Competitiveness and nominal divergences

12It is rather obvious to state that members of a monetary union are barred from using periodic devaluations to address their drifting price-competitiveness. Member States nevertheless failed to closely monitor the evolution of their costs and prices relative to that of their main partners. As Figure 1 illustrates, the divergence pre-dates monetary unification and has resulted in major discrepancies in real exchangerates between Member States. Explanations are threefold. First, the peculiar trajectory of wages in Germany is the result of the decentralisation of the wage bargaining process in the second half of the 1990s, following German reunification. [7] Second, capital inflows in some peripheral countries bolstered private consumption and encouraged the development of non-tradable sectors with low productivity gains, the first of which is the construction industry. Increases in consumer prices, real-estate prices and nominal wages followed (these three dynamics being mutually reinforcing), especially in Ireland and Greece and to a lesser extent in Spain. This is a failure of the liberalisation of capital flows without proper supervision in the 2000s: capital found itself invested in bubbles rather than in the productivity catch-up. [8] A third element was the surprisingly sluggish productivity in countries such as Spain and Italy over the 2000s, which contributed to the relative increase of their unit labour costs compared to other European countries.

1

Nominal unit labour costs in % of the EA 18 average, 100 in 1999

Nominal unit labour costs in % of the EA 18 average, 100 in 1999

Lecture: Unit labour costs are defined as the total remuneration of workers per unit of production (for the whole economy). They are also equal to the unit wage divided by hourly labour productivity.

13These nominal differences have been largely addressed since the beginning of the crisis in Ireland, Greece, Portugal, and Spain (not so in Italy). However, the adjustment was asymmetrical and based mainly on the curtailment of unit labour costs in crisis countries. In a fixed exchange-rate regime, asymmetric price adjustment is known to introduce a deflationary bias. The new macroeconomic imbalances procedure (established in 2011; see below) can be read as an attempt to apply part of Keynes’s 1942 ideas to the European Monetary Union. [9] Yet, the procedure itself is asymmetrical (with more importance granted to deficits than to surpluses), leading to a deflationary bias weighing on the Eurozone; this bias is reinforced by the impact that lower prices have on the debt ratio of countries initially in deficit.

Financial imbalances

14In most countries, rising public debt was a consequence to the financial and economic crisis. For example, the Irish government, in a bid to avoid the destabilisation of the European financial sector, extended a blanket guarantee to Irish banks at the beginning of the crisis. Public debt surged from a precrisis 25% of GDP to a peak of 123% of GDP in 2013 and government revenues, driven by real-estate, were also severely hit; yet private debt (households, non-financial companies and banks) was not being monitored before the crisis. In 2001, when the Council issued a recommendation to Ireland under the BEPGs, the prescribed remedy to the economy’s overheating was to implement a more restrictive fiscal policy, in spite of the country already enjoying a surplus; slowing the credit bubble by using instruments such as mortgage regulation (higher input and/or income requirements for loans) was not part of the recommendations.

15Europe’s debt consolidation strategy continues to this day to limit itself to the issue of public debt, which is dealt with through fiscal adjustment. The implementation of the banking union was accompanied by partial bank deleveraging, with no concerted debt consolidation strategy for households or non-financial companies being set up; in addition, reflection on alternative strategies to lower public debt levels is progressing with reluctance, under the threat of a unilateral Greek default.

16The Eurozone must give a great deal of thought to the best way of restoring the credibility of the “no bailout” clause without triggering a major financial crisis, and more generally to ways of reducing debt other than through the primary budget surplus. Several suggestions have been made that go in this direction, some of which involve debt restructuring. [10] Further consolidation of Eurozone banks and greater diversification of their balance sheet is probably a prerequisite.

