The euro: past successes and new challenges.

Buti, Marco ; van den Noord, Paul

The successes of the first decade of European Economic and Monetary Union are impressive, but it is fair to stress these were achieved in a relatively benign economic environment characterised by steady global growth, supportive financial conditions and fiscal windfalls associated with booms in asset markets. Although all this has come to an abrupt end with the financial crisis, there is a silver lining of fiscal stimulus being more effective in EMU than without the single currency, with offsetting exchange rate responses absent, trade multipliers stronger and the fiscal framework credible. But the financial crisis also clearly demonstrated the need for stronger coordination of national policy actions to internalise crossborder spillovers. Meanwhile, the European Commission has a major role to play in striking the right balance between short-term emergency measures and longer-term priorities. Against this backdrop, this article sheds light on the longer-run challenges and the policy agenda for meeting them.

Keywords: Monetary union; economic governance; European Union

JEL Classifications: E60; F50; H00

Introduction

We are living in challenging times. The subprime crisis in the United States developed into a full-blown global financial crisis and what may well be the worst global downturn since the 1930s. World trade, stock markets and confidence have fallen at an unprecedented pace. Banking systems are under extreme stress and calls for capital injections and guarantees from governments are the order of the day. Fiscal stimulus, state aid for ailing industries and plummeting tax revenues hit public finances. It is not easy a task to take a longer-term view on European and Monetary Union (EMU). Yet this is what we have been asked to do.

This crisis may be seen as the acid test of EMU, but, if so, in a rather unexpected way. From the outset sceptics and critics have been wondering if and how the Euro Area would survive recurrent 'asymmetric shocks' affecting individual countries amid a 'one-size-fits-all' monetary policy and exchange rate. But now we are in a very different situation: a massive common shock that is hitting all member countries of the Euro Area simultaneously, albeit with a differentiated impact dependent on countries' initial conditions. We are entering uncharted territory.

The Commission's Communication and staff report 'EMU@10, Successes and Challenges After 10 Years of Economic and Monetary Union' (European Commission, 2008a) released in May 2008, on which we will draw extensively in this article, predicted such a shock to be the archetypical one in the second decade of the Euro Area. The drafters had obviously no clue that the subprime crisis would develop into one--and that soon. Yet many of the policy recommendations in the Report were based on such a predicted change in the 'typology of shocks' and therefore, in our view, are more relevant than ever.

In section 2 of this article we shall look back to the first ten years of EMU, or more precisely, the first nine years and three quarters, which started with the launch of the European single currency on 1 January 1999 and ended in September 2008 with the default of the investment bank Lehman Brothers. In section 3 we will look ahead, starting from the current crisis and then looking beyond the crisis to consider the longer-term challenges and priorities. Section 4 lays out the policy agenda for the second decade and section 5 concludes.

2. The first decade in restrospect

On 1 January 1999 the euro became the currency of 300 million people in eleven EU Member States--Belgium, Germany, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland. This move established the second largest currency area in the world (after the United States), producing roughly one fifth of the world's GDP. Five other EU Member States have joined the Euro Area since its inception: Greece in 2001, Slovenia in 2007, Cyprus and Malta in 2008 and this year Slovakia, the first member of the former Soviet bloc to adopt the single currency.

2.1 A historic move

The creation of the euro--and the European Central Bank--was a defining moment in European postwar history. Although the origins of the single currency go back to the 1970s, the process accelerated in the early 1990s when the lifting of the Iron Curtain and the ensuing political uncertainties prompted the perception that stronger common goal setting in Europe was needed. Among the related political events of the early 1990s was the reunification of Germany, which had serious macroeconomic ramifications and contributed to tensions and turbulence in the European Exchange Rate Mechanism (ERM). This eventually led to the go-ahead for monetary union in Europe, as laid down in the Maastricht Treaty signed in 1992.

With EMU a unique stability-oriented policy framework was created. It comprises a single monetary policy in combination with fiscal policies conducted at national level --albeit subject to rules and coordination--by its participating Member States. This is unlike federal monetary unions, like the United States, where a federal government is endowed with sovereignty to tax and to provide common public goods.

Aside from the political motivations for the creation of a single currency for Europe, the euro was intended to serve several economic goals:

* Macroeconomic stability. As noted, the single currency was a response to the episode of financial turbulence in the early 1990s. The use of the exchange rate and monetary policy instruments had lost much of their efficacy, especially in smaller countries, after the removal of capital controls.

* Growth and jobs. The single currency was seen as a decisive move to complement the completion of the European single market in 1992. The associated reduction in transaction costs and risk premia were expected to boost intra-area trade and finance, competition and efficiency.

* Cohesion and convergence. It was hoped that by fostering integration real economic convergence towards the best-performers would receive a boost. Moreover, as economies would become more similar, policies would become easier to co-ordinate as the importance of national desiderata diminished.

2.2 Initial expectations

Before it was created there was a lively academic and political debate on the viability or desirability of a monetary union for Europe. There was a very broad spectrum of views on the subject: some predicted a bumpy start or even collapse, while others were more sanguine (Buti and Sapir, 1998 and 2002). However, many tended towards a pessimistic view and this may have adversely affected perceptions of the euro area's performance in its early years.

But even its fiercest proponents saw the creation and management of a single currency in Europe as a major challenge for several reasons:

* With the loss of the exchange rate mechanism other channels would have to take over responsibility for adjustment in case of country-specific disturbances. However, without a 'federal budget' it would be impossible to direct fiscal transfers from booming to slumping states. Moreover, labour mobility within and across borders was deemed to be low and prices and wages weakly responsive to the local business cycle. Further, it was feared that real interest rates might behave pro-cyclically at the country level, going down as inflation rose in upturns and vice versa (the so-called 'Walters critique').

