Policy mix in EMU: how well has it managed the European business cycle ?

Policy mix in EMU: how well has it managed

the European business cycle ?

US and Euro Business Cycles USA :

Cyclical experience and culture,

Statistical and analytical tools of cyclical dynamics

contribute to the governance of the growth:

long expansions and strong but short recessions

Euro area: Since 25 years, the return of business cycles, due to liberalization of controlled economy, but :• Euro-cycles are shorter and more irregular than in USA

• Expansions are lagged and damped, compared to USA • Recessions are sensitive to financial influences from USA

US and Euro Area GDP Cycles (% of trends)

-7

-6

-5

-4

-3

-2

-1

0

1

2

3

4

5

1960

-1

1962

-1

1964

-1

1966

-1

1968

-1

1970

-1

1972

-1

1974

-1

1976

-1

1978

-1

1980

-1

1982

-1

1984

-1

1986

-1

1988

-1

1990

-1

1992

-1

1994

-1

1996

-1

1998

-1

2000

-1

2002

-1

Cycle global américain

Cycle global européen

USA

Euro area

Shortness and irregularity of cycles have long term consequences, by the way of firms’ depressive expectations By using the cyclical gap between USA and Europe, dynamic US growth absorbs excess of european savings, due to the weakness of the incentives to investment in EuropeSensitivity of euro-cycles to US monetary and financial influences is an excellent justification for the creation of euro...

... but also for the completion of this creation by an active exchange rate policy.

Long term trend growth rates

of US and Euro Area GDP

0

1

2

3

4

5

6

19

60

-1

19

62

-1

19

64

-1

19

66

-1

19

68

-1

19

70

-1

19

72

-1

19

74

-1

19

76

-1

19

78

-1

19

80

-1

19

82

-1

19

84

-1

19

86

-1

19

88

-1

19

90

-1

19

92

-1

19

94

-1

19

96

-1

19

98

-1

20

00

-1

20

02

-1

SlUSr

SlEUr

USA

Euro Area

A partial and reversible unification of Euro Area cycle

The common and symmetrical component of Euro Area cycles explains at most 50% of the member countries’ specific cyclical dynamics. After the euro: Durable persistence of asymetries among countries, due to a mix of differences concerning:

• Dynamics of internal demand• Sensitivity of competitiveness to common exchange rate of euro• Political national choices

The suited management of these persistent differences is an important question for the macroeconomic coordination of Euro Area

-4

-3

-2

-1

0

1

2

3

4

Euro-zone

Belgian and Euro-zone Cycles (% of trend)

Belgium

-10

-8

-6

-4

-2

0

2

4

6

8

10

FinlandEuro-zone

Finnnish and Euro-zone Cycles (% of trend)

The Enlargement to the Eastern European countries adds a dimension to this problem

GDP Growth Rates of EU15 and NMC10 1996-2006, ± standard deviation for NMC10

Source: DG Ecofin

To manage the cycle is to consolidate expansion, not to wait for recession passively

When the economy is in expansion stage, the duration of this stage is uncertain: managing fiscal policy by expecting a short duration (two or three years) is to lose the game before to play !

The consolidation of the expansion depends on:• the accomodation by monetary policy • the quality and efficiency of public expenditures• the continuous creation of high quality jobs

The ability to respect a sensible medium term target for public debt depends on the durability of expansion

During the first business cycle of Euro Area, two critical moments

First critical moment : small transitory inflationist shocks (food, energy) during the first part of 2000, while the expansion is not strong enough yet and the unemployment is still high.

The ECB has well accomodated the start of Euro Area but the 2000 tightening is precipitate, particularly if the vulnerability of real wages and household consumption to prices shocks is taken into account. Consequences:

• a negative impulse to the domestic demand of the Euro area, before the negative shock of 2001 on export • this impulse is prolonged by the rise of precaution savings

INFLATION AND INTEREST RATES IN EUROPE, 2000-2001

0

0,5

1

1,5

2

2,5

3

3,5

4

4,5

5

In %

Main refinancing rate

Inflation rate (HICP t/t-12)

Core Inflation rate (HICP t/t-12)

-0,5

0

0,5

1

1,5

Quarterly variation (%)

GDP growth rate

Exportations

Domestic demand

Contributions of demand components to the Eurozone growth rate (2000-2001)

Savings rate of european households (% of income)

Source: Economic Outlook 75, May 2004

Second critical moment : the pro-cyclical management of the slowdown 2001-2003

After the downturn of 2001, stabilizers play freely first but, subsequently, fiscal policies in Euro Area are based on the hypothesis of a fast recovery, from 2002. The fiscal impulse (the variation of structural public deficit) is too brief and small to consolidate the expected recovery. When this expectation is denied by the persistent slowdown , restrictive fiscal policies become pro-cyclical. Moral of this episod: the stability pact is not adapted to the appropriate management of a slowdown which is rather persistent than strong (approximately three years !). A big difference with USA : the epicentre of the 2001 downturn is in USA but the slowdown is more persistent in Euro Area !

The recovery of the Euro Area,

since the middle of 2003

Compared with previous recoveries (1975, 1982, 1999), the 2003 recovery is particularly sluggish (as in 1993). A weakness of both domestic demand and external trade:

• stagnation of real wages and consumption • high level of Euro exchange rate

Both factors are differently distributed between countries:• A decrease of the household consumption in Germany• A strong loss of export markets for Italia• An intermediary position of France

A striking lack of coordination adapted to this heterogeneity

2003: a sluggish revival of GDP, in Euro Area, compared to previous upturns

Recovery 2003

Source: Diagnostics, Prévisions et Analyses Economiques, n°61, Février 2005, Ministry of Economy, Fiannces and Industry, France

What is true for GDP is also verified for domestic demand of Euro Area…

Source: Diagnostics, Prévisions et Analyses Economiques, n°61, Février 2005, Ministry of Economy, Finances and Industry, France

Recovery 2003

… and for the contribution of the external trade to the Euro Area growth

Source: Diagnostics, Prévisions et Analyses Economiques, n°61, Février 2005, Ministry of Economy, Finances and Industry, France

Recovery 2003

Conclusions

The appropriate management of the cycle needs an intertemporal coordination between institutions managing the policy mix (ECB, Commission, Governments): the right decision at the right time ! This coordination is easier if:

these institutions share a common view of the potential growth (but does ECB believe in 3% Lisboa growth target ?) Short term policies are not paralysed by excessive constraints : it is a justification for criteria of long run sustainability of public debt.

A spatial coordination is also necessary, in order to take persistent differences of national cyclical dynamics into account.

• An active exchange rate policy should be part of this coordination

• Fiscal common criteria should admit a sufficient autonomy of the national policies in order to correct idiosyncratic shocks and drifts.