Coming of age: Report on the euro area BY JEAN PISANI-FERRY, PHILIPPE AGHION, MAREK BELKA, JÜRGEN VON HAGEN, LARS HEIKENSTEN AND ANDRÉ SAPIR RAPPORTEUR: ALAN AHEARNE BRUEGEL BLUEPRINT 4 Coming of age: Report on the euro area BY JEAN PISANI-FERRY, PHILIPPE AGHION, MAREK BELKA, JÜRGEN VON HAGEN, LARS HEIKENSTEN, AND ANDRÉ SAPIR RAPPORTEUR: ALAN AHEARNE BRUEGEL BLUEPRINT SERIES BRUEGEL BLUEPRINT SERIES Volume IV Coming of age: report on the euro area Jean Pisani-Ferry, Philippe Aghion, Marek Belka, Jürgen von Hagen, Lars Heikensten, and André Sapir Rapporteur: Alan Ahearne © Bruegel 2008. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quo- ted in the original language without explicit permission provided that the source is acknowledged. The Bruegel Blueprint Series is published under the editorial responsibility of Jean Pisani-Ferry, Director of Bruegel. Opinions expressed in this publication are those of the author(s) alone. Editor: Andrew Fielding Production: Stephen Gardner Cover design: Jean-Yves Verdu Printed and bound in Belgium by IPM S.A. BRUEGEL 33, rue de la Charité, Box 4 1210 Brussels, Belgium www.bruegel.org ISBN: 978-9-078910-06-0 This report is dedicated to the memory of Riccardo Faini, a great scholar and friend of ours. Riccardo was part of this group before passing away much too soon in January 2007. We miss his stimulating intellect and his amiable personality. Contents About the authors . .vi Foreword . .viii Executive summary . .x Introduction . .1 1. Analytical framework . .6 2. The record . .13 3. Monetary policy . .23 4. Fiscal policy . .31 5. Structural reforms . .50 6. Financial stability . .61 7. Enlargement . .69 8. External dimension . .88 9. Governance . .99 10. Conclusions and recommendations . .108 Bibliography . .114 v About the authors Philippe Aghion is Professor of Economics at Harvard University and Non-Resident Fellow at Bruegel. He was previously Professor at University College London, Official Fellow at Oxford’s Nuffield College, and Assistant Professor at MIT. His main research work is on growth and contract theory. With Peter Howitt, he developed and extended the so-called Schumpeterian Paradigm. He is the co-author of the book Endogenous Growth Theory. Alan Ahearne is Vice Dean for Research at the JE Cairnes Graduate School of Business and Public Policy at the National University of Ireland, Galway, and Non-Resident Fellow at Bruegel. He was previously Senior Economist in the International Finance Division of the Board of Governors of the Federal Reserve System in Washington, DC. His areas of expertise are macroeconomics and international finance. Marek Belka is Professor of Economics at the University of Lodz and Executive Secretary of the UN Economic Commission for Europe. He has been Prime Minister of Poland (2004-2005), Deputy Prime Minister and Minister for Finance of Poland (1997, 2001-2002), Director of Economic Policy, Coalition Provisional Authority in Iraq (2003-2004), Adviser to the Prime Minister of Albania (1997-2001) and a Senior Adviser to JP Morgan (2002-2003). Jürgen von Hagen is Professor of Economics at the University of Bonn and Non- Resident Fellow at Bruegel. He previously taught at Indiana University and the University of Mannheim. He is a Research Fellow of CEPR and a member of the Academic Advisory Board to the Federal Minister of Economics and Technology in Germany. He has served as a consultant to the IMF, World Bank, European Commission, ECB, Federal Reserve Board, and numerous governments in Europe and elsewhere. Lars Heikensten is a Doctor of Economics and a Member of the European Court of Auditors. He was Governor of the Swedish Central Bank (Sveriges Riksbank) from 2003 to 2006 and before that, Deputy Governor (1995-2003). He has represented COMING OF AGE ABOUT THE AUTHORS Sweden at the IMF, the Monetary Committee (later Economic and Financial Committee) of the EU and the WP3 of the OECD. He was a member of the board of the BIS and of the General Council of the European Central Bank. Jean Pisani-Ferry is Director of Bruegel and Professor at Université Paris-Dauphine. He is a member of the European Commission’s Group of Economic Policy Analysis and of the French Prime Minister’s Council of Economic Analysis. In 1990, he was one of the co-authors of the European Commission’s One Market, One Money report on the economics of EMU. André Sapir is Professor of Economics at the Université Libre de Bruxelles and Senior Fellow at Bruegel. He is also a Research Fellow of CEPR and a member of the European Commission’s Group of Economic Policy Analysis. He was Economic Adviser to European Commission President Prodi from 2001 to 2004. His main fields of expert- ise are economic integration and international economics. Narcissa Balta and Jérémie Cohen-Setton provided research assistance to the authors. vii Foreword The euro marks its tenth year in 2008. It