* The use of fiscal policies to stabilise the national economies was seen as possible to some extent, but the experience of previous decades had given rise to scepticism. Countries would be tempted to 'free ride' in the absence of the disciplining effect of exchange-rate risk, by running budget deficits. The adverse effects of fiscal profligacy risked spilling over to other participating countries. It would also result in an unbalanced policy mix, with monetary policy tighter to offset aggregate fiscal ease.

These concerns led to the convergence criteria for inflation, exchange rate stability, interest rates and public deficits and debt enshrined in the 1992 Maastricht Treaty, and which countries must comply with to qualify for Euro Area accession. It also led to the adoption of the Stability and Growth Pact in 1997 which fixed rules for fiscal policy and penalties if those rules were breached. (1) This led sceptics to point to a risk of pro-cyclical fiscal policies, as participating countries would be forced to tighten their budgets in a downturn while feeling little urge for fiscal restraint in good times.

The concerns over the weak adjustment capacity of the countries participating in the Euro Area gave impetus to the EU's Lisbon Strategy, which was adopted in 2000 to steer structural reform in product, labour and financial markets. While the Strategy was designed to boost growth and jobs over the longer haul in the whole EU, evidence has been mounting that structural policies also have favourable knock-on effects on the economic adjustment capacity of countries. In addition, the integration and development of financial markets can be seen to create opportunities for risk sharing and consumption smoothing, thus easing the stabilisation role of macroeconomic policies.

2.3 A success story overall

Inflation banished

The inflation performance of the Euro Area has improved decisively in comparison with previous decades. Inflation rates came down substantially and so did the volatility of price changes (figure 1). The bulk of the disinflation in the Euro Area occurred in the 1990s as a result of the efforts to meet the Maastricht inflation criteria. Since then, on average inflation has been broadly on a par with the ECB's benchmark of price stability of close to but below 2 per cent. Even though inflation exceeded this mark during most of 2008 due to increases in energy and food prices, long-term inflation expectations remained consistent with the price stability goal, suggesting that this goal is well anchored and credible.

Admittedly, a long-term decline in inflation has also been observed in other developed countries. But it is fair to say that without the institutional changes that accompanied the creation of the single currency--notably the establishment of an independent central bank with a clear price stability mandate--this would have been much more difficult to achieve in the Euro Area. The public perceptions of the euro in many participating countries are still unfavourable, but this is probably attributable to radical shifts in relative prices, with, in particular, prices of frequent expenses (food and energy) having risen while those of less frequently purchased items steeply fell (see Box).

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Extraordinarily job-rich growth

Another tangible economic achievement in the first ten years of the Euro Area has been the massive growth in employment--with the creation of 16 million jobs and the unemployment rate plummeting from 9 per cent in 1999 to 7 per cent in 2008. This has occurred in spite of growing numbers of people retiring, as labour market participation has risen sharply. It would be inappropriate to attribute this achievement solely to the single currency, and there is indeed evidence that labour market reforms in the 1990s have facilitated the labour market participation of 'marginal' workers (e.g. with low skills or limited job histories). We would judge that it is unlikely that job gains would have been as impressive under the more volatile monetary conditions and fiscal instability that used to prevail under the previous system.

As a counterpart there has been a significant productivity slowdown, with growth in output per worker halving from 1 1/2 per cent in the period 1989-98 to an estimated 3/4 per cent in 1999-2008 (table 1). This is in sharp contrast to the rapid pace of productivity growth observed in the United States over the same period, which is attributable to a large extent to a major differential in productivity growth in the services sector (Havik et al., 2008). It largely explains why the Euro Area has seen its growth rate stalling at around 2 per cent per annum, the same as in the preceding decade--despite a much faster growth in labour utilisation. On a per capita basis, output growth has matched the US performances, but this means that the Euro Area continued to lag behind US living standards, with per capita income having settled at slightly over 70 per cent of the US level.

Obviously it is tempting to assume the recent jobs 'miracle' itself has caused the productivity slowdown. A trade-off between more jobs and productivity may indeed emerge if faster employment growth leads to lower capital use per worker and if greater numbers of low-skilled workers are employed. But this combined effect is found to be small, indeed tiny in comparison with the impact of the slow development and diffusion of new technologies and best work practices (European Commission, 2007a). A number of Euro Area countries are not yet fully reaping the benefits of the information technology revolution and the spurt in the global division of labour.

Even so, there is evidence to suggest that without the introduction of the single currency labour productivity (and per capita income) would have been weaker in the Euro Area than it has been (Baldwin et al., 2008 and Barrel et al., 2008). The euro has favoured productivity as it has offered firms greater opportunities to trade, specialise and invest--owing to economies of scale, stronger competition and lower cost of capital. Growth performance may not have been brilliant, but without the euro it would have been worse.

Integrating financial markets

The creation of the single currency has contributed to the financial integration of Europe which has had many favourable effects on the functioning of the Euro Area economy. Financial capital is easily transferred from countries with an external surplus to those with a deficit and there are more opportunities for international risk sharing. The associated lower cost of capital, as noted, has contributed to productivity and growth. It is obvious though that financial regulation and supervision must keep pace with these developments, which it has not done.

The most immediate impact of EMU on financial integration was felt on the Euro Area markets for unsecured money and derivatives. Almost as soon as EMU was launched, interest rates on inter-bank deposits and derivative contracts across the Euro Area converged fully on the benchmark Euribor and Eonia rates. EMU also had a very substantial impact on the integration of the market for government bonds, which are important not only as a source of government financing but also in providing reference pricing for other financial instruments. Well ahead of the launch of EMU, there was a process of sustained convergence in yields on bonds issued by the Euro Area Member States (figure 2). Although yield spreads have widened since the onset of the financial crisis, this must be seen as reflecting exceptional circumstances. Moreover, they are still considerably smaller than the huge spreads that were common prior to the creation of the single currency. And in some ways the persistent widening of yield spreads is a good sign: it shows that financial markets price fiscal sustainability risk even in a monetary union.

