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International Monetary Fund: Concluding statement of the IMF mission on the economic policies of the euro area

30 January 2001

The Concluding Statement of the International Monetary Fund (IMF) mission describes the preliminary findings of IMF staff at the conclusion of a visit to euro area authorities, including the European Central Bank.

This mission was undertaken as part of the regular consultations on the economic policies of the euro area under Article IV of the IMF's Articles of Agreement.

The views expressed in the Concluding Statement are those of the IMF mission.

1. In its fourth year of recovery, the euro area - which has recently welcomed Greece as its newest member - continues to make marked economic progress, undoing a legacy of lackluster growth and disappointing labor market outcomes. With broadly stable prices underpinned by a credible monetary policy, real GDP in all likelihood expanded by a robust 3 1/2percent in 2000, and unemployment declined by almost a full percentage point to 9 percent. However, the global environment is shifting - from being supportive of euro area growth but risky to price stability in 2000, to the reverse on both counts in 2001. The task ahead is to maintain the area' s strong economic performance amidst changing circumstances. While this is of course vital to the area itself, it is also central to the international community which looks to the euro area to help sustain global growth in a context of weakening growth elsewhere.

2. At least as remarkable as the strength and duration of the area's expansion - and even more comforting - is its roots in domestic demand, which has resiliently grown at a pace of some 3 percent per annum since late 1997 in the face of sometimes considerable international turbulence. Basically, improved macroeconomic fundamentals, especially sustained wage moderation, and supportive policies have fostered a favorable investment climate and steady employment creation, laying the basis for the virtuous growth circle that is needed to roll back unemployment. These auspicious internal dynamics seem set to continue: confidence indicators suggest that private consumption and investment growth remains on a steady path.

3. In contrast, the forces shaping the euro area's external environment have reversed in recent months. First, with faltering growth in the United States and renewed weakness in Japan, global demand seems poised for a possibly marked loss of momentum. Second, world oil prices have receded from their peaks and, according to the oil futures market, are likely to settle at levels significantly lower than expected earlier. And third, the prolonged slide of the euro came to a halt at year end, as market sentiments against the currency subsided, in part because of the official interventions of the early fall.

4. Considering the proven resilience of domestic demand, real GDP growth close to potential for 2001 and 2002 remains the most plausible central scenario. The impact of the change in the external environment is likely to be moderate mainly because of the relatively closed structure of the euro area economy and the scope for corrective policy action in the United States. The risks, however, appear to be on the downside. The global imbalances accumulated in the 1990s could trigger a swift shift in momentum when a turning point is reached. Moreover, global integration carries with it the potential for rapid transmission of adverse confidence effects that might undermine internal demand and an orderly adjustment in exchange rates.

5. Against this background, there are two main readings for the inflation outlook over the medium term. On one view, the prospect of a global demand slowdown, the reversal in the run up of oil prices, the apparent break in the euro's depreciation trend, and - critically - increased confidence that wage moderation will continue (as it has in the face of a significant acceleration in prices), suggest that the odds have shifted against last year's concern about upside risks to price stability. On another view, the possibility that price and wage setters might attempt to restore eroded profit margins and purchasing power as slack is being taken up in product and labor markets keeps upside and downside risks broadly in balance. The first view finds support in still subdued domestic cost pressures (unit labor costs and profit margins), in the declining path of recent monetary growth toward its reference value under the first pillar of the ECB, and in the disinflationary impulses of past interest rate increases still in the pipeline. The second view stresses instead the danger that the upward creep in underlying inflation may catalyze in time a flare up in wage claims, and sees a potential for rising unit labor costs.

6. On balance, the first view seems more convincing: whether because of past tightening or otherwise, a certain amount of headroom for price stability seems to be developing. Core inflation is likely to peak soon and headline inflation to move back within its target range, barring worse-than- feared effects from the BSE scare, which, in any case, should be viewed as a supply-side shock for policy making purposes. Yet, indicators of inflationary trends are either above target or still moving that way - something that is problematic, especially for a central bank still engaged in reputation building. What, then, are the implications for interest rates? In this setting, it is reasonable to await more information. For example, core inflation might stabilize or the U.S. economy slow sharply, in which case the need for a monetary easing would become more clear-cut.

7. The conduct of monetary policy has been complicated by unambitious, albeit stability-oriented, fiscal policies. From this perspective, the recently updated Stability Programs remain somewhat disappointing in as far as key countries continue to lag in the attainment of underlying balance and a fortiori of the medium-term fiscal position needed to meet the looming budgetary demands from population aging. Equally worrisome, the scope for meaningful tax reductions to reinforce the supply side of the euro area - a goal only partly achieved in recent tax cut packages - remains constrained in several cases by overly timid steps toward a meaningful restructuring of public spending. These tendencies do not augur well for sustaining the expansion through possibly turbulent times. Medium-term budget plans ought to be stronger.

8. That said, the weaknesses of fiscal plans are not such as to warrant "corrective" discretionary action, as has been the pattern in the past whenever the operation of automatic stabilizers or one-off events resulted in deviations from nominal deficit targets. From this angle, more if not all of the unexpected buoyancy of tax revenues in 2000 ought to have carried over into smaller deficits or larger surpluses. Similarly, budget executions in 2001 in the face of a prevalence of downside risks ought to be informed by the need to eschew discretionary measures - to let the chips fall where they may as regards actual fiscal balances. While such a conduct may run the risk of reawakening earlier concerns about excessive fiscal deficits and public debt, it reflects the key stabilization role of fiscal policy and the spirit of the Stability and Growth Pact. Unfortunately, the underlying principle remains to be fully integrated into the public policy debate and actual policy making.

9. The longer-term sustainability of growth hinges as much on further structural reforms as on sound financial policies. In some areas, the extent of structural improvements continues to surprise, for example as regards greater competition in product markets, added flexibility in many labor markets, and the higher employment content of growth throughout the euro area. However, more is needed. From the long - and well known - unfinished agenda, two items stand out as requiring priority attention. First, in the labor markets, the lack of resolve to overhaul many national tax-cum-benefit systems with a view to restore work incentives for the unemployed and the inactive inhibits effective labor supply and remains particularly detrimental to sustained non-inflationary growth. Second, in the financial sector, the payoff from EMU will not be fully reaped without further integration, which calls for actions to remove barriers to cross-border activities. The concern, however, is that reform efforts (which inevitably end up upsetting vested interests) may weaken as electoral deadlines in many euro-area countries loom closer.

10. More effective internal EU surveillance can help counteract these tendencies. The forthcoming Synthesis Report from the Commission could facilitate the identification of good performers, while the Eurogroup's intention to discuss structural reforms and their nexus with macroeconomic performance - an intention endorsed by the Nice Council - promises an additional avenue for the exercise of peer pressure and the implementation of best practices. More broadly, EU internal surveillance has recently been highlighted by the Commission's proposal to recommend a modification to a member's budget which is in violation of agreed economic policy guidelines. In a fundamental sense, the procedural principle transcends in importance the specifics of the case, and it should continue to be evenly applied so that policies are pursued consistently and coherently to strengthen the monetary union.


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