european monetary integration and economic policy co-ordination: an overview

European Monetary Integration and Economic Policy Co-ordination:

An Overview

FromBretton Woods

toEuropean Monetary

Union

Bretton Woods Regime(fixed exchange rates)

• Stable exchange rates, but adjustable– US dollar fixed in terms of gold ($35 an ounce)– fixed parity for other currencies in terms of dollar– band around dollar parity: plus or minus 1.0 %– adjustment of parities after consultation with the IMF

• adjustments discouraged, allowed in case of serious balance of payments disequilibria, postponed by IMF loans

– Central Banks of member countries hold reserves in gold or dollars

– and have right to sell dollars for gold to Federal Reserve

Bretton Woods Regime(fixed exchange rates)

• Consequences– dollar becomes the international currency

(international dollar standard or gold exchange standard)

– dollar takes on role of reserve currency (interest bearing)

– Central Banks must intervene in foreign exchange markets to stabilise the exchange rate of their currencies by buying and selling dollars

Problems of B-W regime• Problem 1: Nth Currency Problem

– two currencies means one exchange rate• (N currencies mean N-1 independent exchange rates)

– both countries cannot independently fix the exchange rate.

– EITHER both co-operate (symmetric solution) – OR one follows a policy of “benign neglect”

(asymmetric solution). Role played by the USA

• Problem 2: Realignments– definition: changing the exchange value of a currency.– rendered difficult by the rules of the regime– postponed as much as possible. – Result:

Problems of B-W regime• Problem 3: Speculative attacks

– Exchange rate value loses credible– Massive sales (normally) or purchases of the currency.

• Breakdown of Bretton-Woods regime– Inflation rises in the United States of America

• accelerates because of expansionary fiscal and monetary policies (Vietnam war)

– Two effects• Purchasing power value of US$ falls• Other countries “import” American inflation.

– Markets start selling dollars in large quantities– Movement started by request of the Banque de France

(de Gaulle) to USA to convert its dollar holdings into gold (“exorbitant privilege”).

Problems of B-W regime

• Breakdown of Bretton-Woods regime (cont’d)– August 15th 1971. Nixon closes “gold window”– December 1971. Smithsonian Agreement: general

realignment and increase of band to plus or minus 2.25% March 1973: free floating

– Strong fluctuations of European currencies against the dollar – and, therefore, even stronger fluctuations between the European currencies

– In this context, the European Monetary System (EMS) is born.

– 1976: Jamaica Agreements (official end to Bretton-Woods period)

First Steps Towards European Monetary Integration

• Establishment of the European Payments Union (EPU) with effect from July 1950.

• Principal purpose of EPU: facilitate payments for trade in goods between the OEEC member countries in a world where currency convertibility was still an issue.

• The EPU was a clearing union that replaced the existing agreements by a multilateral settlement and credit mechanism:

– bilateral claims and liabilities for each country were consolidated on a monthly basis in a single net position which defined the balance of payments situation of the country vis-à-vis the rest of the EPU countries.


• Settlements could occur by payment in gold or dollars, or by automatic credit limited by quotas.

• EPU set up to allow OEEC countries to liberalise trade in goods during the transition to currency convertibility.

• Eichengreen (1993): immediate introduction of currency convertibility would have required large devaluations in addition to the currency realignments of 1949 and a consequent immediate loss in real income. Introduction of EPU avoided this, and gave member countries the time to redeploy their economies before rendering their currencies fully convertible. Without the EPU, multilateral trade in goods would have been endangered.


• In December 1958, after many European currencies had become convertible, EPU replaced by European Monetary Agreement (EMA) between OEEC member countries.

• The EMA was essentially a “code of behaviour designed for an environment of convertibility” (Ungerer (1997)). Credit for balance of payments financing was no longer automatic but had to be negotiated in each case, and when granted, had a maturity of at most two years. The EMA was ended by the OECD Council in December 1972.


• On 1 January 1958, the Treaty creating the European Economic Community (EEC) took effect.

• Monetary matters were one of the least concerns in the Treaty. Exchange rate policies came under the jurisdiction of the International Monetary Fund (IMF).

• The Treaty did require that the Member States of the newly formed EEC follow economic policies which were compatible with the Brettton-Woods commitments:

- currency convertibility, - stable nominal exchange rates, and - liberalisation of capital markets “to the extent necessary to ensure the proper functioning of the common market” (Article 67, EEC);


• and with fundamental economic policy objectives (balance of payments equilibrium, high level of employment and a stable level of prices).

• The Treaty also required of the Council of Ministers of the Member States that they ensure the coordination of the general economic policies of the Member States (Article 145).

• The general rules regarding economic and monetary policies were laid down in Articles 104 to 109 and for the liberalisation of capital movements in Articles 67-73.

• A Monetary Committee was created with a purely advisory role.


• One event in this period is telling: the German revaluation of 1961, but its lessons were not learnt when the Maastricht revision of the Treaty was undertaken.

