Report on the State of the European Union, Volume 3: Crisis in the EU Economic Governance

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Author: Jean-Paul Fitoussi | Jacques Le Cacheux

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Report on the State of the European Union

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Report on the State of the European Union Volume 3

Crisis in the EU Economic Governance Edited by

Jean-Paul Fitoussi and

Jacques Le Cacheux

© OFCE 2010 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No portion of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, Saffron House, 6-10 Kirby Street, London EC1N 8TS. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2010 by PALGRAVE MACMILLAN Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan in the US is a division of St Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: 978–0–230–24156–5 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. Logging, pulping and manufacturing processes are expected to conform to the environmental regulations of the country of origin. A catalogue record for this book is available from the British Library. A catalog record for this book is available from the Library of Congress. 10 9 8 7 6 5 4 3 2 1 19 18 17 16 15 14 13 12 11 10 Printed and bound in Great Britain by CPI Antony Rowe, Chippenham and Eastbourne

Contents List of Tables and Figures

vi

Notes on Contributors

ix

1 Europe’s Economic Problem Is Political After All! Jean-Paul Fitoussi and Jacques Le Cacheux 2 Globalization and the Twin Protections Jean-Paul Fitoussi 3 Euro Area Policies and Macro Economic Performance, Ten Years On: Institutions, Incentives and Strategies Jérôme Creel, Éloi Laurent and Jacques Le Cacheux 4 Peer Pressure and Fiscal Rules Jean-Paul Fitoussi and Francesco Saraceno 5 The ECB’s Quiet Hijacking of the Euro Area’s Exchange Rate Jérôme Creel, Éloi Laurent and Jacques Le Cacheux 6 The Irish Tiger and the German Frog: A Tale of Size and Growth in the Euro Area Éloi Laurent and Jacques Le Cacheux 7

Funding the EU Budget with a Genuine Own Resource: The Case for a European Tax Jacques Le Cacheux

8 The EU Environmental Strategy Jean-Paul Fitoussi, Éloi Laurent and Jacques Le Cacheux

1 11

21 53

82

104

132 160

9 If It’s Broken, Don’t Fix It: The Government of the Euro Area in the EU “Reform Treaty” Éloi Laurent

187

Index

203

v

Tables and Figures Tables 3.1 Income gap and income inequality between the United States and the euro area in 2004 3.2 Breakdown of the per capita income gap (2005) 3.3 Comparison of the status of large central banks 3.4 Average annual inflation rate per country, euro area, 1999–2007 6.1 GDP per capita index, 2005 for EU countries 6.2 Trade to GDP in 2005 for OECD countries 6.3 Germany’s GDP use from 1995 to 2005 at current prices, billion euros 6.4 First 15 trade partners of Germany in 2005 6.5 Gap with Germany in unit labour costs growth (whole economy) from 1999 to 2005, % points 6.6 Nominal exchange rate of Germany (euro) with main trade partners outside the Euro area from 1999 to 2005 6.7 German growth, domestic demand, share of exports in GDP, unemployment and long term unemployment, 1999–2005 6.8 Domestic and trade indicators for Ireland, 2004–2006, in % growth 6.9 Main economic indicators for Germany in 2005 and 2006, in % growth 6.10 Imports variation from 2005 to 2006 for Germany’s main trade partners, in % 6.11 Unit labour costs variation from 2005 to 2006 for Germany and its main trade partners in the Euro area 8.1 The top 20 biggest GHG polluters, 1990–2004 8.2 Distribution of GHG due to energy consumption among countries and regions, in CO2 million tonnes 8.3 Kaya’s Breakdown (1990) for the EU 15 (1990–2004) and the rest of the world (1970–2004) 8.4 GHG emissions reduction forecast for 2010 compared to the Kyoto commitments in the EU 15 8.5 GHG sources in the EU vi

26 27 33 36 114 116 119 122 122

123

124 126 126 127 127 165 168 170 175 177

Tables and Figures

vii

Figures 3.1 Per capita GDP as a % of that of the US, 1991–2005 (in PPP) 3.2 Per capita GDP as a % of that of the US, 1970–2005 (in PPP) 3.3 Breakdown of the living standard lag between Euro area countries relative to the United States in 2005 3.4 Real GDP annual growth rates from 1999 to 2006 3.5 Euro area countries’ real GDP annual growth rates (1998–2006) 3.6 Euro area’s consumer price index (1999–2006) 4.1 Fiscal impulses 4.2 Output gaps and fiscal impulses 4.3 Threshold value as a function of 5.1 The pro-cyclical evolution in the euro’s exchange rate 5.2 The euro to dollar exchange rate 5.3 The euro area’s real growth rate 5.4 Euro/dollar parity in the long-term euro to dollar parity 5.5 The U.S. exchange policy, 1992–2005 5.6 The U.K.’s exchange policy, 1992–2005 5.7 Japan’s exchange policy, 1992–2005 5.8 Australia’s exchange policy, 1992–2005 5.9 Sweden’s exchange policy, 1992–2005 5.10 Work unit costs in large continental European economies 6.1 Real GDP growth in the Euro area, 1995–2005 6.2 Long term unemployment, 1995–2005 in % 6.3 Long term unemployment in the Euro area, 2005 6.4 Real GDP growth among OECD large and small countries, excluding Euro area members, 1995–2005 6.5 Real GDP growth among large and small members of the Euro area, 1995–2005 6.6 GDP per capita in Ireland, U.K. and Western Europe, 1870–2001, in 1990 international Geary-Khamis dollars 6.7 Irish export and imports, 1977–2005, in million euros 6.8 Corporate taxation in Ireland, the EU 15 and the EU 10, nominal tax rates on profit (%) 1979–2005 6.9 Use of German GDP, 1995–2005, in % 6.10 Trade to GDP ratio for selected EU member states, 1991–2005 6.11 Annual growth rates of nominal compensation per employee in the private sector, 2000–2005 6.12 Real GDP growth among the “big two,” 1995–2005 6.13 Real domestic demand among the “big two,” 1995–2005

