econstorMake Your Publications Visible.

A Service of

zbwLeibniz-InformationszentrumWirtschaftLeibniz Information Centrefor Economics

CPB Netherlands Bureau for Economic Policy Analysis (The Hague) (Ed.);Institut fur Weltwirtschaft (Kiel) (Ed.); National Institute of Economic andSocial Research (London) (Ed.); Observatoire Français des ConjoncturesEconomiques (Paris) (Ed.); Prometeia (Bologna) (Ed.)Working Paper — Digitized Version

The European economy in 1998 and 1999

Kieler Diskussionsbeiträge, No. 319

Provided in Cooperation with:Kiel Institute for the World Economy – Leibniz Center for Research on Global EconomicChallenges

Suggested Citation: CPB Netherlands Bureau for Economic Policy Analysis (The Hague) (Ed.);Institut fur Weltwirtschaft (Kiel) (Ed.); National Institute of Economic and Social Research(London) (Ed.); Observatoire Français des Conjonctures Economiques (Paris) (Ed.); Prometeia(Bologna) (Ed.) (1998) : The European economy in 1998 and 1999, Kieler Diskussionsbeiträge,No. 319, ISBN 3894561688, Institut für Weltwirtschaft (IfW), Kiel

This Version is available at:http://hdl.handle.net/10419/47996

Standard-Nutzungsbedingungen:

Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichenZwecken und zum Privatgebrauch gespeichert und kopiert werden.

Sie dürfen die Dokumente nicht für öffentliche oder kommerzielleZwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglichmachen, vertreiben oder anderweitig nutzen.

Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen(insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten,gelten abweichend von diesen Nutzungsbedingungen die in der dortgenannten Lizenz gewährten Nutzungsrechte.

Terms of use:

Documents in EconStor may be saved and copied for yourpersonal and scholarly purposes.

You are not to copy documents for public or commercialpurposes, to exhibit the documents publicly, to make thempublicly available on the internet, or to distribute or otherwiseuse the documents in public.

If the documents have been made available under an OpenContent Licence (especially Creative Commons Licences), youmay exercise further usage rights as specified in the indicatedlicence.

www.econstor.eu

KIELER DISKUSSIONSBEITRAGE

K I E L D I S C U S S I O N P A P E R S

The European Economy in 1998 and 1999

Joint report of the following European economic research institutes:

CPB Netherlands Bureau for Economic Policy Analysis, The Hague

Institut fur Weltwirtschaft an der Universitat Kiel, Kiel

National Institute forlEconomic and Social Research, London

Observatoire Francais~des Conjunctures Economiques, Paris

PROMETEIA, Bologna

I N S T I T U T F U R W E L T W I R T S C H A F T K I E L J U L I 1 9 9 8

ISSN 0455-0420

Contents

I. Situation and Prospects for the European Economy 3

1. External Environment 3

a. Relatively Small Effects on Europe of the Asian Crisis 3

b. No Fundamental Improvement in Japan 5

c.. United States: Growth Is Losing Momentum 6

d. World Trade Slows Down and Raw Material Prices Remain Subdued 7

e. Recovery in Transition Countries Broadens 8

2. Western Europe 9

a. The Upturn in Western Europe Continues 9

b. Special Country Reports 14

3. Some Facts about Euroland 19

II. Economic Policy in Europe for the Short and the Medium Term 20

1. On the Implications of the European Monetary Union for Economic Policy 20

2. Monetary Policy 22

3. Exchange Rate Policies of theNon-EMU Members of the EU 24

4. Fiscal Policy , 26

a. On the Consequences of the Stability Pact 26

b. On Tax Harmonization / 29i

5. On Social Policy and Wage Setting in Europe 30

a. Harmonizing Wages? 30

b. Harmonizing Institutions and Common Standards 31

The five European research institutes listed on the cover have joined in the project "European Business CycleAnalysis" (EBCA). They intend to publish a joint report twice a year including an analysis of the cyclicalsituation and a forecast for the European economy. In addition, they cooperate in basic economic research onmedium-term issues.

I. Situation and Prospects for the European Economy

World economic activity remains relatively ro-bust, although the Asian crisis casts a shadowover the picture. The rate of growth of worldtrade has slowed down since last fall, but is ex-pected to remain above its trend level. Interna-tional price developments remain quite moder-ate. Oil prices have declined substantially, andare among the lowest of the decade. Inflationarypressures are also limited in the industrialcountries, as capacity constraints are not yet sig-nificant there and excess supply has material-ized worldwide. The industrial countries show asustained growth rate between 2Vi and 3 percent on average. However, the combination ofstrong growth and low inflation is the result ofdivergent developments between countries.• The US economy has been until recently par-ticularly buoyant, as strong domestic demandhas more than offset the dampening effect offalling exports to Asia. The Japanese economyremains in the doldrums. The threat of a defla-tion has recently prompted a substantial stimu-lation programme aiming at preventing a furtherdeterioration of confidence. \^

Economic growth in Asia has been-severely_restricted, in particular in the ASEAN countriesand Korea, although extensive rescue opera-tions have brought the situation in the worst hitcountries more or less under control. The im-pact on the European countries is as yet ratherlimited, as negative trade effects are largelycompensated for by beneficial effects of lowerimported inflation and lower interest rates.

Thus Western Europe is in a position to sus-tain the recovery that began in mid-1996. Pros-pects have been strengthened as uncertaintiesassociated with the implementation of the EMUhave now been dissipated. The time has nowcome to begin to view the EMU countries as asingle entity from the viewpoint of economicmanagement, even if differences persist in manyfields.

1. External Environment

a. Relatively Small Effects on Europe ofthe Asian Crisis

The turmoil on the Asian currency and stockmarkets worsened in the final months of lastyear. The crisis spread from the ASEAN-4countries (Indonesia, Malaysia, the Philippines,and Thailand) to other countries in the region,notably to South Korea. When the Japanese fi-nancial markets were subsequently hit as well,the problem took on a more than regional di-mension. The financial crisis led to significantdeclines in exchange rates that were caused by amajor reduction of capital flows into the region.This change has helped to reduce real interestrates and strengthen equity prices in the OECD,offsetting some of the effects of the crisis.

Extensive international rescue operations, ledby the IMF, seem to have brought the situationmore or less under control and to have helped toprevent the crisis spreading to other regions. InIndonesia, however, the situation remains wor-rying, while social unrest has recently devel-oped in South Korea.

The depth and the duration of the crisis re-main uncertain. In our projection it is assumedthat during this year a basis will be establishedin the most affected countries for a restorationof confidence. Thus the crisis will be bottomingout, and the area will enter a gradual export-ledrecovery with positive growth returning to allcountries involved. The volume of GDP in theASEAN-4 will drop substantially this year andshow only a marginal increase next year. In par-ticular these countries have had to reduce theirexternal deficits, at first mainly by a compres-sion of domestic demand and drastic importcuts. An export boom has so far been hamperedby credit shortages. However, those countriescan profit from improved competitiveness. Theimpact of the crisis on other Asian countries isessentially smaller. Economic growth in Asiaexcluding Japan may pick up from 3V2 per centthis year to 4*72-5 per cent next year.

Weaker demand in the adapting countries haslowered the net exports of their trading part-ners. Developing and transition countries aremost affected, because their goods compete di-rectly with Asian goods. Moreover, they aremost vulnerable to financial disturbances, whilstforeign investors and banks now are more awareof the risks in these markets. There have alsobeen effects on industrial countries. The Asianseconomies are importing less, and their cheapergoods are driving out western products. The im-pact on output in the affected countries dependsprimarily on two factors, namely the import-ance of Asia as an export destination and theimportance of trade for the national economy.The adverse effects on growth should not beoverestimated. Trade with the ASEAN-4 andKorea accounts for less than 1 per cent of theindustrial countries' GDP (Table 1). Moreover,the loss of output is compensated in most coun-tries by lower inflation and lower interest rates.Europe is not very vulnerable to setbacks inAsia, as only a relatively small proportion ofexports is destined for that region, and the shareof Asia in imports is not large. The impact onGDP growth may be limited to about a\quarterof a percentage point this year, as long as^eco-nomic policy responses continue to be appropri-ate, and the crisis does not spill over to otherAsian and developing countries.

The Asian crisis has a depressing effect onthe prices of manufactures. The usual assump-tion is that Asian suppliers are price followers,

which means that trade prices do not neces-sarily change with shifting exchange rates. Butnominal depreciations vis-a-vis the dollar rang-ing from 40 to 75 per cent mean that this is notvery plausible. However, the effect on priceswill be much smaller than suggested by thesedepreciations. First, exchange rates have depre-ciated much less in effective terms, as thesecountries have significant trade with each otherand with other countries with weak currencies.Second, the real effective depreciation is muchsmaller, as production costs of exportables willrise because of higher import prices (dependingon the share of imported inputs), while infla-tionary pressure on domestic inputs will tend toerode the competitiveness gain. Third, Asianfirms might prefer a widening of profit marginsover market gains.

For the non-industrial world as a whole theeffective depreciation is less than 10 per cent onaverage, but these shifts in exchange rates willhave a significant impact on patterns of compe-titiveness. For the developing world excludingOPEC the terms-of-trade loss due to exchangerate changes is estimated at some 3 per cent. Ofthe industrial countries in particular the compe-titive position of the United States will haveweakened. For Europe the impact is much smal-ler, given the smaller share of Asia in its trade.For Japan on the other end the boost to compe-titiveness from the depreciation against the in-dustrial countries is broadly offset by the appre-ciation against the currencies in the Asian region.

Table 1 - Bilateral Trade Shares for European Union, United States, and Japan in 1997

Per cent

Exports to :European UnionUnited StatesJapanAsia, excl. JapanASEAN-4 plus KoreaWorld

Exports from:

European Union

Share ofexports

Shareof GDP

61.0 15.37.7 1.92.0 0.57.8 1.92.4 0.6

100.0 25.0

United States

Share ofexports

20.6—

10.920.4

8.7100.0

Shareof GDP

.1.6—0.91.60.79.5

Japan

Share ofexports

Share ofGDP

15.4 1.427.5 2.5— —

44.6 4.019.4 1.7

100.0 10.3

Source: European Commission.

Table 2 - South Korean Trade and Korea's Competitors in Industrialized Countries in 1994

Country

United StatesJapanGermanyUnited KingdomCanadaAustralasiaMexicoNetherlandsFranceItalySpainBelgiumSwedenAustriaSwitzerlandNorwayDenmarkIrelandFinlandPortugal

Share in Korean exports

21.4014.084.491.861.451.441.341.171.040.790.660.430.370.290.230.200.180.000.000.00

Competitors in third markets

19.7413.829.665.87

14.754.124.853.095.834.791.522.591.691.112.270.901.211.030.760.41

Source: Econometric Model of NIESR (NIGEM).

However, direct patterns of trade are not theonly thing to take into account in assessing theeffects of the Asian crisis. Table 2 shows withwhom Korea, for instance, competes in thirdmarkets. Although direct trade between Europeand Korea is low they are major competitors inUS markets, for instance.

b. No Fundamental Improvement inJapan

There were strong recessionary tendencies inJapan during the second half of 1997 causedmainly by fiscal tightening, the consequences ofthe Asian crisis, and the implications of finan-cial deregulation. Fiscal policy was tightenedby over 2 per cent of GDP in the third quarter.The restructuring of financial markets made theproblems of the banks and pension funds moretransparent, and consequently affected consumerconfidence and reduced spending. In March1998, manufacturing production was 9 per centbelow the peak level of mid-1997. Domestic de-mand was reduced by a sharp fall of the resi-dential investment and household consumption(especially after December 1997, the period ofdistribution of bonus payments). These devel-

opments induced a decline of corporate profits(about 2.2 per cent among large non-financialcompanies, for the fiscal year which closes inMarch 1998), a downturn of productive invest-ment, and a slowdown in wage growth. Duringthe first quarter of 1998, domestic demand hasstabilized at a low level. In addition, the slumpin Asian imports since the beginning of 1998has worsened overall demand. In these circum-stances, inventory-sales ratios are shooting upand the decline in domestic production prices ispicking up speed. In addition, the growing shaki-ness of the banking system has induced a creditsqueeze, especially toward small and medium-sized enterprises.