• Germany was subject to inflationary pressures both on account of a high level of domestic demand and large surpluses in the balance of payments current account.

• A restrictive monetary policy on its own would have led, and did lead, to an increase in capital inflows and in inflationary pressures.

• It also resulted in an excessive squeeze on domestic demand. • A revaluation of the currency was not encouraged by the IMF nor by

certain domestic authorities. • The German central bank, the Bundesbank, did not have the authority

to revalue the currency which was a competence of the Federal Government.

• In the end, the Bundesbank was obliged to stop its restrictive monetary policies,

• and a revaluation of the Deutsche Mark occurred.


• The conflict between internal and external balance could have been avoided to a large extent

• if both monetary and exchange rate policies had been under the same authority.

• But is this politically feasible?.


• Meeting of Heads of State or Government of the EEC at the Hague in December 1969

• Requests Council of Ministers to draw up a plan by stages for creation of an economic and monetary union.– task proves difficult because of opposing “economist”

and “monetarist” views.

• “economists”: first a high degree of convergence in economic fundamentals and policies;

• “monetarists”: rapid introduction of a monetary union followed by economic convergence


• Creation of Werner Commission in March 1970 to address the issue.

• Werner Report (October 1970)– complete liberalisation of capital flows

– monetary union = irrevocable fixing of exchange rates

– community system of national central banks

– centralised economic policy

– to be achieved in 3 stages completed by 1980• compromise between “economist view” and “monetarist view”


• Werner project endorsed by European Council in 1971 but... was overtaken by events

• The Snake (in the Tunnel)– block floating between March 1973 and Dec. 1978

– tunnel between April 1972 and March 1973

– members change frequently and realign frequently

– snake lasts till 13 March 1979

dollar parity

upper intervention point (+2.25%) (sell $)

lower intervention point (- 2.25%) (buy $)

Creation of the European Monetary System (EMS)

• 13 March 1979: EMS comes into existence

• Result of initiative taken by Roy Jenkins in Oct. 1997 and followed up by Helmut Schmidt (German Chancellor) and Valéry Giscard d’Estaing (French President)

• Based on a European Council Resolution dated5 December 1978

• Main characteristics and operating procedures contained in an Agreement Between [all] the Central Banks of the Member States of the EEC.

• Defined a system of fixed but adjustable exchange rates between participating countries.

How EMS addressed Bretton-Woods Regime Problems

• Asymmetry– introduction of ECU

• a basket of currencies of all Member States• each currency in the basket assigned a weight

– the weight could change over time• replaced European Unit of Account

The ECUA basket of all EC currencies

Belgian franc = Belgian (3.301) and Luxembourg (0.13) franc


• Asymmetry (cont’d)– introduction of an Exchange Rate Mechanism

• participation in ERM not obligatory• each participating currency assigned a (bilateral)

central parity with respect to each of the other participating currencies (defines a parity grid )

• maximum variation of 2.25% on either side of central parity allowed

– Italy granted exception of 6% on either side.


• Asymmetry (cont’d)– obligatory and unlimited intervention at the

margin• suppose 1 DEM equalled 20 BEF (central parity)• market exchange rate could vary between

19.55 and 20.45 BEF• if market rate reached either bound, both the

Belgian National Bank and the German Bundesbank had to intervene in the market


• Asymmetry (cont’d)– obligatory and unlimited intervention at the margin

(cont’d)• if the exchange rate rose to 20.45 (appreciation of mark

and depreciation of franc)• the Bundesbank and the Belgian National Bank would

have to sell marks and buy francs• German Bundesbank at an advantage because it could

print as many marks as it needed• Belgian National Bank at a disadvantage because it had

a limited stock of marks to sell.• Why oblige both to intervene?


• Asymmetry (cont’d)– obligatory and unlimited intervention at the

margin (cont’d)• because as a result of the intervention, the

German money supply increased and the Belgian money supply decreased

• German interest rates fell and Belgian interest rates rose, stabilising the exchange rate

How ERM addressed Bretton-Woods Regime Problems

• Realignment– At the request of one or several countries participating in

the ERM, a consultation occurred involving the Ministers of Finance and the Governors of the Central Banks of all the participating countries.

– These decided whether and to what extent a realignment should take place.

– Consequently, realignments were carried out rapidly and with the agreement of the participating countries.

– The consultation often limited the extent of the realignment out of fear of loss in competitiveness.

How ERM addressed Bretton-Woods Regime Problems

• Speculative Attacks– obligatory and unlimited interventions by the two

Central Banks whose currencies were involved– markets would then know that between them the

Central Banks would not run out a currency– this would reduce the probability of a speculative

attack

Functioning of ERM of EMS• Four phases in the functioning of the ERM

– March 1979 to March 1983• Participating countries going there own way policy-

wise. 7 realignments.

– April 1983 to January 1987• Participating countries beginning to recognise the

constraints on policy imposed by the ERM. 4 realignments.