24 24 27 28 29 34 58 58 71 94 95 95 96 97 97 98 98 98 100 105 105 106 109 109 113 117 117 118 120 121 124 124

viii

Tables and Figures

6.14 Trade to GDP ratio, 1995–2005 6.15 Exchange rate variations between the euro and Germany’s main trade Eastern EU partners, 2005–2007 6.16 Corporate taxation in the world in 2006 (nominal tax rates on profits, in %) 7.1 European budget 1971–2005: Breakdown of revenue 8.1 GHG emissions in billion tonnes of CO2e, according to the Kyoto Protocol reference years (1990 or 1995) 8.2 The European consensus on climate change 8.3 Environmental legitimacy in the EU 8.4 Distribution of GHG emissions among the EU 25 in 2004 8.5 GHG Emissions in the EU, 1990–2006 (1990 = 100%)

126 128 129 135 169 170 171 176 176

Notes on Contributors Jérôme Creel is Associate Professor of Economics, ESCP-EAP European School of Management, Paris, France, and a Deputy Director at OFCE/ Sciences Po, Paris, France. He is a member of the Editorial Board of Revue de l’OFCE. He is the author of a book on the EU and has published more than 40 papers in refereed journals and books. Jean-Paul Fitoussi is Professor of Economics at the Institut d’Etudes Politiques de Paris (Sciences Po), President of the Scientific Council of the IEP in Paris and President of the OFCE, Sciences Po Center for economic research). Expert at the European Parliament under the Economic and Monetary Affairs, Fitoussi has since 1996 been a member of the Economic Commission of the Nation. His main contributions have focused on the theories of inflation, unemployment, open economies and the role of the macroeconomic policies. He has published many books and articles. Recently, he has been co- chairing, along with Joseph Stiglitz and Amartya Sen, the Commission for the Measurement of Economic Performance and Social Progress. Éloi Laurent is a Senior Research fellow at OFCE (Sciences Po Center for economic research), France. Based in Paris, he teaches at Sciences Po, Stanford University in Paris and the Collège des Hautes Études Européennes (La Sorbonne). He was a former aide in the French Parliament and to the French prime minister. He has been a visiting scholar at New York University, Columbia University and at the Center for European Studies at Harvard University. Jacques Le Cacheux is Professor of Economics at the Université de Pau et des Pays de l’Adour. He has been working at the OFCE since 1983 and has been the Director of its Economics Research Department since 1993. He also teaches at the Paris Institute for Political Science (Sciences Po), Stanford University in Paris, the European Online Academy, and the Collège des Hautes Etudes Européennes (La Sorbonne). His areas of research include European integration issues, taxation and international macroeconomics. Professor Le Cacheux has been a member of the INGENUE Team since the launching of the project in 1999, and a member of various European research projects and networks financed by the EC Commission (EUROMOD, MOCHO, EUROCAP, CONNEX, CONSENT). ix

x

Notes on Contributors

He is the author of a number of journal articles and books, including recently Les Français et l’impôt. Francesco Saraceno is Senior Research Fellow at OFCE/Sciences Po, Paris, France. He majored in Economics at the University of Rome “La Sapienza” and in 1994 enrolled in the PhD programme at the University of Rome, where he specialized in disequilibrium macroeconomics. In 1995 he was awarded the Bonaldo Stringher Scholarship from the Bank of Italy, and was accepted for a PhD in Economics in the Department of Economics at Columbia University. In January 2000 he became part of the Council of Economic Advisors for the Italian Prime Minister’s Office. He moved to Paris to work in the OFCE, a prestigious think tank headed by Jean-Paul Fitoussi.

1 Europe’s Economic Problem Is Political After All! Jean-Paul Fitoussi and Jacques Le Cacheux

1.1 Shield or curse? Will the Euro zone survive the current crisis? Is it threatened by implosion, as financial markets would seem to believe, judging from the much increased interest-rate spreads on public debts of Euro zone members? Or is it not, instead, a haven of peace and quiet amid an ocean of banking and financial turmoil, as some smaller non members are tempted to believe, attacked as they are by speculative waves and suddenly eager to join the Holy land of stability, behind the shield of the single European currency. The banking and financial crisis that initially hit the US in the 2007 and soon spread to the UK was long seen as specifically hurting those economies that had been indulging into the financial excesses of the new millennium, but not those—Continental economies—that had stronger banking systems, sounder financial practices, and a better managed currency. It soon became apparent that many a European bank had been, in a way or another, participating in the financial excesses and that European financial markets were being hit as badly as those of the rest of the world. While, during the fall of 2008, the various economic forecasts for the Euro zone and its constituent economies were turning more and more negative, European governments were slow to react. As usual, the temptation was first to put the blame on others and to wait for partners to act. In spite of the enhanced leadership under the French Presidency, during the second half of 2008, the bank rescue effort remained essentially national and even admittedly contrary to the principles of the common competition policy and the single market for goods and services. And the lack of cohesion, or indeed even coordination, was more visible yet when national governments started 1