The level of activity in Japan in past yearshas been strongly affected by large swings inthe stance of fiscal policy. In April 1998, thegovernment proposed amendments to the FiscalStructural Reform Act, postponing the target fordiscontinuing deficit-covering bonds issuance,and removing caps on social welfare spending.The additional measures officially announcedon April 24, amount to 16.65 trillion yen (3.3per cent of GDP). However, the stimulating im-pact of the fiscal package is likely to be lesspronounced than it might appear as the original

budget incorporated a significant negative im-pact on domestic demand. If one third of thepublic works package becomes effective thisyear, public investment might stagnate insteadof decreasing by 7 per cent (as planned in theoriginal budget). Next year public investmentmight experience only a small increase. In addi-tion, half of the current 4 trillion yen fiscal re-bate was already planned, and hence the addi-tional 2 trillion rebate that will occur next yearimplies that tax policy will be neutral.

In a context of persistent deflationary tenden-cies, monetary policy will remain expansionaryin 1998 as well as 1999. However, low interestrates will not stimulate credit demand becauseof the weakness of the banking system. As a con-sequence the credit squeeze will encourage com-panies to improve self-financing, which may im-ply further labour market and wage adjustment.

Nominal wage growth (including bonusesand overtime payments) has decelerated sincemid-1997. In the first months of 1998 even re-gular wages were no higher than a year ago. De-creasing overtime and a reduction of bonus pay-ments (indexed on company profits) have fur-ther worsened the situation. In addition, increas-ing unemployment (which has reached 3.9 percent in March) has helped to prevent a decreasein the savings rate.

The expected stabilization of the exports toother Asian countries will help total exports togradually recover. A slight depreciation of theyen vis-a-vis the dollar will also have a positiveeffect. Domestic demand is likely to be ratherweak as the fiscal stimulation package will onlyhave its full impact in 1999. Capital spendingwill decline this year and gradually increasethereafter. Consumption is likely to be weak asunemployment will pick up. Consequently therewill be only a small increase in real GDP in1998 and a somewhat faster growth in 1999.

c. United States: Growth Is LosingMomentum

According to the preliminary estimates for thefirst quarter of 1998, growth continued to bestrong as compared to the fourth quarter of1997. Real GDP increased at an annualized rate

of 4.8 per cent. Personal consumption expendi-tures accelerated further and there was a sharprebound in non-residential investment led byproducers' durable equipment. Also residentialinvestment performed rather favourably. Con-trary to that, there was a negative contributionof net exports due to the impact of the Asiancrisis and the appreciation of the US dollar. Im-ports were soaring while exports weakened sig-nificantly. Businesses have continued to in-crease inventories: they nevertheless remain incheck with regard to sales. Inflation is still verymoderate, with consumer prices in April in-creasing by 1.5 per cent over the precedingyear. The fall of the unemployment rate to 4.3per cent in April indicates that the labour mar-ket is getting tighter. However, the sharp de-cline from the level of March (4.7 per cent) ismainly due to a decline in the labour forcerather than an increase in employment.

The Federal Reserve Board decided not to in-crease interest rates at its meeting in May. It be-lieves that inflationary dangers are small, andthat strong growth in GDP in the first quarterwas mainly related to the mild winter weather.As declining net exports will put a further dragon the economy, an increase in interest rates isbeing given a low probability. The outlook forfiscal policy never appeared so good for the fis-cal year ending next September with a surpluson the Federal Budget of the order of $43-$63billion according to the last estimates of theCongressional Budget Office. The stance of fis-cal policy is likely to be neutral in this fiscalyear.

The US economy appears to be operating ator above capacity. As a result, tensions on wag-es have begun to materialize. Increases in la-bour costs accelerated at the end of 1997 andare now higher than the inflation rate. Realwages are likely to grow slightly faster than pro-ductivity over the next year.

Less favourable export prospects, followingin part from the recent strength of the dollar,and rising unit labour costs will worsen the pros-pects for production and investment. Wealth ef-fects will no longer have such a strong impacton consumption, and hence the savings ratemay rise. These factors will lead to a modera-

tion of output growth in the course of this year.Real GDP will nevertheless increase on averageby 3 per cent in 1998. In 1999, real GDPgrowth will slow down to 2 per cent. Lowerprofit growth will induce lower growth of cor-porate investment and we expect that inven-tories will be reduced. The projected slight de-preciation of the US dollar, the recovery inSoutheast Asia, and the broadening of the up-swing in Europe together with a smaller in-crease in domestic demand will lead to a posi-tive contribution of net exports to growth. Theunemployment rate will gradually increase, butdespite this inflation will be increased by therise in import prices.

d. World Trade Slows Down and RawMaterial Prices Remain Subdued

Last year the volume of world trade grew byabout 10 per cent (Table 3). In particular Northand South America recorded very dynamictrade developments. Asia, Western Europe, andthe transition countries all recorded strongergrowth than in the previous year. However, thisrapid expansion will not be sustained because

of the Asian crisis and the expected slowdownof the American economy. Although the impactof the crisis will be diminishing rather soon,next year's trade will also be affected, in parti-cular flows within the Asian region will be re-duced. Total world trade growth will slow tosome 6V2 per cent in 1998 and 1999, while in-ternational prices will move quite modestly.

The Asian crisis has caused a sharp decelera-tion in growth of world trade, and depressedprices. Asia including Japan accounts for abouta quarter of total world trade (Table 4). The ef-fects are most apparent for Asia itself, becausethe bulk of the trade of the Asian countries re-mains within the area.

In most Western European countries, exportsare still booming, but growth is expected to mo-derate. The effects of last year's improved com-petitiveness are ebbing away, and the Asiancrisis has intensified international competition.At the same time import demand is weakeningin the United States and in Asia. However, ex-ports are not very vulnerable to setbacks in thatregion, and the Asian share in European im-ports is not large.

Table 3 - World Trade, 1997-1999

Percentage change

World trade volume, goodsExport market growth EUa

World trade prices, $World trade prices, nat. currencies

including intra-EU trade.

1997

109 V*

-7'/2- > / 4

1998

6'/263/4-5

0

1999

6'/26'/21%

1

Source: EBCA estimates.

Table 4 - Importance of Asia

Percentage share

Worldpopulation

WorldGDP

Worldimports

EU-15exports

AsiaJapanASEAN-4 plus Korea

5627

3486

2577

1022

In the past few years, Europe's cyclical re-covery was substantially supported by exports,but the contribution of net exports is rapidly di-minishing. Export growth of the area will de-velop largely in line with market growth, slow-ing from 9 per cent in 1997 to 7 per cent thisyear and some 6lA per cent next year.

Western European imports are gradually de-celerating, from 71/2 per cent last year to 6V2 percent next year. Most countries show the sameprofile. Weakening domestic demand is reflec-ted in slow import demand in the United King-dom, Norway, and Denmark. In other countriesa slight pick-up in domestic demand may leadto a smaller contribution of net exports togrowth.

Primary commodity prices in dollar terms de-creased sharply in late 1997 and early this year,in part because of the collapse in demand inEast Asia. The potential spread of the Asiancrisis has made manufacturers reluctant to re-plenish inventories. Also the rise of the dollarhas depressed dollar-denominated prices. Thesharp fall in oil prices was the result of weakenergy demand because of a mild winter in theNorthern hemisphere, and rising OPEC produc-tion. For 1998 and 1999 only a small rise incommodity prices is expected, given the slowerpace of the world economy, especially in Asia.For crude oil, copper, and oilseeds the share ofthe five worst hit countries in world importswas 8 per .cent, and for grains, sugar, and lead10 to 12 per cent. Asian suppliers, on the otherhand, will shift towards the industrial exportmarkets, helping to reduce the prices of rubberand tin in particular.

Although weakening demand has led to over-capacity, dollar prices may pick up somewhat,supported by the recovery in the transitioncountries, and the continued upswing in Wes-tern Europe, who are major consumers of rawmaterials. Moreover, the moderating effect ofthe rising dollar will vanish. Year on year, com-modity prices will still drop substantially in1998.

The decline in energy prices became steeperat the end of last year. In November OPEC de-cided to raise production quotas by about 10 percent starting January 1998. This is one of the

reasons why in March the oil price dropped by30 per cent to a level of around $13 per barrel.Other reasons were weak demand from Asiaand the mild winter in the Northern hemisphere.In reaction, OPEC and non-OPEC countries an-nounced a plan to reduce oil production byaround 2 million barrels per day. However, theprospects for a strong price recovery are rathersmall. World activity is slowing this year, andoil stocks are above . normal. Consequently,world oil demand will be only 2 per cent higherthis year than in 1997. Assuming that the agreedsupply reductions will come in time, prices mayslightly recover in the second half of this yearand remain at around that level next year.

e. Recovery in Transition CountriesBroadens

In the transition countries in Central and Eas-tern Europe output growth slowed down some-what in 1997. Tightening of monetary and fis-cal policy has meant that growth of domesticdemand has decelerated. On the other hand ex-ports expanded more rapidly as the upswing inWestern Europe gained momentum. The changein the driving forces helped to slightly reduceexternal deficits. High current account deficits,upward pressures on currencies, and weaknes-ses in the banking system make some of thesecountries vulnerable. In 1998 and 1999 outputgrowth is likely to be in the order of 4 to 4.5 percent, compared to 3.3 per cent in 1997. Coun-tries like Romania and Bulgaria may show somepositive growth. Labour markets there will showonly a small improvement, and inflation willslow down further, but nevertheless remainhigh. Growth in the Accession countries Po-land, Estonia, Hungary, Slovenia, and theCzech Republic has generally been strong, withthe first two showing particular promise. For-eign direct investment has shown a strong up-turn recently, in part because of closer ties tothe EU.

In the CIS countries the decline of output hascome to a halt in 1997 and there was remark-able progress with respect to reducing inflationwhile fiscal deficits became larger again. Atpresent the Russian economy seems to be rather

fragile also because it is heavily dependent onoil revenues. The central bank had to raise in-terest rates dramatically, the lombard rateamounts to 150 per cent, now. However, withthe expected stabilization of oil prices the pres-ent turmoil in the financial markets is likely tocalm down again. All in all a small positivegrowth rate of real GDP may occur. Employ-ment will fall further and unemployment willkeep on rising.

2. Western Europe

a. The Upturn in Western EuropeContinues

In the course of 1997 the cyclical upswing inWestern Europe regained momentum after ithad been interrupted in 1995 and 1996, due to amarked appreciation of most European curren-

Box 1 - Potential Output and Output Gaps in EMU Countries

The stage of the business cycle in the EMU area will be an important indicator for the European Central Bank (ECB)with respect to its interest policy. As long as there is sufficient slack in the economy an acceleration of inflation isnot likely to occur. At present inflation risks are subdued, however, with output continuing to expand at a rapid paceinflationary risks might increase in the future. It would therefore be helpful to know the trend growth of EMU econ-omies and the corresponding output gaps. This would also help to determine structural budget deficits.

At present two different methods are used for this purpose. The first alternative involves smoothing real GDP us-ing a Hodrick-Prescott (HP) filter, this is based on calculating a weighted moving average of GDP including a four-year forecast. The second approach, used for example by the OECD, is based on a production function relationshipand the factor inputs that are available to the economy. At present both methods give slightly conflicting results. Ac-cording to the HP filter method capacity utilization in EMU was back to normal already in the course of 1997. Con-trary to that the production function approach still indicates a negative output gap of about 1.5 per cent at the end of1997 (graph). Since no full cycle is included into the analysis the HP filter is likely to have a bias towards under-estimating trend growth and thus overall capacity utilization seems to be exaggerated somewhat. The productionfunction approach on the other hand seems to have a bias in the other direction as the utilization of factor inputs isnot only affected by cyclical but also by structural elements. These calculations suggest that there is a wide marginof uncertainty.

EMU Countries : Output Gap% output gap (deviation from the OECD potential GDP and Hodrick-Prescott filter)

72 74 76 78 80 82 84 86 88 90 92 94 96 98

Source: OECD, EBCA estimates.