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There is evidence that the elimination of currency risk has spurred corporate bond issuance while the integration of stock markets has proceeded faster in the Euro Area than at the global level. Home bias in stock markets has diminished and cross-border holdings of long-term debt securities increased. Integration of financial market infrastructure has also advanced. Progress has been made in cross-border wholesale financial services, while the Single Euro Payments Area (SEPA) is set to eliminate differences between national and cross-border retail payments.

However, financial integration remains work in progress. In particular, cross-border provision of retail financial services is lagging and regulatory and supervisory costs for financial intermediaries operating in a multi-jurisdictional environment remain high. And, more urgently, the cross-border cooperation in arrangements for crisis prevention, management and resolution need to be stepped up. The recently released de Larosiere report (de Larosiere Group, 2009) is a welcome first step.

A balanced macroeconomic policy mix

The adoption of the single currency implied a radical change in the macroeconomic policy framework. Monetary policy was centralised while fiscal policy remained in the remit of the participating countries, subject to rules, surveillance and co-ordination at the EU level. The rules required the member states to create sufficient fiscal space to let the automatic fiscal stabilisers work--which are deemed powerful in the Euro Area owing to extensive public social safety nets and progressive taxes--without breaching the 3 per cent of GDP reference value for the fiscal deficit. The Stability and Growth Pact, which aims at making fiscal discipline a permanent feature of EMU, encountered difficulties with its enforcement and was eventually reformed in 2005. The reform of the Pact, which emphasised structural adjustment and sustainability, helped to strengthen its political ownership and contributed to sizeable deficit reductions in the subsequent years.

As noted above, monetary policy in the Euro Area is fully credible, with inflation expectations firmly anchored in the ECB's price stability goal. And notwithstanding occasional difficulties in enforcing the fiscal rules, budget deficits have declined significantly, averaging 0.6 per cent of GDP in 2007 (figure 3). Without these achievements, joint monetary and fiscal stimulus to cushion a major economic downturn, as presently engineered, would have been completely out of reach or counterproductive.

A concern at the outset was that fiscal policies in the Euro Area tend to be pro-cyclical, which adds to overheating in the upturn, complicates fiscal management in the subsequent downturn and jeopardises fiscal sustainability in the long run. While pro-cyclical behaviour appears to have become less prominent with the adoption of the euro (Turrini, 2008 and Von Hagen and Wyplosz, 2008), it has not been entirely eradicated. Two episodes stand out in this regard. First, fiscal policies were eased while the dotcom bubble was inflating in 1999-2000, based on (wrong) beliefs that the economy would slide in recession in the wake of bursting of the bubble. In 2006-7, policymakers failed to appreciate the extent of the financial and housing bubbles and wrongly perceived the associated tax windfalls as 'structural'. While on conventional measures such windfalls may be recorded as fiscal tightening, it de facto is not. (2) These windfalls are now rapidly evaporating, with large deficits opening up in Spain and Ireland where housing busts are particularly severe (figure 4).

The early debates also highlighted the risk of unbalanced policy mixes, with fiscal policies working against, rather than supporting, monetary policy. Euro sceptics have pointed out that in monetary union the fiscal authorities will be inclined to run higher deficits, knowing that they can 'share the bill' with the other members via an increase in the area-wide interest and exchange rate. However, these fears have proved to be unfounded. As shown in figure 5, fiscal and monetary policies have consistently moved in the same direction--i.e. supporting each other aside from short spells of procyclical fiscal policies in the aforementioned periods 1999-2000 and, though not captured by the conventional data, 2007-8. Perhaps even more importantly, the rapid deterioration in public finances in some countries recently has been reflected in widening yield spreads rather than in a rise in the benchmark bond yield.

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It is evident from a comparison of figures 5 and 6 that in the United States fiscal and monetary policies respond much more strongly to the cycle than in the Euro Area. It should be recalled though that the United States has much weaker automatic fiscal stabilisers (smaller government, less elaborate social safety nets) than the Euro Area. Moreover, the United States has been the epicentre of economic shocks that have shaped recent cycles, so it is not surprising that policy activism is most prominent there. Moreover, this greater policy activism, notably the pronounced swings in the stance of monetary policy, may well have fuelled recent boom-bust cycles in the United States, if not their contagion to the rest of the global economy.

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Converging or diverging?

From the outset it was clear that the business cycles of the participant countries must be more or less in sync for the favourable effects of monetary union to materialise. Otherwise, the one-size-fits-all monetary policy would be too loose for buoyant economies and too tight for the others. There is evidence that business cycles have indeed become more synchronised between participating countries since the mid-1990s--possibly driven by the establishment of the Single Market in 1992 and the joint policy efforts in the run-up to the euro (Gayer, 2007).

Even so, while high frequency fluctuations have become more synchronised, there have been persistent differences in economic performance between countries in a medium-term time frame. Specifically, two of the three largest countries in the Euro Area (Germany and Italy) have experienced considerably weaker growth than the average (figure 7). Germany has been grappling with the consequences of unification in 1991, which led to large losses in competitiveness and excessive construction activity. Painful corrections on both fronts have persistently depressed domestic demand. Italy's sluggish performance has been due to continued losses in competitiveness associated with weak productivity growth (figure 8) and an industrial structure that is particularly prone to competition from emerging economies.

By contrast, most other Euro Area countries--notably those in the area's 'periphery'--have seen comparatively robust growth. Many of them have seized the opportunities stemming from globalisation, reformed their economies and have seen sharp declines in real interest rates thanks to the euro. Moreover, some of them had not yet fully completed their catching-up towards EU average living standards. Three of the four 'cohesion countries' (Spain, Ireland and Greece) have shown a strong catch-up performance, while the fourth (Portugal) has disappointed because of growth-unfriendly fiscal management.