2

Jean-Paul Fitoussi & Jacques Le Cacheux

to make their independently conceived fiscal stimulus plans public, with a highly heterogeneous list of tax cuts and expenditure increases, mostly targeted to national suppliers, and the sum of which amounted to much less than even the modest, 1.5%-of-GDP fiscal recovery plan the Commission had called for in November 2008. In the various summit meetings hastily convened in the first weeks of 2009 to face the seemingly spiralling depression and rapidly increasing unemployment all over Europe, no common action plan has emerged. Within the Euro zone, Southern countries—Greece, Ireland, Portugal, Spain, and, to some extent, Italy—, some of whom had been hailed as the best performers in the European growth race not so long ago, are now being charged very high risk premiums on their public debt, as if rating agencies and financial market participants were effectively expecting either defaults on their public debts or exit out of the single currency. And most EU countries that are not yet members of the Euro zone, in Central and Eastern Europe, many of them also praised as success stories in the years preceding the crisis, are on the brink of bankruptcy. The only answer to date has been a call for reinforcing the IMF intervention capacity! The list of shocks which have hit the European economy in 2008 is unusually long: huge increase in the price of oil and other primary goods, in the price of agricultural products, decrease in housing prices, bank’s crisis, appreciation of the Euro, and increase in the inflation rate. No wonder that international as well as national institutions have been revising their growth forecasts downward, turning them into more and more negative figures. Early in 2009, it clearly appeared that the EU was being hit by the most severe recession since at least the Second World War. Of course, it may be argued that most developed economies in the world, and indeed many emerging ones, are also suffering the current downturn. But weren’t the euro and its prudent policies supposed to shield the EU from external excesses and macroeconomic shocks?

1.2 Rules and discretion Why then this malaise vis à vis the European situation? One reason for it may be the passive acceptation of the recession as if it were a meteorological dictum. What is worse is that European officials are inviting the government of the countries of the zone to adapt to the lower level of growth, not to try to contradict it! The “excessive deficit” rule included in the Stability and Growth Pact has effectively been waived, in agreement with the 2005 reformed version of the Pact that emphasizes the

Europe’s Economic Problem Is Political After All! 3

need to take circumstances into account. But the Commission proceeds to launch the routine procedures for excessive deficits. At minimum the economic analysis behind the interpretation of the Stability Pact by the Commission is faulty—at maximum the Commission is no longer in charge of the general interest of Europe, but of applying to the letter policy rules whatever harming to the economic situation they may be. What is puzzling is the autonomous dynamic of the Stability Pact which despite reforms to allegedly increase its flexibility seems to become more and more rigid. The focus of the Commission is by now much less on the level of the deficit than on its medium term evolution towards zero! Many European economists are now advocating the introduction in national constitutions of a fiscal rule whose effect will be to constrain countries to obey the stability pact. Germany is praised to prepare for such a revision in its constitution. Notice that outside Europe almost no economists, nor politicians are pleading for such a move, and that inside Europe but mezzo voce many politicians are criticizing the Stability Pact. Two questions are usually mixed in the European public debate: bad government which through demagogy leads to expenditures of bad quality, and deficit. The confusion between the two leads the population to consider deficits as a symptom of bad government. Economic rules because they have to be explained to an internal political audience, and to be agreed upon by other governments should have at least two properties: to be simple and to be associated with a principle of good government. Hence whence they are (loudly) legislated, it becomes very difficult to call for their change without appearing as derogating to a principle of good government. This is especially true of fiscal rules because of the common wisdom according to which fiscal discipline, whichever the expression means, is always the sign of a good management. Then any departure from the rule, provided it is not the fact of all the member states, conveys the idea of bad government, lack of courage, demagogy etc. Grades are given to the member states in the European classroom and the mauvais élèves are publicly designed (early warning etc.). What is then at stake is the reputation of the different governments both vis à vis their electorate (and the opposition being in the left or in the right side is prompt to denounce deviations from the rule in the public debate) and their peers. Notice that this European way of confusing the issue is in contradiction with the European appraisal of Anglo-Saxon countries considered, wrong or right, to have good government and institutions but characterized by higher deficits.

4

Jean-Paul Fitoussi & Jacques Le Cacheux

The second overwhelming proof of the passivity of the “European government” with respect to the shocks which are hitting the European economy is the relative inertia of the interest rate of the ECB. How can it be? Is the Fed completely wrong for having, over a period of a few months, brought its own interest rate to almost zero, despite an inflation rate in the US slightly higher than the European one? For long, the ECB seemed to be worrying about a possible reaction of wages to the increase in the inflation rate. In other words, to avoid a wage-price inflation spiral, the “external tax” due to the increase in oil prices in particular should be paid only by the wage earner. Then the decrease in purchasing power of the median worker would calm inflationary pressure helping the ECB to reach its inflation target. To that mechanism will cooperate also the decrease in purchasing power due to the increase in food prices. Notice that the different shocks alluded to above have a deep inequalitarian effect, as they disproportionately hit lower incomes: their burden is inversely related to the level of income. It is even the case of the bank crisis as access to credit will become more difficult for lower income recipients. And as soon as the fall of 2008, it had become clear that these external price shocks had vanished and were being replaced by serious risks of deflation, calling for strong monetary policy reaction from the ECB that had been forthcoming. Hence on both accounts—fiscal and monetary policy—the first staying passive or even becoming more restrictive, the second as a “police” of wage being clearly restrictive, the European policy mix is badly adapted to the gloomier growth prospect of Europe. When one adds the obvious fact that both the slowdown of world growth and the previous significant appreciation of the Euro are reducing European net exports, it is all the components of demand which are likely to decelerate. But we are told this is the only robust policy, the only virtuous one through which we may hope to reach a higher rate of growth in a more or less remote future. “Promises commit only those who are hearing them” once said a French politician. Why should we believe in this one? The other big economy of the world, namely the US is engaged in an exactly inverse policy, trying to boost both external demand, through the depreciation of its currency and internal demand through expansionary fiscal and monetary policies. Maybe the US policies are wrong, but to say the least such an appreciation can’t be sustained on account of past performances. The puzzle is then the following: why are the two biggest economies of the world, while confronted with almost similar shocks, pursuing radically divergent policies?

