Current fiscal and monetary policy issues in the euro area
Speech by Dr. Willem F. Duisenberg, President of the European Central Bank, Taxpayers Association of Europe's, Taxpayers' Award 2001, Brussels, 12 December 2001.
It is a great pleasure for me today to accept the Taxpayers Association of Europe's prize for the year 2001 and I would like to thank you very much for this honour. In awarding me the "European Bull", you also recognise that your association and the ECB share some common goals.
Indeed, high taxes and inflation have much in common. Both, for instance, reduce the purchasing power of citizens. This similarity is also reflected in the economic literature on the so-called inflation tax. In this literature, money holdings are the tax base, and inflation is the tax rate. And history shows inflation to be a tax which is particularly heavy on those who have less capacity to shelter from a decrease in the purchasing power of money, usually those in the lower income groups of society. Moreover, inflation causes a number of distortions which negatively affect welfare, as do high taxes.
Today, I would like to speak to you about recent budgetary developments and the outlook for fiscal policy in the euro area. In doing so, I will of course not leave the subject of taxes untouched. At the end of my speech, I would like to say a few words on the relationship between monetary policy and fiscal policy.
The European fiscal framework
Discussing fiscal policy in Europe is only useful with reference to the budgetary provisions in the Maastricht Treaty and in the Stability and Growth Pact. These legal provisions govern fiscal policies in Europe, and provide guidance to the national fiscal authorities.
The budgetary provisions in the Maastricht Treaty, which limit the level of government deficits and government debts, have been key to achieving sounder public finances. In addition, the Stability and Growth Pact, agreed upon in 1997, introduced the goal of budgetary positions close to balance or in surplus as a medium-term objective for Member States. In this respect, there is a well-developed surveillance procedure, requiring countries to submit medium-term budgetary plans in the form of stability programmes every year. In a case where a country were to exceed the 3% limit on the deficit ratio, a procedure would be set in motion that required adjustment measures and could ultimately lead to sanctions. Finally, the Maastricht Treaty prohibits monetary financing of deficits and debt and rules out the Community or Member States being liable for the debt of national governments or any other public authorities (the so-called "no bail-out" clause). All in all, this framework should be a sufficiently strong deterrent against unduly lax fiscal policies.
The budgetary outlook
In recent years, these provisions have ensured good progress towards the goal of achieving sound budgetary positions. With an eye on joining monetary union, countries intensified fiscal consolidation, reducing deficits from over 5% of GDP at the beginning of the 1990s to around 1% last year. Most of the 12 euro area countries now have balanced budgets or surpluses, in line with the requirement of the Pact. In view of still high debt levels in some countries, and the adverse consequences of population ageing on budgetary expenditures, countries may be advised to go even further and seek significant surpluses over the medium term. If not, there is a risk that in the future taxes will have to be raised again to finance increasing pension and healthcare expenditure.
In the euro area as a whole, unfortunately, progress towards achieving sound budgetary positions has now come to a standstill. It is apparent that most countries in the euro area will not achieve the budgetary targets they set themselves for this year. This deterioration of the budgetary outlook was initially caused by large tax cuts which were welcome but which were not compensated by sufficient expenditure restraint. Furthermore, the current slowdown in macroeconomic growth has an adverse impact on fiscal balances. Lower economic activity automatically results in lower tax receipts and higher unemployment-related government expenditure, causing a deterioration in fiscal positions.
The majority of the euro area countries have used good economic conditions in the past to achieve healthy public finances. As a result, they are now in a reasonably comfortable position. These countries can now allow the worsened economic conditions to have a negative effect on public finances without taking countervailing fiscal action. By allowing these so-called automatic stabilisers to operate freely, demand is supported, and economic fluctuations may be dampened. This is a major advantage for those countries that managed to achieve budgetary balances or even surpluses.
However, some countries have not sufficiently grasped the opportunity to achieve a fiscal position close to balance or in surplus. The latest available forecasts indicate that government deficits in these countries may be in the vicinity of 2% of GDP or even exceed that level this year and in 2002. This is uncomfortably close to the 3% limit. These countries do not have full leeway to allow the automatic stabilisers to operate freely, and in the current circumstances, meeting the targets of the Stability and Growth Pact needs to be given continued priority. Countries with remaining imbalances are of critical importance in this regard. If they failed to meet their commitment to reach sound positions in the agreed timeframe, they would not only put the credibility of their own fiscal strategy at risk, but also that of the Stability and Growth Pact. In such a case, spillovers from lax fiscal policies could be detrimental to maintaining the favourable long-term financing conditions in the euro area. It would also endanger the stability progress achieved in the euro area in the 1990s.
What is the role of taxation?
Taxation is of course a very important issue. Central bankers need to monitor it closely, for several reasons. At least in the short run, changes in taxes affect prices. Changes in indirect taxes typically feed directly into consumer prices. Lower direct taxes and social security contributions affect the cost of labour, and can thus contribute to lower consumer prices. There are also many more indirect channels through which changes in taxes affect price developments.
More importantly, lower taxes and tax system reforms have an important role to play in fostering medium-term economic growth. The European Union has set itself an ambitious goal of achieving growth rates around 3% per year. Changing the level and composition of taxes would help to achieve this goal. Compared with our main economic competitors, it is obvious that tax rates in Europe are still quite high. Lower taxes may lead to a higher quantity and quality of labour and capital, which increase the potential growth rate of the economy. In particular, lower taxes raise the incentive for people to take up further education and training, as a larger share of the additional income they could earn as a result stays in their hands. Similarly, investors and entrepreneurs benefit from lower taxes, which enhances the dynamism of the economy. In addition, lower taxes can increase the pool of savings available for investment. In these ways, lowering taxes can contribute to solving two of the most pressing economic problems facing Europe: high unemployment and relatively low potential economic growth.