is unlikely to be the easiest one in its suc- cessful first decade. At the end of 2007, inflation in the euro area had jumped to above three percent, yet with economic growth slowing and unsteadiness in financial markets persisting, the European Central Bank is faced with a serious dilemma. The euro has appreciated recently to record levels against other major currencies but, at the same time, the global balance-of-payments adjustment is still far from complete and the risk of major exchange rate instability remains. With the entry of Cyprus and Malta, the euro area now counts 15 members, but the climate of uncertainty and mis- trust generated by the rejection in 2006 of Lithuania’s euro application lingers, and it is still unclear when the new EU member states of central and eastern Europe will join the euro. The time is right, therefore, to look back and assess whether Economic and Monetary Union (EMU) is equipped to sail through less calm, perhaps even stormy, waters. This was Bruegel’s intention when in 2006 it assembled a group of highly experienced policymakers and academics from countries within and outside the euro area. In this report, the group delivers a sobering assessment. It emphasises that the euro is a major achievement of European integration; that the European institutions deserve high marks for giving birth to a new entity out of what was initially a group of very different member economies; and, especially, that there is much to praise in the con- duct of monetary policy by the ECB and in its handling of the 2007 liquidity crisis. Worryingly, however, the group also notes that, in spite of an exceptionally support- ive international environment, the euro area’s economic performance over the last nine years has been adequate at best; that governments have sometimes failed to realise that membership in a currency union requires a change in behaviour; and that almost twenty years after the start of the Maastricht negotiations, competing visions of future EMU continue to coexist. The group makes a number of concrete proposals to improve euro area policy and governance. But the main message in this report is broader. When the EMU project was launched, it was often regarded as a step towards a fully-fledged federal union COMING OF AGE FOREWORD in Europe. For many advocates of EMU, the goal was political – and money was a building block. After Maastricht, Amsterdam, Nice, the aborted EU Constitutional Treaty and Lisbon – five treaty changes or would-be treaty changes in less than twenty years – federal union is today a more remote prospect than it was in the late 1980s. For all practical purposes, the assumption must be that no federal govern- ment will emerge in the foreseeable future as a counterpart to the ECB, and that EMU will remain a sui generis policy system. Fortunately, however, EMU is also an evolv- ing entity and only time will tell what the sharing of a currency will mean for the member economies and their mutual relationship. The euro’s first decade has provid- ed important insights, but ten years is a short time in the life of a monetary union. This is why the group emphasises that, if the euro is to be a lasting success, all par- ticipants must be more willing than they have been so far to draw lessons from their joint experience. Jean Pisani-Ferry, Director, Bruegel Brussels, January 2008 ix Executive summary This report: • Looks at the euro’s record so far; • Tests the performance of the euro area in key fields for the future success of the euro: monetary policy, fiscal policy, structural reform, financial stability, enlarge- ment, the external dimension; • Examines governance issues and the role of the Eurogroup; • Makes concrete proposals for reform of both euro area policy and governance. The report identifies three drivers of reform: • The first is political. European projects can come adrift from political reality and discourse in member states. The euro is not immune to such a risk; • The second is economic. The performance of the euro area since the launch of the euro has not been spectacular. The global environment, favourable since 1999, is unlikely to be as helpful in the coming years; • The third is related to enlargement. The euro rules were not designed with the new member states in mind. If they are applied mechanically, there is a risk of incom- prehension and real political or economic damage in new member states. The report starts from the essential requirements of an appropriate policy system: stability, predictability, incentives for good policies, and adaptability. It identifies shortcomings in the current functioning of the euro area and singles out the Eurogroup as the essential institution potentially capable of fostering change. Its greatest weakness – absence of a clear mission – is also its greatest strength – ability to learn and base policy on evidence.