni are two examples.The components of structural policy that concern the internal market - compe laws, the whole of the market for goods and services, the mobility of capital, and lab mobility - are largely regulated at EU level.

The competition laws are one example here.Another component of structural policy is the regulations and other matte apply to the labour market.

Many initiatives here have recently been taken at EU level speed things up and comply with political requirements in the Union.

In these matters, most decisions have to be made at the national level.

But the connection with condi monetary policy is evident: the better the economy can be made to work, the higher the that can be achieved without this generating increased inflation.Monetary union is likely to accelerate the process towards increased integr Europe.

In this way it will also contribute to new demands for structural adjustmen monetary union's primary purposes is, in fact, to stimulate competition and structura primarily to the benefit of consumers in the EU area.

At the same time, such a develop probably entail a greater degree of joint action and harmonisation in the Union.

## 3.

InteractionAs I have outlined, monetary union involves a central direction of monetary and a broadly national direction of budget policy, though discretion in budget demarcated by the Maastricht Treaty and the Stability Pact, for instance, and is bei curtailed by the gradual extension of international integration.

At the same time, stru is to varying degrees a common EU concern.

This raises the question of how a balanced can be constructed in such an environment.

## Bodies for decision-making and cooperationOne approach to this question involves describing the EU institutions tha been set up for economic policy decision-making and cooperation.- Ecofin, as the decision-making body for the ministers of finance and econ is the principal forum in the field of economic policy.

It is in this g for example, many of the decisions were taken so that monetary union co start on time.

The budget policies of the Member States have also monitored here and this will continue under the Stability Pact.

More Ecofin draws up an annual 'budget statement', the Broad Economic Polic Guidelines, containing the principles for economic policy in the EU area.- Most of the matters on the Ecofin agenda have been prepared by the Monet Committee, which besides representatives for each of the fifteen Mem States (normally an under-secretary of state or a deputy central bank go includes representatives for the Commission and, more recently, for the When monetary union starts, the name of the Monetary Committee will b changed to Economic and Financial Committee but at present it seems that composition will be unchanged apart from the EMI being replaced by t ECB.Work on monetary union has been a heavy burden for these bodies in recent ye Meetings have been protracted and business has ranged from major issues like the Stabi Growth Pact, the new European exchange rate system (ERM2) and legislation for monet union to matters such as the design of the European coinage.Some of the structure is now changing with the advent of monetary union but its basic features.

The preparatory work is over, as is a good deal of the work conn ERM.

A number of processes, such as those concerning government finances, are be modified.

But this is accompanied by an increased need to discuss issues raised by t monetary union.Now that the countries which will be participating initially in monetary have been singled out, moreover, an informal group - the Euro 11 Group - is being se discussions among the ministers of finance and economy in the euro area.

The idea is group will concentrate on matters that concern just the participating countries and c greater need for dialogue and cooperation that they perceive in connection with the in monetary union.

However, this is not a decision-making body and all matters conside Euro 11 are prepared by the Monetary Committee, in which all fifteen EU Member State represented.The crucial institutional change is, of course, that as of next year the monetary policy will be fully centralised.

The Treaty explicitly states that the ECB swayed by political considerations; its task is to concentrate on monetary policy.

But dialogue will be needed with the governments in the EU and euro areas, in the first pla ministers of finance and economy.

The Treaty actually provides for this in that th president may participate in meetings of the ECB Governing Council and even submit mot Moreover, representatives of the NCBs and finance ministries will continue to meet Economic and Financial Committee.Monetary union raises many other institutional questions that I will not b up today.

Not the least of these is relations with countries and organisations outside Union.

Where, for instance, does the primary responsibility for the exchange rate lie and what about relations between euro area countries and the International Monetary FundI now want to hark back to the issues I touched on earlier: fiscal policy i to the business cycle, and how the labour market functions.

How will these matters be h the system for economic policy decisions?

## Cyclical disparities and fiscal policyThe past year has seen a general strengthening of economic activity in t area.

This has helped improve government finances and provided better conditions in respects for the start of monetary union.

But it has been accompanied by increased disparities between the future euro countries.

This is clear from a look at how obse revised their growth predictions as compiled, for example, in 'consensus forecasts'. the euro countries divided into two groups with higher and lower predicted GDP gr respectively, shows that in the past year the gap between these groups has widened.

T applies in terms of predicted inflation.One should not make too much of this; the differences have grown but are small and assessments for 1999 suggest that they will narrow again.

But the pictu illustrate a problem that will have to be addressed.

The single monetary policy is i both stimulating the economy in some countries and curbing it in others.

Pressure on fi will accordingly vary across countries.

For one thing, differences in automatic stab thus in cyclical sensitivity will automatically lead to country differences in budget another, different degrees of active fiscal policy will be needed to manage tensions th from a single interest rate throughout the monetary union.This question has been deliberated informally for some time by economic po decision-makers in the European Union.

It also underlies the discussions that are now EU's broad economic policy guidelines.

In a way, it also contributed to the initiativ German finance minister before the weekend at the beginning of May, when some fur reinforcement of budget policy in the coming year was achieved by agreeing on an implementation of the Stability and Growth Pact's objective and an earlier productio annual convergence and stability programmes.This is ultimately a question for which each country is responsible.

Countr fulfil the Stability Pact's criteria will be entitled to a fiscal stance that is more e the ideal for European inflation.