– February 1987 to September 1992• The “hard” EMS. 1 “technical” realignment (Italy).

– October 1992 to end 1998• the period following the “breakdown” of the EMS

and preceding monetary union

Functioning of ERM of EMS• Four phases in the functioning of the ERM

Functioning of ERM of EMS

Inflation

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1950-1972 1973-1978 1979-1985 1986-1991 1992-1998

France

Germany

Italy

Netherlands

Functioning of ERM of EMS• Why did the ERM “break down” in Sep. 1992?

– Remote causes• the system had become too rigid

– markets convinced no more realignments before monetary union (Delors effect)

• loss of competitiveness of certain countries

• large capital flows into high interest rate countries (Italy, Spain and Portugal)

– is this compatible with interest rate parity?

– risk premium.


– Remote causes (cont’d)• the system had become asymmetric and dependent

on Germany

– the Bundesbank set the interest rate for Germany

– the other ERM countries tied their currencies to the German mark

– the other ERM countries adapted their interest rate to Germany’s

» In the ERM, Germany played the role that the USA played under Bretton-Woods


– Proximate causes:• capital flows (liberalisation of capital flows in 1990)

• the Bundesbank hikes up its interest rate after re-unification

• Maastricht Treaty vote in Denmark and in France

• Solution: either floating exchange rates or move to monetary union

» Britain chose floating

» as did Italy and Spain temporarily

– fluctuation margins increased to 15% on both sides of central parity

Transition to a Monetary Union• The Delors Report

• The Maastricht Treaty– The 3 stages– Stage Two: preparing for monetary union

• establishment of the European Monetary Institute

• countries shall endeavour to avoid excessive fiscal deficits

• the criteria for membership

– Stage Three: monetary union

Criteria for membership

1. The government deficit may not exceed 3% of Gross Domestic Product at market prices. If it does, the Commission must take into account

whether it has declined substantiallyand continuously or the excess is temporary in nature.

Furthermore, it must examine whether the deficit exceeds expenditure on investments as well as certain other elements

Criteria for membership (cont’d)

2. Government debt may not exceed 60% of Gross Domestic Product. If it does, the Commission should take into account

- whether the ratio is diminishingsufficiently and

- approaching the reference value at asatisfactory speed.


3. The inflation rate is sustainable

and, over the year preceding examination,does not exceed by more than 1.5% that of, at most, the 3 best performingMember States.

The consumer price index shall be used


4. Long term interest rates (on long-term government bonds or comparable assets) shall not exceed,

over the year preceding examination,

by more than 2% that of, at most, the 3 best performing Member States in terms of inflation rates.


5. The Member State - shall have participated in the ERM of the EMS and - respected the normal fluctuation margins without severe tensions for at least two years before the examination.

It shall not have devalued its currency against any other Member State's currency on its own initiative for the same period.


Some authors also add a legal convergence criterion, i.e., the countries legislation should conform to the Treaty in matters such as central bank independence and the ESCB Statute.

Transition to Membership

• Public finances consolidation

• Exchange rate mechanism

• Real convergence– not included in Maastricht Treaty criteria– was not a problem for “old” Member States– but may be one for new Member States

Cost – Benefit Analysis

Costs• Loss of exchange rate as

adjustment mechanism

• Loss of monetary policy independence

• (Partial) loss of fiscal independence

• Conversion costs

∑ costs > ∑ benefits ?

Benefits• Elimination of exchange rate risk

• More price transparency

• Price stability

• More trade

• Lower interest rates

• International role of the currency

• Stronger position in international policy negotiations

European Monetary Union

1. One Currency

• Creation of a Euro-area

• Transition period from 1 January 1999 to 31 December 2001– because of time needed to print notes, mint

coins and adapt banking systems.

• Legal Framework– Council Regulation 974/98 of 3 May 1998– Council Regulation 110397 of 17 June 1997

Situation of “Pre-ins” or Outs• Opt-out countries

– United Kingdom and Denmark• Countries with a derogation

– those that have not satisfied the convergence criteria

– Sweden• joined EU too late to obtain an opt-out• still does not satisfy exchange rate and legal

convergence criteria (chooses not to do so)– Greece (joined on 1st Jan. 2001)– New Member States are countries with a

derogation

2. One Monetary Authority• Single currency single monetary

authority– Federal Reserve System in USA

• Federal Reserve Banks, Board of Governors

– Bundesbank in Germany• Land Central Banks, Bundesbank

– Land Central Banks redefined as Regional Offices (2002)

– European System of Central Banks (ESCB) in Euro-area

• National Central Banks (NCBs) of all Member States, plus European Central Bank

2. One Monetary Authority• Two models of Central Bank design and

behaviour– 1. The “Anglo-French” model.

– The Central Bank is subject to the authority of the government (mostly through the Ministry of Finance)

– The Central Bank must simultaneously take into account several objectives, mainly price stability, growth and unemployment.