The counterpart of this has been, however, growing imbalances within the Euro Area. Divergences in productivity growth and unit labour cost developments have proved persistent, involving major shifts in intra-Euro Area real effective exchange rates, which in some cases must have gone beyond their longer-term equilibrium values (figures 8 and 9). Moreover, several of the strong performers have been thriving on construction booms, spurred by immigration and capital inflows facilitated by the single currency and the integration of financial markets. This squeezed exporting industries, cut into competitiveness and led to persistent current account deficits (figure 10). In particular, Spain and Ireland are now facing painful adjustments, with house prices and construction activity rapidly declining (figures 11 and 12). While the financial crisis has accelerated these corrections, they were already underway.

What happened to TINA?

From the debate of the 1990s two opposing views emerged regarding the impact of the euro on participating countries' efforts to reform their economies. According to the Alternative (TINA) hypothesis (Bean, 1998), the single currency would spur governments to undertake structural reform, as this was seen as the only way to strengthen market-based adjustment so as to offset the loss of the exchange rate instrument. Others, however, argued that the disappearance of the exchange rate adjustment would rather lead to more protectionism and hence weaken the incentives for structural reform (Calmfors, 2001).

The evidence so far is not very conclusive, although on balance the single currency seems to have had little positive effect on structural reform (Duval, 2005 and Duval and Elmeskov, 2006). Analysis reported in European Commission (2008a) indicates that Euro Area countries have on average been slower to implement the structural policy recommendations under the Broad Economic Policy Guidelines (BEPGs)--a Treaty-based tool for economic policy coordination--in the period 2000-2005.

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Importantly, progress in the cross-border integration of services has been more muted than expected. Price rigidities in this area are particularly problematic since it impedes reallocation of resources from non-tradeable to tradeable sectors in countries with unsustainable current account deficits. This has led to intensified surveillance of national structural policies in the Euro Area under the Lisbon Strategy for Growth and Jobs when it was revamped in 2005.

A global role for the euro

It was clear from the outset that the euro would not quickly overtake the US dollar's dominant position. Even so, the euro has emerged as the second most important international currency alongside the US dollar and continues to consolidate this position. The euro has become a prominent currency of denomination in international debt markets and its role as an invoicing and reserve currency has been growing as well (figure 13). It has become a reference currency in the managed exchange rate regimes of about 40 countries. Accordingly, the euro serves as a stability anchor for many countries. However, Europe's external representation in international fora-such as the Bretton Woods institutions--has remained fragmented, reducing its influence despite the large number of seats that EU (and Euro Area) countries hold in them. While a problem in itself, it is also a symptom of the recurrent political resistance against policy coordination at the EU centre. This takes us to the issue of Euro Area governance.

Governance of the Euro Area

The economic governance of the Euro Area is anchored in the principle of 'subsidiarity', which leaves policy responsibilities to the participating countries wherever possible, subject to coordination where needed. Softer forms of coordination are employed in the Lisbon Strategy, whereas fiscal coordination is stricter and rules-based. Although there have frequently been frictions, the governance structure of the Euro Area has helped promote a common understanding among Euro Area policymakers of the importance of sound public finances and flexible product, labour and capital markets for a smooth functioning of EMU.

Even so, EMU's governance has at times suffered from a deficit of political and national ownership, with some Member States reluctant to translate a common understanding of policy challenges into policymaking at home. Decisive steps to improve this situation were taken in 2005, when the Stability and Growth Pact was reformed. The Lisbon Strategy for Growth and Jobs was equipped with a Euro Area dimension, and the President of the Eurogroup--the informal gathering of Euro Area Finance Ministers that traditionally precedes the meetings of the Council of Economics and Finance Ministers (ECOFIN)--henceforth appointed for a term of two years (as opposed to a biannual rotating presidency).

The Stability and Growth Pact was designed to have a dissuasive effect on countries who would be tempted to run large fiscal deficits. The Pact has a 'preventive arm', calling on countries to run surpluses or balanced budgets in 'good times', and a 'corrective arm' that may result in penalties if countries durably fail to respect the 3 per cent rule. But, as noted, underlying budgetary imbalances were built up during good times even if not to the same extent as previously. And there have been sizeable deviations from agreed adjustment paths of the fiscal position (figure 14). Moreover, attempts to comply with the 3 per cent of GDP reference value for budget deficits in some cases led to only cosmetic improvements (Buti et al., 2007, Koen and Van den Noord, 2006).

Since the adoption of a reform of the Pact in 2005, which introduced inter alia provisions for country-specific circumstances such as desirable--yet deficit-unfriendly-pension reforms, the enforcement of the corrective arm has been running much more smoothly. (3) However, further progress concerning the preventive arm would be warranted in view of the impact of unsustainable asset booms on public finances.

As noted, structural reform has remained largely within the remit of the Member States. The 'softer' form of coordination employed here has its legal basis in Article 99 of the EC Treaty, which requires all EU Member States to 'regard their economic policies as a matter of common concern and shall coordinate them within the Council'. The Broad Economic Policy Guidelines (BEPGs), to which the Treaty has assigned a central role in the coordination of economic policies, help to internalise Euro Area priorities such as the need for flexible and effective adjustment of prices and wages in the absence of internal exchange rates into Member States' reform priorities. However, the potential benefits of structural policy coordination are not yet being exploited to the full.

Another important area of EMU governance concerns the conduct of exchange rate policy. Formal or informal agreements on exchange rates with partners outside the Euro Area require a decision by the Council, while the Eurosystem (the National Central Banks and the ECB) holds the foreign exchange reserves of the Euro Area and has sole responsibility for exchange rate intervention. In practice the conduct of exchange rate policy has not encountered major problems, but inconsistencies in public statements of Eurogroup members have occasionally occurred. With the 2005 decision to appoint the Eurogroup President for a term of two years, the situation seems to have improved in this respect. However, as noted, there is still an issue of international representation.

