Communication from the Commission - The EU Economy: 2006 Review - Strengthening the euro area: key policy priorities {SEC(2006) 1490}
Date: 2006-11-22
Institutions: European Commission
Subjects: economic analysis, economic policy, economic situation, euro, euro area, monetary union

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels, 22.11.2006 
COM(2006) 714 final 

COMMUNICATION FROM THE COMMISSION 

The EU Economy: 2006 Review 

STRENGTHENING THE EURO AREA: KEY POLICY PRIORITIES 

{SEC(2006) 1490} 

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COMMUNICATION FROM THE COMMISSION 

The EU Economy: 2006 Review 

STRENGTHENING THE EURO AREA: KEY POLICY PRIORITIES 

Over the past eight years since the creation of the euro area, the euro has established itself as a 
strong and stable currency on domestic and international markets, and has emerged as one of 
the  pillars  of  the  international  monetary  system.  It  is  a  major  vehicle  for  global  financial 
transactions, and has changed the face of international capital markets. It has embedded low 
inflationary  expectations  and  economic  stability  throughout  the  monetary  union.  And  it  has 
shielded Member States' economies from the episodes of exchange rate turbulence that, in the 
past, at times engulfed them during global financial stress. 

But this is not to say that the euro area is functioning with full efficiency, or that the policy 
agenda  is  complete.  Continued  subdued  growth  performance  and  persistent  divergences  in 
growth  and  inflation  raise  questions  as  to  whether  internal  adjustment  in  the  euro  area  is 
working  smoothly,  and  whether  members  have  internalised  fully  in  their  economic  policy-
making  the  implications  of  living  in  a  monetary  union.  Such  divergences,  if  they  were  to 
result  in  tensions,  could  weaken  cohesion  in  the  euro  area,  make  policy  co-ordination  more 
difficult and complicate the task of the common monetary policy. 

These challenges need to be seen in a context of intensified international competition, ageing 
populations and persistent global imbalances. To face the future with confidence and ensure 
sustained  growth,  policy-makers  must  ensure  that  economic  incentives  are  right,  that 
surveillance is well-targeted and that euro area governance is fully effective. 

Challenges  in  the  euro  area  must  also  be  placed  in  a  broader  EU  perspective  so  that  key 
overlapping  interests  of  all  Member  States  are  strengthened,  not  diluted,  by  targeted  policy 
efforts  of  euro  area  members.  Synergies  can  and  should  be  pursued,  for  example,  between 
smooth euro area adjustment and the broad structural priorities of the Lisbon, Internal Market 
and  Trade  agendas.  Policy  options  need  to  be  rapidly  identified  and  spelled  out,  leading  to 
concrete  action.  This  means  building  on  themes  identified  in  the  Annual  Statement  on  the 
Euro Area – 2006, and deepening their analytical foundations1. 

The  2006  EU  Economy  Review2,  published  together  with  this  Communication,  focuses  on 
questions raised by recent adjustment experience in the euro area. Analysing this experience, 
the review highlights possible inefficiencies in the functioning of the monetary union, serving 
as a basis for action to strengthen the adaptability and resilience of EMU for the period ahead. 

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2 

"Annual  Statement  on  the  Euro  Area",  Communication  from  the  Commission  -  COM(2006)  392, 
12.7.2006. 
2006  EU  Economy  Review,  "Adjustment  Dynamics  in  the  euro  area:  experiences  and  challenges", 
European Economy, Directorate General for Economic and Financial Affairs, 
http://ec.europa.eu/economy_finance/publications/european_economy/2006/the_eu_economy_review20
06_en.htm 

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Mixed experience in the early years of the euro area 

The  preparation  of  the  monetary  union  in  Europe  was  dominated  by  debate  on  the  benefits 
and  costs  of  the  euro,  and  on  the  prerequisites  for  ensuring  its  success.  In  the  run-up  to  its 
launch in 1999, the major question was already how the participating countries would adjust 
to shocks and differences in competitiveness in a context of low labour mobility, incomplete 
integration of product and services markets and the retention of national budgetary autonomy. 
During  this  time,  many  predicted  that  the  European  monetary  union  would  not  work  and 
would be short-lived. 