Demand management

17As noted above, the coordination of fiscal policies in the euro area is limited to trying to prevent a Member State from engaging onto an unsustainable fiscal path. This goal is not only difficult to achieve without simultaneously monitoring private debt, it is also insufficient as can be seen today. Two indicators suggest that demand in the euro area is low relative to supply:

• The drop in the inflation rate (below 0.5% in 2014; 0.7% when excluding energy and commodity prices);
• The simultaneous increase in the current external account, which is none other than the Eurozone’s net savings (savings in excess of public and private investments). [11]

18Several factors had a clear impact on these developments. [12] Over-indebted businesses and households opted for debt consolidation, which was met by mixed results across the continent. Fiscal consolidation policies carried out in 2011-2013 also contributed strongly to reducing demand. [13] Uncertainty, which weighs negatively on investments, continues to linger as a result of the loss of confidence in the stability of the Eurozone and of the political uncertainty in some countries –as can be seen in the gap in interest rates paid by Member States. Consumers’ purchasing power was dampened by wage reduction policies in Southern Europe. Accordingly, companies continued to produce below capacity in 2014. [14] Finally, European monetary policy proved less expansionary than its British or American counterpart, particularly so between autumn 2012 and the January 2015 announcement of quantitative easing measures. [15]

19Fiscal policy cannot play its counter-cyclical role in countries under an adjustment programme (case of Greece in 2014), in countries under the Excessive Deficit Procedure within the SGP’s corrective arm (case of France) or in countries committed to reducing their deficit under the SGP’s preventive arm (case of Italy). In 2014, Germany was the only major Eurozone country truly free to set its fiscal policy; it opted for a balanced budget (coalition agreement). The fiscal policy of Eurozone members is thus largely inactivated, in spite of the Commission’s efforts to relax the SGP rules, in particular with regard to its preventive arm. [16]

20Could the adjustments made by the peripheral countries have been partially offset by a less restrictive German fiscal policy? The literature on Keynesian cross-multipliers (the impact of one country’s stimulus on another’s economic activity) offers little in the way of encouragements: a fiscal stimulus in Germany has an ambiguous effect on Italy or France because of the resulting rise in Eurozone-wide interest rates. However, this literature only covers “normal” time periods. In a period of prolonged monetary expansion, the interest rate channel is neutralised and a less restrictive German fiscal policy would unambiguously have supported activity elsewhere in the euro area. Germany, which enjoys a situation of full employment, had however no reason not to get back to a balanced budget. [17]

Institutional constraints

21The Eurozone is not a federal state. Had it been, it could have taken quicker decisions and substantially reduced the cost of adjustment. For example, the delay in tackling the banking crisis can be directly linked to there being no federal agency to address it at the beginning of the crisis. Furthermore, a federal Eurozone would have set its fiscal policy at a central level, taking into account the economic situation at the time, and coming under a lot less market-pressure given that its overall debt level compares with that of the US. As for the ECB, it would have had a standard instrument for balance sheet management at its disposal. In addition, the banking risk-sovereign risk loop would have been mitigated by banks holding federal rather than national sovereign bonds on their balance sheet.

22Instead, and with the exception of the 2009 stimulus package, the fiscal response to the crisis was in no way coordinated, but by the SGP’s rules whose aim is to ensure fiscal sustainability and not to manage the economic cycle. Although the SGP rules were amended in 2005 to better reflect the business cycle (see Box), they have been rather unsuccessful in achieving demand stabilization: firstly because the SGP relies on the notoriously difficult-to-compute indicator of potential GDP (used to calculate the structural balance) and secondly because the SGP’s new guidelines offer very limited genuine “flexibility”, especially to those countries with a deficit in excess of 3% of GDP.

23Having pledged to coordinate their economic policies (art. 121 of the Treaty on the Functioning of the European Union, TFEU), Member States still struggle to see through this coordination other than via the SGP rules. This hardly comes as a surprise, given that governments derive their legitimacy from national elections and not European ones. This difficulty is well-illustrated by the German coalition agreement, which came into force following the 2013 elections, [18] and which led Germany –representing 25% of the Eurozone’s GDP– to return to a balanced budget faster than foreseen in the SGP. In a federal union, this would not have been an issue. Indeed, in existing federal countries (USA, Canada, Brazil, Switzerland…), macroeconomic stabilisation is provided for by the federal budget, be it with temporary transfers between States (federal unemployment insurance for example) or with the ability to borrow in times of crisis. [19] With no federal budget, coordination of Eurozone fiscal policies is made all the more necessary; however, because each Parliament is sovereign in approving its national budget, such coordination contradicts national political systems.

