Macroeconomic conditions in the euro area were rather mixed at the time the single currency came into being. The 1997-98 string of emerging market crises was hurting exports, and growth was marking a pause. Sooner than many expected, however, economic conditions improved, helped by the strengthening of growth around the world and favourable monetary conditions at home. As the euro depreciated, exports and output picked up, while deflation fears subsided.
The vigorous ongoing recovery is creating more jobs than previous upturns, thanks to efforts to address some of the traditional labour market rigidities. The hope is now that this recovery will be sustained long enough to bring unemployment down well below what in many countries is still an unacceptably high level. This is a plausible scenario, provided the external environment does not deteriorate and the momentum of structural reforms, including the enforcement of the single market legislation, does not abate.
Pragmatic policy mix
The macroeconomic policy mix in 1999 was broadly satisfactory, and helped support domestic demand in the face of the adverse external trade shock. The Eurosystem’s two interest rate moves (down in April, up in November) met with little criticism and were indeed well-advised. Fiscal consolidation continued. It is proceeding only gradually, however, owing in part to “Maastricht fatigue” following several years of serious adjustment. Hence fiscal balances in a number of countries still need to move closer to what can be viewed as a range safe enough for automatic fiscal stabilisers to come into play, to allow for some slippage in the budget balance in the event of a downturn. Furthermore, business cycles in the euro-area countries are not perfectly synchronised. In those more advanced in the cycle – such as the smaller, fast-growing ones – there is a clear need for a relatively tight fiscal stance, given that monetary policy is tuned to the cycle of the euro area as a whole, for which output remains below potential. High public debt ratios as well as future pension liabilities also call for a measure of fiscal restraint in several countries.
Against this background, the emphasis of fiscal policy is starting to shift from deficit reduction per se to the composition of spending and the trade-offs between further deficit compression (or surplus generation) and supply-side friendly tax cuts. This set of questions is being looked at closely in the OECD’s surveys of individual euro economies, and the answers vary from country to country.
Talking to the markets
One lesson from the euro's first year is that the Eurosystem’s policy framework and communication policy could be improved. The definition of price stability remains somewhat vague and the hierarchy of indicators used fuzzy (in particular with respect to the role of the broad money indicator, M3). Transparency is limited on some counts, for example, by omitting to publish the Eurosystem's own projections. It has also been difficult for policymakers to speak with one voice, or at least one message, on the exchange rate. Expressing any view on the euro is all the more challenging as, despite the widespread feeling that it is by now distinctly undervalued, it is extremely difficult to pin down what the "equilibrium" exchange rate level actually is. Econometric studies deliver a wide range of estimates, depending on the methodologies and benchmarks used, but they lack a fully credible empirical foundation, since the euro's history is so short. Nevertheless, there seems to be a genuine potential for the currency to appreciate over the longer run: growth is picking up in Europe, and at some point in the future the deterioration of the current account deficit and net external debt of the United States will have to be reversed. But how long is the long run?
Structural reforms are taking place in Europe – witness the gradually increasing flexibility of labour markets, which translates into higher job creation per unit of output growth. This is a structural improvement in the labour market, as opposed to a temporary, cyclical one. Reforms have also transformed the network sectors, with prices tumbling in telecommunications and more recently electricity. Many of these reforms are desirable in their own right, irrespective of the single currency, be it for consumers or workers. But carrying them out helps reduce unemployment, and thereby contributes to making price stability a more acceptable policy goal.
Progress thus far has been good, but there remains a long way to go. Labour markets are still fairly segmented, as evidenced by the high dispersion of unemployment rates across countries and regions (see also last year's OECD study on EMU). Combined with wage and price rigidities, this means that the euro area-wide unemployment rate consistent with stable and low inflation is higher than it would be with more integrated and flexible markets. Further labour market reforms are clearly important. However, they might not deliver the results hoped for if product market reforms are not carried out at the same time. That is how structural reforms work, by taking a broad approach and exploiting synergies. After all, it would be a pity to suffer the pain of partial reforms and yet achieve little in return.
OECD, EMU One Year On, Paris, 2000 (available in electronic format, paperback version forthcoming).
OECD, EMU: Facts, Challenges and Policies, OECD, Paris, 1999.
©OECD Observer No 220, April 2000