Europe’s Economic Problem Is Political After All! 5

The most obvious answer is that one economy has a government the other not, or to be fairer the other has a system of governance. A government has to be reactive; a system of governance if badly designed can’t be so. The lack of reactivity of the European “government” is not contingent to the present crisis but structural. It stems from the dissociation between legitimacy and power. The federal institutions of Europe which dispose of the instruments of economic policies (monetary, fiscal and industrial) lack the legitimacy to react once actions exceeding their mandate have to be implemented. The local governments (i.e., the national governments of the Euro area) which enjoy full legitimacy through the electoral process lack the instruments to react. If one adds that because no institution can survive without legitimacy, the federal institutions of Europe have tried to found theirs in economic doctrine, there is no wonder that they consider as absolute priorities of economic policy price stability, budget balance and competition. The contrast with the US which consider as absolute priorities, growth, employment and purchasing power is thus striking but not astonishing: a government that has to be re-elected has to care above all for the welfare of its citizens whatever the predicaments of economic doctrine. In a nutshell, our economies are paying the economic cost of the non political Europe, that is of the absence of an accountable federal government.

1.3

Contents

Chapter 2 provides the general framework for thinking about the future of globalization and the European integration process. It argues that nation-states have been the locus of protection against the instability and negative effects of globalization, by organizing welfare and the provision of other public goods, favourable to economic growth. In the present and foreseeable future, there is a need for similar mechanisms, but at a higher level, especially if one wants to avoid protectionist reactions in developed economies, and given the challenges facing the global economy in the fields of knowledge and the environment, both having the nature of global public goods. Chapter 3 is dedicated to a review of macroeconomic policies in the Euro zone over the past decade, that is, since the launching of the single European currency. This account clearly shows that monetary authorities have been over-preoccupied with the exclusive objective of monetary stability which is most strictly defined. Monetary policy therefore

6

Jean-Paul Fitoussi & Jacques Le Cacheux

appears insufficiently reactive to economic slowdowns, yet over reactive in times of economic recovery. On the other hand, it appears that the fiscal rules comprise incentives that are not too favourable to sustainable growth policies. Thus, the policy mix spontaneously emerging from the strategies by the various economic agents in response to the institutions and their policies leads to euro exchange rate changes that incite Member States’ national governments to favour non-cooperative strategies, such as for example “competitive disinflation” as well as tax and social competition. Chapter 4 offers an analysis of the fiscal rules governing the national fiscal policies in the European monetary union. It suggests that, rather than being grounded in economic rationales, the Stability and Growth Pact has to be viewed as a social norm, dictating the conduct of EU governments. Chapter 5 explains the absence of an explicit exchange rate policy in the Euro zone by the lack of political will in the Eurogroup. Indeed, the European Union Treaty includes the possibility for the European Council to define an exchange-rate regime, which would then be managed by the European Central Bank, as is indeed the case in all developed economies and was actually also the case in national monetary arrangements—including that prevailing in Germany—prior to monetary unification. Due to an early choice not to mingle with the external exchange rate of the euro, exchange-rate management has, in practice, been left in the hands of the ECB. Though not explicitly running an exchange-rate policy, the latter has tended to influence the exchange rate in a pro-cyclical and asymmetric manner, due to the priority given to price stability. Chapter 6 is dedicated to a case study of the effects of size on macroeconomic strategies chosen by national governments in the EU, and most specifically in the Euro zone. It takes two extreme examples: Germany, an illustration of a “large” economy that, in recent years, has embraced a small-country strategy; and Ireland, a small open economy that has long been hailed a success story for a small open economy in the European context. Chapter 7 emphasizes the weaknesses and shortcomings of the current EU budget and argues that one way to improve its functioning and promote the provision of European public goods, as well as ensuring a better role of the EU budget in the stabilization process, would be to reform its funding by introducing a genuine European tax. Several tax instruments may be considered as potential candidates. The chapter

Europe’s Economic Problem Is Political After All! 7

concludes that a European carbon tax or a European corporate income tax would probably be the most appealing instruments. Chapter 8 focuses on the EU environmental strategy, as a major area of public good provision. Taking the example of climate change, it shows that the EU has, for a number of years, taken the lead in establishing instruments and procedures for effectively promoting greenhouse gas emissions. However, we also show that even the ambitious EU goals for fighting climate change might fall well short of what is required in the absence of new policy instruments. Chapter 9 argues that the Lisbon Treaty is not likely to improve the situation of the Euro zone in terms of economic policy coordination, essentially because it contains no provisions for a better decision-making on macroeconomic policy coordination, nor on monetary policy.