However, a necessary condition for this to hold is that tax reductions are financed in an economically responsible way. Introducing tax cuts without offsetting expenditure restraint results in fiscal imbalances, putting at stake the consolidation progress made so far. Especially in the countries that have not yet established sound public finances, this is not a route to follow. Furthermore, the short-term economic effects of deficit-financed tax cuts may be limited if economic agents doubt the sustainability of the cuts. Only if tax reductions are accompanied by expenditure restraint can the achieved fiscal consolidation be safeguarded.
Another point worth stressing is that expenditure restraint may reinforce positive medium-term effects of tax cuts. Spending reforms can improve the efficiency of the public sector by reducing unproductive government spending. Responsible tax cuts may then have significant growth effects in the medium term. Combining fiscal prudence with structural fiscal reform will be a major challenge for policy-makers in the future.
Monetary policy considerations
Let me finally add a few thoughts on the relationship between monetary policy and fiscal policy. The ECB closely monitors fiscal policy since this is one of the main areas where significant shocks to price stability – and also to long-term interest rates – can originate. In fact, many episodes of high inflation in the past were related to a mismanagement of public finances combined with a very accommodative monetary stance.
While the ECB takes fiscal developments throughout the euro area into account in setting monetary policy, its monetary policy framework does not envisage any mechanistic reaction to fiscal policy changes. Monetary policy decisions are based on a much broader information set. This includes a comprehensive analysis of all economic, financial and monetary factors which could threaten the maintenance of price stability over the medium term. Having said this, disciplined and sound fiscal policies combined with lower tax levels, as well as fiscal and structural reforms, support the ECB's stability-oriented policy, for example by reducing inflation expectations and supporting potential growth.
The maintenance of price stability in the euro area is the primary objective of the ECB, assigned to it by the Treaty establishing the European Community. A credible and lasting maintenance of price stability is the best way for monetary policy to enhance the welfare of euro area citizens. This is rooted in the long-standing experience of the participating national central banks, and, moreover, the experiences of the 1970s demonstrated that central banks are ill-suited to fine-tune economic developments. Actively using monetary policy to pursue output objectives only feeds inflation without yielding lasting increases in real activity. By contrast, by focusing on its mandate, and therefore avoiding both inflation and deflation, the central bank can provide the stable environment and the incentives required for fiscal and structural policies to enhance the productive potential of the economy.
To support and safeguard the pursuit of price stability, the Treaty endows the ECB with a high degree of institutional independence from fiscal authorities and ensures it the necessary autonomy from any political interference.
The ECB has announced a medium-term oriented monetary policy strategy setting out how it goes about achieving its Treaty mandate. In particular, to enhance clarity, to anchor expectations and to offer a yardstick against which the ECB can be held accountable, the Governing Council of the ECB has provided a numerical formulation of price stability by defining it as "a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%".
On the basis of its strategy, the ECB regularly explains its monetary policy decisions and its assessment of economic developments. In doing so the ECB has gone beyond the already stringent reporting requirements foreseen in the Treaty, meeting very high standards of transparency and accountability. Explanations of monetary policy decisions are regularly provided in the Monthly Bulletin, in the speeches given by members of the Executive Board of the ECB as well as in my testimonies at the European Parliament. In the press conference I give every month, the main arguments underlying the Governing Council's decisions are explained in detail.
With this high degree of transparency, the ECB provides the public and the fiscal authorities with extensive information to understand and thus to anticipate responses of monetary policy to economic developments, including those concerning fiscal variables.
Conversely, on the basis of its mandate and in full recognition of its independence, the ECB welcomes a regular exchange of views and information with the other policy-making bodies of the European Union. The ECB has a natural interest in being informed about fiscal and structural policy measures taken in the euro area as these may also influence price developments and the transmission mechanism of monetary policy.
All this exchange of information should not, however, be seen as a form of ex ante co-ordination of monetary policy with other policies. Indeed such a co-ordination is explicitly ruled out by the Treaty, which foresees a clear division of responsibilities and policy objectives. The clear allocation of responsibility sets proper incentives for all policy actions and ensures genuine accountability.
In fact, ex ante co-ordination of fiscal and monetary policy would risk distracting national governments from carrying out their own responsibilities. Moreover, political pressures on monetary policy to facilitate or "reward" developments on the fiscal and structural side would raise uncertainty about the objectives of monetary policy, thereby endangering credibility and reducing the benefits associated with the maintenance of price stability.
All authorities should thus act within a clear, medium-term-oriented policy framework and pursue their objectives in a transparent manner.
Let me conclude. For the first time since agreeing on the Stability and Growth Pact, economic growth is significantly lower than previously expected. This puts the European macroeconomic framework to a real test for the first time. In a few countries that still have high deficits, the prospects for a sound budgetary position are not improving sufficiently. This implies that these countries must give full priority to consolidation. The countries that have used strong economic conditions in the past to pursue fiscal consolidation, on the other hand, are now in a position to let the automatic stabilisers operate freely.
Combining sound budgetary positions with ways to enhance the growth-supporting role of government expenditure and revenue is a major challenge ahead. Tax and structural reforms, backed by expenditure restraint, have significant positive effects on employment and economic growth in the medium term; a conclusion which is supported by economic research. They thus represent an important contribution to citizens' welfare. At the same time, such reforms make it easier for the ECB to maintain price stability.