– 2. The German model– The Central Bank is politically independent– Its primary objective is price stability

» and output and employment goals as long as there is no prejudice to price stability

Objectives and Tasks of ESCB

• Primary objective– price stability

• Subordinate Objective– without prejudice to the primary objective, to

support the general economic policies in the Community

– with a view to contributing to the achievement of the objectives of the Community

Objectives and Tasks of ESCB (cont’d)• Tasks of the ESCB

– define and implement the monetary policy of the Community

– conduct foreign exchange operations, hold and manage foreign exchange reserves of the Euro-area countries

– promote the smooth operation of the payments system (TARGET = Trans-European Automated Real-time Gross settlement Express Transfer system)

– contribute to prudential supervision and stability of financial system

Organisation of ESCB

13 “out” NCBs 12 “in” NCBs ECB

ExecutiveBoard

Governing Council

General Council

Euro System

European System of Central Banks (ESCB)

Organisation (cont’d)• Governing Council

– composition• all the members of the Executive Board (6) and the governors

of the NCBs of the Member States without a derogation– appointment: minimum five years renewable– main tasks

adopt guidelines and take decisions necessary to ensure performance of tasks entrusted to the Eurosystem;

formulate the monetary policy of the euro area, incl., as appropriate, decisions relating to intermediate monetary objectives, key interest rates and supply of reserves in Eurosystem;

establish the necessary guidelines for their implementation– composition has implications for decision making

Organisation (cont’d)

• Executive Board– composition

• President, Vice-President and four other members, all chosen from among persons of recognised standing and professional experience in monetary or banking matters.

– appointment: eight years non-renewable– main tasks

implement monetary policy in accordance with the guidelines and decisions laid down by Governing Council of ECB and, in doing so, give the necessary instructions to the NCBs; and

to execute those powers which have been delegated to it by the Governing Council of the ECB

Organisation (cont’d)

• General Council– composition

• President, Vice-President and governors of NCBs of all 25 Member States

– main tasks• tasks which the ECB took over from the EMI and

which, owing to the derogation of one or more Member States, still have to be performed in Stage Three of Economic and Monetary Union (EMU).

Plus (see below)

Organisation (cont’d)The General Council also contributes to: the ECB's advisory functions;

the collection of statistical information; the preparation of the ECB's annual reports; the establishment of the necessary rules for standardising the

accounting and reporting of operations undertaken by the NCBs;

the taking of measures relating to the establishment of the key for the ECB's capital subscription other than those already laid down in the Treaty;

the laying-down of the conditions of employment of the members of staff of the ECB; and

the necessary preparations for irrevocably fixing the exchange rates of the currencies of the Member States with a derogation against the euro.

– problem: the role of the “out” NCBs

Independence, Accountability and Transparency

When exercising the powers and carrying out the tasks and duties conferred upon them by this Treaty and the Statute of the ESCB, neither the ECB, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Community institutions or bodies, from any government of a Member State or from any other body. The Community institutions and bodies and the governments of the Member States undertake to respect this principle andnot to seek to influence the members of the decision-making bodies of the ECB or of the national central banks in the performance of their tasks.

2.3 Independence, Accountability and Transparency

•Different Kinds of Independence– personnel, financial, and policy

•Why independence?•How is independence insured?

– security of tenure•Accountability

– formally, accountable to no person or institution•Transparency

– the degree of genuine understanding of the monetary policy process and policy decisions by the public

3. One Monetary Policy

• preparatory work done by European Monetary Institute, precursor of European Central Bank

The Monetary Policy Strategy of the ESCB• Specification of the primary objective of

price stability– a year-on-year increase in the Harmonised

Index of Consumer Prices (HICP) for the euro area of below 2%• why HICP? because only harmonised index

available !!• increase (so no deflation)

Monetary Policy Strategy

• A strict focus on price stability– The ECB has interpreted its dual mandate in a

highly idiosyncratic way.• “maintaining price stability in itself contributes to

the achievement of output and employment goals– (Monthly Report, January 1999, p.40)

• this reduces its dual mandate to a single one– and narrows down its responsibility, and does not

require of it a balancing act.

– Price stability has been interpreted as a medium-run objective


• A low target range for inflation– The ECB has interpreted “price stability” to

mean that inflation should stay between 0% and 2%

– In May 2003, the ECB reviewed its monetary policy, and “clarified” its price stability goal as:

• maintain inflation rates close to 2% over the medium term

Inflation Rate Mostly Above Upper Limit of 2%


• The “two pillar” framework for the assessment of the risks to price stability– an “economic analysis” pillar (short term)

• assessment of current economic developments and associated short to medium-term risks to price stability. Includes an analysis of shocks hitting the euro area economy and projections of key macroeconomic variables

– a “monetary analysis” pillar (medium term)• developments in a wide range of monetary indicators

including M3, its components and counterparts, notably credit, and various measures of excess liquidity.