Annex

1. Consumer Price Index, annual growth in %

Three big euro area Euro area EU non-euro US

Average 1979–1991

Average 1992–1998

Average 1999–2007

6.34 8.09 7.32 5.88

2.65 3.06 2.34 2.60

1.75 2.06 1.58 2.71

Data source: OECD.

2. Unit labour cost, annual growth in %

Three big euro area Euro area EU non-euro US Data source: OECD.

Average 1979–1991

Average 1992–1998

Average 1999–2007

5.95 5.90 7.60 4.76

1.55 1.83 1.86 1.91

1.33 1.59 2.48 2.29

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Jean-Paul Fitoussi & Jacques Le Cacheux

3. GDP and GDP per head, annual growth in % Average 1979–1991

Three big euro area Euro area EU non-euro US

Average 1992–1998

GDP (volume)

GPD per head (GDP/Working age population)

2.56 2.5 1.99 2.74

Average 1999–2007

GDP

GPD per head

GDP

GPD per head

1.77

1.48

1.28

1.72

1.65

1.68 1.62 1.44

1.76 2.59 3.56

1.44 2.35 2.49

2.18 2.77 2.75

1.82 2.09 1.36

Data source: OECD.

4. Unemployment rate (in % of labour force)

Three big euro area Euro area EU non-euro US

Average 1979–1991

Average 1992–1998

Average 1999–2007

6.61 7.52 8.15 7.00

9.46 9.89 8.25 5.85

8.64 8.31 5.14 4.95

Data source: OECD.

5. Labour productivity, annual growth in %

Three big euro area Euro area EU non-euro US Data source: OECD.

Average 1979–1991

Average 1992–1998

Average 1999–2007

1.70 1.80 1.58 1.00

1.66 1.60 2.45 1.56

0.78 0.78 1.81 1.87

Europe’s Economic Problem Is Political After All! 9

6a. Economic performance before and after the creation of the Euro (EU countries) Euro area

Nominal performance Inflation (%) Fiscal balance (% of GDP) Gross public debt (% of GDP) Long term interest rate (%) Real long term interest rate (%) Real performance Real GDP (% rate of change) Real GDP per capita (% rate of change) Real GDP per capita (index, US = 100) Employment (% rate of change) Labour productivity (% rate of change) Unemployment (% of labour force)

EU non-euro

1989–1998

1999–2008

1989–1998

1999–2008

3.3 −4.3

2.2 −1.7

3.4 −3.6

1.7 −0.9

68.6

68.6

48.7

43

8.1

4.4

8.6

4.9

4.7

2.4

4.2

3.3

2.2

2.1

2

2.7

1.9

1.6

1.7

2.2

73

72

74

76

0.6

1.3

0.1

0.9

1.6

0.8

1.9

1.8

9.3

8.3

7.9

5.2

Data source: European Commission.

10 Jean-Paul Fitoussi & Jacques Le Cacheux

6b. Economic performance before and after the creation of the Euro (Euro area and the US) Euro area

Nominal performance Inflation (%) Fiscal balance (% of GDP) Gross public debt (% of GDP) Long term interest rate (%) Real long term interest rate (%) Real performance Real GDP (% rate of change) Real GDP per capita (% rate of change) Real GDP per capita (index, US = 100) Employment (% rate of change) Labour productivity (% rate of change) Unemployment (% of labour force)

US

1989–1998

1999–2008

1989–1998

1999–2008

3.3 −4.3

2.2 −1.7

3.3 −3.3

2.8 −2.5

68.6

68.6

67.8

60.7

8.1

4.4

7.1

4.8

4.7

2.4

4.3

2.4

2.2

2.1

3

2.6

1.9

1.6

1.8

1.6

73

72

100

100

0.6

1.3

1.5

1

1.6

0.8

1.5

1.6

9.3

8.3

5.8

5

Data source: European Commission.

2 Globalization and the Twin Protections Jean-Paul Fitoussi

Economic integration brings openness. Openness triggers volatility. Volatility fuels insecurity. Insecurity requires protection. The central problem of globalization, now and then, is thus how the demand for protection resulting from economic, social and environmental insecurity is met. This is the reason why the most urgent tasks for governments in the world in which we live is to devise the future, in a way to invent it to unveil what is considered by a large majority of our fellow citizens as an obscure road towards tomorrow. If the present fog continues to prevail, we will have great difficulties to be actors of our own destiny. In other words, we need new utopias to show the way. These utopias, unlike ideology and religions, have to be sustainable on earth. By sustainable utopia, I mean a system which is both feasible and acceptable. For example, globalization as a process is a feasible utopia, but for a large section of the population it is not acceptable, because of the huge inequalities—both between countries and inside countries—it apparently leads to. If we try to disentangle rhetoric from reality, globalization is not exactly what we think it is. In effect, we have to recognize from the outset that the phenomenon of globalization is happening in a world populated by nation states without any emptiness in between the Nations. And what could be the function of a nation if not to protect its population? More than ever the nation states of the world are alive and well: the hyper power of the United States, the super power of Europe, Russia, China, India and the like. Hence the rhetoric of globalization clashes with the reality of the phenomena as power and protection are putting strict limits on the interplay of free markets. For example, the selling of a nuclear plant by a country to another (in a context where such a trade is allowed) 11