10

Box 1 continued

Germany% output gap (deviation from the OECD potential GDP and HP filter)

liter

OEGD

1 FRfi before 19SJ1

France% output gap (deviation from the OECD potential GDP and HP filter)

72 74 76 78 80 82 84 86 88 90 92 94 96 98 72 74 76 78 80 82 84 86 88 90 92 94 96

Italy% output gap (deviation from the OECD potential GDP and HP filter)

Spain% output gap (deviation from the OECD potential GDP and HP filter)

CECD

72 74 76 78 80 82 84 86 88 90 92 94 96 98

Netherlands% output gap (deviation from the OECD potential GDP and HP filter)

72 74 76 78 80 82 84 86 88 90 92 94 96 98

United Kingdom% output gap (deviation from the OECD potential GDP and HP filter)

OECD

72 74 76 78 80 82 84 86 88 90 92 94 96 98 72 74 76 78 80 82 84 86 88 90 92 94 96 98

Source: OECD, EBCA estimates.

11

cies vis-a-vis the US dollar and a marked in-crease in long-term interest rates which had oc-curred in 1994. In the fourth quarter of last yearreal GDP was about 3 per cent higher than ayear ago. The available information suggeststhat overall economic growth in Western Europein the first quarter of this year was even stron-ger. However, due to the mild winter weatherand specific factors, the first-quarter growthsomewhat overstates the underlying pace of therecovery. The negative output gap for the EMUarea as a whole has closed further, following acontinuing rapid growth of industrial produc-tion (Box 1). Employment increased slightlyand the number of unemployed decreased some-what. Due to sharply declining energy and rawmaterial prices, price increases almost came to ahalt; according to the new harmonized index ofconsumer prices set up by Eurostat the inflationrate on a year over year basis was down to 1.2per cent in March.

Within the EMU area there are pronounceddifferences with respect to the current state ofthe business cycle. In some of the smaller coun-tries, Ireland, Finland, Portugal, and the Nether-lands, and also in Spain, demand is expandingmore rapidly than in Austria, Belgium, Den-mark, Germany, France, and Italy. The fastergrowth in the smaller countries does not onlyreflect a higher trend growth but also a moreadvanced position in the business cycle. In ad-dition the reduction in interest rates in Ireland,Finland, and Portugal that is associated with theEMU process will raise consumer demand.

During the winter, exports continued to bethe main driving force of the upswing althoughgrowth rates have slowed down, in large partdue to declining exports to Southeast Asia. Inaddition the stimulating effects of the recent ap-preciation of the US dollar and the pound ster-ling are getting smaller. However, slower ex-port growth was fully compensated by a moremarked expansion of domestic demand. Im-proving labour market prospects and a cessationof the tightening of fiscal policy induced con-sumption to grow more rapidly, with car regis-tration showing an especially strong increase.Corporate investment growth also picked upconsiderably, supported by low interest rates,rising capacity utilization, and improving sales

and profit expectations. However, residentialand public investment have not risen signifi-cantly, but there are indications that there hasbeen some stabilization.

The short-term prospects are in favour of acontinuing upswing in the EMU countries. Theconfidence of consumers and enterprises hasbeen rising, and the inflow of new orders hasremained in a clear upward trend. Even moreimportant is that the underlying conditions,which are described below, remain favourable.

Monetary policy continues to support the up-swing. The transition to EMU is likely to besmooth. Low inflation, slightly appreciating cur-rencies, and continuing moderate wage in-creases suggest that interest rates in EMU coun-tries will converge to the lower end of the rangeamongst the members. In Italy, Spain, Portugal,and Ireland short-term interest rates are likely tofall in the course of the year while in Germany,France, and other members there may be a mi-nor rise in interest rates. At the end of the year,in all EMU countries the three-month moneymarket rate will be close to 4 per cent. In thecourse of next year the Institutes expect theECB to increase money market rates by half apercentage point as output gaps close (Table 5).

Long-term interest rates are expected to pickup somewhat already in the course of this yearand remain stable afterwards. With 10-yearbond yields edging up to 5.7 per cent next yearthe overall financial conditions remain favour-able. The expected slight increase in long-termrates mainly reflects that with the stabilizationin Southeast Asia capital flows to 'safe havens'in Europe and the US will reverse again.

As has been described above, conditions inmarkets outside EMU have worsened some-what. Lower output growth in Southeast Asiaand in North America will dampen exportgrowth, although with an expected stabilization,the dampening effects will get smaller nextyear. After a slowdown of growth rates in 1998world trade in 1999 will expand at the samerate. Despite the fact that the euro is expected toappreciate slightly vis-a-vis the dollar the com-petitive position of EMU countries will not de-teriorate as unit labour costs will show only asmall increase.

12

Table 5 - Assumptions for the Outlook

Interest ratesUS 3m

lOyEMU 3m

lOyOil pricea

Raw material pricesb

Exchange rate $/euroc

1998

1Q 2Q

5.6 5.75.6 5.74.0 3.95.2 5.1

14.2 14.5-6.0 -1.0

0.92 0.91aNorth-sea Brent in US$. — bHWWA Index excluding energyUS$.

3Q

5.85.93.85.3

14.500.91

[S-based)

4Q

5.86.03.95.5

15.000.90

1999

1Q 2Q

5.8 5.86.0 6.04.0 4.15.7 5.7

15.5 15.51.0 1.00.90 0.89

quarter-to-quarter in per cent

3Q

5.86.04.35.7

15.51.00.88

4Q

5.86.04.55.7

15.51.00.88

— cVis-a-vis the

Source: EBCA.

In 1997 fiscal policy has had dampening ef-fects on economic activity as in a number ofcountries taxes were raised and expenditureswere cut in order to meet the Maastricht criteriafor the budget deficit. This year, governmentsare not likely to give up their consolidation ef-forts and they will continue to try keep expendi-tures in check in order to further reduce thelevel of public expenditures in relation to GDP.On the revenue side, contrary to last year, there- -will in only a few countries be increases in taxrates and social contributions rates. Some coun-tries will even lower taxes and contributions inorder to give some relief to the private sector.All in all fiscal policy in 1998 and 1999 will bemore or less neutral.

In recent years wage growth has moderatedsubstantially and productivity growth has been

rather strong. In 1997 wages were 2.6 per centhigher than a year ago. With the upswing con-tinuing and the improvement in the labour mar-ket the reduction in wage increases is likely toslow down this year. Only in Italy and Franceare pay increases expected to slow down some-what. Next year wage growth will slightly accel-erate towards a rate of about 3 per cent. Someof those countries which are more advanced inthe business cycle may experience wage in-creases above the average rate. As productivitygrowth in EMU countries will slow gradually,unit labour costs which have been decliningwill again edge up slightly.

Against this background the upswing inEMU countries is likely to continue in 1998 andin 1999 at a rather solid pace (for the risks, seeBox 2). Real GDP will increase by 2.9 per cent

Box 2 - Risks Associated to the Forecast

As usual this forecast incorporates certain risks. A significant downward risk is still that the stabilization in South-east Asia will take longer than assumed in this forecast. This would mean that the related drag on European exportswould be more pronounced..In addition, losses on loans to the East Asian economies could present some liquidityproblems in the European banking system. It cannot be excluded that confidence in the progress in the transitioncountries could decline, creating financial turbulence in these countries and hampering recovery. Because of strongtrade links this would significantly affect exports of EMU countries in a negative way. Another risk to the forecast isthat, starting in the US, stock prices which have risen markedly in the last two years will decline. However, thiswould only be a correction of overly optimistic expectations and not bear a major risk for the recovery in Europe.The correction is likely to be smaller for Europe than for the US as the underlying conditions for profits remain fa-vourable. Besides the downward risks there are also upward risks to the forecast. With the progress made in terms ofprice level stability and sounder fiscal policy, interest rates in Europe may stay low for a longer time than anticipatedhere. This would lead to a stronger acceleration of investment growth, consumer confidence and finally also realGDP growth.

i o t n e k$©s Instituts fur Weliwirtsdrf

13

Figure 1 - Real GDP in EMU Countries8

Per cent8

6 hr

Seasonally adjusted 1996=100

2 -

1—J Quarterly growth rateLevel, 1996=100Yearly average growth

- i

yI I I — i m

r - i

JL

-

—

y

- '

r - i

*

2.9

-4

—

2.9. - '

*

— -

••' . ..v ~ . - F o r e c a s t ;?-.'-':•'.•. - '.• ..' * " '•

112

108

104

-2

-4

-6

-8

1995 1996aExcluding Ireland and Luxembourg.

Source: OECD, EBCA forecasts.

100

961997 1998 1999

in both years compared to a potential outputgrowth of slightly less than 2.5 per cent (Figure1). Capacity utilization will thus rise further.However, even at the end of next year it will onaverage still be significantly lower than in theboom at the end of the eighties. In some of thesmaller countries some tensions are likely to be-come visible as they are more advanced in thebusiness cycle.

The upward momentum in the EMU countrieswill increasingly be driven by domestic de-mand. Export growth, in contrast, is likely toslow down somewhat as growth in main tradingpartner countries will be weaker than in 1997and as the stimulus from the devaluation isfading. Domestic demand will continue to ben-efit from the stimulating effects of monetarypolicy. Those countries where interest rates areexpected to be reduced further will get a strongimpulse on domestic demand. In 1998 real dis-posable income of private households will beincreased through the slight improvement in theterms of trade induced by lower raw materialprices and the stabilization of European ex-

change rates. Together with the turnaround inthe labour market consumer confidence in mostof the countries has increased significantly. Pri-vate consumption will therefore support the up-swing. In the presence of low interest rates, in-creasing capacity utilization, and improvingprofits corporate investment will remain brisk.The upturn will be largely confined to invest-ment in machinery and equipment, whereas in-vestment growth in structures will be dampenedby the excess supply in office buildings.

In line with the continuing upswing employ-ment will further rise. As a consequence unem-ployment will go down somewhat. The averageunemployment rate is expected to go down byabout half a percentage point in both years.Despite the improvement the number of unem-ployed will still be around 14.5 million in 1999.

The price climate in EMU countries in gen-eral will remain favourable throughout the fore-cast period. Capacity utilization is rising, but onaverage its level will still be too low to begin toexpect tensions. Although wages will be in-creasing at a slightly faster pace next year they

14

will exert no significant pressure on price infla-tion. Energy and raw material prices are alsoexpected to pick up only slightly in 1999. Themain difference with respect to inflation in1999 will be that labour costs and raw materialprices will no longer put a downward pressureon prices.

b. Special Country Reports

Germany: Upswing Continues at a ModeratePace

After a slowdown in the final quarter of 1997,economic activity picked up again in the firstquarter of 1998. Real GDP expanded at an an-nualized rate of slightly more than 4 per cent,benefitting from mild winter weather and ad-vance purchases of consumers due to the VAThike on April 1. Besides consumption, also in-vestment performed strongly as companies havestarted to enlarge capacities. The price climate

remained rather favourable, in April consumerprices were only 1.4 per cent higher than a yearago. The labour market has shown clear signsof a turnaround; in the first four months unem-ployment fell by 139,000.

Fiscal policy in 1998 and in 1999 will bemore or less neutral, contrary to 1997, when ithad a strong dampening impact on economicactivity. At the beginning of April, the VATrate on most products was raised by 1 percen-tage point. However, there will be no additionalburden for private households since at the be-ginning of this year the surcharge on the in-come tax was reduced and the tax-free subsis-tence level was raised. Next year, a tax reformis likely to be implemented; however, indepen-dent of the new government a sizable net taxrelief is not likely to occur. Public expenditureswhich were stagnating last year will again showa slight increase this year as well as next year.

Table 6 - Real Gross Domestic Product, Consumer Prices, and Unemployment Rates, 1997-1999

Percentage change over previous year

GermanyFranceItalySpainNetherlandsBelgiumAustriaFinlandPortugalIrelandLuxembourgEMU countriesUnited KingdomSwedenDenmarkGreeceEU countriesSwitzerlandNorwayWestern EuropeUnited StatesJapanCanada

Totala1996 GDP weights. —

Weightsin totala

10.87.05.62.71.81.21.00.60.50.30.131.65.31.10.80.639.41.30.7

41.434.921.02.7

100

- Forecasts.