Experience has not supported these pessimistic forecasts. The euro quickly established itself 
as a strong and stable currency. The euro area economies responded surprisingly well overall 
to  common  shocks  such  as  the  more  than  doubling  of  the  oil  prices  and  the  effects  of 
international  financial  turbulence.  Inflation  also  remained  remarkably  low  and  stable  by 
historical  standards,  as  evidenced  by  the  very  low  impact  of  energy  price  rises  on  inflation 
and  wages.  In  turn,  this  has  enabled  euro  area  members  to  enjoy  the  most  favourable 
financing  conditions  ever  in  a  context  of  increasingly  deep  economic  integration  resulting 
from the reinforcing effects of EMU and the Internal Market. 

Despite these successes, the individual economies in the euro area have not always adjusted to 
country-specific  developments  as  smoothly  or  swiftly  as  would  be  desirable.  It  is  natural, 
under monetary union, for adjustment to take place through divergences in national inflation 
and  growth  rates.  But  long-standing  differences  in  inflation  and  large  current  account 
imbalances  in  the  early  years  of  the  euro  have  in  some  cases  been  the  result  of  rather  slow 
adjustment.  The  latter  also  accounts  for  some  variations  in  growth  rates,  which  have  been 
wider  than  would  be  expected  in  terms  of  potential  output.  If  adjustment  had  been  more 
efficient,  economies  that  were  slowing  down  after  losing  competitiveness  would  have 
returned to their medium-term growth trends more swiftly. Similarly, periods of high national 
inflation  (relative  to  the  euro  area  average)  would  not  have  been  so  prolonged.  More 
generally, the euro area has not yet been able to achieve high growth and employment over a 
sustained period. 

It may seem tempting to blame such adjustment difficulties wholly on the fact that some euro 
area members lagged in their action to strengthen fiscal policy and structural reforms. While 
this  certainly  played  a  significant  role,  policy-makers  and  economic  agents  were  also  faced 
with  the  new  experience  of  adjustment  under  monetary  union,  which  posed  challenges  that 
had not been fully anticipated. For example, financial market developments played a greater 
role  than  expected  in  fuelling  imbalances  and  influencing  consumption  and  investment 
patterns.  Moreover,  economic  developments  interacted  with  one  another,  and  with  policy 
initiatives, in ways that often triggered mutually-reinforcing consequences. 

The  following  elements  can  explain  in  greater  depth  the  prolonged  divergences  in  growth, 
inflation and current account imbalances within the euro area: 

Developments during the run-up to monetary union can be linked to prolonged imbalances 
and  shifts  in  real  effective  exchange  rates  during  the  first  years  of  economic  and  monetary 
union.  In  some  Member  States,  these  included  a  strong  decline  in  interest  rates  during  the 
approach to euro adoption, and a relaxation of credit constraints on households following an 
improved  access  to  credit  in  the  more  integrated  financial  market.  Furthermore,  German 
unification had a sizable impact on relative competitiveness within the euro area. There were 

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also country-specific developments in productivity in the traded or non-traded goods sectors 
in addition to effects from migration and tourism. 

An  important  factor  in  individual  euro  area  economies  has  been  the  way  that  economic 
developments interacted in certain cases to make current account imbalances larger and more 
protracted.  A  prime  example  was  the  strong  and  sustained  shift  of  resources  into  the  non-
traded goods sector, such as real estate investment, fed by the compound effect of declining 
risk premia, easier credit constraints, migration, tourism, and demographics. 

In  some  cases  national  policies  interacted  with  market  behaviour  in  a  way  that  inhibited 
smooth  adjustment.  For  example,  in  the  Netherlands  pro-cyclical  effects  emerged  in  the 
labour  and  financial  markets  and,  with  the  benefit  of  hindsight,  in  fiscal  policy  at  the 
beginning  of  this  decade.  These  factors  contributed  to  a  "boom-bust"  cycle,  a  surprising 
occurrence for a country that had been in a de facto monetary union for some thirty years. A 
more  general  experience  in  the  euro  area  was  the  difficulty  in  assessing  underlying  fiscal 
balances, during country-specific adjustment cycles, and this highlighted hazards in designing 
fiscal policies in "good times". 

Prices  and  wages  in  some  cases  adjusted  too  slowly  to  changes  in  national  cyclical 
conditions, especially at times of slowing activity. This lack of flexibility was present despite 
a general background of marked wage moderation, which helped foster a decline in structural 
unemployment. A contributory factor was low productivity growth, which placed the burden 
of real depreciation heavily on wages. 