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Jean-Paul Fitoussi

depends much more on the interplay of power than on economic considerations. The same can be said about the trade of energy, airplanes and the like. Trade between countries often obeys geopolitical considerations rather than sheer economic ones. There are political externalities to economic trade. Most of the time, trade between countries stems at the boundary between economics and diplomacy. Although this is an obvious assessment, it is necessary to belabour it to shaken the certainties of the free market believers. In such a setting free trade is more an ideological construct than a description of the state of the world. Another example of utopia is democracy. It is a utopia because democracy is always unfinished and has always to be reinvented. But, contrary to globalization, democracy is both feasible and acceptable. It is an acceptable utopia because it accomplishes inside each nation the right (with respect to the will of the people) mix of competition and cooperation which helps the system to survive. It is not a kind a doctrinal construct, but a pragmatic one because if the mix achieved is not acceptable, the system through election has the capacity to change the government, hence to change the policy. As a meta-institution, democracy is thus a self-correcting institution, which learns from its own mistakes. Its interplay with globalization implies that the latter can’t be a transcendent mechanism imposing its rules whatever they may be to political regimes. Hence for globalization in the effective sense, not the rhetoric one, to be a sustainable utopia, it has to become an acceptable one. For that it has to achieve a more balanced emphasis between competition and cooperation (or solidarity). A progressive globalization policy means essentially confronting the two challenges of economic insecurity and environmental destruction without resorting to either the protectionism of the riches or the growth limiting of the income of the poor.

2.1 To protect: A social democrat trade policy For reasons said above which pertain to the main duty of a nation state, globalization forces countries to define an optimal degree of protection (or at least an acceptable one), where benefits surpass losses for the economy such as it becomes possible for the winners to compensate the losers inside each country. Otherwise globalization would have either a detrimental effect or, in the absence of redistributive measures, the country would face political instability.

Globalization and the Twin Protections

13

There are two policies through which governments can reach the optimal degree of protection: welfare state building, that is social protection, and protectionism. Both have been implemented during the twentieth century with divergent fortunes. The rise of protectionism has led to the end of the first globalization and the world disasters of the first half of the twentieth century. On the contrary the rise of the welfare state has gone hand in hand with the internationalization of the economies of the world, that is with the progressive dismantling of barriers to trade. The contradiction of our times lies precisely with the fact that—for doctrinal and/or vested interests reasons, knowing that lobbyists are expert in the art of using doctrine to persuade politicians that their interests confound with general interest—politically correct policies are calling for welfare state (public education, social protection, public housing) retrenchment and hands-off macroeconomic policies (rules rather than discretion) to better confront economic integration. Yet, it is a reasonable assumption to think that the end of the first globalization occurred because of a choice made among industrialized powers to opt for strategic protectionism instead of welfare state building to meet the demand for protection triggered by economic insecurity. In the absence of a welfare state, protectionism was, so to speak, the protection of the last resort. The disastrous effect of these non-cooperative choices was overcome by the development of the welfare state only after 1945, which in turn made it possible for globalization to re-emerge progressively afterwards. But it seems that we have come to the end of this cycle: social protection is seen as a brake to competitiveness and hence as a handicap in a global world. It is why a mounting discontent of the people vis à vis globalization and a call for protectionism is present above all (but not exclusively) in rich countries. This attitude is logically consistent: if it is the satisfaction of the demand for social protection which has fuelled the globalization process, what would happen if once globalization installed, common wisdom tries to persuade people that social protection has to be leaner because of globalization? If you persuade the people of rich countries that they are handicapped in the globalization game because they are rich, there is no wonder that they are no more wiling to play the game. Fortunately we know that both welfare retrenchment and protectionism (by rich countries) are non-cooperative policies which for this very reason can’t be sustained through time. The reason why welfare state building has to be pursued and why protectionism refrained in developed countries has to do with the nature

14

Jean-Paul Fitoussi

of our growth regime. Social protection is not charity, but insurance, that is risk guaranteeing and innovation stimulating. Combined with a reactive macroeconomic policy, it protects individuals and firms by maintaining a high degree of economic activity. In a global environment, there exists on the part of the curve which is relevant for a developed country, an inverse relationship between risk aversion and protection: the less protected, the more risk adverse people are. Risk taking would become otherwise a question of survival. That may explain why small economies which are the most open economies are usually more socially protected. Benefits from globalization are linked to the capacity of the people to take risk for building the future. For example, investment and/or innovation are risk-taking activities. In other words, the higher the propensity to innovate (to take risks), the higher will be the benefits to the country accruing from globalization. Globalization becomes a win-win game only for those countries which develop the right strategy. Such a strategy should have at least two components: one geared to the protection of firms, the other to the protection of workers, that is social protection. (1) Protection of firms. There are three instruments of such a protection: ● The first is fairly general and it may be termed a “collective insurance” of activity. It implies that the government will not let growth slowdown, but for very short period, that is, that it will use the instruments of economic policy. Such a guaranty has two effects: to reduce the uncertainty linked with investment, and hence to foster it; to increase the dynamism of the labour market. ● A non-dogmatic doctrine of competition to allow more investment and innovation by firms, without fearing a too restrictive interpretation of competition laws. ● Institutions amicable for entrepreneurs, especially a wellfunctioning financial market. (2) Protection of workers (social protection). Without such a protection, workers will most likely oppose change, because they would not be willing to take risk without being insured that if they fail they will get a second chance. To take just an example, globalization increases the risk of delocalization and outsourcing. These phenomena can be seen as opportunities for firms and also for emerging countries, but they put the workers of the country of origin under stress. Without a

