Transcript

Transcript of a Conference Call on the Euro Area, By Michael Deppler, Director, European I Department, IMF

October 29, 2002

MR. DEPPLER: Good morning, everybody. I just want to start by a few words on what exactly we're doing this morning, and then go into the substance of importance.

The Article IV process that we're concluding this morning is with the Euro Area; that is, it covers basically the policy of the ECB and of the area wide policies of the EU, the Commission, the ECOFIN and the Eurogroup more exactly. Hence, it's a somewhat different process than the bilateral Article IVs, like the conference call on Italy that was held last week, and on France and Germany which will be held within the next few days.

The process involves a mission in late June/early July that led to a concluding statement that is on our website that was released in early July. The bundle that you have in front of you consists of a staff report, a supplement to that staff report and some supplementary issues papers, all of which have been prepared by the staff.

Next, you have the so-called PIN, which expresses the views of the Executive Board of the Fund. And, finally, in the bundle, there is the views of Mr. Vittas, who is the Executive Director having the presidency of the Eurogroup at this juncture, and his statement both reflects the views of his authorities, which in this case is the Eurogroup and the ECB.

I think the main newsworthy item out of this set of papers is the strong support of the Fund for the Stability and Growth Pact. Basically, we view it as a sound framework that is being wrongly undermined by inadequate policies in the three largest countries, but before I emphasize on that point, let me sort of cover some of the other major facets of the report.

In the main, I will speak about the views of the staff, but I will try to flag areas where the Board, or some parts of the Board, were at variance with the views of the staff. But unless I say so, you should assume that the Board and the staff basically think the same way.

Now the first item is the recovery. There the news is no news. It's coming, but in our view, not till next year. As you know, recent developments have been rather flat, and we expect the second half to be a bit like the first half, quite weak. However, we do expect the recovery thereafter, potentially, to grow during 2003, led by consumption, because wages have been relatively strong, and employment is not falling, which in turn would lead to pick up in inventory a positive contribution and inventories, all of which are assisted by a rebound in exports, owing to continuing strength in the U.S.

Overall, for the Euro Area, we expect 2-percent growth, with Germany below average and France above average. The risks are weighted to the downside, partly for external reasons—the U.S., and oil prices, Iraq-kind of uncertainties—but also because of internal ones. We've been impressed by the fact that there seems to have been more overinvestment in Europe than we had previously realized, and this has led to weak corporate and bank balance sheets. Nevertheless, we expect these effects to wane during the second half and for a recovery to begin around the turn of the year.

On monetary policy, the basic message of the papers is that the policies of the ECB have been generally appropriate, striking the right balance between the risks stemming from shock-driven cost push forces and from the ongoing weakness of activity.

In this regard, inflation has proven quite persistent, basically, because of lagged adjustments to past shocks. In the staff's view, and in the Board's view, I think, inflation is expected to recede next year to about 1.5 percent. Hence, given the downside risks to the recovery, in our view, a bias towards interest-rate cuts is needed. This is the view of both the staff and the Board.

One part which we devoted a fair amount of attention to in this latest cycle is the monetary framework of the ECB. Here, we have three special technical papers which are included in the Supplementary Issues Paper, focusing on the definition of price stability, the monetary pillar or first pillar of the ECB, and the predictability of the ECB. Let me briefly say a few words about each of these.

On the definition of price stability, we welcomed the de facto narrowing of the price stability range of the ECB, which, as you know, is zero to two, and has, in effect, been narrowed to one to two in recent statements.

We, on the Board, consider this a useful step towards balancing the risks of an ambitious inflation objective, versus the need for some scope for adjustments to shocks across countries and to protect against the risks of inflation. But the staff, in its analysis, ends up with the view that the inflation objective really ought to be at the upper end of that 1 to 2 range.

The second paper is on the monetary pillar. Here, I would say that the staff is a rather strong supporter of the monetary pillar in the ECB's analysis. It's not a view which I would say is as firm in the rest of the Board, the Executive Board of the Fund, where there's more diversity at least. But the staff thinks it's an analytical and meaningful way of looking at inflation risks, but only in the very long term, and in that framework, therefore, with the second pillar having a short-run focus and the first pillar having a long-run focus, we see continuing problems with the ECB in communicating the roots of its policy.

The third paper is about the predictability of the ECB, and there the basic conclusion is that the predictability of the ECB for the markets is on a par with that of the Fed and the Bank of England.

Possibly, the main focus of the Article IV process has been on the fiscal framework. Basically, the conclusion is that it's fundamentally sound, with its thrust in line with the requirements both of the union and of its members.

