Public Information Notice No. 05/103

Executive Board Assessment

While expressing disappointment with the struggling recovery and continuing high unemployment, Executive Directors noted that the economic fundamentals in the euro area have continued to strengthen, reflecting significant structural reforms in several member states. In particular, past labor market reforms and continued wage moderation have further improved labor market resiliency, while corporate profitability has strengthened. At the same time, Directors observed that the burden of accumulated rigidities, and aging, continue to weigh heavily on the euro area, and fiscal policies fall well short of the area's fiscal consolidation requirements. Furthermore, business and consumer confidence remains low, reflecting the still significant economic challenges facing the euro area.

Against this background, Directors called for a more decisive and consistent pursuit of forward-looking policies aimed at strengthening fiscal adjustment and structural reform, while harnessing the complementarities within and between fiscal adjustment and structural reform. In this regard, they considered that Europe's restructured policy frameworks chart the right course, and the increased weight they place on ownership will be helpful for strengthening public trust and confidence. At the same time, now more than ever, effective implementation will call for the leadership and determination of both national capitals and the European Council.

Directors considered that the fundamentals remain in place for the modest recovery to resume in the second half of 2005, but with downside risks continuing to prevail. Continued wage moderation, improved corporate balance sheets, accommodative financing conditions, and reaccelerating world demand point to renewed momentum during the second half of the year. Nevertheless, the outlook is uncertain, and the risks lie mainly on the downside, including from further sharp increases in oil prices, multilateral euro appreciation in the context of unwinding global imbalances, a reversal in the benign global financial conditions, and a potentially sluggish investment recovery in the face of weak business confidence.

Directors agreed that the European Central Bank's monetary policy stance remains broadly appropriate. While headline inflation is still hovering around 2 percent, underlying inflation pressures remain subdued. With the latest activity indicators not painting a consistent picture of the future course of the recovery, Directors agreed that a wait-and-see attitude remains appropriate. However, many Directors stressed that, absent new information on prices or wages, a cut in interest rates would be appropriate if evidence of a fading recovery continues to accumulate over the coming months. These Directors felt that a rate cut would also be warranted if the euro appreciates significantly on a multilateral basis. Some Directors, however, questioned the case for a rate cut, pointing to the upside risks to headline inflation and the predominantly structural nature of the area's sluggish activity. Given the considerable uncertainty surrounding the economic outlook, Directors encouraged the European Central Bank (ECB) to remain vigilant, and to stand ready to respond flexibly, as warranted.

Directors underscored the need to prepare the euro area's public finances for the looming demographic shock. This will require steady progress toward achieving underlying fiscal balance by 2010, when population aging is set to accelerate. Many Directors advocated policies that consistently correct current and intertemporal fiscal deficits to anchor consumer confidence. This will require sustained fiscal adjustment of about ½ percent of GDP annually over the medium term-complemented by further structural reforms that address fiscal liabilities and strengthen the tax base. Fiscal adjustment is also needed to achieve adequate safety margins below the 3 percent Maastricht deficit ceiling and restore the credibility of the Stability and Growth Pact. Directors reiterated the crucial importance of achieving these objectives, especially in view of the limited progress that has been made in shoring up the area's public finances over the past five years and the modest objectives for the medium term. Given the constraints imposed by the single monetary policy, a few Directors thought that fiscal policy should continue to have some role in smoothing out cyclical fluctuations, taking account of country-specific circumstances.

Directors welcomed the renewed agreement on the Stability and Growth Pact but underscored that its credibility depends on effective implementation. The reforms that allow for a greater sensitivity to economic circumstances under the Pact's dissuasive arm, and call for minimum annual adjustment under the preventive arm, are improvements over the old framework. Nonetheless, many Directors cautioned that potentially open-ended tradeoffs between fiscal adjustment and structural reform and the restrictive definition of "good times" could be used to justify insufficient consolidation during upswings. A transparent, evenhanded, and sufficiently ambitious implementation of the reformed framework will thus be essential for Europe to address successfully its fiscal policy challenges.

Directors agreed that actions to boost potential growth and employment are crucial, and called for particular attention to the appropriate sequencing of product, service, labor, and financial market reforms. Key actions include reforming entitlement systems, boosting labor utilization, deregulating and strengthening competition, completing the internal market, and integrating national financial systems. In this regard, the new integrated guidelines under the revamped Lisbon Strategy were welcomed, as they should aid in the formulation of consistent National Action Plans. Directors observed, however, that with the agenda-setting shifting away from the center, the prospects for reform will hinge on the leadership and determination of national governments. In this regard, Directors acknowledged that national governments may be concerned about pressing ahead with structural reforms that may temporarily weaken demand. They nevertheless stressed that pursuit of clear and credible policy objectives that leverage the complementarities between product and labor market reforms should help boost investment without imparting undue effects on domestic confidence and consumer spending.

Many Directors considered that growth-enhancing structural reforms will be helpful in underpinning an orderly unwinding of global current account imbalances. While recognizing that global imbalances are attributable to a complex combination of factors, they noted that structural reforms needed from the euro area's own perspective-namely to unlock the area's productive potential, boost its demand, reduce its vulnerabilities, and enhance confidence-would also aid the global economy. However, some Directors believed that, while structural reforms will be crucial to raise the area's growth potential, their effects on the euro area's saving-investment balance remain ambiguous.

Directors agreed that the experience with the Stability and Growth Pact and the Lisbon agenda points to the importance of garnering domestic support for strong, forward-looking policies. They considered that debating Stability Programs and National Action Plans in parliaments would be important steps toward increasing transparency, informing the public, and building ownership. Many Directors believed that achieving these objectives would also be aided-especially in countries facing large consolidation and reform agendas-by developing independent, non-partisan institutions that are tuned to country-specific needs and inform the public about the larger strategic economic issues they confront, engage in the policy debate, and assess policies and their implementation. The policy mandate, however, should remain in the hands of elected representatives. Some Directors noted, however, that similar institutions already exist in several countries and that additional focus on them might detract attention from policy implementation. Directors agreed that intensive, peer-driven multilateral surveillance of policies remains essential.

Directors welcomed the progress that has been made through the Financial Services Action Plan and the so-called Lamfalussy process in laying the foundation for further integration of financial markets and convergence of supervisory practices in Europe. The onus now is on all member states to take a pan-European view to make this process work effectively, and on the Commission to enforce existing rules, including through competition policy. Directors agreed that growing cross-border activities of major, complex financial groups are placing an increasing burden on national supervisors. Many Directors also thought that a more integrated approach to supervision, including provision of up-to-date information on key groups through an existing area-wide structure, deserves consideration. A few Directors, however, felt that entertaining such moves at this stage is premature, with implementation of the Plan still incomplete.

On trade policy, Directors welcomed the EU's continued commitment to playing a leading role in forging agreement on the Doha Development Agenda. They underscored the importance and the multilateral benefits from greater access to the EU's agricultural markets. Many Directors regretted the recent moves to limit imports of textiles, clothing, and footwear.

Directors stressed that effective area-wide surveillance calls for improvements in the quality, availability, and timeliness of statistics, and strengthened statistical institutes. While the availability of statistics is broadly adequate, better fiscal data remain a key priority for a number of countries.