Note: * PPP is the artificial common reference currency unit used to express the volume of economic aggregates for the purposes of spatial comparison in real terms. One unit of PPP buys the same given average volume of goods and services in all countries, whereas different amounts of national currency units are needed to buy this volume of goods and services, depending upon the national price level. For any given product, the PPP between two countries A and B is defined as the number of units of country B's currency that are needed in country B to purchase the same quantity of the product as one unit of country A's currency will purchase in country A. These adjustments are made to account for the way in which exchange rate fluctuations do not properly reflect what can actually be purchased with units of currency when comparisons are made between countries (or over time).Thus, for the next five years at least, the USA and Japan will remain the most obvious comparative competitive cases as far as the EU is concerned. Table 2 provides data which signal some of the key characteristics and differences between these economies presented in terms designed to bring out the importance of differences within the EU as well as between the EU and the USA and Japan (note that these data are measured in respect to the Euro).The population of the EU-15 was already larger than that of the USA before the ten new members joined in 2004. Note also that if the three largest next most likely new members (Turkey, Romania and Bulgaria) were to join, another 100 million people would be added to the EU total (Croatia has already gained agreement on detailed accession negotiations, but it is a very small economy compared to these three, with a population of 4.6 million in 2003). In terms of national output (GDP), the EU-15 and the USA were almost the same size, so it is when national income is divided by population that differences begin to emerge. Both the USA and Japan have higher GDP per head than the EU. Clearly, the USA is way ahead on this per capita measure (the average US citizen had a 42 per cent greater PPP adjusted income than the average EU-15 citizen in 2005). As shown in Table 2, the growth rates of the USA and the EU were almost identical over the period 2001–05 (but these forecasts overestimated actual turnout rates for the EU for 2004 and 2005, which were considerably lower). Note that Japan had a negative growth rate over this period. Its economy shrank in absolute size (this was also the case for Romania and Bulgaria over the transitional period 1990–2002).
Table 2 Comparative data for the EU, the USA, Japan and the main EU candidate countries (estimates for 2005)
Population (millions)
GDP (at market prices) Euro bn
GDP (PPP) Euro bn
GDP per head of population (EU-15=100)1
GDP per head of population at PPP rates (EU-15=100)
Growth rate annual % change 2001–052
EU-15
385
10.0
10.0
100
100
3.8
EU-25
460
10.5
11.0
87.8
91.9
3.9
Japan
128
4.2
3.5
124.4
104.6
−0.3
Turkey
73
0.262
0.442
13.8
23.2
3.1
Romania
21
1.155
0.165
9.9
29.4
−0.1
Bulgaria
8
0.021
0.067
10.7
30.5
−0.7
(adapted from European Union, 2004; World Bank, 2003)
Note:1For this and the next column the comparative figures are measured as an index number relative to that of the EU-15 countries, which are designated as 100. 2For Turkey, Romania and Bulgaria, growth rates are averaged over the period 1990–2002.The differences between the EU-15 and the EU-25 shown in Table 2 arise because the ten new members who joined in 2004 were considerably less wealthy in 2005. And these differences would be further exaggerated if Turkey, Romania and Bulgaria were to join. Even on a PPP adjusted basis Turkey's per capita GDP in 2005 was just a quarter of the EU average. Because it is such a large country in terms of population, this could have the effect of dragging down the EU averages significantly.Of course the fact that these, and the majority of the ten countries who joined in 2004, are considerably less prosperous than the EU-15 is part of the reason for them wanting to join, and why they should perhaps be welcomed. If the EU is not to become simply a ‘rich man's club’ it is reasonable for less wealthy countries to join so they may be able to prosper by this move, and the already existing members could also benefit by the addition of new markets and sources of labour. However, the economic challenge posed by this is obvious. The EU-15 had achieved a considerable degree of convergence and integration; they had developed common rules and policies that suited their stage of development. As will be discussed later in this course, the