1997

2.22.41.53.43.32.72.55.93.510.53.72.53.31.83.43.52.60.73.52.63.80.93.8

2.7

Real GDP

1998b

2.63.02.43.63.72.72.74.23.87.53.52.92.23.03.03.02.82.04.52.83.00.33.3

2.4

— cStandardized rates

1999b

2.62.82.93.43.02.72.83.03.56.53.52.91.62.52.53.52.72.03.52.72.01.63.0

2.2

Consumer prices

1997 1998b 1999b

1.8 1.4 1.81.2 1.0 1.01.8 2.0 2.12.0 2.0 2.52.2 2.0 1.81.6 1.5 2.01.3 1.3 1.81.2 1.9 2.12.1 2.2 2.41.4 2.5 3.01.4 1.3 1.51.7 1.5 1.82.8 2.5 2.50.9 1.3 1.82.1 2.4 2.55.6 4.7 3.51.9 1.7 1.90.6 0.5 1.02.5 2.5 2.71.8 1.7 1.92.3 1.8 2.21.7 0.9 0.51.4 1.5 2.0

2.0 1.6 1.7

Unemployment rates

1997

9.712.412.120.85.29.24.414.06.810.23.711.37.110.26.110.410.54.44.110.24.93.49.2

6.9

in per cent0

1998b 1999b

9.7 9.211.9 11.311.8 11.619.4 18.24.3 4.08.8 8.44.3 4.111.9 10.56.4 6.09.3 8.53.6 3.510.8 10.36.8 7.28.6 8.25.2 4.710.4 10.210.1 9.73.7 3.33.5 3.29.8 9.44.6 5.04.0 4.48.6 8.3

6.7 6.8

Source: OECD, EBCA estimates.

15

Wage increases which have decelerated mar-kedly in the last two years will accelerateslightly this year and next year. After a mere1.4 per cent rise in 1997 the increase in overallhourly contractual wages is likely to average2.0 per cent this year and 2.6 per cent next year.Contrary to the previous years, non-wage la-bour costs will not rise faster than contractuallabour costs. In line with the continuing up-swing, in 1998 unit labour costs will again besomewhat lower than last year, in 1999 a smallincrease is likely to occur.

The overall conditions for a continued up-swing in Germany are favourable. Real GDP in1998 as well as in 1999 will expand at a paceslightly above the growth rate of potential out-put (2.3 per cent). The rather rapid exportgrowth of last year is likely to slow down some-what as the economic turmoil in Southeast Asiawill cut exports over the coming 18 months byabout 2 percentage points. However, this ismore than compensated by a pick-up of dom-estic demand. Especially investment in plantand machinery is likely to expand more rapidlyas profits continue to rise and more and morecapacity constraints show up. Helped by fasterrising real disposable income, private consump-tion will increase at a solid 2 per cent growthrate after having been virtually stagnant lastyear. In line with the ongoing recovery, em-ployment is likely to rise again. Unemploymentin 1999 will decrease significantly; this is partlydue to a pronounced decline in the labour sup-ply. Inflation will remain low this year andslightly pick up next year. The main reason forthe higher inflation rate in 1999 (1.8 per centinstead of 1.4 per cent in 1998) is that the dam-pening impact of the decline in raw materialprices and in unit labour costs will run out(Table 6).

Low Inflation in France

Foreign trade was the component driving theeconomy last year. It contributed to 1.5 out of2.5 per cent of GDP growth. At the beginningof 1997 domestic demand was weak and net ex-ports were the only GDP component to sustaingrowth. Households' income and hence con-sumption were hampered by past tax rises, slug-

gish employment growth, and efforts to controlhealth expenditure. At the end of 1997 as thetax burden on households eased and confidenceremained at a high level, private consumptionsharply accelerated. Moreover, business confi-dence has stabilized at a high level since De-cember 1997 in all sectors. Thus, all domesticdemand components should show some growthin the first half of this year.

The public finance situation has changedmuch since summer 1997. New fiscal measuresand the revival of growth have increased publicreceipts. Emergency measures of last August in-cluded a temporary contribution of 15 per centon corporate taxes as well as the extension ofthe tax base to the long-term capital gains incur-red with the sale of fixed assets. Also expendi-tures were cut to limit the public deficit to 3 percent of GDP. The draft budget for 1998 as-sumes that stronger growth will be used to re-duce the deficit, in order to regain margins ofmanoeuvre in case of future recessions The re-vival of growth should allow for stronger fiscalreceipts, at unchanged fiscal pressure. Benefit-ting from lower interest rates and smaller defi-cits, the debt burden will grow more slowlythan in the past. On the whole, the public deficiton EMU definition could reach 2.6 per cent ofGDP in 1998 and 2.2 per cent in 1999.

Since 1994, unit labour costs in the wholeeconomy have grown only very slowly at an an-nual growth rate of 0.5 per cent. Although thereturn of net job creation in 1995 put for awhile a brake on productivity gains, labourcosts have continually slowed down since thefirst quarter of 1996 and diminished in 1997.More job creations in 1998 would raise labourcosts in 1998 albeit moderately: the real aver-age hourly wage would grow by 1.6 per cent in1998 and slightly less in 1999.

Consumer price inflation is moderating de-spite the cyclical upturn. Prices will rise by 1.0per cent in 1998 and 1999. The sustained com-petition, fairly stable labour costs, and no pres-sure from raw material prices considerablylighten production costs.

In 1998 and 1999, the contribution of net ex-ports is expected to turn slightly negative as ex-ports slow down and imports accelerate. The

16

smaller contribution of external demand togrowth will be largely compensated by strongerdomestic demand. GDP growth is projected at 3per cent this year, slowing down to 2.7 per centin 1999. The purchasing power of the house-holds will increase this year and next year at thesame rate (2.3 per cent). The most dynamiccomponent of income will be wages, in 1998 asin 1999, especially due to job creation. In thisfavourable environment, the financial savingsrate is expected to fall to around 6 per cent in1998 and 1999.

As the impeding factors for investment (wait-and-see posture of entrepreneurs rememberingthe shocks of the early 1990s and looking for ahigher profitability) will be lifted by thestrengthening of demand, a more significant up-turn is expected soon. The investment volumewill grow by 5.6 per cent in 1998 and 7.6 percent in 1999. This revival will remain broadlyself-financed.

As growth develops, the number of new jobsmay reach 370,000 in 1998 and 230,000 in 1999,after 155,000 in 1997. Given a continuing in-crease in labour supply, unemployment will bereduced by only 90,000 and 30,000 persons in1998 and 1999, respectively. Still this is a largereduction as compared to recent history. Thelast time that unemployed diminished appre-ciably was in 1988-1989, that decline amountedto 80 000 persons in two years.

Recovery in Italy Is Developing

Italian economic activity continues to recover:real GDP growth is expected to increase byabout 2.3 per cent in the first half of this year.Once the special incentives for car purchaseend, consumption (which rose by 2.4 per cent in1997) will be sustained by high consumer con-fidence. The most dynamic component of dom-estic demand, however, has become fixed in-vestments, both in plant and machinery and inbuildings. Stockbuilding now seems at a normallevel. In the first months of 1998, imports grewstrongly, while exports stabilized at the level ofyear-end 1997, partly reflecting the Asiancrisis. In spite of the recovery in demand infla-tion remains low: the average increase of con-sumer prices between January and April was

1.7 per cent at annual rate. Although very slow-ly, the labour market is improving, with risingemployment and falling unemployment.

The 1998 Budget Law and the stabilizationprogramme for the years ahead do not implyany change in the fiscal policy stance. Rather itis aimed at consolidating the results achieved sofar, by making permanent the temporary meas-ures from the 1997 budget (about 1 per cent ofGDP) and reinforcing structural adjustment. For1998 a budget deficit is projected at 2.8 per centof GDP, obtained with a reduction in expendi-tures and an increase in revenues. Nevertheless,thanks to falling interest rates and increasingGDP, budget policy will not be more restrictivethan in 1998. The public current balance is ex-pected to show a surplus of 0.9 per cent of GDP(a government saving for the first time since thebeginning of the seventies), in spite of interestexpenditures amounting to 8 per cent of GDP.This could imply a reduction in the fiscal pres-sure of around 1 percentage point. The publicdebt-to-GDP ratio is expected to reach 114 percent in 1999, which means a reduction of 7 per-centage points in two years, thanks to lower in-terest rates, stronger economic activity, and pri-vatization and sales of public real estate.

Nominal wage growth could remain at some3.5 per cent both this year and next, given theweak labour market and the expectation of sus-tained low inflation. An acceleration of labourproductivity will allow labour cost increaseswell below 2 per cent in 1998-1999. Lower realinterest rates will foster a GDP growth of around2.5 per cent in 1998 and 3 per cent in 1999,without strong inflationary pressures. With lowimported inflation and moderate growth in unitlabour costs consumer price inflation will fluc-tuate around 2 per cent. In 1999 consumptionshould increase again as strongly as GDP, stimu-lated by gains in real disposable income, lowinterest rates, and improving labour market con-ditions. Employment will grow at 0.6 per centin the next two years. Standardized unemploy-ment will fall gradually from 12.1 per cent in1997 to 11.6 per cent in 1999.

Investment in machinery and equipment willrise by nearly 6 per cent this year and 9 per centin 1999, supported by strengthening demand, a

17

high level of capacity utilization and declininginterest rates. Moreover, financial stability hasimproved the situation in Italy: less uncertaintyabout public deficit reduction, more favourableconditions in the capital markets accompaniedby a strong performance in the equity market,and the implementation of reforms aimed at in-creasing competition and productivity, especial-ly in the non-tradeable sectors. Growth in hous-ing investment is expected to show a marked re-covery, thanks to incentives for restructuring re-sidential buildings, while also public invest-ment in infrastructure will rise again signifi-cantly. On the external side, the current accountsurplus is expected to remain stable, and Italywill become a net international creditor thisyear.

The United Kingdom: Slowdown of EconomicActivity

The UK has now enjoyed five years of strongeconomic growth following the sharp recessionof 1990-92. Unemployment has fallen marked-ly over this period from 10.4 per cent in 1993 to5.7 per cent last year. The rapid growth has notbeen accompanied by any marked pick-up in in-flation. Indeed inflation, as measured by the con-sumption deflator, has eased markedly from 7.5per cent in 1991 to 2.1 per cent last year.

The rapid decline in unemployment has ledto concerns that labour shortages may begin toput upward pressure on wages and prices. Thusmonetary policy was tightened following theelection of the Blair administration in May1997. One of its first acts was to give greater in-dependence to the Bank of England. Since thenits monetary policy committee has steadilyraised short-term interest rates from 6 per centto 7.25 per cent. The bank has been particularlyconcerned about the strength of consumer spen-ding which grew by 4.6 per cent last year, sup-ported by the gains in consumers' net wealthstemming from the windfall profits from build-ing society conversions and the generalized risein equity prices.

There are mixed signals coming from the la-bour market with regard to inflationary pres-sures. Average earnings growth has picked upas unemployment has fallen with average earn-

ings rising by around 4.8 per cent last year, thefastest rate of growth since 1992. However, someof this increase is due to higher overtime pay-ments and bonuses, reflecting the overall buoy-ancy of the economy. The rate of growth of paysettlements remained around 3 per cent, al-though recent figures suggest, that pay settle-ments may now be beginning to accelerate some-what. Measured inflation is also giving con-fusing signals. The retail price index (RPI) hasrecently accelerated to 4 per cent but underlyinginflation, once temporary factors have been re-moved, is growing far more modestly.

Fiscal policy has tightened significantly inrecent years. The public sector borrowing re-quirement (PSBR) has been reduced from ap-proaching 8 per cent of GDP in 1993 to virtualbalance last year (although the EMU deficit was1.9 per cent last year). The recent improvementhas been particularly marked with the PSBRimproving by 2.8 per cent of GDP over the lastyear. Half of the improvement is due to budg-etary measures introduced by 1997 budget plan.The remainder comes from previous measuresand from lower-than-expected governmentspending.

Overall the UK is likely to enjoy a soft land-ing with growth slowing to around 2 per centthis year and 1.5 per cent in 1999. Inflationshould remain close to the target of 2.5 per cent.However, there is a significant chance that theeconomy will slow more quickly than expectedunder the combined influence of tight monetaryand fiscal policy and a high exchange rate. It isunlikely though that there will be a markedpick-up in unemployment. The government'sWelfare to Work Programme should reduce thenumber of claimants without putting too muchupward pressure on wages. This is because thepolicy, which involves providing training andwork experience, is targeted at the long-termunemployed who may not fully participate inthe labour market. However, the beneficial ef-fects of the Welfare to Work Programme maybe partially offset by the introduction of the na-tional minimum wage in the spring of next year.Depending on the rate chosen this may push upwages and reduce employment.