24The lack of consistency in State-level policies has resulted in monetary policy taking full responsibility for managing aggregate demand in order to achieve the objective of an inflation rate “below 2%, but close to 2%”.

25In the nutshell, the euro area lacks a central decision-making power that would act more swiftly and efficiently than a combination of weakly coordinated Member States. This will weigh on economic policy making until the institutional setup is revised.

A macroeconomic surveillance that is doubly-asymmetric

26The imbalances that led to the Eurozone crisis were of a budgetary nature for some countries (Greece), but not so for others (Ireland, Spain). Indeed, while not all countries hit by the crisis ran a high budget deficit in 2007, all had recorded large external deficits (Fig. 2); this is linked to rising private debts. The fiscal balance of pre-crisis Spain was clearly in surplus but a combination of rising real-estate prices and negative real interest rates encouraged private agents to invest in real-estate and lower their savings. This private-sector imbalance is reflected in the current account balance, which is the sum of net public savings and net private savings.

2

Fiscal balance and external current account in 2007, % of GDP

Fiscal balance and external current account in 2007, % of GDP

27In recognition of this surveillance error, the EU widened the monitoring process in 2011 with the introduction of the Six Pack [20] and its Macroeconomic Imbalance Procedure (MIP, see Box). The MIP is not based on specific policies, as opposed to the SGP’s focus on budget balance (cyclically adjusted or not). As a result, macroeconomic surveillance gets nothing other than lost in a list of structural recommendations, some of which (reforms of the labour market, education…) should instead fall under the European growth strategy.

28It is obviously desirable that the European Commission disseminate best practices in terms of structural policies in order to raise the Eurozone’s potential growth prospects. However, doing so as part of the MIP weakens the procedure: countries find it nigh impossible to respond quickly to all the Commission’s requests, some of which are quite distant from short and medium-term macroeconomic imbalances. In turn, the Commission may think twice about placing a country in a situation akin to it being under an ESM (European Stability Mechanism) adjustment programme.

29The MIP itself was built asymmetrically. For example, the scoreboard, upon which the Commission relies to identify imbalances before performing in-depth reviews, uses different thresholds depending on whether the country has an external surplus (+ 6% of GDP) or a deficit (– 4%); additionally, some thresholds can be sensitive to the Eurozone’s inflation average or even to the euro exchange-rate.

A dichotomy between Eurozone and Member States

30The “European Semester”, which came into force in 2010 and runs from November to July, has restructured macroeconomic surveillance in the euro area (Fig. 3). [21] The Eurozone’s policy mix is discussed mainly through the examination of the Annual Growth Survey at the beginning of the semester, followed by the adoption of recommendations to the euro area (end of semester). A Eurogroup discussion on the orientation of the Eurozone’s aggregate fiscal stance has been planned since 2013, yet does not seem to have been the focus of much attention. Above all, these various elements of consultation at European level have no tangible impact on country-specific decisions. In 2014 for example the recommendation to the euro area asked to “foster appropriate policies in countries with large current account surpluses to contribute to positive spillovers”. [22] However, the Council’s recommendations to the two largest surplus Eurozone countries –Germany and the Netherlands– [23] showed no sign of this recommendation. The Netherlands were asked not to falter in their budgetary adjustment. As for Germany, it was asked to reduce taxes on low-skilled labour in order to “support domestic demand”; a very similar recommendation was made to France with a view this time to restoring competitiveness. The rapid adjustment of the German budget deficit (the 2010 deficit of 4.1% had disappeared by 2012) gave rise to no objections.