advent of a large number of new, less prosperous and somewhat differently organised economies may upset the delicate balances forged between the EU-15 and require a radical rethink of how the expanded EU economy can be managed and governed (see Section 1.6).1.2.2 SummaryThe EU-15/25 is a large and prosperous player on the world economic stage.It represents a continental-sized economy, able to compete with the USA and Japan (and China and India, somewhere down the line).The new EU members who joined in 2004, and those lining up to join later, are at a different level of development to the EU-15.This will pose considerable challenges for those managing and governing the newly expanding EU economy.1.3 The arrival of the Euro and the European Central BankThe ECB (founded in 1998) is a formally independent body charged with defining and implementing monetary policy for the EU. It holds the reserves of the national banks of those participating in the Euro-zone, and also has responsibility for the Euro exchange rate (see Section 1.5). This independence is ensured by the fact that the ECB does not have to ‘take instructions’ from any EU government or institution and it does not act as the ‘banker’ to the EU or its governments by granting them credit or managing their debt (a task undertaken by national treasuries or finance ministries). But its overriding goal is delivered to it by the Maastricht Treaty: to achieve price stability, though exactly how this is defined and how to achieve it is left up to the Bank to decide. Thus what the ECB has is not ‘goal independence’ but ‘instrument independence’ since it can only independently decide on how to best achieve the goal of price stability.The most important role in the ECB is that of the president; and it was over the appointment of its original president that the first of what will no doubt be many battles between member states, in respect to the actual operation of the ECB, was fought. Two rival candidates emerged in 1999: the Dutch central banker Wim Duisenberg (favoured by the Germans and others) and the French candidate Jean-Claude Trichet (particularly favoured by the French). After several months of deadlock and fierce infighting, Duisenberg was appointed in a messy compromise that saw uncertainty about whether he would serve a full eight-year term or only a four-year term, giving way to Trichet in October 2003. However in October 2003 Trichet did take the helm, somewhat controversially, after being indicted by a French court for a banking scandal in 2002 (he was cleared).The central problem encountered by the Bank in its management of monetary policy, almost since its inception, has been to balance its main concern with inflation – which implies a ‘conservative’ and restrictive stance vis-à-vis interest rates (i.e. keeping them high) – with the fact that the EU economy has been performing relatively badly in real terms, implying the need to keep interest rates low to stimulate business and commercial activity. By and large, and as might be expected, it has opted for caution in its interest rate and money supply policy, although it did drive interest rates down to 2 per cent during 2004–05. However, the bank reluctantly lowers interest rates only when under extreme pressure to do so, and has maintained a generally ‘tight’ monetary stance overall; although, as we shall see in the following paragraphs, one perhaps not quite tight enough to ameliorate all of its critics (European Commission, 2005a).In the initial phase after the Euro was established there was understandably great uncertainty over the way in which the ECB should operate and the reaction of the financial system to its policies. But the bank may have added to this uncertainty by adopting a dual approach to monetary policy: neither a pure-inflation targeting approach nor a monetary-aggregate approach, but a combination of both of these. First it established its definition of price stability as a ‘year on year increase in the index of consumer prices in the Euro area of below 2 per cent’. Then it proposed to keep inflation rates to ‘below or close to 2 per cent over the medium term’ (usually understood as about three years). This was taken as a lack of a precise point target (‘below or close to’, and ‘over the medium term’ express the ambiguities). Furthermore, to achieve this it would monitor a money growth aggregate in the economy (termed ‘M3’) and take this ‘money supply growth’ as another indicator of possible inflationary pressures. It would also look at other relevant aggregates (various asset prices and macroeconomic measures) in making final