3. The second decade: new challenges ahead

The long-standing sceptics proved largely wrong about the Euro Area. It did not fall apart (it expanded), monetary policy quickly established a credible price stability anchor, fiscal and monetary policies turned out to be mostly supportive of each other and the single currency reinforced the European single market. Not all objectives were achieved. Public perceptions of the euro remained muted at best, growth disappointed despite a measurable positive impact of the euro on activity, intra-area imbalances developed and need to be corrected, and the governance of the Euro Area keeps calling for attention. But one is left with a favourable picture of EMU's first decade overall.

However, the economic successes of EMU, laudable as they may be, were achieved in a global economic environment that--with hindsight--can only be qualified as exceptionally benign. The 'great moderation' of output and inflation volatility in the world facilitated macroeconomic policymaking in the Euro Area. New technologies and globalisation created favourable supply conditions that helped to keep inflation in check, despite soaring prices of raw materials and energy associated with rapid growth in emerging economies. Demand was buoyed by low interest rates and (perceived or genuine) wealth gains. Fiscal windfalls enabled governments to expand their budgets without immediately raising alarm bells. The tide suddenly turned when the global financial system entered its most pervasive crisis since the 1930s.

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3. 1 First priority: resolving the financial crisis

In its initial stages the financial crisis led to severe and persistent liquidity shortages and soaring risk premia on financial products. With the default of the American investment bank Lehman Brothers in September 2008 the crisis entered a second phase in which liquidity almost completely dried up and a credit squeeze paralysed economic activity. Consumer and producer confidence plummeted to historic lows and global trade declined at a pace that dwarfs the 2001--3 downturn (figure 15). No Member State of the Euro Area, or of the European Union as a whole, will escape a sharp contraction in activity and a surge in unemployment.

The origin of the crisis resides in the period of historically low global interest rates during the late 1990s and 2000s and lax regulation and supervision that failed to keep pace with (often misguided) innovation in financial markets. The crisis began in the United States, but the mechanisms at work have been global. Bubbles inflated in many markets, including in real estate markets, due to excessive leveraging. Several emerging economies in Central and Eastern Europe, but also several Euro Area countries with large current account deficits and excessive leveraging, have been severely hit by capital flows now being reversed.

To prevent a collapse of the global financial system, central banks both in Europe and elsewhere have injected massive liquidity, eased their collateral requirements and cut their policy rates. Governments recapitalised financial institutions or guaranteed bad loans and other 'toxic' assets. Several have provided guarantees on new bank lending and in some cases banks have been nationalised. Other measures include the extension of deposit guarantees (in the EU based on a coordinated initiative), limits on short selling and adjustment of accounting rules with regard to mark-to-market valuation. Several EU countries are now receiving emergency balance of payment support from the International Monetary Fund and the European Union.

The European Union has initiated a coordinated fiscal stimulus package in response to the crisis. The European Economic Recovery Plan (European Commission, 2008b) was the centrepiece of the December 2008 European Council, at which an aggregate stimulus of 1.5 per cent of EU GDP was agreed. Many third countries have also put national economic recovery plans in place. At the international level, the EU is playing a leading role in the G20 process, which has been the focus of efforts to address the downturn in global economic confidence.

It should be emphasised that without the euro the handling of the crisis would be a lot more difficult. The existence of a single central bank has facilitated the implementation of liquidity injections and transatlantic interventions in money markets. The effectiveness of fiscal stimulus is stronger in the absence of offsetting exchange rate movements and the incentives for co-ordination are stronger since each country benefits from trade-spillover effects. The presence of the EU-backed fiscal framework helps to contain 'non-Keyenesian' responses to fiscal stimulus.

The main priority in the short term for the monetary and fiscal authorities is to implement the necessary monetary and fiscal stimulus without de-anchoring inflation expectations, jeopardising the sustainability of public finances or aggravating intra-area imbalances. This requires that simultaneously sound 'exit strategies' are developed. It also requires that the fiscal stimulus is appropriately dosed according to the fiscal space and the competitiveness situation of each country. Fiscal stimulus may be counterproductive if it is not credibly viewed as limited in time, conflicting with competitiveness requirements or adding to already very high levels of public debt. It is essential also that fiscal stimulus is coordinated so as to internalise the cross-border spillover effects. The Commission's role is to ensure a right balance is struck between short-term urgency and the longer-term requirements.

3.2 Challenges and priorities for the longer run

The longer-term priorities for the Euro Area have not fundamentally changed with the financial crisis, which are to safeguard macroeconomic stability, foster economic growth and employment, enhance the quality and sustainability of public finances, ensure a smooth enlargement of the area and promote a more prominent role of the Euro Area in the global arena. Moreover, well before the crisis erupted it was clear that these priorities needed to be pursued in a world economy that continues to globalise and become more dominated by emerging economies, while aging population and environmental and energy constraints put a brake on trend economic growth.

But obviously the crisis will leave its mark also in the longer run. In particular, potential economic growth may be further weakened by lower investment associated with surging capital cost and higher structural unemployment due to industrial restructuring. This will bear on public finances, but the crisis will also affect the longer-term fiscal situation directly, via a legacy of banking rescues, fiscal stimulus and higher bond yields in some Member States. Moreover, the financial crisis has clearly demonstrated that global shocks, common to all Euro Area countries and calling for coordinated responses, take precedence over 'asymmetric' country-specific shocks. So the longer-term policy agenda of EMU has become even more pertinent with the financial crisis.

Globalisation and other secular trends

Globalisation has been progressing apace and the share of the emerging economies in the global economy is set to rise progressively (figure 16). Globalisation offers major opportunities for efficiency gains and implies lower prices and bigger choice for consumers. But it also makes a strong call on the adjustment capacity of the industrialised countries, including in the Euro Area. Declining industries will need to restructure and be replaced with new activities. Research, innovation and human capital building will become ever more important drivers of economic growth and dynamism.