Globalization and the Twin Protections

15

well-functioning social protection system, they will lead to huge welfare losses not only for the workers but also for the territory where the firm was installed. These two components of protection are complementary. Without the first, the second would become too costly as the spending on social protection increase more proportionally than GDP when growth is below potential. But in such a situation, decreasing social protection will have a detrimental effect on growth (which, by assumption, is already too low). Welfare state building is also the most efficient answer—from the point of view of social cohesion to the development of inequalities that globalization could lead to. The greatest challenge emerging countries face is indeed the explosion of income and social inequalities stemming from their access to globalization. It seems plausible, when one thinks about countries like China, Russia or Brazil, that this development of inequalities could trigger a political instability such that ultimately development would be jeopardized (and openness with it). By now, it has been widely recognized that globalization is not that good for a substantial fraction of the wage earners; inequalities in rich countries have reached such a degree that it is hard to think that their costs are still worth bearing. Yet if plain protectionism should be prohibited for developed economies, it has some merits for potentially emerging and emerging one. It has been established long ago that trade protectionism may help “infant industries” and so foster the long term rate of growth of developing countries. The integration of those countries into the world economy requires almost as a pre-requisite a richer industrial structure. Financial protectionism has also much to recommend to it in view of the catastrophic effect that capital market liberalization has had, continues to have and could have in the future for developing economies. Today’s global imbalances are a threat for the world at large, especially for developing countries. These imbalances turn around the increasing current account deficit of the United States. Consumption and investment have been growing at excessive pace, while savings (private and public alike) were excessively reduced. This has a mirror image in the excessive savings of East Asian emerging countries and in Europe and Japan. While the former is justified by the absence of a functioning welfare state, and by the need to build up international reserves, in Europe and Japan excess savings reflect slow growth and aggregate demand insufficiencies.

16

Jean-Paul Fitoussi

Overall, these imbalances compensate each other and the system is in a fragile equilibrium. If this fragile equilibrium collapses, industrial countries’ retrenchment would lead to capital outflow from emerging countries hurting them according to their degree of exposure to capital market liberalization. Let me add that there is no such thing as a purely liberal trade policy even in the richest countries. Free trade is a matter of degree or to be politically incorrect, protectionism is a matter of degree. If we always find a modicum of protectionism in rich countries, it is because a grey area exists in each country where protectionism in some transition periods is an element of the social protection system of the workers. If we consider three coordinates, namely the level of development, that of social protection and the degree of protectionism, there theoretically exists in the most developed countries a trade-off between social protection and protectionism, but in actuality small economies have no freedom of choice, and this trade-off is only available in big economies. (It seems to me that the degree of (hidden) protectionism in the US is higher than in Europe). For rich economies the optimal choice lies towards the social protection end of the trade-off. Such is not the case for developing countries where fiscal and social receipts are too low and the welfare state embryonic. Protectionism would then bring two benefits: to allow for a richer industrial structure and to provide through tariffs the necessary public funds to build a social system. One has to emphasize that this mix of protectionism and (almost) free trade which should characterize the world economy design a cooperative policy, which is of an entirely different type from the strategic protectionism that has characterized the interwar period. Its aim is to allow for social inclusion on a broad scale—inside countries through the social protection system in the richest ones and among countries through the progressive catch up of the developing ones allowed by a regulated protectionism. In a nutshell, the general principles of a social democrat trade policy should be as follows: social protection and openness (especially to emerging countries products) in developed countries; trade protection for industrial development reasons but integration in the world economy for developing countries. In achieving a better balance between competition and cooperation (or solidarity) globalization could become a sustainable utopia because it would be an acceptable one. Regulating competition is the first step in this direction. Promoting cooperation to decrease environmental insecurity should be the second.

Globalization and the Twin Protections

17

2.2 To sustain: The new technologies of energy and the environment The locus of solidarity at the global level is the provision of global public goods. Cooperation leads to a clearer design of the future because it raises the level of solidarity between nations. Furthermore, the provision of global public good, such as health, education, environment and energy should be an engine for growth. I will focus here on the provision of two public goods—environment and knowledge—to show that contrary to common wisdom they may be the engine for growth of tomorrow. The good news brought about by the high rate of growth of large emerging countries (China, India, Brazil, etc.) is increasing our consciousness of the probable exhaustion of the natural resources on which our present growth model is dependant. It is also increasing our consciousness of the already disastrous effect that our growth model had on the environment and of the potential catastrophic effect it may have in the future, notably through climatic change. To avoid these effects, some scholars or green political parties are promoting in the public debate the choice of another model of development, more “environment friendly” and less geared towards “material” growth. They sometimes refer to it as the “negative growth” model. In a world characterized by such huge inequalities both between and within countries, and by a strong aspiration of the poor to access to a minimum level of dignity, the message of these scholars is hardly understandable. The development of the new technologies of the environment and energy in the EU and the US, and the creation of a global market for those technologies seems a much more sustainable utopia. By new technologies of the environment and energy (NTEE) I mean all technologies able to lower the energy content of our standards of living, all technologies leading to the production of energy from renewable resources and all technologies helping to preserve, repair and ameliorate the environment. Thinking about the interaction between economic processes and the natural environment, one has first to realize that no economy is a closed, autonomous universe, governed by rules independent from law, morals and politics. Indeed, the most interesting economic questions are generally located on the borderline with neighbouring disciplines. Nowhere is this clearer than in the interaction between economic processes and the natural environment.