decisions about interest rate changes. So, there is a range of possibly conflicting measures and aggregates that the Bank was to concentrate on in making its decisions about monetary policy, which was thought to have added to the confusion over what was actually being measured and monitored.All of this was thought to offer a somewhat imprecise set of signals to the financial system about the Bank's policy stance. It does not rule out deflation (negative price changes) as an acceptable policy outcome, and 2 per cent or under is not the same as a zero inflation rate. In addition, Euro-zone actual inflation has been above 2 per cent over most of the operational period of ECB activity so far, though it has not acted to explicitly suppress this. These points are independent of the controversial link that the ECB establishes between growth of the money supply (M3) and inflation (that the growth of the money supply leads to inflation – a classic ‘monetarist’ position), although in its actual operational environment the reference money supply growth target of under 4.5 per cent per year has in practice been continually overshot. All this has gone towards raising concerns over the adequacy of its capacity to meet the goal commitment to defeat inflation.During 2004–05 the EU economy was in a recovery phase, so the question of inflationary pressures moved up the Bank's agenda. In addition there was an increase in international oil prices and those of other raw materials (predicated on China's enormous demand for energy and raw materials), which could eventually feed back into domestic prices. But here the dilemma appears again, since the EU recovery was very weak (with unemployment at 9 per cent across the EU as a whole). Pressure for interest rate rises was acknowledged, however, confirming the suspicions of those opposed to the ECB's whole strategy in dealing with economic management and the governance regime imposed upon it by the Maastricht Treaty.A further issue for the ECB has been the way it is governed internally. Apart from the importance of its president, already mentioned, there is a Governing Council made up of a six member Executive Board and the governors of the national central banks of those member states who participate in the Euro-zone. This Council makes the decisions. Thus, monetary policy decision making is centralised, but monetary policy operations are left to the participating national central banks to implement on the instructions from the Board – they are decentralised. It is this functional centralised and decentralised structure that is thought to impart another level of uncertainty and potential conflict into the overall running of monetary policy. In addition, if all the current EU members were to eventually participate in the Euro-zone the decision-making Council could have expanded to a possible thirty-two members, making it almost impossible to reach ‘sensible’ decisions. To address this, the ECB Council has been restricted to a maximum of twenty-four members with a rotating membership, but this is still a very large number for decision making.The final issue circulating around the ECB concerns the transparency of its decision making and its political accountability. The bank is formally independent, as outlined earlier, though it must meet its externally imposed ‘political’ objective of controlling inflation. In addition there is the inevitable political wrangling over the appointment of its president. But to whom does the bank report on its conduct of monetary policy? Unlike several other central banks (including the Bank of England) the ECB does not publish the minutes of its meetings that decide monetary policy. This is thought to undermine its transparency. And it is only through a rather ill-defined process of ‘dialogue’ with the European Parliament, for instance, that the ECB can be formally called to account for its actions. Thus the political accountability and transparency of the ECB is weak and lacks comprehensiveness.1.4 The fate of the Stability and Growth Pact1.4.1 Nature of the pactWith the advent of EMU and the Euro the question of the SGP embodied in the Amsterdam Treaty of 1997 was raised once again (Linter, 2001, p. 68). This pact is designed to ensure that EU member states’ fiscal policies (involving government taxation and expenditure decisions) do not clash with their monetary policies (or, in the case of the Euro-zone countries, with the monetary policy pursued by the ECB). As we have seen, by and large, the monetary policy pursued by the ECB is the one embodied in the Maastricht Treaty of 1992 – namely to have an overriding