18

Strong Growth in Spain

The good economic performance since 1997continued in the first quarter of 1998. GDP roseby 1.3 per cent with a strong acceleration indomestic demand. Consumer confidence re-mained at a high level, while business surveysbecame more optimistic. Industrial productionrose by 10.7 per cent year on year; also qualita-tive indicators suggest a buoyant investment be-haviour this year. The unemployment rate fellto 19.6 per cent in March, contributing to con-sumer confidence. The stable inflation in thefirst quarter of 1998 (1.9 per cent on average)has permitted a further cut in the discount rate.

Fiscal policy is expected to be accommoda-ting this year, after several years of tightening.Thanks to the continued decrease in interestrates and the increase in revenues due to the fa-vourable cyclical development the general go-vernment deficit target for this year is reducedto 2.2 per cent of GDP. The main factors af-fecting revenues are a raise of tax rates on oiland insurance premiums, an increase in advancepayments of self-employed, some cuts in in-come tax are also to be introduced along withprivate pension allowances; public spendingwill be held in check by wage increases for civilservants in line with the inflation target (2.1 percent).

In 1997 nominal wages rose by 2.7 per cent,while the private consumption deflator in-creased by 2.5 per cent. In .1998 wage rises areexpected to be moderate, given the low infla-tion. Collective bargaining in January involvingaround two and a half million workers resultedin an agreement on a wage increase of 2.5 percent.

GDP growth is projected to remain strong in1998 and 1999 at around 3.5 per cent, sup-ported by a decline in interest rates and a lesstight fiscal policy. Private consumption shouldaccelerate, as wages increase in real terms andunemployment falls, and consumer confidenceis improving. Private investment should also ac-celerate in the light of a further reduction in in-terest rates, improved profitability, and highrates of capacity utilization. Stronger demandfrom the Euroland countries, which representaround 60 per cent of Spain's export markets,

should sustain Spanish exports in spite ofslower demand outside Europe and the weakerdollar. In 1998 inflation should remain near thetarget (2.1 per cent), thanks to low internationalcommodity prices. With economic activitygrowing by over 3 per cent on an annual basis,labour market conditions should improve. Un-employment should gradually come down.

The Netherlands: Soft Landing of the Economy

The Netherlands' economy expanded by 3.3 percent last year accompanied by a considerablejob creation. Employment rose by 2.5 per centand the unemployment rate reached 6.5 per centof the labour force. However the Dutch figurefor the labour market is not as good as it looks,because there is a considerable hidden unem-ployment. Unlike in most European countries,Dutch growth in 1997 was driven by domesticdemand, while net exports were seriously affec-ted by the outbreak of swine fever. Private con-sumption grew around 3.5 per cent, with a par-ticularly strong demand for consumer durables.Real disposable income of households rose sub-stantially, largely because of the strong employ-ment growth. Positive wealth effects throughthe surges in house and share prices supportedconsumption as well.

The public sector deficit fell to 1.3 per centof GDP in 1997. Government expenditure, as apercentage of GDP, follows a downward trend,mainly due to lower interest payments andlower transfers to the unemployed. Both in thepast and the present year the burden of taxesand social security premiums has been loweringsubstantially, for 1998 a reduction of about 1percentage point of GDP is expected. However,this is not likely to continue, as a hike in socialsecurity contributions is needed to strengthenthe capital base of the public insurance system.The public deficit is expected to rise to about1.75 per cent this year, but to fall back again tobelow 1.5 per cent in 1999, largely reflectingthe improved balances of the social funds. Grosspublic debt will fall steadily to below 70 percent of GDP in 1999.

Wage and price movements will remain mod-erate. There are yet no clear signs of tensionson the labour market. Despite falling unemploy-

19

ment the rise in contractual wages was just over2 per cent last year, and in the present andcoming year the increase will be edging up to 3per cent.

GDP growth is projected to be above 3.5 percent this year and around 3 per cent in 1999. Agradual slowing down of economic growth isprojected from the second half of this year on-ward until late next year a quarterly rate of 2.5will be reached which is about the potentialgrowth rate of the economy. Next year's easingof economic growth will take place on the ex-port as well as the domestic side. On the exportside this is due to slower market growth andsome weakening of Dutch price competitive-ness. This year consumer demand will beboosted by job growth and a substantial in-crease in purchasing power, while in 1999 con-sumption growth will slow for several reasons.First, fewer new jobs are expected. Second,purchasing power will rise much slower, as —on present policies — there will be no moreburden relief from the fiscal side. Third, thewealth effects on consumption growth will de-cline. This year the cyclically sensitive invest-ments will accelerate, given improved profitabi-lity and rising capacity utilization. This will notshow up in the total investment figures, how-ever, because major energy projects were com-pleted last year, while investment in aircraftwill also be significantly down. In 1999 invest-ment will weaken in line with lower outputgrowth.

Employment is expected to rise by 2.5 percent this year and a still respectable 1.7 per centin 1999; the unemployment rate will reach 4.0per cent in 1999 (as regards the standardizedrate). The expected low level of unemploymentis not seen as an obstacle for sustained eco-nomic growth. Bottlenecks can be avoided atleast for a while, thanks to the increased flexibi-lity of the labour market, and the expectationthat the strong employment growth will en-courage more people to enter the market andpart-timers to work longer hours.

3. Some Facts about Euroland

European Monetary Union and United States inComparison

The economies that from 1 January 1999 willshare the euro as common currency constitutean economic area comparable in size to theUnited States. In 1997, Euroland's populationwas slightly larger than that of the UnitedStates, whereas the GDP amounted to roughly80 per cent of the US level as can be seen fromTable 7. The GDP composition shows some dif-ferences in the allocation between domestic andnet foreign demand. In Euroland, private con-sumption and investment were around 80 percent of GDP, whereas in the United States theweight was higher at around 88 per cent. Euro-land's economy is more open, with the sum ofexports and imports over GDP coming toroughly 23 per cent as compared to 19 per centfor the US. This result is partly due to tradebetween Euroland and those countries like theUnited Kingdom, Greece, Denmark, andSweden which will not join the European Mon-etary Union, but are important trade partners.These countries absorb more than 25 per cent ofEMU exports and are the suppliers of around 23per cent of EMU imports. Hence from 1999 thede facto euro area will presumably be largerthan that associated with the eleven officialmembers.

It is interesting to compare the geographicalcomposition of trade for Euroland and the Unit-ed States. Asia, as a whole, represented around30 per cent of the US export market, but only17 per cent for Euroland. On the other hand,Asia covered nearly 40 per cent of US importsand only 22 per cent of Euroland's. Central andEastern Europe absorb 15 per cent of Eurolandexports but less than 2 per cent of US exports.The same proportion applies to them as theorigin of imports.

Noticeable differences between Euroland andthe United States are also evident in the labourmarket and in the general government budget.Unemployment in Euroland was more than 12per cent in 1997, whereas the United States isclose to full employment at 5 per cent. The differ-

20

Table 7 - Euroland and United States: Key Indicators, 1997

Population (mill.)a

GDP (bill, ecu)Private consumption as a % of GDPTotal investments as a % of GDP

Inflation (consumer prices)

Employment rateParticipation rateUnemployment (standardized rate)

Trade balance as a % of GDPCurrent account balance as a % of GDPShare in world exports8

Share in world importsa

Degree of openness a ' b

General govern, net borrow, as a % of GDPGeneral government debt as a % of GDPa1996. — Sum of exports and imports of goodsinfra-area flows.

Euroland

285.2

5684.959.621.0

1.7

56.664.611.3

2.92.0

18.516.622.9

-2.575.3

in relation to GDP in nominal terms.

United States

265.5

7127.665.622.3

2.3

72.877.04.9

-2.5-2.114.017.618.9

-0.361.5

For Euroland, exports and imports are net of

Source : European Commission, IMF, OECD, EBCA estimates.

ferent structure of the two labour markets isclearest in participation rates which are around13 percentage points higher in the United Statesthan in Euroland. The possible reasons varyfrom the different welfare states in the two re-gions to differing degrees of flexibility in therespective labour markets. The situation inEuroland is worse than in the United States

with respect to the general government budget.According to the European Commission statis-tics, in 1997 the public deficit for the euro re-gion was around 2.5 per cent of GDP, with acumulated debt approximately equal to 75 percent of GDP, compared with a roughly bal-anced budget in the United States and a debt ofaround 60 per cent of GDP.

II. Economic Policy in Europe for the Short and the Medium Term

1. On the Implications of theEuropean Monetary Union forEconomic Policy

At the beginning of May, the heads of state de-cided to start the Third Stage of EMU onJanuary 1, 1999 with eleven countries participa-ting. Bilateral exchange rates will be fixed onthe basis of present ERM central rates, i.e. theserates will be the conversion rates on December31, 1998. The ecu will then be replaced by thenew currency, the euro, at a rate 1:1. Since Junethe governing council of the ECB is de facto incharge of monetary policy in Euroland, al-

though de jure monetary policy remains in na-tional sovereignty until the end of the year.

The European Central Bank has a clear man-date to ensure price level stability in the Euro-pean Monetary Union. According to the Maast-richt Treaty, the ECB is independent. The per-sonal independence of the members of the ECBcouncil is an important element. However, thedispute among the heads of state about the pre-sidency has created concerns about political in-terference.

With the introduction of the single currency,the individual countries give up their nationalsovereignty concerning monetary policy and the

21

possibility to use this instrument in domesticstabilization policy. It will also, for example,not be possible for individual countries to pur-sue an expansionary monetary policy with theintention of stimulating the economy. By thesame token, it will not be possible to use ex-change rate policies influencing real wages afteran external real shock. For many countries,however, the transition into EMU does not im-ply a major change because they have more orless followed a unified monetary policy andhave held nominal exchange rates fairly stablevis-a-vis the D-mark in recent years. All in all,the European Monetary Union will function asan economic entity. This will leave the neces-sary adjustments in case of disturbances to themarkets and to other areas of economic policy.

Monetary policy in the EMU will be conduc-ted according to the economic conditions in thewhole currency area, so the ECB will not beable to take regional differences in the develop-ment of income, prices, and employment intoconsideration. A common monetary policy doesnot imply that the business cycles of the partici-pating countries will be fully synchronized inthe future. Fiscal policy and wages will con-tinue to be determined in the individual econ-omies and will therefore differ from country tocountry. In addition, shocks from outside willaffect the individual economies differently be-cause of differences in economic structure. Lastbut not least, some economies are more sensi-tive than others to interest rate changes becauseof a higher share of lending at short-term or va-riable interest rates and because of the diversityof current financial structures. The single cur-rency will over time reduce the differences be-tween countries as a Euroland market for creditis created and will hence make them similar interms of the impact of the common monetarypolicy on output and on other macroeconomicvariables.

It will be very important that the ECB willexplain its policy not only to politicians but alsoto the broad public and to financial markets.Transparency can be achieved in various ways,one being regular publications. In addition, boththe British and the US experience has shownthat, for example, the publications of the min-

utes of the council meetings may help to in-crease the central bank's credibility. Also regu-lar meetings with policymakers and the Euro-pean Parliament can be helpful. Its accountabi-lity does not mean, however, that there is politi-cal interference or even political control.

The current ERM bilateral central exchangerates of the EMU currencies have for most cur-rencies already prevailed for several years with-out creating major structural problems, indica-ting that they are consistent with a sustainableeconomic development in the EMU area as awhole. Also, there has not been any speculationagainst one of the participating currencies. How-ever, the irrevocable fixing of nominal ex-change rates within EMU does not mean thatthe real exchange rates which are important forthe competitiveness will remain unchanged. Inparticular, differences with respect to productiv-ity growth as well as different price and wagedevelopments will lead to differences in infla-tion and thus to real exchange rate changes,although they are limited in size.