In this regard, I mean, in the U.S., there's no such thing as the SGP, but the big difference between the U.S. as a monetary union and Europe is that Europe is fiscally decentralized. In the U.S., you have a strong central government, which is able to absorb shocks, both interregional and at the national level, and this is what Europe is lacking. In this context, we view the SGP, the stability pact, as a good framework, good in both the long run and in terms of managing policies in the short run.

In the long run, the SGP calls for close balance of surplus for all of the countries of the Union. We see this as a good norm, in the medium term, essentially, because all of the countries in the Euro area face steep increases in indebtedness arising from aging populations. If you look in the table on Page 14 of the staff report, you'll see the very steep increases in spending, occasioned by pension and health expenditures of the aged.

Against that background, and absent reforms in these areas by government, the norm of the SGP is only prudent, in the staff and the Board's judgment. I would also note that in this context that this norm of the SGP is the same one that the staff and Europeans call for the U.S. to reflect; that is, have a surplus, a balance of surplus in the medium term. So this is really quite a basic and common requirement.

The other aspect of the SGP is, as you know, the requirement of the 3-percent deficit limit. From our point of view, that gap of 3 percent in between the medium-term norm and the limits that has to be respected every year, allows ample room for the role of the cycle on budgets, and therefore precludes the need for procyclical policies. Hence, on this ground, also, we see the SGP as a good framework for the monetary union in the medium term, year-by-year and in the medium term.

Now, why are there so many problems with the SGP?

Well, basically, the core of the problem is the fact that the three largest countries basically haven't lived up to the rules. If you look at the chart on Page 12 of the staff report, you will see that the smaller countries all move from significant deficits to significant surpluses between '98 and 2002. Whereas, the three large countries essentially are back where they started from, with deficits in the 1.5- to 2-percent range. By deficits here, we mean underlying deficits, not the cyclically affected actual deficits. So, in our view, the problems with the framework are not the framework, but the fact that the policies have not been in line with the framework.

The question then becomes where do we go from here? As you know, the economy is fairly weak. We don't see a very robust recovery in prospects, and so what should the policies of the Big Three countries be going forward?

Here, the view of the staff and of the Board is a need to strike a balance between the long term and the short term. In the long term, as I said, strong support for these countries moving towards underlying balance in their fiscal accounts. Because of the short-term considerations, there is a need for a measured approach to that balance criteria.

The basic advice is that countries adjust, in structural terms, by at least half a percent per annum, beginning in 2003. Now this is the same advice as the Commission has given recently. I would only point out, however, that it was also the advice that we gave back in June/July, which you can verify by looking at our concluding statement on the website.

However, the staff and the Board's advice in this regard comes with a complementary recommendation, and that is that around those adjustments of a half a percent per annum of the underlying structural fiscal deficit, countries should be allowed to let the automatic stabilizers play freely.

One implication of that is there is no date in our scheme of things for countries to achieve balance. They should do half a percent per year and continue doing so until they satisfy the medium-term norm, at least half a percent per year, and continue to do so until they satisfy the medium-term norm.

Now, here, the reason for the Board's and the staff's insistence on this point is because many of the problems associated with the SGP really are not rooted so much in the SGP as in the public perceptions of the SGP, as communicated by some of its supporters, particularly in political circles.

As you know, in this context, there's a tremendous emphasis on achieving particular nominal targets by particular dates. This is not something that's inherent to the SGP. It's something that has been sort of built in tangentially along the way, but it's basically ended up giving, lending a perception of the SGP as a procyclical device, which, in fact, it is not, if understood the way all of the technicians, the officials understand the SGP.

But there is a real problem about how this is communicated in public and leads to these periodic controversies. But if you look at how the thing works in practice, you'll find that it's a rather flexible tool. For instance, in 2001, there was a big issue about whether or not to let the automatic stabilizers play, but in fact at the end of the day, if you look at what happened in 2001, and indeed in 2002, you will see that the stabilizers were allowed to play. So it's important to distinguish between the rhetoric that is sometimes applied to the SGP and what is actually happening on the ground.

Finally, a point on structural reforms. Basically, this is, as you can expect, a strong view of the Board about the need for more emphasis on structural reform in Europe. I would commend to you a study in this regard, a table on Page 16, which shows, in effect, that Europe does somewhat better than is often perceived, in terms of growth performance over the past four years, per capita growth rates are comparable to those of the U.S., but at the same time shows that, while productivity levels in Europe are fairly high in absolute terms, per capita income are now much lower, about two-thirds the level of the U.S.