• The “two pillar” framework for the assessment of the risks to price stability– a “monetary analysis” pillar

• a “reference value” for the rate of growth of the monetary aggregate, M3, is calculated on the basis of the quantity theory of money:

– rate of growth of money stock

= inflation rate + trend growth rate of output – rate of change in velocity of circulation of money

= (below 2 %) + (2 % to 2.5 %) – (-0.5 % to –1 %)

= (more or less) 4.5 %


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Rate of growth of M3 (“reference value: 4.5%)

Monetary Policy Instruments

• a. Standing facilities

– marginal lending facility (ceiling)• no bank will borrow for more

– deposit facility (floor)• no bank will lend for less

Monetary Policy Instruments (cont’d)

• b. Open market operations

– buying and selling government bonds to “counterparties” (financial institutions with whom the ESCB deals directly)

– open market operations allow the Central Bank to steer the interest rate within the bounds.

Monetary Policy Instruments (cont’d)

• c. Minimum Reserves– banks have to deposit at the ESCB a certain

percentage of the deposits they themselves receive from clients. Which means that liquidity is withdrawn from the system. But also affects the profitability of banks who are paying interest on these deposits to clients but cannot lend them to others.

4. Exchange Rate Policy• Who is responsible ?

– It is the responsibility of the Council, in virtue of Article (EC) 111 and by way of derogation from Article (EC) 300, acting on a recommendation of the Commission or the ECB.

– It must act unanimously if it concerns (i) “conclud[ing] formal agreements on an exchange rate system for the ECU in relation to non-Community currencies”;

– by a qualified majority if it concerns (ii) “adopt[ing], adjust[ing] or abandon[ing] the central rates of the ECU within the exchange rate system”, or (iii) “in the absence of an exchange rate system in relation to one or more non-Community currencies Y formulat[ing] general orientations for exchange-rate policy”.

– The ECB must be always be consulted “in an endeavour to reach a consensus consistent with the objective of price stability” in the first two cases, and “without prejudice to the primary objective of the ECB to maintain price stability” in the third case.

Exchange Rate Policy• Fixed Exchange rate policy vis-à-vis Pre-ins

(ERM 2)– participation is voluntary– hub and spoke: the Euro is the hub.– unlimited intervention by both parties, UNLESS danger

to price stability– actual participants: Denmark, Estonia, Lithuania and

Slovenia

• Exchange rate policy vis-à-vis the Rest of the World– floating exchange rates– external representation of the Euro-area countries (see

further)

External representation of the Euro-Area countries“The President of the ECB (replacing the national central bank governors from the euro area) and the President of the EuroGroup will take part in the meetings of G7 Finance Ministers when the world economic situation, multilateral surveillance and exchange rate issues are being discussed. The Commission will be involved to the extent required to enable it to perform the role assigned to it by the Treaty, and it will attend the meetings in connection with specific issues, to be determined by the Ministers.”

Furthermore, the ECB has been granted observer status at the International Monetary Fund where only the governments are represented. The Economic and Monetary Union will be represented by the president of the Euro-area countries assisted by a representative of the Commission.

Macroeconomic Policy Co-ordination in EMU

• Broad Economic Policy Guidelines (BEPG)

• Luxembourg Process

• Cardiff Process

• Cologne Process

• Stability and Growth Pact

Broad Economic Policy Guidelines (BEPGs)

Article 99 (EC): MS shall regard their economic policies as a matter

of common concern and shall coordinate them within the Council.

The Council shall, acting by a qualified majority on a recommendation from the Commission, – formulate a draft for the broad guidelines of the

economic policies of the Member States and of the Community,

– shall report its findings to the European Council..


The European Council shall then – discuss a conclusion on the broad guidelines of

the economic policies of the Member States and of the Community.

– acting by a qualified majority, adopt a recommendation setting out these broad guidelines

– shall inform the European Parliament of its recommendation.

.


At present the BEPG serves as co-ordinating mechanism for all the processes mentioned above as well as the Stability and Growth Pact

Since 2003, the whole process has been streamlined, with the Spring European Council playing a central role.

European Employment Strategy

• Essen European Council (1994) called on the Labour and Social Affairs and Economic and Financial Affairs Councils and the Commission to– keep close track of employment trends, – monitor the relevant policies of the Member

States and– report annually to the European Council on

further progress on the employment market, starting in December 1995


• Amsterdam European Council (1997) breathed new life into the new strategy– established a legal and institutional framework through

a new employment title in the treaty which declared employment a matter of common concern and required coordinated action

– took the political decision not to wait for treaty’s entry into force (1 May 1999) to launch the surveillance and co-operation procedure on national employment policy

– agreed to hold a “Jobs Summit”


• The Amsterdam Treaty’s Employment Title 1. Member States retain main responsibility for

employment policies, but shall regard promoting employment as a matter of common concern and shall co-ordinate their action. (Art 126)

2. All areas of Community policy must take account of their impact on employment. The objective of a high level of employment has to be taken into account in all policy (Art. 127)