Apart from the consequences for the mone-tary conditions, there are implications of EMUfor fiscal policy. The Stability Pact implies aconstraint for fiscal policy. Public sector defi-cits will have to be reduced so that in the caseof recession the deficit-to-GDP ratio does notexceed the level of 3 per cent. Therefore, in anumber of countries, among them the two larg-est economies of Germany and France, the struc-tural deficits will have to be reduced further. Inaddition, the Pact calls for a balanced budget ora surplus in the medium term. All in all, thesetargets have the purpose to let the automatic sta-bilizers work, i.e. to avoid, for example, a re-strictive policy in the case of a recession. Be-yond these limits for the overall measure ofbudget deficits, the introduction of EMU doesnot have any major consequences for fiscal pol-icy. In particular, it does not call for a harmoni-zation in the field of, for example, tax policiesor social policies.

The introduction of a single currency will nothave a major impact on employment. High un-employment will continue to be the greatest chal-lenge for economic policy in Europe. For a num-ber of countries it will be necessary to continue

22

their efforts in reducing unemployment for ex-ample by means of reducing the growth of realwages in the medium term and by raising theflexibility of the labour markets. It would becounterproductive to impose a common wagepolicy for Europe, for example, in the form ofwage standards, because this would aggravatethe unemployment problems in countries with arelatively low level or growth rate of productiv-ity.

2. Monetary Policy

The European Central Bank will start to operateat a time when the overall economic conditionsin Euroland are quite favourable and do not callfor drastic interest rate moves to counter majorimbalances. The capacity utilization in the EMUarea appears to be close to its historical average;furthermore, the average inflation rate is quitelow and there is no immediate danger of an ac-celeration of inflation.

According to the Maastricht Treaty, the ECBhas to keep the price level in the EuropeanMonetary Union stable. Similar to the policy ofthe Bundesbank and other central banks, theECB is likely to announce a target of 2 per centas being compatible with this goal. A higherrate is not likely as it could easily be interpretedby markets that the euro would be less stablethan major currencies in the recent past. With apresent inflation rate of about 1.5 per cent onaverage for the EMU area, this would also im-ply that the slight acceleration of inflation ex-pected for 1999 will not call for a substantialtightening. The ECB is likely to neverthelessraise interest rates somewhat in order to demon-strate its commitment. The expected increasedoes not, however, mean that monetary policybecomes restrictive but rather moves in the di-rection of a neutral policy stance.

The ECB will have to decide quickly how toturn its mandate for price stability into a con-crete strategy for monetary policy. Accordingto the EMI, there are two possible strategies, anintermediate monetary target and a direct infla-tion target. A monetary target would follow thelong-standing strategy of the Deutsche Bundes-

bank. In the past, it allowed for an annualmoney supply growth (in terms of M3) whichafter taking into account the growth of potentialoutput and the medium-term change in the in-come velocity of money would limit the in-crease in the price level to 2 per cent. The mon-etary target is based on a stable long-term rela-tionship between money and prices. While thisstability obviously did not exist in a number ofEuropean countries, for example Italy, it seems— according to various empirical investigations— to have prevailed in Germany. Other coun-tries have more or less followed the policy ofthe Deutsche Bundesbank by fixing the ex-change rate of their currency against the D-mark. By means of this policy, they have alsoachieved a low rate of inflation. Whether thedemand for money in the EMU will be as stableas in Germany is uncertain as in several coun-tries, the demand for money showed structuralbreaks. However, there are empirical studies in-dicating that the money demand has been morestable for groups of European countries than forindividual countries. Nevertheless, in the start-up phase of EMU a greater volatility in the mon-ey stock cannot be ruled out for several reasons:with the enlargement of the currency area theremight be a reduction of currency holdings; also,changes in the financial structures are likely tolead to shifts in the portfolio; and finally, it isuncertain which role the euro will play outsidethe EMU countries or as an international re-serve currency.

In view of these problems, the ECB is likelynot to focus on a monetary target alone but alsofollow a direct inflation target. That means thatthe ECB will monitor a set of indicators whichhave a close correlation to future inflation. Thecentral bank has to have reliable informationhow a change in these indicators will affect theprice level or to what extent the ECB has tochange its key interest rates in order not to missits inflation target. In practice, there is a lot ofcommon features between the two strategies,with direct inflation targeting taking into ac-count additional variables.

With respect to ensuring that monetary con-ditions will be adequate to achieve price stabili-ty, the ECB will face a lot of problems at the

23

start. First, the statistical data basis for the newcurrency area is less reliable than that for indi-vidual countries. Second, the new monetarypolicy regime can lead to portfolio shifts whichespecially in the beginning might affect mon-etary aggregates. Third, most importantly, inter-est rate changes affect the individual economieswith different speed and different intensity.This makes it difficult to estimate the impact onoverall economic activity and prices. In addi-tion, it can lead to tensions in the decision-mak-ing process of the ECB. However, most of theproblems will be transitory. There will soon beharmonized statistical data comparable to thestandards in the individual countries. Increasingcompetition in the financial sector will narrowthe differences in the financial structures andthus in the transmission process in EMU coun-tries.

In the meantime, the ECB will carefully lookat all factors affecting the price climate. Withmonetary aggregates likely to be influenced byportfolio shifts, the development of short- andlong-term interest rates will be of special im-portance for a judgement on the current stanceof monetary policy. It is the level of real andnot of nominal interest rates that matters, butthat cannot be influenced by central bank in thelong term. Since it is difficult to calculate realinterest rates and as there is no clear indicationwhat their "normal" level is, the yield curve hasbecome a very common indicator with respectto assessing the impact of monetary policy oneconomic activity. If the difference between the10-year bond yield and the 3-month money mar-ket rate is above (below) its long-term averagethis normally indicates an expansionary (restric-tive) stance of monetary policy. In order to getan estimate of the neutral yield spread, the ECBmay take the experience in Germany as a guide-line. Here, the long-run difference between long-and short-term interest rates amounted to aboutone percentage point on average. Some of theother European countries show a significantlylower long-term average. This is mainly due tothe fact that from time to time they had to raiseshort-term interest rates significantly in order todefend their exchange rates in the EMS; also,the strong convergence of long-term rates in the

advance of EMU reduced the spread in a num-ber of countries. At present, the difference be-tween long- and short-term interest rates in theD-mark bloc amounts to about 1.3 percentagepoints thus indicating a relatively relaxed stanceof monetary policy.

Real long-term interest rates are central to in-vestments and thus to the growth trend. Theserates are the results of market forces but eco-nomic policy may influence them. It will thusbe highly desirable that the ECB and the govern-ments give clear messages to borrowers andlenders. This implies a reciprocal knowledge ofintentions, an understanding of the interactionsof expected policy stances , and as high as pos-sible an agreement about the cyclical positionof countries.

A single interest rate in the EMU area willhave quite different consequences for the cycli-cal development in the individual countries be-cause the situation, for example, in terms of in-flation and the output gap differs considerably.Calculations using the "Taylor-rule" for mon-etary policy suggest that the average short-terminterest rate in the EMU countries of 4 per centis too low for countries that are ahead in thebusiness cycle (e.g. Ireland and the Nether-lands) and too high for those countries that arelagging behind (e.g. France and Germany).Therefore the common interest rate prevailingin EMU may turn out to be stimulative in somecountries and dampening in others (Table 8).

The ECB will also watch the real sector ofthe economy. In the case of emerging tensions,indicated by a high level of capacity utilizationand faster growing labour costs, an accelerationof inflation is likely to occur sooner or later. Atpresent there are hardly any signs of substantialbottlenecks in the EMU countries as a whole.However, in some countries, notably Ireland,and Spain, there is a risk of strong growth turn-ing into an overheating.

In order to achieve its monetary goals theECB will act in a way similar to the nationalcentral banks in the past strongly relying onopen market operations to control liquiditygrowth, steering interest rates and signalling thestance of monetary policy. According to a pro-posal of the EMI, the ECB will conduct differ-

24

Table 8 ~ Short-term Interest Rates in Eurppe, According to a Taylor Rulea

Per cent

EMU countriesAustriaBelgiumFinlandFranceGermanyIrelandItalyNetherlandsPortugalSpainaAssumption is

1998

3.63.93.46.52.63.0

10.43.75.85.94.9

being made that the ECB will refer to a Taylor's rule such as : r = n + y + 0.5stands for the rate of inflation, measured as the consumer price index; y: GDP growth in realforecasts); gap, the gap between production and potential output (as estimated by OECD).

1999

4.14.54.55.72.83.8

10.04.74.86.15.8

(n -2) + 0.5 gap where : nterms (according to EBCA

Source: OFCE estimates.

ent types of open market operations. The mostimportant instrument will be a two-week tenderwith repurchase agreement which allows theECB to influence daily money market rates. Inaddition to that, standing facilities like a mar-ginal lending facility and a deposit facility willdetermine the upper and the lower range of theshort-term interest rate spectrum. Changes inthe respective interest rates will have a signalcharacter.

It is not decided yet whether the Europeancommercial banks will be subject to minimumreserve requirements. There may be good argu-ments in favour of minimum reserve require-ments. They act as a buffer and thus stabilizemoney market rates. In addition, they strength-en the control of the ECB on banking liquidityand thus make it easier for the central bank toachieve its goals. However, in the past mini-mum reserves in Germany have given incen-tives to shift banking activities to offshore cen-tres outside the country where no minimum re-serves were required. Such a loss of competi-tiveness can be avoided if market interest ratesare paid on minimum reserves.

The European Central Bank is likely to intro-duce a minimum reserve requirement, charac-terized by a reserve requirement on deposits ofbetween 2 per cent and 3 per cent, with a re-serve remuneration close to money marketrates. This will create, for example, in Italy a

transition problem, as at present the minimumreserve rate in Italy amounts to 15 per cent. Thenew requirement rate would imply reducing re-serves by approximately 60 thousand billions oflira, slightly less than 30 billion ecu. Huge a-mounts of liquidity would then be released in asingle move at the beginning of 1999. However,it would be easier to sterilize the freed liquidityand thus to avoid a swing in short-term interestrates if the minimum reserve rate were reducedin tranches. The best timing for this would beJune and December when there is normally astrong demand for liquidity due to major taxand social security payments.

3. Exchange Rate Policies of the Non-EMU Members of the EU

The decision of the eleven member states topress ahead with the single currency raises im-portant questions for the four countries outsidethe monetary union. The UK, Sweden, Den-mark, and Greece need to decide when and ifthey should join the EMU and what their ex-change rate policies should be in the inter-vening period. They have to take account ofboth real developments and the progress of in-flation. Joining EMU at an overvalued ex-change rate, or at one where inflation wouldrise relative to the rest of the Union would have

25

undesirable long-run consequences for marketsshare and import penetration. Joining at too lowa rate would induce inflation and defeat one ob-jective of a stable and independent monetaryauthority. Although inflation rates will not di-verge significantly in EMU, they can do so forlong periods as some regions overcome under-valuations and others change the balance ofdemand in response to lower interest rates.

It seems most likely for the UK that a bid tojoin EMU will be made following the next gen-eral election, likely in 2001/02. Current marketexpectations suggest an entry rate with respectto the D-mark of a little over DM 2.60. Swedenand Denmark are likely to try to join EMU ifand when popular support can be secured.Greece, which failed to meet the Maastrichtconvergence criteria, is likely to join EMUwhen it has made sufficient progress towardsreducing inflation and improving the fiscalposition.

These four countries face differing questionsabout the appropriate exchange rate policy inthe period before they join. Two countries arelikely to participate in the successor to the Ex-change Rate Mechanism, ERM II, namely Den:

mark and Greece, whilst Sweden and the UKmay stand outside, at least for the time being. Itwould appear likely that the Danish authoritieswill seek to maintain their currency's paritywith the euro until they choose to join thesingle currency. Long-term interest rates areslightly above those for the ecu, suggesting thatthe markets expect short-term interest rates tomove in line with those in the rest of Europe.Moreover, the European Monetary Institute hasindicated that it will take account of conditionsin the Danish economy when it sets euro in-terest rates. All in all Denmark is likely to be ade facto member of the monetary union rightfrom the start, and will become a de jure mem-ber as soon as the population is ready for it todo so.

Despite improvements, Greece is not expec-ted to be so successful in maintaining paritywith the euro. The authorities will continue tofollow a policy of using a relatively strong ex-change rate to put downward pressure on infla-tion, but it will take some time for inflation tobe reduced to the euro area rate of below 2 per

cent. During this period short-term interest ratesin Greece are likely to be above those in the restof Europe, and hence the exchange rate can beexpected to decline steadily. Exchange controlto the drachma market makes it easier for theauthorities to manage the exchange rate. How-ever, EMU membership will require the priorremoval of these controls, and possibly moreexchange rate instability before entrance.