There  is  scope  for  significant  spillover  effects  across  euro  area  economies.  Analysis  of  the 
adjustment  experience  shows,  for  example,  that  a  housing  boom  in  several  economies  will 
affect  both  the  demand  for  traded  goods  and  the  level  of  interest  rates  for  other  euro  area 
members. And fiscal and wage developments, as they interact during adjustment, will affect 
other economies in the monetary union through both demand and competitiveness channels. 

Spillover effects  from the global  economy can also impinge on euro area  members in ways 
that  pose  adjustment  challenges  within  the  monetary  union.  Due  to  diversity  in  their 
geographical  and  sectoral  specialisation,  Member  States  are  affected  differently  by 
developments in world trade, in international price and export markets, and in the value of the 
euro with respect to the currencies of their main trading partners. These issues gain particular 
relevance given the significant imbalances emerging at global level. 

Finally,  experience  with  nominal  and  real  convergence  has  varied  considerably,  partly 
reflecting national policy approaches. During nominal convergence, some economies, such as 
Spain, channelled savings in interest payments to achieve permanent budgetary improvement, 
whereas  others  (such  as  Italy)  did  not  fully  seize  this  opportunity.  Furthermore,  during  real 
convergence, policy and market factors led to differing outcomes. In Portugal, expansionary 
fiscal policy during a strong boom added to cyclical pressures, and it also limited budgetary 
flexibility and the resilience of the economy during the subsequent downturn. Simultaneously, 
resources  shifted  strongly  into  the  non-traded  goods  sector,  while  productivity  performance 
was poor. The corollary was an insufficient basis for sustained catching-up.  This  contrasted 
sharply with the favourable experience at a similar stage of real convergence in Ireland. 

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Action is needed to ensure the smooth-functioning of the euro area 

A number of possible policy lessons emerge from the above analysis. Such lessons can help 
foster an increasingly smooth functioning of monetary union in the future. On the one hand, 
national  fiscal  policies  need  to  be  prudently  managed,  so  as  to  minimise  negative  spillover 
effects.  Structural  policies  are  also  matter  of  common  interest,  given  the  high  degree  of 
interdependence as euro area economies respond to shocks or strive to increase their growth 
potential.  Moreover,  the  challenges  facing  members  must  be  seen  in  an  international 
perspective. 

Five  specific  policy  considerations  are  outlined  below,  followed  by  suggestions  of  further 
avenues for progress that broadly fit within the Commission priorities for the period ahead: 

Budgetary policies must be run even more prudently. This requires analysing fiscal positions 
carefully, improving the measurement of underlying balances, taking into account a broader 
range of indicators and increasing the focus on the composition of growth and real exchange 
rate adjustments within the euro area. This should allow making full use of economic "good 
times" to assure improvement in fiscal positions. These recommendations are closely in line 
with  the  reformed  Stability  and  Growth  Pact,  which  provides  a  stronger  framework  for 
guiding national policies throughout the cycle and takes into account long-term sustainability 
concerns. 

Markets for goods and services must become more flexible and budgets more supportive of 
active  adjustment.  The  experience  with  adjustment  to  shocks  in  the  early  years  of  the  euro 
area  calls  for  greater  downwards  price  flexibility.  Rigid  prices  are  accompanied  by  an 
increased  resistance  to  adapt  nominal  wages,  since  that  would  result  in  larger  real  wage 
losses. Thus adjustment costs in terms of output and employment are higher. Inertia in the re-
allocation of resources across companies and sectors can also increase the pain of adjustment. 
Therefore,  ensuring  open  and  competitive  product  and  service  markets  does  not  only  foster 
the  medium-term  growth  potential,  but  is  also  an  indispensable  element  of  any  strategy  to 
reduce  the  welfare  cost  of  cyclical  adjustment  processes.  From  this  perspective,  tax  and 
expenditure policies at EU, national and local level may also need to be reviewed. 

Financial  market  integration  needs  to  be  accelerated.  Important  progress  has  been  made 
across the EU, but more needs to  be done to  tap the potential and maximise the benefits of 
financial  markets  in  the  euro  area.  Greater  financial  integration  can  smooth  the  impact  of 
economic shocks on incomes and on national credit markets. In this regard, full transposition 
and  enforcement  of  the  Financial  Services  Action  Plan  and  ongoing  efforts  to  enhance 
financial market integration should deliver further significant results. 