3

The simplified European Semester in 2015

The simplified European Semester in 2015

Weak ownership of the semester

31At Member States level, the semester begins in November of year n – 1 when they receive the Commission opinion on their draft budgetary plans for year n as part of the SGP: adjustments are required if they are at risk of non-compliance. The Commission already ruled in May on this issue, based on national Stability Programmes; however, the November opinion takes into account the national budgetary debate and the Commission’s new macroeconomic forecasts on growth and potential growth or inflation, also published in November. In the event that, for example, potential growth has been revised downwards, an additional effort may suddenly be required, close to the end of the budget process, if governments are to achieve their structural adjustment target. The Commission is by no means going beyond its mandate in ensuring that passed budgets comply with SGP rules. However, it is of little use to change underlying budgetary assumptions when the budget process is about to end; it merely urges governments to look for emergency solutions in finding the missing billions in a pro-cyclical way.

32At the start of each European Semester, the Commission also publishes both the Annual Growth Survey (AGS) and the Alert Mechanism Report (AMR) under the MIP. The latter pinpoints critical imbalances country-by-country –be it lack of competitiveness in France or an excessive current-account surplus in Germany. The report determines for which country an indepth review is warranted. Under the SGP, countries almost automatically fell under the Excessive Deficit Procedure when their deficit breached the 3% threshold; in contrast, the MIP suffers from having no single key indicator upon which to rely. The AMR builds on the analysis of a scoreboard that scrutinizes 11 “headline” indicators and 29 “secondary” indicators. [24] In-depth reviews also touch upon many issues. Using multiple criteria allows for gradual pressure on Member States (the MIP has six “step-up” stages, see Box); it also leads to some key elements of the analysis being set aside (see for example the differences between the Commission‘s Country Reports and the final recommendations adopted by the Council). Upon receiving their country-specific recommendations governments tend to perceive them to be both too intrusive and not properly prioritised. Notwithstanding goals being seen as fully legitimate, they find it difficult to endorse all the requirements given a level of detail that impinges on national sovereignty.

33The In-depth Reviews are submitted to Member States early in the year, so that they orient their National Reform Programmes. [25] These reviews are important and well-structured, but seldom debated at the national level, especially so in Parliament.

Better integrated surveillance between the Eurozone level and the national level

36To better integrate the two levels of macroeconomic surveillance (Eurozone level and Member States level), we suggest dividing the European “semester” into two successive “trimesters” and to articulate them around three key chapters for short and medium-term monitoring: fiscal policy, competitiveness policies and macro-prudential policy.

37The first “trimester” (November of year n – 1 to February of year n) would be devoted to assessing the Eurozone situation. It would start with the Council and the European Parliament [26] reviewing a single document (AGS+) focused on the macro e conomic situation of the euro area and its key imbalances with cross-country heterogeneity whenever meaningful. The issue of impediments to long-term growth, however fundamental it may be, would not be dealt with here. Three chapters would be covered:

• Fiscal policy (sustainability, but also fiscal stance with regard to the business cycle);
• Competitiveness policies (changes in unit labour costs, in the share of tradable sectors in value added…);
• Macro-prudential policies (credit growth, debts, realestate prices… in relation to both financial stability and the business cycle).

38The Commission would simultaneously draw up a list of countries for which an in-depth review is warranted under the MIP, on the basis of a simplified alert mechanism (see below). The Council would then vote, after seeking the opinion of the European Parliament, on a recommendation concerning the euro area (including the desirable aggreagte fiscal stance) and on a list of in-depth reviews to be carried out.

39Recommendation 1. Start the European Semester by assessing Eurozone macroeconomic imbalances at the aggregate level and by pointing out cross-country heterogeneity whenever meaningful. This assessment covers three major topics: fiscal policy, competitiveness and macroprudential policy. After the European Parliament has given its opinion, the Council decides on recommandations for the euro area (including its fiscal stance) and on the list of countries to come under “in-depth” review.