And this difference, in terms of the productivity performance versus the per capita income performance, is really rooted in different rates of utilization of labor, and pointing to the need for Europeans to focus much more on labor market reforms.

Another concern of the Board in this regard has been trade policies, where the Board has been pressing for much freer arrangements on trade in a number of areas, but the one capturing the most attention being the cap.

Finally, I should mention the financial sector reforms at the area wide level, which are, in fact, starting to move ahead and which the Board strongly welcomes. Thank you. I guess we'll take questions from here on out.

QUESTIONER: Between the communication problems you raised around the Stability Pact in the Euro Zone, do you consider that the recent statement from the President of the European Commission, Romano Prodi, that the pact is stupid, is one of those problems?

MR. DEPPLER: I think our view is that there is an issue, a superficial issue about the SGP that needs to be addressed, and this is why we emphasize very strongly, and we have emphasized for several years, the importance of letting the automatic stabilizers play. This is perfectly permissible under the rules of the SGP, but there have been chronic deviations from that understanding, particularly at political levels, where there's an emphasis on nominal targets, which we find inappropriate.

Let me be very clear. The focus on nominal targets is inappropriate for a monetary union simply because, in a decentralized monetary union like the Euro Area, you need a fiscal system which absorbs shocks, rather than propagates shocks, which is what the implication of focusing on nominal targets is. So there is a need to, it's not so much to redo, but to rethink about what the SGP amounts to, and there is a problem in Europe about this perception, and this must be addressed directly.

QUESTIONER: Hello, Mr. Deppler. I'm just wondering, in the PIN, the Executive Board called for a concerted and credible commitment by the three largest countries to achieve fiscal balance over the next several years. Do you think that what has been pledged so far amounts to a concerted and credible commitment or are you and the Board calling for something beyond what is already in train?

MR. DEPPLER: Our basic view is that the SGP is a sound framework, but it has a credibility problem right now, and that credibility problem needs to be addressed. And the best way to address that credibility problem would be for the three largest countries, who are three countries who share the feature that over the past five years they have not adjusted in line with the norm, they need to make a credible, cooperative effort to fall into line with the SGP.

Now, because of the weakness of the situation, they should do it at a pace of half a percent per annum, too. Now, when you look at the situation overall, you find that the fiscal policies next year for the group as a whole are of the order of half a percent per annum. We don't know exactly what the budgets are going to be, so it's not entirely clear, but it's of that order.

However, if you look within the Big Three, what you see is Germany, which has by far the weakest economy, is going to do the most; France, which has the strongest economy of the three is going to do the least, in fact, is not going to do anything at all; and in the middle, you have Italy, where one is not entirely clear about what fiscal underlying adjustment is going to be because of the reliance on one-time measures.

Now this is not the most credibility-enhancing approach to fiscal policies in those Big Three countries. But if you look at the Board's advice on those three countries, not all of which has been finalized, you've seen the Board's conclusion on Italy, France, and Germany should be coming out very soon, but again you will see that the majority of the Board supports the idea that these countries should each be moving by half a percent per annum.

Now why a concerted approach is better? Because, in our view, this would provide a credibility to policy, a clarity to policy, but it will also permit the ECB to make its sums as to what the implications of fiscal policy for inflation are earlier and sooner than otherwise. In the staff's analysis, this would permit, in setting interest rates, taking account of the effects of fiscal policy on growth, and hence would have a lower cost than the adjustment would otherwise have. So this is the basis for the call for a coordinated approach, and I would say that the countries do not need it as of now.

QUESTIONER: Mr. Deppler, regarding the issue of credibility, which you obviously emphasize in the reports, I was wondering if you'd give some kind of indication of what might be the consequences for the Euro Area if they fail to address this problem of credibility with the pact. Are we talking about an investment backlash of problems for the Euro? What exactly would be the implications?

Second of all, regarding Germany, you also mentioned the risk of demand in Germany falling short of expectations. I was wondering to what extent you consider Germany being penalized in this respect as a result of the common monetary policy in the Euro Area. Is it an economy that argues for a lower interest?

MR. DEPPLER: The lack of credibility is having costs. There's a sense of drift, vis-à-vis policies, which needs to be addressed, which is not good for confidence. But maybe even more directly, as I said earlier, the smaller countries have undertaken fiscal adjustments. If the larger countries do not start to proceed down this path, it can be questioned whether the smaller countries will continue to be able to hold the good fiscal policies they've been able to put together so far. So it's quite important that something be done for the credibility side, particularly when you think in terms of forward-looking spending, notably investment.

