xperience to Date Paul van den Noord Economics Department OECD 1 - - PowerPoint PPT Presentation

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xperience to Date

Paul van den Noord Economics Department OECD

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Monetary union in Europe: progress and headwinds

Exchange risk disappeared, financial markets

deepened, interest rates converged, competition strengthened

The euro system weathered major stress tests (911,

the introduction of the cash euro)

But growth has been sluggish, fiscal policies fared

less well, the Stability and Growth Pact lost credibility

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The beauty contest

Inflation must be close to best performers Fiscal house in order (deficit 3% of GDP, debt 60% of

GDP)

Long term interest rates must be low (close to best

inflation performers)

Two years in ERMII But convergence stalled when the euro was created

....

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1996 1997 1998 1999 2000 2001 2002 2003 0.0 0.5 1.0 1.5 2.0 0.0 0.5 1.0 1.5 2.0

• A. Standard deviation of inflation

Euro area (1) United states (2)

• 1.0
• 0.5

0.0 0.5 1.0

• B. Inflation differential against the aggregate rate (3)

United States

West urban Northeast urban Midwest urban South urban

• 1.0
• 0.5

0.0 0.5 1.0

Smalls Italy France Germany

Euro area

• 2

2 4 6 1 2 3 4

Inflation (1)

• C. Correlation between inflation and activity (3)

Output gap (4)

R2 = 0.26 DEU FRA ITA AUT BEL FIN GRC IRL NLD PRT ESP LUX

2 4 6 8 1 2 3 4

Inflation (1) Real GDP growth

R2 = 0.42 DEU FRA ITA AUT BEL FIN GRC IRL NLD PRT ESP LUX

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“Start-up shocks” worked out favourably for the smaller countries

Interest rate shocks (monetary union meant sharply

lower interest rates in some countries with high inflation histories)

Exchange rate shocks (initial misallignments, sharp

drop in the euro exchange rate in the first two years)

These shocks produced inflation, low real interest

rates and housing booms in small economies.

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Macroeconomic management more challenging in euro area if ...

Countries are frequently hit by “asymmetric shocks” Countries differ in their responses to common shocks Market adjustment to shocks is slo and automatic

fiscal stabilsiers weak

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monetary union will reduce asymmetries

Greater integration of product markets means dilution

• f shocks

Greater integration of financial markets and

diversification of portfolios means dilution of shocks

Risk of asymmetric policy shocks diminishes, risk of

asymmetric exchange rate shocks vanishes

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Fiscal co-ordination is essential

Spillovers result in high interest rates elsewhere Automatic stabilisers are sorely needed in the face of

asymmetric shocks

Fiscal sustainability must be safeguarded

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The longer term: integration will lead to three possible scenarios

Concentration (US model, mobile labour and capital

and stong agglomeration effects); implies strong growth but regional disparity of activity (not income)

Dispersion (Mobile capital, immobile labour, flexible

real wages); implies weaker growth but even distribution of activity and income

Polarisation (Mobile capital, immobile labour, rigid

real wages); implies strong growth but uneven distribution of activity and income (motivates structural funds)

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The Irish miracle

Impressive employment and productivity growth Massive foreign direct investment inflows helped by

strategic location

EU membership gave US businesses easy access to

European markets

EU aid cleverly used Wage moderation, pruden fiscal strategy An ICT front runner

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Decomposing potential output growth in Ireland Annual average, percentage points

1983- 1993 1993- 2003 Potential GDP growth 5.4 7.2 Potential labour productivity growth 4.8 4.5 Potential labour input growth 0.5 2.6 Contributions from Working age population 1.1 1.8 Trend participation rate 0.1 1.0 Change in structural unemployment

• 0.1

0.9 Hours worked per person

• 0.7
• 0.9

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To sum up

Start up shocks worked out favourable for the smalls Loss of policy sovereignity may be offset by greater

flexibility and integration

Investment opportunities open up in a credible low

inflation environment

Integration may carry social adjustment cost due to

specialisation

Benefits will be higher if policy settings are right

(strong human capital and technology, flexible markets, fiscal prudence)