The UK and Sweden are likely, for the timebeing, to stand aside from both the euro and theERM II. The UK is unlikely to rejoin the ERMat least in the short term. It would be politicallyand economically difficult for the UK not to de-lay re-entry into the ERM, even though the pre-sent administration shows a much more positiveattitude to Europe than its predecessor. Institu-tional change has begun in preparation for po-tential membership. The Bank of England hasbeen made genuinely independent, and finan-cial sector regulation is to split of, much as isrequired for membership of EMU.

There are major economic obstacles in theway of immediate entry. Cyclical positions dif-fer. The economies of continental Europe arepossibly below capacity output, but are recover-ing. The UK economy is operating at or abovefull capacity, and in recent months the inflationrate has been at or above its median target. Inthese circumstances we would expect the Bankto be raising interest rates, but this might causethe exchange rate to appreciate, and sterling isovervalued already.

The situation in 1998 is worrying. Estimatesof the equilibrium exchange rate suggest that abilateral rate of DM 2.5 to 2.6 per pound wouldbe the maximum that would be sustainable gi-ven current price levels. Joining at rates seen inearly 1998 would have meant that the exchangerate would have been 15 per cent or more over-valued.

The UK cannot go into EMU at the presentrate. If it devalues then all the inflationary pres-sure held in check by the appreciation of 1996will re-emerge. Inflation would rise, and if theexchange rate fell to 2.5 DM, it could well ex-ceed 4 per cent for several years, and hence areal overvaluation would re-emerge. Contrac-tionary monetary policy would be counterpro-ductive, as it would raise the exchange rate

26

again. The only option left appears to be a tight-ening of fiscal policy. Calculations by NIESRsuggest that a substantial fiscal tightening wouldbe necessary to ensure that the exchange ratewas sustainable upon entry into EMU in 2002.

The other major outsider faces a much lessonerous choice. Sweden left the ERM soonafter the UK, and experienced a larger subse-quent devaluation. In late 1995 it appreciated alittle against other currencies, and since then ithas maintained an approximately stable ex-change rate at around what appears to be a sus-tainable level. Sweden's exchange rate policy isbased on making all the necessary preparationsso that it can join the euro at a year's notice.This will require certain legislative measures,including increased independence for the Riks-bank (due in 1999) and a stable exchange rateagainst the euro.

Exchange rate developments in the two north-ern outsiders will of course be subject to thevagaries of the market. Both countries havemaintained inflation targets around the same asthose set in Germany or to be set by the ECB.The effects of the targeting regime on the ex-change rate depends, inter alia, upon the credi-bility of the Banks and the degree to which theywill allow inflationary or deflationary shocks toaffect the price level in the long run. If they ac-commodate inflation shocks, we cannot be cer-tain where the exchange rate will end up, but ifthey do not, then the current rate may be a goodindicator of the long-run rate. This would ap-pear to be wise in the case of Sweden, but to beof limited value for the UK. The former countryis at about its equilibrium exchange rate, andhas the same inflation target as the ECB. Hencemembership is sustainable. The UK has a morecomplicated choice to make.

4. Fiscal Policy

a. On the Consequences of the StabilityPact

In 1997, fiscal policy in the prospective EMUcountries was struggling to keep the budget de-

ficit within the 3 per cent limit set in the Maast-richt Treaty. With the exception of Greece, allcountries which wanted to participate succeed-ed. To accomplish this task, taxes and social se-curity contributions were raised and expendi-tures were cut. However, several countries haveadopted one-time measures, for example specialtaxes were levied and expenditures were post-poned into 1998. In addition, most of the coun-tries benefitted from the cyclical upswing anddeclining interest rates. In Italy and Belgium,the debt-to-GDP ratio declined but is still twiceas high as the reference value in the Treaty. Allthis has created fears that the fiscal adjustmentin the EMU member states will not be sus-tainable.

In order to avoid that large fiscal deficits inone country have negative externalities forother EMU countries, the member states havecommitted themselves to keep budget deficitswithin 3 per cent of GDP unless there are ex-ceptional circumstances such as a severe reces-sion. Furthermore, the Pact calls for a balancedbudget or even a slight surplus in the mediumterm. The practical implication of the Pact isthat in order to avoid fines in the case of adownturn the countries in a normal cyclicalsituation have to have a budget deficit that iswell below 3 per cent. Otherwise there wouldbe no room for the working of the automaticbuilt-in-stabilizers. With the loss of monetaryautonomy of member states, the importance offiscal stabilizers has increased.

In the past, the individual countries haveshown differences in the size of output varia-tions, also the present position in the businesscycle varies. In general, the actual and the struc-tural deficits in 1997 were below 3 per cent(Table 9). In many countries, the structuralprimary balance was significantly positive, be-cause of the restrictions implied by the StabilityPact. However, in most countries structural de-ficits were still significantly higher than wouldbe sufficient to allow for a working of the auto-matic fiscal stabilizers in the case of a reces-sion. As a consequence, further consolidationefforts are necessary in most of the countries.

27

Table 9 - Indicators of Fiscal Position in EU Countries, 1997

Per cent of GDP

AustriaBelgiumDenmarkFinlandFranceGermanyGreeceIrelandItalyLuxembourgNetherlandsPortugalSpainSwedenUKaPrimary structuralthe interest rate will

Public balance

-2 .5-2 .1+ 0.4-1 .0-3 .0-2 .6-4 .0+ 0.9-2 .7+ 1.7-1 .4-2 .5-2 .6-0 .4-1 .9

deficits as estimated by OECD. —

Public debt

65.2122.461.855.857.761.3

108.465.3

121.66.7

71.465.369.376.953.3

Structural primarybalance8

Required primarypublic

1.76.53.21.11.51.46.33.05.91.93.02.72.92.91.1

- t>To stabilize the debt-to-GDP ratio. It is assumed thatbe 2 percentage points above the average GDP growth.

balanceb

0.92.40.80.00.91.02.21.32.20.10.91.31.10.40.9

in the future

Source: OECD, EBCA estimates.

Trying to reach balanced budgets as soon aspossible is widely recognized as a pre-requisitefor recapturing margins of manoeuvre in case offuture slumps. However, in the long run, ba-lanced budgets are not necessarily, from an eco-nomic point of view, the best of all worlds.

Although in many countries the debt-to-GDPratio was above 60 per cent, the heads of statedecided at their meeting in early May that thedebt criterion was satisfied in all countries. Ac-cording to the Maastricht Treaty, the referenceis that "the ratio is sufficiently diminishing andapproaching the reference value at a satisfactoryspeed". In their convergence reports the EMIand the central banks shared this view. How-ever, with respect to the highly indebted coun-tries Italy and Belgium with a debt to GDP ratioof approximately 120 per cent, there was someskepticism about the sustainability of the fiscalposition. Without additional efforts, it wouldtake about 15 to 20 years before the debt-to-GDP ratio is back to the target value of 60 percent. In the meantime, the budgets of the twocountries will be very sensitive to interest ratechanges.

The risk that the high indebtedness will havenegative consequences for the stability of theeuro and for other countries is low. With an in-

dependent ECB it will not be possible to reducethe real value of long-term government liabili-ties through inflating the economy. Also, the ef-fect on interest rate will be limited as bothcountries have relatively high savings. The "no-bail-out clause" in the Treaty stipulates thatneither individual member states nor the com-munity shall be liable for the commitments ofother government bodies. Furthermore, it is inthe interest of the countries themselves to re-duce their debt ratio, this would not only lowerthe risk premium in the interest rate, lower in-terest payments would also give more scope forfiscal policy in general.

Judging the fiscal sustainability is a difficulttask, particularly because all government liabili-ties should be taken into account, not only thoseexplicit in the statistics. In almost all countriesthe population is ageing. In the future, statepension systems which operate on a pay-as-you-go basis will face huge additional outlayswhich cannot alone be financed through a re-duction in benefits or an increase in contribu-tions. Like the explicit debt, the implicit debtwill therefore put a further strain on public fi-nances. As a consequence, not only Belgiumand Italy will have to take additional measuresin order to further consolidate public budgets.

28

Box 3-A Minority View on Policy Coordination in EMU (By NIESR and OFCE)

Fiscal and Monetary Policy in Europe

The economic debate over policy has contained two strands. Some economists advocate that the monetary and fiscalauthorities should follow simple and transparent rules. These views stem from Milton Friedman in the 1950s, and hedescribed them as advocating a 'monetary constitution' for the USA. At the same time other economists, such as JamesMeade, advocated a more discretion-based approach, where the authorities did not act in isolation and attempted tomaximize welfare over time. At present the European institutions are following the current trend and moving toward arule-based solution to policy setting. It is, however, generally recognized that Europe is in a completely new situation, andwe should expect the authorities to proceed with caution. The original debate on rules and discretion had one fiscal andone monetary authority 'playing a game' to determine outcomes. The conduct of economic policy in EMU will raise somenew problems as there will be 1 ECB and 11 fiscal authorities. The 'game' is much more complex, and its progress willhave to be monitored carefully.

The Relationship between the ECB and National Governments

It cannot be denied that discordant monetary and fiscal policies may have harmful consequences, and they should beguarded against in political discussions. A Euro Council has been set up to facilitate the dialogue amongst the eurocountries and between these countries and the ECB. Although the ECB is an independent body, it is not advisable thatmonetary policy should be conducted completely independently of the fiscal authorities, and dialogue within the Councilshould help to co-ordinate the actions of the authorities. They will have a difficult task in co-ordinating demand because agiven level of demand may result from various policy-mix, so choices have to be made.

There are a number of situations to consider. A negative shock may simultaneously hit all countries of the area, andthen monetary policy should help to sustain activity. However, the extent to which it may do so may depend upon theaverage fiscal stance, and some countries may take on more of the burden of adjustment than others. As a result we maysee some 'free riders' who allow others to adjust whilst they do not. The Stability Pact does not give any prescription inthat case.

The ECB will fix a single interest rate that will apply to 11 countries even when there are asymmetric developments.The average rate may not fit to the specific situation of the different countries, and hence the Euro-11 Council will have toplay an important role to reconcile the objectives of differing European countries. If some countries are overheating thenthey should take appropriate fiscal action rather than ECB increase euro interest rates. In the reverse case a country hit by aspecific negative shock will have to act alone with expansionary fiscal policy whilst respecting the constraints of theStability Pact. Given the loss of monetary autonomy the member states will clearly have a greater need for counter-cyclical fiscal policy, and this will have to be carefully monitored by the Euro Council, who should not encourage aberrantbehaviour. However, cohesive fiscal policy setting is not the only problem that a new Europe may face. We are in a newworld with many uncertainties.

The setting of fiscal targets will have to fulfil three roles, and they may conflict, and hence there is a debate that mustcontinue as the monetary and fiscal constitution of the new Europe is constructed. Fiscal policy must respect the StabilityPact, and it must also take account of the maintenance of optimal government finance in the long run. Finally, in our newworld with harmonized monetary policy we see a need for more active counter-cyclical fiscal policy. All three objectivesneed to be transparent. There are few reasons why governments should borrow (or lend) except to finance investment, andprudence requires an acknowledgement of longer-term commitments to pensions and other expenditure. The Stability Pactsets sensible opening guidelines for the setting of fiscal policy as EMU is built, but as the years pass and the regime settles,we would expect there to be a discussion on sensible fiscal polices that is wider than the current discussion. It is best ifsuch a discussion start now so that debt can be restrained to acceptable levels quickly.

Monetary Policy Targets

It is widely agreed that the ultimate target of monetary policy is price stability, but we are aware that the ECB will takeaccount of other developments in the short run. Those who believe in rules often argue for the publication of relativelysimple and transparent rules, where the interest rate would vary with inflation, output and unemployment. However, theECB may choose to have a target for the money supply, and also take account of inflation developments in the short run.Clearly the ECB will act with caution. It appears that European-wide money demand is stable, but targeting it has not beentried before. We all know that money demand is subject to shocks that may only be due to portfolio reallocations resultingfrom financial innovations or from changes in taxation. These shocks may be more common in the transition phase afterEMU is set up. The ECB should be cautious when setting money supply target as it may have to permanently modifythem, and it should make it clear that its ultimate goal, price stability, will dominate its commitment to an uncertain inter-mediate target. It has to accept the uncertainties in the new situation.