Now, with respect to Germany, I think Germany is really surprisingly weak. When you compare the growth-rate figures, it doesn't come through so much because Germany has done rather well on exports. But if you compare Germany with the rest of the Euro Area, in terms of domestic demand, you really are talking about a country which has really been much weaker than I think anyone would have expected.

Now, in this, I mean, the causes of this weakness in the staff's view are basically structural. They're not macroeconomic. In terms of the interest rates, it's true that the ECB is properly focused on the Euro Area as a whole, and this is leading to somewhat higher interest rates in Germany than would otherwise be desirable.

But I wouldn't see this as at the core of Germany's problem. Germany needs to undertake, basically needs to adjust to a shock which it has yet to adjust to, namely, unification, which has led to big increases in labor costs and together with sort of much older rigidities in the labor markets, which really need to be addressed directly, and you could see reflections of it in pension systems and in health care. These are the problems that will get Germany out of its immediate problems.

QUESTIONER: I noticed in your recommendation that the ECB should adopt a clear easing bias. As a supplement to the report, there's the contribution from the person representing Greece, representing the Euro Zone, Mr. Vittas, who I understand is speaking on behalf of the ECB. In fact, it uses, you know, "we," and he's obviously speaking for the ECB, and they basically reject your advice, and they interject that the ECB price risk has been balanced and, in fact, they say that they differ slightly from your appraisal. Are you just going to agree to disagree on this kind of thing or do you have a further comment to make on that?

The other thing I would just like to ask you is do you consider that the Euro is still undervalued?

MR. DEPPLER: We are in the business of the Article IV process, which is basically trying to pull together the views of the international community on the policies of a particular member, in this case, the ECB. And the view of the staff, and of the Board, is that there should be a clear bias towards easing. As you pointed out, the ECB has a different view.

We tried to make it clear in the paper that there are real concerns, in terms of ongoing inflationary developments, so that the ECB's point of view is not one that you can view as outlandish, but by the same token, in our view, inflation has been shock driven and should, absent further shocks, recede to 1.5 percent next year, and therefore there is scope for an easing bias. But this, as you say, this is a point on which we have to agree to disagree.

On the Euro, I think the appreciation of the Euro that took place in the spring has widely been welcomed, both by the staff and the ECB. We still, both ourselves and the ECB—well, certainly ourselves, but also I think in Europe—see the Euro as continuing to be undervalued, and hence scope for further appreciation from here on out.

QUESTIONER: The criticisms you made of the ECB and its sort of failure to explain its strategy, I'm just wondering why these criticisms couldn't also have been made of the Bundesbank, on which the ECB was somewhat modeled, and which had also rather opaque intermediate targets and yet, nonetheless, is one of the most successful central banks the world has ever seen.

MR. DEPPLER: You're quite right, and notice that our criticism is of the framework from a communication point of view. As I emphasized at the beginning, the view is basically the policies have been appropriate is the judgment both of the staff and of the Board.

But the fact is, is when you go to markets, you find that it sort of ebbs and flows, depending on the extent of the emphasis put by the ECB on monetary developments, but there is a basic skepticism in markets about that framework. Indeed, I would say that some of the Board members also are skeptical about that framework. They would much rather have a strict inflation-targeting approach.

So, basically, we see the framework as something that is analytically viable. It raises communication issues because of the short-run/long-run dichotomy between the two pillars, but basically not something where we would argue that has caused visible policy problems at this juncture.

If you look at the inflation expectations in the Euro Area, they are basically as stable as those that you see in the U.K., for instance. So there is no basis for thinking that the framework has actually led to policies which have destabilized anything.

QUESTIONER: In the report, you referred shortly to the need of having reliable figures. Is that a major concern to you that the figures that you get from the Euro Area countries are not always reliable?

MR. DEPPLER: A very good question. I mean, there's a big issue about fiscal data in Europe. There is far too much reliance on one-off operations, but not only that, but these numbers are also subject to large and unexpected revisions. The report calls for moving towards quarterly fiscal data so that there's more ongoing information about developments. But also, the problem with any set of rules is you set up incentives for breaking them. In a sense, this is inherent to any world-based system, and it may be unavoidable.

But the Fund, in its advice, the staff, in its advice, focuses on so-called underlying structural adjustment, excluding asset sales. So, for instance, on that basis, Italy, which otherwise looks rather good, looks very similar to France and Germany. But clarification of numbers is an important issue.