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But globalisation has also led to global imbalances building up. Saving surpluses in the emerging economies in Asia have facilitated excessive borrowing in economies with developed capital markets that attracted foreign capital, notably the United States, where excessive leveraging put the stability of the global economy at risk. The financial crisis is a short-run manifestation of this risk, a release of tension emanating from these tectonic shifts. Once the dust has settled, the world economy will most likely not return to its pre-crisis state as saving behaviour across the world must change fundamentally. The external imbalances within the Euro Area in some ways replicate this global 'model' and will have to go through a similar adjustment--which has yet to begin.

One of the triggers of the financial crisis has been the surge in energy and food prices in response to the rapid growth of the world economy and changing consumption and production patterns. These price increases may well resume once the global economy recovers. In addition, with the integration of China's and India's labour force into the global economy nearing its completion, global disinflation may have run its course--and this is likely to present an increasingly stiff challenge for monetary policy.

Adverse global 'supply' shocks--including those possibly stemming from climate change--may be recurrent, and will be a common concern for all Euro Area countries.

The rapid ageing of populations is bound to leave its mark on the growth potential and public finances of the Euro Area economy. The ratio between the number of people at retirement age and those at working age is projected to double in the coming four decades. Under unchanged policies trend economic growth in the Euro Area would gradually fall to just over I per cent per annum (figure 17). This projection was made prior to the economic crisis; if the crisis proves to be protracted (and it most likely will), capital formation and productivity growth suffer and lower trend growth may result. Ageing may also reduce the adjustment capacity of the economy--particularly unwelcome if supply shocks become more frequent.

Requirements for economic policy

The imminent increase in ageing-related public expenditure calls for careful long-term fiscal planning so as to safeguard the sustainability of public finances (figure 18). This was perceived as a major challenge even before the financial crisis. Now there is no escape; fiscal positions must move towards a sustainable path as quickly as possible once the crisis is over. Moreover, as noted, official long-term projections foresee potential growth of the Euro Area to be slashed from 2 to i per cent per annum over the next decades. To reverse this tendency, both productivity and labour force participation need to be boosted, so as to strengthen competitiveness, maintain or improve living standards and facilitate fiscal management.

In addition, the adjustment capacity of the Euro Area needs to be bolstered. From the outset this was seen as a prerequisite for the success of EMU. During the first decade of EMU the adjustment capacity of Euro Area members has hardly been tested, owing to the benign economic environment. The financial crisis and the ensuing deleveraging process, along with the need for industrial restructuring (with the construction, automotive and financial industries most affected), will cater for such a test. It is essential that the necessary restructuring is not hampered by keeping ailing industries alive at all costs. It is therefore essential also that the achievements of the Internal Market remain intact and that governments do not give in to protectionist sentiments.

The Euro Area is blessed with developed social security systems, which underpin the automatic fiscal stabilisers and are welfare enhancing, especially in times of crisis. The sustainable financing of these systems is an important challenge. The projected low potential growth and the aging of the population underline the need for timely measures to avoid an explosive development of public debt, harmful cuts in public infrastructure investment or distorting tax increases. Tax and benefit systems must be shaped so as to minimise the disincentives to work. Medium-term budgetary frameworks should be developed or improved.

Well functioning financial markets are a precondition for macroeconomic stability and contribute to the growth potential and adjustment capacity of market economies. They share risk and promote the inter-temporal smoothing of consumption, and tend to increase the impact of structural reform by ensuring that capital flows 'down hill', i.e. to destination countries where the marginal return on capital is highest. Well-functioning financial markets also heighten the incentives for governments to embark on bold structural reform in labour and capital markets (Buti et al. 2009).

[FIGURE 17 OMITTED]

However, financial integration cannot be left unattended, as it can contribute--and the Euro Area has contributed-to unsustainable current account imbalances, housing bubbles and financial contagion risks (European Commission, 2007b). These risks, in turn, tend to be exacerbated by market distortions and rigidities in the real economy. The financial crisis strongly revealed these risks and has clearly demonstrated that closer cross-border cooperation on crisis prevention and resolution are a necessity along with regulatory and supervisory arrangements in the EU that are consistent with the ongoing financial integration. However, it is important to guard against excessive or misguided re-regulation so as to not throw the baby away with the bathwater. Eventually, most current EU members will join the Euro Area. But also in this area the crisis is taking its toll. It has magnified the perceived advantages of participating in a monetary union and therefore, not surprisingly, aroused renewed interest of candidate countries to join. Some of them have been running large external deficits and accumulated large foreign liabilities, often denominated in foreign currency. So it is not surprising they are seeking protection against the financial crisis--to which they are especially vulnerable--via adoption of the euro. However, candidate countries must comply with the nominal convergence criteria enshrined in the Treaty, even if this has become more demanding in the current environment.

4. A policy agenda for the next decade

The second decade of EMU will be more challenging than the first one. Trend growth will be slower and the sustainability of countries' welfare states at risk. The first priority now is to manage the crisis and to implement a viable exit strategy. A balance has to be struck between short-term emergency measures and longer-term priorities. The EMU@10 report offers a policy agenda to meet these longer-term priorities. It is built on three pillars: broader and deeper policy coordination and surveillance, a stronger international role for the Euro Area and more effective governance.

4.1 The domestic policy agenda: propping up coordination and surveillance

Deepening and broadening of surveillance Countries which accumulated large macroeconomic imbalances are those that are most vulnerable to the current crisis. Unsustainable boom conditions put an overly favourable gloss on their--now rapidly deteriorating-fiscal positions while the financing of their typically large current account deficits became problematic with the onset of the crisis.

