In late 2003, the future of the European Monetary Union seemed to be at a crossroads. The Stability and Growth Pact, under which member nations agreed to limit deficits, seemed all but dead. Meanwhile, European leaders were struggling to draft new agreements that would allow the admission of up to ten new members to the European Union. As questions surrounding the continent’s political and economic integration swirled, a panel sponsored by NYU Stern and Blackwell Publishing, Inc. convened on December 5 to discuss the future of Europe. Participants included: NYU Stern Dean Thomas Cooley; Hervé Carré, who represents the European Commission in Washington as Minister for Financial Affairs; Francesco Giavazzi, professor of Economics at Bocconi University in Milan, and a former economic advisor to the Prime Minister of Italy; and Mickey Levy, chief economist at Bank of America. It was moderated by Georges de Ménil, NYU Stern Visiting Professor of Economics from Ecole des Hautes Etudes en Sciences Sociales, Paris.



Hervé Carré: I think the challenges we face now are easier to face than the ones we successfully faced in Europe ten years ago. There are many challenges. But I will just elaborate on three of them.

The first is economic policy coordination. In Europe, we have a single monetary policy, entrusted to a federal institution. And on the other hand, the responsibility for all other economic policies and budgets remains decentralized – although subject to common rules. This decentralization provides the necessary room to adapt to national economic structures and to adjust to country-specific preferences. However, the growing interdependence of member states, and the potential for spillover effects calls for coordination of national economic policies.
“Ten new member states will join the European Union soon next year. This will bring extraordinary benefits: The extension of the zone of peace, stability, and prosperity in Europe.”

The second is structural rigidities. Six million jobs were created in the EU between 1999 and 2001. But since then employment growth has stopped. More structural reforms are needed in the labor market to raise employment and productivity, and ultimately to increase the standard of living of European citizens. In 2002, GDP per capita in the EU was only 71 percent of the level in the U.S. The employment rate is 86 percent of the U.S. level. This means that in Europe we do not work enough. We also need structural reform that allows wages and prices to adjust more quickly to changes in supply and demand.

The third challenge is enlargement. Ten new member states will join the European Union soon next year. This will bring extraordinary benefits: The extension of the zone of peace, stability and prosperity in Europe; the addition of more than 100 million people in rapidly growing economies; and the strengthening of the EU’s role in world affairs. But the criteria for accession to the EU require these countries to be functioning market economies. And our institutional framework must continue to guarantee an efficient management of economic policy.

Tom Cooley: I’ll focus on the countries that have opted to stay outside the monetary union, like the U.K., Sweden and Denmark. And I thought I would relate it to the debate a couple of years ago about whether countries like Mexico and Brazil and Argentina should adopt the U.S. dollar as their home currency.

It turns out there are incentives for countries that are not in a currency union to stay on the periphery. If Mexico could be reasonably disciplined in its monetary policy, there were more gains to Mexico to stay out of the union, but to have a monetary policy that's sort of close to what the U.S. policy is. And this same logic applies to the case of the U.K. and Sweden.

It's clear that the U.K. has had a very different monetary policy than the EU in the last few years, and as a consequence has had a very different inflation rate, as has Sweden. If you conclude that Sweden and the U.K. are achieving growth rates that are closer to their potential growth rates over this period, then it's hard to see what the incentive would be for them to join. So the prediction would be that we're not going to see them joining any time soon. Now, if they decide to stay out and they have weak fiscal discipline, then I could imagine that it might undermine the currency union. But it’s definitely a factor that in the long run has to be thought about.

Francesco Giavazzi: I've been asked to talk about a more mundane problem: Fiscal policy and the stability pact. Do we need rules in the monetary union? Yes, we need some rules. But the stability pact provides the wrong incentives. It forces countries to focus attention on the short run rather than on the long run. It encourages people to focus on this year’s budget, when an issue like pension reform – which the French government enacted in July – is much more significant for deficits over the next ten years. In Germany, issues like pension reform and health reform are more important for the long run sustainability of public finance then an effort to keep the deficit within three percent of Gross Domestic Product at a time when there are 4.5 million people unemployed.

What can be done? I think there are two ways out. My ideal would be to take the U.K. code of fiscal responsibility, put it in the constitution and give the Commission the power to monitor fiscal policies based on that. But this solution is very unlikely. The second is to increase transparency, and, hence, market pressure. Italy has, in a single year, shifted two percent of public expenditures into a special purpose vehicle that under Luxembourg rules, is outside the government accounts. Had that not been done, Italy would be far above the three percent deficit-GDP limit.