• The Amsterdam Treaty’s Employment Title 3. The Treaty sets up the framework for an annual

multilateral surveillance procedure, articulated on three documents: the annual Employment Guidelines, national implementation reports, and the Joint Employment Report for submission to the European Council every year. (Art. 128)

4. As an outcome of the joint surveillance, based on common employment indicators, the Council may issue, upon a proposal from the Commission, specific recommendations to individual Member States for urgent action. (Art. 128)


• The Amsterdam Treaty’s Employment Title 5. There is now a legal base for the promotion of

incentive measures for employment, and for analysis, research and exchange of best practice in employment policy. (Art. 129)

6. The Treaty sets up a permanent structure, a new Employment Committee, which will play an active part in this institutional process and serve as a forum for debate on employment issues at European level. (Art. 130)


• The “Jobs Summit” was held in Luxembourg (Nov. 1997)

• Launched the Luxembourg Process– annual cycle for implementing and monitoring

national employment policies

• Introduced the Employment Guidelines based on four “pillars”


• The four “pillars”:– Employability - initial employment, maintain

employment and new jobs,– Entrepreneurship – environment for starting

new business– Adaptability - flexible ways of working and of

organising work, – Equal opportunities - equal treatment at work

and at obtaining one


• Relies more on co-ordination than on rules– because differences between Member States in

this field are too great to harmonise

• Each MS presents an annual National Action Plan that gives content to the four “pillars” based on the guidelines.

• Benchmarking• Peer pressure

The Cardiff Process

• introduced by the Cardiff European Council in June 1998– to ensure a comprehensive approach to

structural reforms of goods, services and capital markets

– in order to ensure a sustained and durable economic growth

– and to raise employment levels

The Cologne Process

• introduced by the Cologne European Council in June 1999– introduced the macroeconomic policy guidelines in

relation to job creation– introduced a dialogue on this policy involving the

social partners alongside the EU's political and monetary authorities.

– key objective: to facilitate enhanced dialogue and confidence-building between all actors concerned with macroeconomic policy, in order to strengthen Europe's ability to boost growth and employment.

The New Lisbon Strategy• Spring 2005

– The BEPGs and the EGs will be integrated in an Integrated Guidlines Package

• they cannot be replaced because they are enshrined in the Treaty

Chapter 1: Introduction

Part 1

Broad Economic Policy Guidelines (Art. 99)

Part 2

Employment Guidelines (Art. 128)

Chapter 2: Macro

Chapter 3: Micro

Chapter 4: Employment

Chapter 5: Conclusions

The Open Method of Co-ordination

• Introduced at the Lisbon European Council (March 2000)

• Consists of four elements– fixed guidelines set for the Union with short, medium

and long term goals – quantitative and qualitative indicators and benchmarks – European guidelines translated into national and

regional policies and targets – periodic monitoring, evaluation and peer review,

organised as a mutual learning process

• A new method of economic governance ?

The Stability and Growth Pact

Stability and Growth Pact• Origins of the Pact (to caricature a bit)

– French considered ESCB statutes a necessary evil to bring Germany into a monetary union

– France wanted a strong countervailing power– Germany refused a monetary union without

some economic convergence– Germany wanted rules to maintain fiscal

discipline once monetary union achieved

The Macroeconomic Role of Fiscal PolicyThe Stabilisation Role• Automatic Fiscal Stabilisers (no gov’t action

required).– A rise in output increases tax revenues and decreases

government expenditures. This dampens the increase in output.

– A fall in output lowers tax revenues and raises government expenditures. This increases output.

• Discretionary Fiscal Policy.– Policy changes in gov’t. expenditures and/or revenues.

• Cyclically Adjusted Budget Deficits (CAB).– Actual budget deficits minus the automatic changes.

Why Fiscal Rules?• Historical Background

– In the 1980s, there was a large accumulation of government debt in most OECD countries, which was unprecedented in peacetime.

– As a consequence, fiscal sustainability became the main fiscal policy issue, and major reforms of the fiscal policy framework were undertaken in nearly all OECD countries.

The Stability and Growth Pact (SGP)

• Legal Basis– Article 99 of the EC Treaty - multilateral surveillance

• through monitoring of economic policies and the publication of Broad Economic Policy Guidelines

– Article 103 of the EC Treaty – “no bail out” clause

– Article 104 of the EC Treaty - Excessive Deficit Procedure (EDP)

• procedures for establishing existence of, and taking effective action against, excessive deficits and debt levels.

– Protocol on EDP annexed to the Treaty• definition of reference values for excessive government

budget deficit and debt; and other details.


• Relevant texts– Council Regulation 1466/97 on the strengthening of the

surveillance of budgetary positions and the surveillance and coordination of economic policies [the “preventive arm”]

• aims, through regular surveillance, at preventing budget deficits going above the 3% reference value. Requires the submission of stability and convergence programmes.