[FIGURE 18 OMITTED]

Fiscal surveillance did not work properly in the 'good times' that preceded the financial crisis. With the crisis unfolding, deficits in Euro Area countries are now soaring, with four of them exceeding the 3 per cent of GDP mark by large margins--and more trouble ahead. Fiscal surveillance must be improved, with the fiscal impact of asset cycles properly taken into account. Countries should commit to realistic time paths for public expenditure for the medium run and allow automatic stabilisers to operate around this central path insofar as the Treaty deficit and debt rules permit this. Member States should shape their expenditure and funding plans in ways that benefit growth, competitiveness and employment.

The crisis has clearly exposed the harmful nature of divergent external and competitiveness positions within the area. Surveillance must be broadened to include competitiveness and balance of payment issues. The new EU member states still outside the Euro Area should be included in this regular surveillance. Due to the (in itself desirable) large capital flows to them they have been susceptible to overheating and the formation of bubbles--which now cause havoc as they burst. This may affect their macroeconomic stability as well as their prospects of Euro Area membership. Enhanced coordination and surveillance are inevitable, and if the crisis is to trigger this, it has at least served one purpose.

The proposals in EMU@10 do not require revisions of the Treaty. Article 99 of the Treaty stipulates that "Member States shall regard their economic policies as a matter of common concern" and "shall coordinate them within the Council", so the principle of broad and deep policy coordination and surveillance has a firm legal anchor. A first step towards implementing the proposals was taken by the Council last autumn, when it mandated the Eurogroup to review the competitiveness position of the Euro Area member states on a regular basis.

Integrating structural, financial and macro surveillance The crisis has demonstrated the importance of spotting macro-financial risks early and heightened the need for reforms in labour and product markets to boost potential growth and the adjustment capacity of Euro Area Members.

Structural policy was seen as essential for a well functioning Euro Area from the outset. It supports growth and smoothes adjustment to external shocks. Moreover, in a monetary union the multiplier effects of structural reform tend to be larger since the reformers will more easily attract foreign capital, not hampered by exchange risk. The Lisbon Strategy is thus of particular importance for the Euro Area. In particular, the competition in services markets needs to be strengthened, the functioning of the labour market improved and innovation promoted. Against this backdrop the surveillance of structural and macroeconomic policies in the Euro Area must be integrated. Lisbon and Maastricht are not that far apart. In fact, they have come even closer with the financial crisis.

If there is anything the financial crisis has demonstrated it is that close cooperation of EU Member States is crucial for financial stability. Of course there is no point in restricting this to the Euro Area--not least since the EU's largest financial centre (London) is located outside the Euro Area. But the Euro Area should play a leading role because of the particular importance of a well-functioning financial system for the single currency. Euro Area members have been reluctant to play this role until recently, but the acute financial stability risks in the autumn of 2008 drove Euro Area Heads of State and Government together for the first time in history. This precedent should clear the way for macro-prudential surveillance at the centre.

4.2 The external agenda: a global role for the Euro Area

The crisis has clearly shown that there is a need for stronger global governance. Being the second largest currency union in the world, the Euro Area is naturally disposed to be a major contributor in this regard.

The single currency put the Euro Area on the map as a global financial player. Governments in the Euro Area draw financial benefits from the use of the euro as an international reserve currency, and not only eliminated Member States' intra-area exchange rate risk but also reduced their global exchange rate risk because international transactions are increasingly invoiced and settled in euro. Conversely, with massive amounts of financial assets denominated in euro circulating, Euro Area monetary policy decisions are felt all across the globe. Even the smallest Euro Area countries play, at least indirectly, a role in the international economic and financial power play.

It is thus essential that Euro Area countries work together towards a common strategy that reflects the economic weight of the area in the pursuit of stronger global governance. This should of course be embedded in an overarching strategy for the European Union as a whole-there is no point in creating division. But as a minimum the Euro Area should speak with one voice in the international dialogue, for example on issues like exchange rate policies and the surveillance of the global financial system. This is, unfortunately, not yet the case--with the exception of recent dialogues with China.

As part of this strategy the Euro Area could start streamlining its representation in the international institutions that together govern the financial system in the world. European countries are often blamed for being overrepresented in institutions like the International Monetary Fund, but in practice Europe does not draw any benefit from this at all since its negotiation position is often undermined by recurrent internal disputes. Europe may be better off with less seats and a more effective coordination of positions. That would also strengthen the international dialogue by creating room at the table for the emerging countries.

4.3 A better governance of the Euro Area

The financial crisis has made it clear that coordination of economic policies at the Euro Area level is indispensible. Economic governance in the Euro Area is guided by the EU principle of 'subsidiarity'; government action should take place at the lowest possible level. However, cross-border spillovers of policy action call for coordination and this requirement has become more pertinent with the current policy response to the crisis.

As recent events have illustrated, the ECOFIN Council remains at the core of the governance of the Euro Area. This is where policy decisions are formally taken and where the views not only of the Euro Area countries but also of their EU peers outside the Euro Area (who are prospective Euro Area members in most cases) are represented. It also covers a broader set of policy areas-ranging from financial markets to taxation--than the Eurogroup does and is therefore best positioned to oversee the necessary tradeoffs across policy areas.

The Eurogroup should serve as a platform for deepening and broadening of coordination and surveillance in the Euro Area--a role which it is progressively assuming. It should focus on the prevention of pro-cyclical or unsustainable fiscal policies ex ante and reinforce the 'preventive arm' of the Stability and Growth Pact to help countries to prepare for fiscal stress associated with aging populations and also the unwinding of a presumably huge legacy of implicit liabilities--if not outright debt- after the financial crisis is over. To rein in or prevent the recurrence of intra-area balance of payments problems, the Eurogroup should develop guidelines on policies that affect competitiveness.

The Commission should assume a strong supportive role and better integrate EMU-related concerns in the whole range of its policy proposals. It should enhance its fiscal and macroeconomic surveillance and reinforce its role in fostering economic and financial integration--sorely needed in an environment where protectionist instincts risk resuscitating. It should play an active role in improving the cyclical adjustment of fiscal positions in cooperation with the Member States. Considering the external policy agenda, the Commission should strengthen its role in the international dialogues and fora alongside the Member States and take an intellectual lead in debates on global institutional reforms.