Today, moreover, there is cause for concern that cu policy may be too expansionary in some countries.

But it is also clear that the cost policy mainly fall on the countries themselves.

Higher domestic inflation eventually competitiveness; with exchange rates irrevocably fixed, once a cost crisis is there, difficult to rectify.

Improved productivity can provide a remedy but achieving it is practice, this presumably leaves either fiscal tightening at a later stage to retard t increases or an adjustment of labour taxes, neither of which is simple.For the credibility of the EMU project it is important that no country is a such a situation at the start.

Countries with a risk of high inflation are theref experience strong pressure in various processes, for example in Ecofin.

On the whole, i me that the question of adjusting fiscal policies to the ECB's monetary policy will issue.

The same applies to how any fiscal adjustments are to be allocated across countr

## Labour market problemsIt is an established fact that the functioning of the labour market is a many

Member States.

A solution to the employment question clearly presupposes that European labour market is made to work more smoothly than before.

The matter is also d connected with monetary union.

There will no longer be any possibility of using a monetary policy to deal with labour market shocks.

It is then all the more importan labour market functions properly.Employment growth in the EU area has been weak and unemployment in many countries has been high for a long time compared, for instance, with the United State force mobility is also lower than in the United States.

But we also know that the Memb differ considerably.

Some, such as the Netherlands and the United Kingdom, have comparatively successful in generating new jobs.

Others have done considerably worse remedies chosen by the successful countries vary, too.

Some have adopted highly decent solutions and extensive deregulation.

Others have sought to build up a consensus an minor changes in some public systems.The question of how labour markets in Europe work and how they can b improved is already very much a part of the European agenda.

There have been pol initiatives in a variety of contexts in recent years, including national actio employment.

These plans include the analysis of labour market laws, effects of tax sys business conditions.

Processes are being built up, inspired by the Maastricht Treaty's with budget policy.

The annual employment guidelines require each Member State to pres national action plan with a view to improving people's employability, entrepreneuri flexibility and equality.

These national action plans are to be specific, with goa schedules, so that they can be evaluated.

Good examples are to be highlighted so t countries, if they wish, can adopt them.Structural questions have been brought to the fore during the British Pre and there have been somewhat more concrete discussions in various committees about ho get Member States in step here as well.

One approach involves finding good exampl different fields, just as in the case of employment, and analysing the structural prob country.

This process generates what the British call peer pressure, which can also co the desired national changes coming about.Once again, however, the decisions in this field largely have to be m national level.

But to perhaps an even greater extent than with fiscal policy, the majo a successful national policy will accrue to the country in question.

By itself, this s and should facilitate changes.

At the same time, the political resistance in most EU c strong.Some believe that the very fact of monetary union will generate desired refo labour markets.

Possibly but not necessarily - when high unemployment rates in recent in many EU countries have failed to produce changes, why, it may be asked, would mon union be more successful?

In conclusion, I consider that much work at EU level will be in political education and a search for methods to gain support for changes in this fi not foresee the same pressure in the joint processes as in the case of fiscal policy; need of a common approach.

## Laborious but successful processI should like to conclude with a summary and some tentative conclusions a the future course of the economic policy debate in the European Union.1.

There are important interfaces between monetary policy, fiscal polic structural policy.

Problems concerning the composition of fiscal policy workings of the labour market affect the room to manoe uvre in monetapolicy.

This suggests that a vital dialogue will be needed between di parts of EU's economic policy decision-making system that are involved such matters.

More of a joint appraisal will presumably emerge.

N processes and institutions are also likely to develop.2.

The growing need for dialogue and a joint appraisal has already led t tasks and developments for a number of EU institutions.

Many observe consider that this is true of Ecofin, which as a leading actor in the co of EMU has responded to new requirements.

One example of a completely new structure is Euro 11, which is designed for the handling of joint is the euro area's finance ministers.

There are many other opportunitie dialogue, so those who fear that the ECB will be operating in something vacuum are likely to be mistaken.3.

Issues concerning fiscal policies in EU/EMU and labour markets have a arrived on the agenda in other ways, for example at the Monetary Committ This is partly because many consider than monetary union has accentuated need for a joint European discussion.

With monetary union soon to launched, moreover, the agenda has more room for other matters.

The Stabi and Growth Pact is one example of earlier initiatives in connection with Various processes have likewise been started to bring the problem unemployment into the limelight.4.

There are strong grounds, in the fields I have discussed, for keeping d making essentially at a national level.

The effects of the policies, fo in the labour market, mostly occur in the country in question.

There a considerable country differences in such matters as the premises for policy, the structure of government finances, labour market regulations on.

Still, the ongoing integration of markets, which monetary union stimulate, is presumably exerting increased pressure for reform.The process that monetary union is now driving onwards is, in fact, fairly of EU cooperation in general.

The European Union is a highly decentralised organisation and political legitimacy are essentially located at the national level.

The joint budg Matters move forward in a process where external events, for instance in the global and political initiatives modify the agenda.

Problems are often managed with ar negotiated compromises between sovereign states.

Each new initiative and decision f platform for the next phase.

Monetary union, which is now leading to the appearance items on the agenda, is after all largely a consequence in its turn of earlier decision on the internal market.This process may sometimes appear to be rather random and it often provi instances of uncertainties and risks.

But it is a process that has gradually brou countries closer together.

And monetary union is an another, major step.