Wage setting must internalise the implications of monetary union. Given that responsibility 
for  well-adapted  wage  setting  falls  increasingly  within  the  domain  of  social  partners,  it  is 
important  to  ensure  that  the  actors  in  the  wage  bargaining  process  have  the  necessary 
information  concerning  the  challenges  and  the  implications  of  different  lines  of  action. 
Primarily this should allow for a better assessment of whether current and prospective wage 
and price developments are benign in terms of adjustment needs. It should also help to avoid 
significant overshooting in intra-euro area real effective exchange rates. 

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The global dimension must be taken into account. The international dimension needs to be 
considered  in  a  more  systematic  way.  The  differentiated  country  implications  of  global 
developments  –  as  well  as  the  impact  of  the  euro  and  the  euro  area  on  other  players  in  the 
world  economy  through  trade,  financial  and  policy  channels  –  must  be  factored  into  the 
assessment  of  policy  stances  at  the  euro  area  and  country  level.  Moreover,  the  EU's  Trade 
agenda and the deepening of the Internal Market can help strengthen the competitiveness of 
the euro area economy in global markets. 

The way ahead to a stronger euro area 

Monetary  union  has  brought  great  gains  to  its  members,  but  it  remains  to  be  deepened  and 
completed,  a  priority  that  becomes  all  the  more  compelling  in  today's  international 
environment.  Recent  divergences  have  to  some  degree  reflected  initial  developments  that 
affected  member  economies  in  the  run-up  to the  euro  area's  creation  in  1999.  However,  the 
future  is  expected  to  bring  new  challenges  in  the  form  of  major  changes  in  global  markets, 
whether in terms of competitive pressures, export market slowing, or financial market shifts. 
In some cases, individual euro area members could face heightened adjustment challenges. 

It is essential to ensure that the euro area economy as a whole responds to future shocks with 
adaptability and resilience. Indeed, it must prove capable of strong and sustained growth in an 
international  setting  where  some  other  drivers  of  global  activity  may  be  slowing.  This  can 
contribute  to  keeping  international  markets  open  and  growing  strongly,  and  thus,  crucially, 
increase the welfare of European citizens. As we approach the end of the euro's first decade, 
policies and institutions in the euro area must prove well equipped for this challenge. 

Accelerating structural reforms and fostering integration 

A  first  priority  is  to  accelerate  structural  reforms.  Together with  the  new  governance  of  the 
partnership  for  Growth  and  Jobs,  the  current  economic  recovery  provides  a  unique 
opportunity to vigorously pursue the necessary structural reforms3. These can improve growth 
potential  over  the  medium  term  and  boost  the  efficiency  with  which  member  economies 
respond  to  shocks.  Market  mechanisms  will  be  more  responsive,  and  higher  productivity 
growth can ease adjustment, and here the goals of raising R & D expenditure to 3% of GDP 
and  fostering  innovation  are  most  important.  Structural  reforms  will  also  help  address  the 
longer-term  challenges  of  population  ageing  and  global  economic  change.  In  the  euro  area, 
therefore, the Growth and Jobs agenda, including Internal Market and Trade policies, assumes 
a special importance. A fuller and less uneven integration of markets could bring significant 
welfare  gains  and  a  smoother  adjustment  process.  Among  other  priorities,  the  potential  of 
financial  markets  to  spread  risks  and  smooth  incomes  has  yet  to  be  fully  tapped.  Euro  area 
members  must  identify  those  structural  measures,  including  those  favouring  the  mobility  of 
labour  that  is  currently  very  low,  which  are  most  relevant  to  enhancing  both  growth  and 
adjustment capacity, ultimately resulting in beneficial effects for the whole euro area. Already 
outlined above is the related priority for actors in the wage-setting process to fully internalize 
the euro area context, allowing adjustments in competitiveness to proceed smoothly. 

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The  European  Competitiveness  Report  2006  documents  areas  where  additional  efforts  may  be 
necessary.  See  in  this  respect  the  Communication  from  the  Commission,  "Economic  reforms  and 
competitiveness:  key  messages  from  the  European  Competitiveness  Report  2006"  -  COM(2006)  697, 
14.11.2006. 