An effective governance of the Euro Area is also an important precondition for a smooth enlargement of the Euro Area. The second decade will undoubtedly see the adoption of the euro in most EU Member States, notwithstanding (or perhaps because of) the financial crisis. The accession criteria are enshrined in the Treaty, so Euro Area accession countries will need to respect these. The Commission will continue to provide an honest assessment of countries' readiness to join on the basis of the criteria while the Eurogroup and ECOFIN Council will continue to issue policy advice in the pursuit of a smooth accession of these countries, several of which are suffering more than average from the consequences of the crisis.

5. Conclusions

Economic and Monetary Union emerged from the currency crises in the early-1990s and the ensuing breakdown of ERM mark 1. Although it met a lukewarm reception; it represented a leap forward in European monetary, economic and political integration. The transition to a monetary union in 1999 went smoothly, the euro instantly became the world's second international currency, the ECB achieved a strong reputation and several new EU members in the East have gained membership of the Euro Area.

With hindsight the first decade of EMU may not have been particularly challenging and economic conditions are now deteriorating very rapidly. With countries facing very different exposures to the crisis the risk of conflict is real. But speculation that this could lead to a break-up of the Euro Area is ill-founded. Europe's post-war history is one of progress and compromises, and this is likely to continue, not least since the euro proves an invaluable asset from which each country derives major benefits.

It is useful to recall that in its initial stages the US federal system allocated very limited powers to the centre, with the system evolving towards more federalism with each major crisis (Bordo and James, 2008). This may also be Europe's future. The coordinated policy responses to the crisis may well portend another leap forward in the integration of the Euro Area and, ultimately, the European Union as a whole.

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The public's perception of the euro

Since the introduction of the cash euro, the European Commission has conducted regular opinion polls to monitor citizens' attitudes towards the single currency (Eurobarometer). According to these polls people are aware of the microeconomic benefits of the euro, such as the reduction of transaction costs, the ease of travel and the increase in price transparency. But they remain more sceptical about the euro's macroeconomic benefits such as price stability and stronger growth. Moreover, while around two-thirds of respondents consider the euro to be "a good thing for Europe"; less than half consider it to be a "good thing for their country". Men, younger people and citizens with higher education or higher incomes generally judge the euro more favourably than women, older people and citizens with lower education or income. (a)

Research suggests that popular support for the euro is correlated with inflation perceptions. Inflation perceptions, as measured by the European Commission's Consumer Surveys, increased significantly with the euro cash changeover in 2002. A number of factors have been identified which could explain this phenomenon. These include the relative price increases for frequently purchased goods (food, energy), the steep increase in house prices in many countries, low increases in disposable income and various psychological factors.(b) It is notable that respondents show little awareness of the actual inflation rate though; two-thirds either have a too high estimate of the actual inflation rate or admit not to know it.

Notes: (a) Dohring, B. and Moronu, A. (2007), 'What drives inflation perceptions? A dynamic panel analysis', European Economy--Economic Papers, 284. (b) Jonung, L. and Conflitti, C. (2008), 'Is the euro advantageous? Does it foster European feelings? Europeans on the euro after five years', European Economy--Economic Papers, 313.

NOTES

(1) Concretely, countries are required to move towards and sustain a fiscal position 'close to balance or in surplus' over the medium term and will be subject to corrective measures if the fiscal deficit exceeds 3 per cent of GDP and/or if public debt fails to converge towards or below 60 per cent of GDP, unless 'special circumstances' can be demonstrated. Participating countries submit annually a Stability Programme which contains a record of current and expected fiscal outcomes and on which the assessment of compliance by the European Commission and the European Council is based.

(2) According to conventional methodologies to cyclically adjust fiscal positions, only the impact of the GDP cycle is considered while the fiscal impact of asset cycles is assessed at best in qualitative terms.

(3) In March 2005 a reform of the Stability and Growth Pact was adopted by the ECOFIN Council. The 'preventive arm' of the Pact henceforth focused on structural balances and allowed the possibility of adopting medium-term budgetary objectives that were better tailored to a country's specific circumstances, while permitting some flexibility in the pace at which this objective should be achieved, depending on a country's structural reform efforts (notably pension reform). In the 'corrective arm', the economic circumstances that could lead to a waiver of the excessive deficit procedure were reinterpreted and clarified. In addition, some flexibility was also introduced regarding the length of the adjustment period, inter alia to take into account possible adverse economic events with major unfavourable consequences for government finances.

Marco Buti and Paul van den Noord, Directorate General for Economic and Financial Affairs, European Commission. e-mail: Paul.VANDENNOORD@ec.europa.eu and Marco.Buti@ec.europa.eu. The authors have written this article in a personal capacity. The views expressed are not necessarily those of the European Commission.

Table I. Growth and employment, average rate of change
per annum, per cent

 1989-1998 1999-2008
Euro Area
Real GDP 2.2 2.1
Real GDP per capita 1.9 1.6
Level of real GDP (US=100) 73 72
Employment 0.6 1.3
Labour productivity 1.6 0.8

United States
Real GDP 3.0 2.6
Real GDP per capita 1.8 1.6
Employment 1.5 1.0
Labour productivity 1.5 1.6

Source: European Commission, OECD.

Figure 13. Currency shares in foreign exchange reserves

 1999 2007

USD 71% 65%
EUR 18% 26%
JPY 6% 3%
GBP 3% 5%
Other 2% 2%

Source: European Commission.

Note: Table made from pie chart.

Figure 16. Geographical composition of world GDP in 2005 and 2050

 2005 2050

Europe 26% 18%
Other, 12% 9%
China, 10% 22%
North America, 35% 37%
Japan, 14% 8%
India, 3% 6%

Source: European Commission.

Note: Table made from bar graph.