concern with controlling inflation – and this has also been the policy objective adopted by all the member states as a result. The only difference between the Euro-zone countries and the other EU members is in respect to the manner in which they might go about meeting this objective. This may differ according to the exact way in which the different financial systems work and the way they are regulated.Formally at least, under the SGP all EU governments are free to conduct their own fiscal policy, but national budgets are to be controlled by limiting government borrowing to a maximum of 3 per cent of GDP per annum, and keeping overall public debt to a maximum of 60 per cent of GDP. In fact, this latter criterion has never been seriously enforced (Greece and Italy have public debts of over 100 per cent of GDP), though, as we will see, the former has been the subject of fierce dispute. Any breaking of this 3 per cent rule would see sanctions initiated by the European Commission, in its role as the ‘guardian of the Treaties’ (which can take the form of fines of up to 0.5 per cent of the offending country's GDP, imposed by the European Court of Justice (ECJ)).But the question this raises is: how far is an independent fiscal policy compatible with a common currency and a single monetary policy? Does convergence organised around the Euro sit comfortably with divergence in respect to fiscal policies?Perhaps rather fortunately, in the run-up to monetary union, there were sharp reductions in the deficits of European governments. In part this was a result of a favourable world business cycle, which made achieving lower deficits easier, but it was also the result of incentives to keep to the rules so as not to be disadvantaged by being excluded from the EMU. This was thought to be particularly the case with Italy and Greece. But, rather bizarrely, Ireland was severely reprimanded in 2001 for what the Commission thought looked like an inflationary inducing expansion as it cut taxes and increased government investment expenditure, even though it had a budget surplus of over 4 per cent of GDP at the time (Alesina and Perotti, 2004). What this indicates however, is that there is a temptation written into the Maastricht Treaty and the SGP for the Commission to try to ‘micro-manage’ the overall fiscal stance of member states (and therefore the scope for their pursuit of independent fiscal policies) in the name of the monetary objective of controlling inflation.1.4.2 Struggles over the SGPThe real political struggles emerged at the end of 2003 when France and Germany were called to account by the Commission for overtly breaking the 3 per cent deficit rule. The background to this dispute can be seen in the data presented in Table 3. Clearly, although the EU-15 as a whole were keeping to the rule during the early 2000s, France and Germany went into a 3 per cent plus deficit from 2002 onwards.
Table 3 General government deficits (−) or surpluses (+) as percentage of GDP at market prices, 2001–05
EU-15
Germany
France
Italy
UK
2001
−0.9
−2.8
−1.5
−2.6
+0.7
2002
−1.9
−3.5
−3.1
−2.3
−1.5
2003
−2.7
−4.2
−4.2
−2.6
−2.8
2004
−2.6
−3.9
−3.8
−2.8
−2.7
2005
−2.4
−3.4
−3.6
−3.5
−2.4
(adapted from European Union, 2004, Table 75 , p. 626)
It might be noted that the Netherlands and Portugal also recorded deficits of greater than 3 per cent of GDP in the early 2000s, as did Greece (−6.1 per cent in 2005); but it was the fact that the two largest countries ‘at the heart of Europe’ fell into this position that really challenged the SGP. The Council of Ministers met in November 2003 ostensibly to condemn France and Germany on the recommendation of the Commission, but this was rejected. Instead, the decision was made to ‘hold the Excessive Deficit Procedure in abeyance’. This unprecedented decision led to a series of harsh exchanges involving accusations and counter-accusations between the Commission and the Council, but it in effect killed the SGP. The rule now lacks credibility; there is little chance it could be realistically applied to any other country given its suspension in these cases. And what, at the time of writing, is happening to Italy in 2005 seems to confirm this prognosis since its deficit is forecast to rise from −3.5 per cent in 2005 to −4.6 per cent in 2006.What is the political lesson to be learned from this episode?If anything, this event has proven that, whatever sovereignty large countries are willing to cede to the Commission in matters of importance like fiscal policy, they will take it back – legally or less legally if necessary for a sufficient number of them. It is probably more constructive to simply recognise this point or realpolitik, declare the growth and stability pact dead, and return fiscal discretion to national governments.