29

b. On Tax Harmonization

The single market and the common currencycould strengthen fiscal competition in Europe.Some countries could decide to lower tax ratesto attract capital and qualified labour. Firms,workers, and the high-income earners have theopportunity to choose in which country they aregoing to pay taxes, while benefitting from pub-lic expenses in a more generous country. Such afiscal competition may force nations to choosebetween cutting back on public spending, andtaxation exclusively based on immobile factors(like real estate or unqualified workers). In faceof this problem, three views can be presented.

According to the decentralized approach, thefact that a single currency exists for Europe andthat monetary policy is now harmonized doesnot imply that fiscal harmonization is necessaryas well. The choice of the appropriate systemshould be left to the individual countries andnot be limited by a "European standard". Ineach country, there are — to a different degree— distortions in the tax and welfare benefit sys-tems, which are an impediment for highergrowth and higher employment. Successfulstrategies of reducing these distortions can becopied by other countries with a positive effecton growth and employment. Such a process oflearning can therefore be productive for the in-dividual countries and for Europe as a whole.This process would not be possible if there wasa far-reaching harmonization of tax rates or taxsystems. If tax systems were more or less thesame, it would also be more difficult for coun-tries with a relatively low income to catch upwith richer countries. Tax competition wouldtherefore be favourable for integration in Eu-rope. De facto there has already been tax com-petition in Europe but the tax burden in mosteconomies is nevertheless high. Also in thefuture, competition with respect to tax levelswill not lead to a "race to the bottom". The go-vernment as well as the population in eachcountry have an interest that public goods suchas investment in infrastructure are provided at ascale which is supportive for economic growth.The introduction of social standards, unlessthey are set at the lowest possible level, would

hamper the economic development of countrieswith a relatively low level of productivity.These countries with a relatively low livingstandard could not afford paying high social ex-penditures without having to accept lower eco-nomic growth and higher unemployment. In theEuropean Monetary Union, it will and shouldbe possible to have different levels of govern-ment expenditures, different tax systems as wellas different social systems. They are the naturalresult of different preferences among the coun-tries on the one hand and different levels of in-come and productivity on the other.

From a federalist point of view, an optimaltax system and a social security system shouldbe settled at the European level to which coun-tries would have to conform. Europe, as a rela-tively closed economy, could determine its so-cial model. However, social, economic, and po-litical integration have not reached a degree atwhich European peoples will accept taxationand social security be defined at a Europeanlevel. The present differences in living stand-ards do not permit a single social legislation:the poorer countries cannot be forced to adoptthe living standards of the richest countries, interms of wages or minimum income. In the longrun (that is to say, roughly in 20 years), thisquestion will be raised. A higher degree of la-bour mobility may force social legislation har-monization (for instance pension systems andunemployment benefits). If political union inEurope were to develop, common taxation andpublic spending would have to be settled to in-crease the European citizenship. Yet, such a re-quirement is only to appear in the future.

A more pragmatic approach can be a gradualharmonization. This process would try to pre-serve national sovereignty as much as possibleat each step towards European unification, bothon taxation and on spending policy, while co-ordinating taxation on the most mobile factorsto avoid that tax payers individually choose tax-ation. According to this view optimal taxationcannot emerge from a market process, sincewhen totally free, each tax payer behaves as afree rider. For instance, young people, educatedin France, where education is free, and havingreceived family allowances, may decide to

30

work in the United Kingdom, where taxes onlabour are low, while their parents benefit fromthe French public retirement system. A Germanresident with savings in Luxembourg couldkeep on benefitting from public expenditures inGermany. The rich could escape any redistribu-tion tax, even if assistance dedicated to thepoorer has, socially speaking, to be consideredin terms of social cohesion. National systemsmay be subject to competition, but this competi-tion shall not be biased. Some would be satis-fied if states were obliged to abandon publicspending and redistribution. But this opinionmay not be broadly shared in Europe. Follow-ing this approach, some guidelines could beproposed. Countries should remain sovereign asregards labour and real estate taxation; the useof tax havens should be kept under strict rules.Capital income taxation should be harmonized,either on the principle of declaration in thecountry of origin, or with minimal tax rates onnon-resident savings. The European Unionshould promote tax reforms, like increasingecotaxes while lowering employers' social con-tributions on low wages. The VAT system mayremain unchanged as long as the differences innational tax rates do not lead to significantcross-country purchases. Taxes on profit shouldbe harmonized (minimum rate, taxation on prof-its abroad); areas in difficulty could however beentitled to have a lower tax rate.

5. On Social Policy and Wage Settingin Europe

The introduction of the euro raises questionsabout the need for reform of national labourmarkets and social institutions. It removes oneof the last remaining barriers to the mobility ofcapital, and hence changes the relative isolationof individual labour markets. In particular itraises questions about whether wages could beharmonized across Euroland, or at the very leastshould there be a co-ordination of wage bar-gaining and the emergence of Euroland bar-gaining institutions ?

a. Harmonizing Wages?

Wage rates differ substantially between themembers of the euro area. These differences re-flect varying levels of productivity and nationalincome and differences between national insti-tutions. If wage increases are harmonized butproductivity is not then production will movebetween countries, and non-national multina-tionals will find it easier to move than mostdomestic firms.

In the service sector where wages are oftenmore strongly related to national income thanmeasures of physical productivity it is clear thatless affluent countries pay their hairdressers andschool teachers less than in wealthier countries.There would clearly be a great danger that ifpay rates were forced up in lower-wage econ-omies, a large fall in employment could be en-gendered. If there were a desire to raise wagesin lower-productivity countries then the appro-priate policy response would be to follow pol-icies which raise productivity. These might in-clude greater investment in education and train-ing and perhaps incentives for physical invest-ment. For the most part these would seem to bequestions for national governments, althoughstructural funds can help smaller and poorercountries adjust, much as they have in Ireland.It cannot be expected that productivity can beraised significantly in a short period of time.

However, national labour market and socialinstitutions also matter in the determination ofwages. They affect the level of wages, the flexi-bility of the labour market, and the speed of re-sponse to changes in the external environment.In the UK and the US, where institutions suchas trade unions, minimum wages, and social se-curity have been weakened in recent years,there has been a widening in earnings disper-sion and a decline in the labour share of na-tional income. Both economies show consider-able labour mobility, with individuals movingbetween firms more frequently than they do in,say, France or Germany. This gives the US andthe UK more flexibility to respond to develop-ments that change the number and size of firmsthat can survive in an industry. However, inother countries where such institutions have

31

been maintained or enhanced we have not seenthe same developments in the distribution ofearnings. In addition, the continued existence ofemployment protection has meant that employ-ment levels are potentially higher but that actualhours worked per person are lower and essen-tially more variable than they are in the UK, forinstance. Other labour market institutions canalso compensate for a lack of labour turnover,and these have meant that in Germany hours perperson and real wages per person hour havevaried more over the cycle than they have in theUK, giving the economy a different form of fle-xibility. Therefore, the question of harmonizinginstitutional practices, rather than wages, maybe of greater interest.

b. Harmonizing Institutions andCommon Standards

There are forces at work that may lead to theharmonization of some institutions in labourmarkets. The Social Chapter, for instance, re-quires some common approaches to non-wagelabour costs and to social protection. It is, how-ever, questionable as to whether it is practical toharmonize labour market and social institutionsacross Europe. Member states have evolved dif-ferent institutional frameworks and practices toreflect national preferences and different cultu-ral and historical traditions. These may be hardto change as they are not reflected in legislationand may not respond to it. Many countries havecentralized bargaining systems covering almostall employees whilst other countries, most no-tably the UK, have adopted much more decen-tralized approaches to pay determination. Socialsafety nets, employment protection, and mini-mum wage provisions also vary considerablybetween countries. It is clearly not possible toharmonize such institutions in a short period oftime but it would be possible to perhaps setsome common standards and begin a process ofgradual harmonization.

There would appear to be two different andapparently contradictory approaches to thequestion of whether this would be a desirabledirection in which to go. One view would bethat the single currency will require a greater

degree of harmonization of wages and social in-stitutions. The case for this is in some wayssimilar to the arguments put forward for the So-cial Chapter of the Maastricht Treaty, as a ne-cessary counterbalance to the competitive pres-sures emerging from the creation of the SingleEuropean Market. It is argued that withoutcommon standards multinational employers,when bargaining with disparate national tradeunions, may be able to drive down wages, asthe threat of relocation becomes more realistic.However, there are clearly limits to the extentto which such a threat is realistic. Wage rateswithin the multinational will reflect differentnational productivity levels that depend uponthe skills and capacities of the workforce andon the general infrastructural environment inwhich they work. However, the existence of theforces of relocation is one of the factors thatwill quickly help make changes in nominalwages move more coherently than they havedone over the last decade. National institutionsaffect national wage levels, and in turn affectparticipation and unemployment levels, but theyare not immutable.

For instance, it is sometimes suggested thatcountries may try to gain a competitive advan-tage within the monetary union by loweringwages and social benefits relative to othermember states. Supporters of this view point tothe Netherlands as an example of a countrywhich has pursued such a strategy. Followingthe Wassenaar agreement in 1982, when Dutchemployers and trade unions agreed to moderatepay increases in order to create more jobs, em-ployment growth has been 1 per cent a year fas-ter than in the rest of the EU. Over this period,whilst the ERM parity has been maintained, thereal effective exchange rate in terms of unit la-bour costs has depreciated by 10 per cent. It issuggested that countries participating in theeuro may decide to follow the Dutch route tocompetitive devaluation through lower wages.If monetary union and a single currency lead tothe gradual breakdown of institutions that re-strict choice within countries and concentratethe benefits of high productivity amongst speci-fic "insider" groups, then it may have served apurpose in increasing welfare in the euro area.

32

The alternative view would be that greater la-bour market flexibility is essential if the singlecurrency is to function effectively. Once thesafety valve of national exchange rates has beenremoved and restrictions are placed on fiscalpolicy through the Stability Pact, national la-bour markets will need to function more effec-tively to ensure that unemployment is kept low.For example, if unit labour costs and pricesgrow more quickly in one country comparedwith the euro area, then this country may rapid-ly become uncompetitive as it faces an appre-ciation in its real exchange rate. Relocation ofactivity both within multinational firms andwithin industries will result, and the combina-tion of the removal of barriers in the SingleMarket and the existence of a common currencywill speed these processes up. We have alreadybegun to see such forces at work in the automo-tive industry, and they will spread quickly.

There is clearly a danger for some countriesat the start of EMU, such as Ireland, who aregrowing much more rapidly than other coun-tries in the euro area. To the extent that thisgrowth is driven by excess demand it will leadto a rise in prices and wages relative to those inthe rest of Europe. Countries who find them-selves in this position will need to demonstrateconsiderable flexibility in both labour and pro-duct markets if they are to avoid a long andpainful period of high unemployment. With theconsiderable language and cultural barriers thatexist within the EU it is unlikely that theseproblems will be solved by migration as hasbeen seen within the US. Supporters of this

view would argue that any attempt to harmo-nize wage bargaining within Europe is likely torestrict national labour market flexibility andmay condemn some countries to protractedspells of high unemployment. Had common Eu-ropean institutions existed in the early 1980s,then it may not have been possible for theNetherlands to address its then very serious un-employment problem through a national agree-ment on wages and employment. Moreover, itis often argued that the introduction of the eurostrengthens the case for deregulation of Euro-pean labour markets and reform of social safetynets so that they do not create poverty traps.

It is clear from the above discussion that anyattempt to bring about a convergence in labourmarket institutions must proceed with great cau-tion. The framework of the Social Chapterprovides a mechanism for providing a baselineof common standards for all member states. Al-so if European trade unions and employers wishto develop stronger international ties, then theywill be free to do so. However, any attempt toharmonize wage rates across countries, not ac-companied by a corresponding rise in produc-tivity, should be resisted as this could jeopar-dize the employment position of workers inlower-wage economies. Also national bargain-ing systems should remain, and arguably devel-op further the ability to respond to local labourmarket conditions. Without this national flexi-bility, individual countries may be left with nopolicy remedy for rising unemployment. Thiscould threaten the cohesiveness and ultimatelythe continuation of the monetary union.