Mickey Levy: If you look at Europe in recent decades, economic performance has been disappointing. Since the EMU was established, the euro-zone growth has averaged nearly a percentage point below the United States. And it doesn't seem like the establishment of the EMU or the euro has had any significant effect on overall economic performance. It seems to me the underperformance is a direct function of misguided fiscal and regulatory policies. The ECB has pursued a consistent and successful low-inflation monetary policy. But when you look at the excessive government spending, taxes, regulations that reduce labor supply and reduce the implementation of capital spending, therein lies the problem.
“The stability pact provides the wrong incentives. It forces countries to focus attention on the short run rather on the long run.”

Fiscal policy reform is constrained and distorted by the Stability and Growth Pact, particularly its deficit to GDP limitation. It limits counter-cyclical fiscal policy and tax reform. It has led to budget gimmickry and it has not addressed the major problems of government spending and taxes. I strongly believe the deficit to GDP ratio is an inadequate, limited and potentially misleading representation of fiscal responsibility. For example, the deficit to GDP ratio in Germany is pretty close to that in the United States. But in Germany, government spending exceeds 50 percent of GDP. In the United States, it's about 33 to 35 percent.

To really address the problems of Europe, the pact needs to focus on government spending and taxes as well as budgets. Firstly, I would put limits on the ratios of government spending to GDP and of taxes to GDP. But I would phase them in over time. And to the extent that taxes are cut before spending, I would relax temporarily the deficit to GDP ratio. That would make policy makers focus on the real issues that are inhibiting economic growth.

What’s more, the figures on national debt and cash-flow deficits don't capture the unfunded liability of the pensions. The long-run projections are very unfavorable. But with regard to the issue of debt, and deficits, you have to ask the question, well, what are you deficit spending for?

Hervé Carré: I'd like to respond to Mickey’s point. We were aware of the crude character of the three percent deficit to GDP ratio when we adopted it. And the level of debt is clearly the major problem in terms of sustainability. On pension reform, I fully agree. The Commission for four years has been recommending to member states that they take necessary measures to change the present system. But here again it's a political problem. Government spending is also a hot potato. All the ministers from the Scandinavian countries will tell you that they don't want to decrease the level of taxation, because their voters want to keep the social safety net. So it’s easier when you're an economist, than when you are a politician.

Tom Cooley: I think all this discussion is kind of missing the boat a bit. It seems to me that the real compelling problem of Europe is that their productivity growth is so much lower than the U.S. And I think the answer lies in structural reforms that will remove the conditions that inhibit Europeans from taking risks and engaging in the kind of innovative activities that drive productivity growth elsewhere in the world.

Francesco Giavazzi: On productivity, one has to be very careful, because the level of productivity per hour worked is higher in most European countries. The productivity per person is lower because as suggested before, the amount of hours worked in Europe are 30 percent below hours worked in the U.S.

Sir Nigel Wicks, Former Member of the EU Committee of “Wise Men” on European Securities Regulation, Former Principal Private Secretary to Prime Minister Margaret Thatcher, and keynote speaker at the dinner following the EMU panel, speaking with Dean Cooley and Hervé Carré.

Mickey Levy: Well, the statement about productivity I think is well stated. I think the problem in Europe is you've seen this sharp decline in aggregate hours worked per employee. And that's in part endogenously determined by misguided policies. I understand the difficulties in implementing my proposal about the ration of deficits to GDP. But if you think about targeting deficits as a percentage of GDP, it's just as silly. Go back to U.S. history in the 1970s. There was abysmal productivity and very high unit labor costs, and double digit inflation and interest rates. The fiscal and monetary policy makers lacked credibility. The highest marginal tax rates were 70 percent. And the forecast of potential growth was less than two percent – less than what potential growth now is forecast for Europe. It took a fairly radical change in tax rates to generate positive economic results and higher standards of living. And so I'm not just pointing to Europe and saying you need a straitjacket, but you need incentives to enact pro-growth changes.

Hervé Carré: For the Commission, the choice of taxation level and choice of spending to GDP ratio, is a political choice. It's the expression of a choice of society. It cannot be taken by bureaucrats. That's all. No taxation without representation.

Audience question: I’m an economic consultant. As I recall there is one success story within the European Union, and that's the Netherlands. They had a debt to GDP ratio which was more or less around 100 percent. And they managed to lower it very, very significantly.

Hervé Carré: Right. At the time of the Mastricht negotiation, the ratio to GDP in the Netherlands was close to 90. Now it's below 60 percent. But I think the best example of a very quick reduction of debt to GDP was Ireland.

Georges de Ménil: Can the Irish miracle be a model for Europe, for the Continent?

Mickey Levy: Ireland is a great story. They certainly didn't need any limitations. But their growth, their economic performance was so bad, what did they do? They lead with tax cuts and a constraint on government and they created an environment that put incentives in place. What if one of the ascension nations recommends sharp tax cuts? And then that nation becomes a very attractive destination for capital and jobs, even though they violate every deficit to GDP concern in Europe? What happens then?

Georges de Ménil: Well, with that open and challenging provocative question, let me thank the panelists.