(Alesina and Perotti, 2004, p. 44)Quite whether this realpolitik reassessment is likely remains to be seen, however. The problem is that although the SGP may be dead, the general question remains: can a single currency and single inflationary objective coexist with such potential variability in fiscal positions? In addition, how is ‘fiscal discipline’ to be organised and guaranteed if there is no effective SGP?. Financial convergence across the Euro-zone is, in large part, predicated upon the ‘confidence’ that inflationary pressures can be coped with. But if ‘fiscal discipline’ fades, and the different EU countries were to expand their economies by indulging in competitive reflations via significantly increasing government expenditures financed by borrowing, this would increase local risk factors at the expense of the carefully crafted common position forged across the Union as a whole. Inflationary pressures could emerge, interest rates rise, and confidence in the Euro be undermined. As a result a ‘one size fits all’ monetary policy would no longer be viable (if, indeed, it ever has been).Within the SGP rules, where there is a presumption that in the medium term government budgets would balance, only differences in tax rates would allow for differences in government expenditure rates; so the way that fiscal policy is constrained is clear. Higher expenditures on social policy objectives, for instance, could only be financed by increased taxes and/or contributions. What this imparts in the system as a whole, then, is a deflationary bias in economic activity almost regardless of the explicit monetary policy stance adopted by the ECB. But given that the ECB's monetary policy has also been restrictive, always operating in the shadow of the need to fight inflation, a double deflationary bias operates. Autonomous large-scale increases in government expenditure for re-distributive or stabilisation objectives are ruled out. And, given the emergence of a single market in Europe, tax increases could only be levied of non-mobile factors anyway. Capital is very mobile so levying taxes on company profits, for instance, is difficult. Indeed, in their attempt to attract capital and companies to their territories, governments have engaged in corporate tax competition to present their business environments as friendly to company activity, with low corporate tax rates; a ‘race to the bottom’ results. (However, the tax take from corporation tax has actually risen in some instances, but this is because of the recovery in the overall levels of corporate profits, so that even with lower tax rates a higher tax take can ensue.)For those not committed to the EU's current overall policy stance (supported by the Commission and the Council of Ministers alike it would seem), one that can be termed neo-liberal and pro-market (i.e. generally in favour of liberalisation and de-regulation), this change could open up some intriguing opportunities. A Keynesian-inspired fiscal policy as the key stabilisation and management tool could come to the fore once again as monetary policy and an obsession with inflation targeting retreated. The so-called ‘Brussels-Frankfurt’ consensus that was thought to politically underpin the Maastricht Treaty process would be broken for the good as fiscal discretion and flexibility replaced fiscal rules (Sapir et al., 2003; EuroMemorandum Group, 2005). From the point of view of the Commission's orthodox position, however, fiscal discretion and flexibility means fiscal indiscipline and inflation. If you let countries borrow as much as they like, they will take advantage of this, ratchet up their public debt positions, which will release money into the economy as they borrow, which will in turn lead to inflationary pressures as too much money chases too few goods in a classic monetarist formulation.In fact, a much looser compromise on policy was forged in March 2005. The SGP was re-negotiated to allow countries to operate ‘close to the reference value’ of 3 per cent deficits rather than to strictly adhere to it. And several new ‘particular circumstances’ were introduced – amongst them expenditure on ‘international aid’, on ‘European policy goals’ (like Research and Development and ‘eEurope’ expenditures), and on ‘European unity’ objectives (for example, convergence and solidarity expenditures) – that were to be given ‘due consideration’ in judging the underlying fiscal position of countries. In effect, this