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Further strengthening fiscal positions and improving the quality of national budgets 

Fiscal  policy,  too,  can  make  a  stronger  contribution  to  efficient  adjustment  and  sustained 
growth.  Experience  in  the  early  years  of  the  euro  underlines  the  need  for  policy-makers  to 
make  better  use  of  "good  times",  and  ensure  medium-term  adjustment  in  line  with  the 
reformed  Stability  and  Growth  Pact.  Budgetary  policy  under  the  reformed  Pact  should 
increasingly  address  the  quality  of  public  finances,  and  notably  the  structure  of  tax  and 
expenditure  polices.  Member  States  have  agreed  to  use  the  next  generation  of  national  and 
regional  programmes,  supported  by  the  Structural  Funds  and  the  Cohesion  Fund,  to 
implement the Lisbon Strategy, thereby enhancing the quality of public expenditure. 

Reinforcing coordination within and outside the euro area 

The  above  challenges  should  be  considered  in  terms  of  national  policy  priorities.  Yet  at  a 
deeper level they also pose a challenge for euro area governance. The euro has brought much 
greater interdependence, including through the speed and scale of financial flows. There is a 
clear  role  for  EU  institutions,  and  the  Eurogroup,  to  coordinate  progress  across  countries, 
policies and sectors. In this perspective, coordination instruments at the national and EU level 
take  on  even  greater  importance  in  fostering  the  efficient  functioning  of  the  euro  area.  
Budgetary coordination under the reformed Stability and Growth Pact needs to be enhanced; 
and the euro area dimension of the Growth and Jobs Strategy must be duly emphasized. The 
integrated  guidelines  for  Growth  and  Jobs  adopted  in  July  2005  by  the  Council  reflect  this 
clear  orientation  towards  an  enhanced  coordination  between  macroeconomic  and  structural 
policies,  in  particular  through  the  guideline  focused  on  the  euro  area.  A  clearer  external 
representation, leading to a single voice, can make an important contribution to promoting the 
interests of the EU and the euro area. 

Promoting the enlargement of the euro area 

An  improved  functioning  of  the  euro  area  will  benefit  its  members  and  the  entire  EU 
economy.  In  the  case  of  Member  States  that  have  not  yet  joined  the  monetary  union, 
moreover, the euro has important potential to function as a policy anchor. At the same time, it 
is essential that policy-makers take full account of the lessons about moving to the euro that 
emerge from the experience of current members of the euro area. This will allow the countries 
preparing to join the euro to draw the full benefits of living with the single currency. On this 
basis, adoption of the euro can help stimulate trade and growth, and also help to protect these 
economies from turbulence in international markets – a benefit that is not always appreciated 
in periods when global liquidity is high and risk premia are compressed. 

Getting closer to the citizens 

A  skilful  steering  of  the  economic  and  monetary  union  by  policy-makers  is  not  sufficient 
however, if the message is not reaching the citizen in the street. Citizens have in fact benefited 
in many ways from monetary union, gaining from stable prices, from cheaper and more easily 
available  credit,  from  ever  deeper  economic  integration,  and  from  protection  against  the 
effects of turbulence in international markets. Yet while opinion polls find citizens aware of 
the  euro's  practical  value,  they  are  less  clear  on  its  wider  macroeconomic  benefits.  Many 
people  feel  that  its  members  could  coordinate  their  policies  more  closely.  There  is  hence 
scope  to  prove  to  citizens  that  membership  of  the  monetary  union  is  a  path  to  strong  and 
sustained increases in living standards, as well as to economic and financial stability. 

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* * * 

Looking  back  over  the  early  years  of  monetary  union,  it  is  evident  that  a  sound 
macroeconomic framework is successfully in place. The question now is to examine how well 
policies are implemented; how strongly structural reforms support the adjustment process; and 
how  decisively  euro  area  governance  can  be  consolidated.  This  communication  has 
highlighted priorities that should ensure the smooth functioning of an enlarging euro area, and 
enhance  its  contribution  to  the  world  economy.  Achieving  this  will  require  deeper  policy 
coordination  and  improved  governance,  in  particular  through  the  Growth  and  Jobs  Strategy 
and  in  the  context  of  the  Eurogroup.  Forging  the  necessary  political  consensus  will  be  a 
challenging  task.  Yet  this  is  essential  if  European  citizens  are  to  benefit  fully  from  the 
economic and monetary union, and if the 10th anniversary of the euro is to be approached on a 
path of sustained growth. 

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