40The second “trimester” (March to July of year n) would be devoted to assessing Member States. It would start with a review of country reports that would include a section on the MIP’s in-depth review whenever warranted. The country reports should cover the same three chapters as the AGS+ report: fiscal, competitiveness, and macro-prudential policies. Both Stability Programmes and National Reform Programmes prepared by Member States should include a section responding to the Commission on each of these three chapters. The trimester would end with the Country Specific Recommandations (CSRs), which should also be required to cover these three topics. The CSRs should set intermediate goals (such as needed adjustments to unit labour costs) rather than specific measures (minimum wage, social security contributions…). [27] The assessment on draft budgetary plans (November) must be consistent with the country specific recommendations (May).

41Recommendation 2. In a second phase, finance ministers discuss country-specific imbalances with regard to the three chapters mentioned, based on the Commission’s country reports and taking into account the recommendations adopted for the euro area. Stability Programmes, National Reform Programmes, but also the country specific recommendations all need to explicitly cover these three chapters; they must also aim for intermediate goals rather than specific measures.

42In this context, an assessment of fiscal policy would give it back its full macroeconomic stabilisation purpose. SGP rules may temporarily and for some countries constrain this policy; this constraint should be taken into account when expressing the desirable stance of other Member States’ fiscal policy. Our recommendation also highlights the role of macroprudential policies not only for financial stability, but also for demand management. Price and wage evolutions would also be at the core of the analysis.

A clearer dividing line between the short or medium-term and the long-term

43As noted, the Macroeconomic Imbalance Procedure (MIP) is hindered by the fact that it has no precisely defined objectives and instruments. With the MIP taking place within the ECOFIN Council, it is rational that only instruments in the hands of finance ministers, or at least ones that are not too far from their reach, be considered. For example, short and mediumterm monitoring of competitiveness should focus on the evolution of prices, wages and levies rather than on innovation and education issues, which form part of the long-term strategy. [28]

44The MIP should be refocused on a small number of issues and instruments; this would lend it greater weight and tie it closer to the SGP. Ideas for long-term growth reforms could still be included in the various documents relating to Member States (Annual Country Report, National Reform Programs, and Country Specific Recommendations). It would however be helpful for them to come under a separate heading within the Europe 2020 growth strategy; it would also be beneficial for these potential reforms to be discussed in another context than that of the ECOFIN Council –for example by the ministers for economic affairs, industry, or energy.

45The dividing line between the short and medium-term and the long-term could take the form of a country-specific assumption on potential growth to be set annually. As noted above, figures for both potential growth and future inflation can be revised upwards or downwards by the Commission in its autumn forecast; this then alters the fiscal effort required of countries undertaking structural adjustments, at a time when the budget for the following year is mostly settled. We propose that assumptions for both potential growth and inflation for year n be fixed permanently at the time of the spring forecasts of year n – 1. Revising potential growth assumptions in the autumn forecast of year n – 1 would only impact the budget of year n + 1. The concept of potential growth is a longterm concept which cannot be revised several times a year.

46Recommendation 3. Refocus the Macroeconomic Imbalance Procedure on short and medium-term objectives. Freeze potential growth and inflation forecasts, which underline the structural adjustment of year n, at the level given by the spring forecast of year n – 1.

Greater awareness and ownership

47The two amendments to the semester presented above –sequential examination of the Eurozone and then of Member States, and a clearer dividing line between the short and medium-term and the long-term– are already likely to help Member States make better use of the recommendations made at European level. To go further, it would be helpful for the main European documents relating to a Member State (Annual Country Report, In-depth Review, specific recommendation) to be systematically discussed by the Parliament of said Member State, and for a hearing of the Commissioner for Economic and Financial Affairs (ECFIN) or of his representative to be held at least once a year.

48Recommendation 4. Systematise within each national Parliament, the debate on the key country-specific documents published by the European Commission, together with at least one hearing per year of the ECFIN Commissioner or his representative.

49We also recommend involving Member States early on in the process by feeding the analytical contribution of three networks of independent committees to the AGS+ report (see Fig. 4). National expertise would then be taken into account upstream of the European Semester and would provide a useful complement to the Commission’s analysis.