• imposes a medium-term objective of a government budget close to balance or in surplus

– measured in cyclically adjusted terms (see Code of Conduct)

– Council Regulation 1467/97 on speeding up and clarifying the implementation of the EDP [the “dissuasive arm”]

• in the event of the 3% reference value being breached, requires Member States to take immediate corrective action, and, if necessary, allows for the imposition of sanctions. Council can provide an “early warning” of an eventual deficit.

The Stability and Growth Pact (SFP)

• Relevant texts (cont’d)– Council Regulation 3605/93 on the application of

the Protocol on the EDP (updated: 475/2000, 351/2002)

• provides precise statistical content to the concepts of government budget deficits and debt

– European Council Resolution on the Stability and Growth Pact (Amsterdam, 17 June 1997)

• a political commitment by all parties involved in the SGP to a proper implementation of the budget surveillance process.


• Relevant texts (cont’d)– Declaration by ECOFIN Council reaffirming

commitment to SGP (1 May 1998)

– Code of Conduct on content and format of stability and convergence programmes

• laid down by Monetary Committee (12 October1998) and revised by Economic and Financial Committee (EFC) (2001), which replaced the Monetary Committee.

Stability and Growth Pact (SGP)• Art. 104.1 Member States shall avoid

excessive deficits– exception: UK (shall endeavour to avoid

excessive deficits)

• Art. 104.2 specifies the meaning of excessive deficits. An excessive deficit exists if– the ratio of the planned or actual government

deficit to GDP exceeds a reference value – the ratio of government debt to GDP exceeds a

reference value

Stability and Growth Pact• The reference values are specified in a

protocol to the Treaty– 3% for the ratio of the planned or actual

government deficit to GDP at market prices – 60% for the ratio of government debt to GDP at

market prices.

• The concepts are defined statistically in Regulation 3605/93 (revised by regulations 475/2000 and 351/2002)

Stability and Growth Pact• Art. 104.3 to 6 concern the procedure for

identifying situations of excessive deficit• Art. 104.7 to 11 concern the procedure for

ensuring the correction of excessive deficits– Art 104.7 and 8 apply to all EU Member States– Art 104.9 to 11 apply only to Euro-area

Member States

• Art 104.12 concerns the abrogation of the EDP when the Member State is deemed to have corrected its excessive deficit.

Stability and Growth PactCouncil Regulation 1466/97

– also known as the “preventive arm”– Euro-area MS must submit a pluri-annual

“stability programme” updated annually– the other MS must submit a pluri-annual

“convergence programme” updated annually– the contents are identical– the programme should lay down how the MS

plan to respect the norms laid down in the excessive deficit procedure

Stability and Growth Pact

• The programme must– include the medium-term objective for a

budgetary position which is close to balance or in surplus

– indicate the adjustment path towards this objective.

• The Council will decide whether to approve the stability programme or to invite the member state to adjust it.


• The Council will also monitor its implementation and may issue recommendations in this context.

• The Council may issue an “early warning” to a Member State before an excessive deficit occurs.

• Article 104.2 of the Treaty allows the ratio of the planned or actual government deficit to gross domestic product to exceed the reference value only if this situation is exceptional and temporary


• Council Regulation (EC) 1467/97 defines what is to be understood by “exceptional and temporary”.

• In particular, it states that an excess over the reference value resulting from a severe economic downturn will be considered exceptional only if there is an annual fall of real GDP of at least 2%.


• A smaller decline can only be considered exceptional by the Council, – on the initiative of the Member State

concerned, – when there is supporting evidence on the

abruptness of the downturn or on the accumulated loss of output relative to past trends. • Annual falls of less than 0.75% will not be

considered as severe

Stability and Growth Pact• The procedure laid down in Article 104 of the EC Treaty

to be followed for establishing an excessive deficit is further specified in Regulation (EC) 1467/97 which lays down– that decisions are taken by (a majority of two thirds of the votes

of) the Council, excluding (the votes of) the representative of the Member State concerned, and acting on a recommendation from the Commission.

– the deadlines that are to be observed– the rules for monitoring and assessment of the corrective actions

taken– and the eventual application of sanctions if corrective action is not

taken or deemed unsatisfactory• sanctions are applied only to Euro-area members• in the event of persistent excessive deficits


• Sanctions– in the first year of sanctions, the MS concerned

must pay a non-interest bearing deposit equal to• fixed component: 0.2% of GDP, plus• variable component: 10% of difference

between deficit and the 3% reference value• a ceiling of 0.5% of GDP is set.

– in subsequent years only the variable component is paid

The Stability and Growth Pact in Action

• The SGP entered into force with the start of monetary union– 1 July 1998 for Regulation 1466

– 1 January 1999 for Regulation 1467

• In the lead up to monetary union:– there was a great effort made towards “fiscal consolidation”

– in order to qualify for membership in the monetary union

• Since the start of monetary union– there has been a steady relaxation in the effort

– so that now we appear to be back in 1991 re: fiscal consolidation


• Portugal– 30 January 2002: Commission proposes that an “early warning”

be issued to Portugal (and Germany) under Regulation 1467/97.