opened up the pact for further political fudging and creative accounting. It was condemned by the ECB and a number of smaller EU countries.1.4.3 SummaryEMU has been accompanied by fiscal rules embodied in the SGP.An issue raised by this is the compatibility of a common single monetary policy target designed to defeat inflation with different fiscal policies ostensibly at the discretion of the individual govern ments.When France and Germany contravened the SGP fiscal rule, it was effectively suspended and broke down. This was a case of the Council of Ministers asserting control over the European Commission.It is possible that inflationary pressures will grow without the fiscal discipline afforded by the SGP.An alternative consequence of undermining the SGP is that more active and discretionary fiscal policies could emerge which will be expansionary and correct the deflationary bias built into the existing EU monetary and fiscal policy regime.1.5 The Euro and the wider world1.5.1 A ‘two currency’ world?The introduction of the Euro threatens to have a significant impact on the international monetary economy as well as on the economies of the EU countries themselves. As yet this impact is not altogether clear since the Euro has only been operating for a few years. But certain trends are emerging and the possibilities are opening up. It is the main features of these trends that we concentrate upon in this section.A preliminary point here is that the Euro exchange rate is not a policy variable or a policy target in the EU context (European Commission, 2005a, p.79). The exchange rate is set by ‘market forces’. The ECB has not intervened in the currency markets to try to influence the value of the exchange rate; all it does is ‘monitor’ exchange rate developments as part of its task of assessing prospects for the Euro-area and setting interest rates.The international bond market is huge and growing; towards the end of 2000 outstanding accumulated bond issues were well over US$ 30,000 billion, with government bonds comprising three-fifths of this total. Table 4 sets out the trends in the total global issue of bonds (both government and corporate). The three main international currencies for bond denomination, namely the US dollar, the EU Euro and the Japanese yen, are shown separately and all the others aggregated together.The general trend shown in Table 4 is that it is the two main currencies of the international system (the US dollar and the EU Euro) that are consolidating their hold over the international bond market. The Euro was launched in 1999, and there was a big jump in Euro equivalent denominated bonds issued in that year. In terms of proportions, the US dollar and the Euro-zone currencies/EU Euro accounted for 54.3 per cent of the total in 1994 compared to 73.6 per cent in 2002. This growth was at the expense of the yen and other currency denominations, including the UK pound. What this demonstrates is the consolidation of international financial activity in the US dollar and the EU Euro, confirming the idea of an increasingly two-currency world. This emerging bi-polar currency world is reinforced by the data contained in Table 5 which shows the currencies in which official holdings of foreign exchange are kept in the international system (note that the UK pound still remains important here).
Table 4 Global net issuance of bonds (debt securities) US$ bn, 1994–2002
1994
%
1995
%
1996
%
1997
%
1998
%
1999
%
2000
%
2001
%
2002
%
US dollar
664.3
33.1
796.9
37.2
1125.4
44.9
1255.5
57.5
1726.4
62.0
1511.9
45.1
1053.5
42.0
1302.1
45.1
1443.6
49.3
Euro
876.4
26.1
626.3
25.0
562.9
19.5
714.0
24.3
Euro-area currencies
425.3
21.2
366.3
17.1
528.7
21.1
326.9
15.0
435.3
15.6
Yen
336.7
16.8
434.6
20.3
458.7
18.3
237.9
10.9
185.8
6.7
496.1
14.8
450.6
18.0
570.6
19.8
280.6
9.6
Other currencies
578.3
28.8
544.1
25.4
392.6
15.7
362.4
16.6
438.9
15.6
470.7
14.0
375.9
15.0
450.6
15.6
494.3
16.8
TOTAL
2004.6
100
2141.9
100
2505.4
100
2182.7
100
2786.4
100
3355.1
100
2506.3
100
2886.2
100
2932.5
100
(calculated from Pagano and von Thadden, 2004, Table 2, p. 533)
Table 5 Official holdings of foreign exchange by currencies (end of year percentage)
Euro
US dollar
Japanese yen
Pound sterling
Swiss franc
Deutsche mark
Unspecified currencies
1994
–
56.5
7.9
3.3
0.9
14.2
6.6
1995
–
56.9
6.8
3.2
0.8
13.7
9.2
1996
–
60.2
6.0
3.4
0.8
13.0
8.6
1997
–
62.2
5.2
3.6
0.7
12.8
8.7
1998
–
65.7
5.4
3.9
0.7
12.2
9.3
1999
12.7
67.9
5.5
4.0
0.6
–
9.3
2000
15.9
67.5
5.2
3.8
0.7
–
6.9
2001
16.4
67.5
4.8
4.0
0.6
–
6.6
2002
18.7
64.5
4.5
4.4
0.7
–
7.3
(adapted from European Commission, 2005a, Table V5, p. 180)