– 12 February 2002: Council decides not to do so: Portugal profits from heavy pressure exerted by Germany.

– 16 October 2002: Commission issues an opinion that an excessive government deficit exists in Portugal. [Art. 104 (5)]

– 5 November 2002: Council declares that an excessive deficit exists in Portugal and recommends action. [Art. 104 (6) and (7)]

– Portugal acts to remove the excessive deficit

– Excessive deficit procedure against Portugal was abrogated this spring (2004)

The Stability and Growth Pact in Action• Germany

– 30 January 2002: Commission proposes that an “early warning” be issued to Germany (and Portugal)

– 12 February 2002: Council decides not to do so under heavy pressure from Germany (pre-election period).

– 8 January 2003: Commission issues an opinion that an excessive government deficit exists in Germany [Art. 104 (5)]

– 21 January 2003: Council decides that an excessive deficit exists in Germany and recommends action [Art. 104 (6) and (7)]

– 18 November 2003: Commission issues an opinion that Germany has not acted on the recommendation and proposes legally binding measures [Art. 104 (8) and (9)]

– 25 November 2003: Commission recommendations do not obtain the required qualified majority. Council proceeds further (see below) and adopts a set of conclusions put forward by the Italian Presidency.


• France– 21 January 2003: France receives an “early warning” from the

Council

– 7 May 2003: Commission issues an opinion that an excessive government deficit exists in France [Art. 104 (5)]

– 3 June 2003: Council decides that an excessive deficit exists in France and recommends action [Art. 104 (6) and (7)]

– 21 October 2003: Commission issues an opinion that France has not acted on the recommendation and proposes legally binding measures. [Art 104 (8) and (9)]

– 25 November 2003: Commission recommendations do not obtain the required qualified majority. Council proceeds further (see below) and adopts a set of conclusions put forward by the Italian Presidency.


• Three elements in the Council proceedings on 25 Nov. 2003:• 1. It did not accept the Commission’s Recommendations under

Article 104 (8) and 104 (9): no qualified majority in favour.

• 2. It used the voting procedure of Article 104 (9) to vote in a new set of conclusions.

• 3. These conclusions were in the nature of a new recommendation.

• The Commission sued the Council before the ECJ which concluded (in substance) on 13 July 2004 that:– The lack of a qualified majority effectively held the “excessive

deficit procedure” in abeyance till the Commissin proposed a new recommendation

– The Council acted illegally in proposing a new recommendation (a prerogative of the Commission)

Reforming the Stability and Growth Pact

Relevant texts• “Strengthening Economic Governance and Clarifying the Implementation

of the Stability and Growth Pact”, Communication of the Commission of 3 September 2004, COM(2004)581 final.

• “Improving the Implementation of the Stability and Growth Pact”, Council report agreed by the ECOFIN Ministers at their extraordinary meeting of 20 March, and endorsed by the European Council of 22/23 March 2005.

• Proposal for a Council Regulation amending Regulation (EC) No 1466/97 on the strengthening of the surveillance of budgetary positions and the surveillance and coordination of economic policies, (presented by the Commission), COM(2005) 154 final, Brussels, 20.4.2005

• Proposal for a Council Regulation amending Regulation (EC) No 1467/97 on speeding up and clarifying the implementation of the excessive deficit procedure (presented by the Commission), COM(2005) 155 final, Brussels, 20.4.2005.

The Eastern Enlargement of EMUThe new Member States• are large in population

• but are small in economic terms

2003Population

(millions)

GDP

(billion euros)

New Member States 75 413

EMU12 305 (24%) 6828 (6%)

EU15 381 (19%) 8843 (5%)

The Eastern Enlargement of EMU

Nominal versus fiscal convergence• Central bank independence and convergence of inflation are prerequisites

for joining EMU

• These increase the burden for government budgets.

• Budget deficits in many new Member States have increased a lot.

Nominal versus real convergence• High divergence of real GDP per capita and of price levels

• Economic catch up leads to (Balassa – Samuelson effect)– high inflation OR

– nominal appreciation of the currency

• Making inflation and exchange rate criteria more difficult to realise for these countries than for present EMU Member States

The Eastern Enlargement of EMUBalassa – Samuelson Effect

Traded goods sector (manufactured goods)• Economic catch up implies higher productivity growth in traded goods

sector

• Higher productivity leads to higher wages for worker in this sector

Non-traded goods sector (services)• As labour is mobile between the traded and non-traded goods sectors,

wages in the services sector rise as well

• But productivity does not increase in the services sector. Consequently, prices of services rise. Inflation is higher than in the EU15

• Real convergence (higher productivity growth) conflicts with nominal convergence (to a common inflation level)

european monetary integration and economic policy co-ordination: an overview

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