18 Jean-Paul Fitoussi

The distinctive feature of this exchange is that it is governed not by the laws of mechanics, but by those of thermodynamics, particularly the law of entropy, according to which the quantity of free energy that can be transformed into mechanical work diminishes with time—an irreversible process culminating in “heat death.” Numerous researchers, inspired by the late Nicholas Georgescu-Roegen’s pioneering work on the relationship between economic processes and physics, tried—not very successfully—to formulate an “entropic” theory of economy and society, especially during the 1970s. The entropic view assumes that economic processes produce irreversible consequences because of their multiple interactions with nature. We draw from stocks of non-renewable natural resources (e.g., oil and metal ores), and we deteriorate or modify the quality of other resources (e.g., water and arable land) by imposing on them a rhythm of exploitation superior to their capacity for regeneration. In fact, the exploitation of non-renewable resources frees the speed of economic growth from that of ecological renewal, aggravating the deterioration of the biosphere, including irreversible climate changes. The law of entropy (which traces a time arrow) reminds us that we will leave to future generations a degraded natural patrimony, probably less adequate to their needs than what we inherited. Unfortunately, there are no simple answers. On what principle can we ask China and India, for example, to limit their economic dynamism so that they use smaller amounts of the planet’s natural resources? After all, the advanced countries’ slower growth is not the consequence of voluntary self-limitation, but of our superior standards of living—and of our incapacity to settle our own economic imbalances. We cannot impose an ecological rhythm on people who are poorer than we are when it is the very fact that we freed ourselves from that rhythm that made us richer. Economic contraction, or even stagnation, is not a solution for the developed countries, either, for a similar reason: it would imply that we either accept existing inequalities or impose a regime aiming at an equal redistribution of resources. That choice boils down to an unbearable cynicism or a totalitarian utopia. But, happily for us, our evolution is determined not only by entropy but also by the accumulation of knowledge and technological progress—a process that is just as irreversible as the decrease in stocks of non-renewable resources and the degradation of environmental quality. It designs another time arrow which applies to the accumulation of intangible assets. Thus, the economy is entropic for resources and historical for the production, organization and spread of knowledge,

Globalization and the Twin Protections

19

with the prospects for economic and environmental sustainability residing in the space left between those two dynamic processes: the level of growth we choose must be conditioned on a sufficient level of knowledge to ensure the system’s survival. Yet nature, like knowledge, is a public good that needs state intervention to be “produced” in sufficient quantities. The only way to overcome the finiteness of our world is to maintain as much space as possible between entropy and history by investing in education and research aimed at increasing renewable energies, reducing the energy intensity of our standards of living, and slowing the pace of environmental erosion. It is widely believed that such a strategy would be useless if the only effect is to allow others to get rich faster by opting out. But if that strategy is conceived as mastering two dynamic processes, overcoming the ecological constraint could be an accelerator of growth. The new technologies of the environment and energy may have as strong an impact on productivity as the new technology of information and communication. But they will at the same time help to produce a cleaner environment and thus a more sustainable economic system. As there is a growing social demand—not just for health reasons—for a cleaner environment, the satisfaction of it will lead to a sustainable increase of growth exactly like the satisfaction for a growing demand of services has been in the past. Let us assume that the utility function is of a lexicographic type: the increase of income will shift the structure of demand towards environmental goods. Those goods are becoming normal goods in rich countries but are still luxury goods in developing ones. The beauty of the thing is that the satisfaction of the demand for environment in rich countries requires the subsidization of the demand for a luxury good in poorer ones, as it is a global public good. (We should have understood earlier that the same is true for the demand for health). Of course, the greatest challenge is to find practical ways to share the financing of these investments, ultimately aimed at the provision of global public goods among countries. A step forward will be to start with already existing institutional framework at the regional level. The European Union exists and a great way to reshuffle its future would be to implement the European Community for Environment, Energy and Research (EC2ER), exactly as the founding fathers of Europe created the community for coal and steel (the most powerful means of the war) in 1951 and made it possible to prevent war through trade.

20

Jean-Paul Fitoussi

Here again, the relation between developed, emerging and developing countries must be strengthened. It is a fact that developed countries are the biggest global polluters today while emerging and some developing countries could be the biggest global polluters tomorrow. It thus makes good sense to invest massively in the EU and the US today to develop those technologies and through technological transfers to make them available to developing and emerging countries. After all we will be the primary beneficiaries if we subsidize less advanced economies so as their growth model becomes more environment friendly. A sustainable utopia would be to create a global public institution for this purpose financed mainly by rich countries which will make the new technologies freely available to all countries of the world. Only democracy, through protection and sustainability, can stabilize globalization the way the welfare state has stabilized capitalism after 1945. Without a progressive globalization policy, the second globalization will soon be history.

3 Euro Area Policies and Macro Economic Performance, Ten Years On: Institutions, Incentives and Strategies Jérôme Creel, Éloi Laurent and Jacques Le Cacheux

Up until the severe slowdown of the summer 2008, the European economies had enjoyed almost two years of relatively faster growth that had tended to mute the criticisms caused by the way the euro monetary zone had been functioning since it was launched. With a growth rate nearing 2.5% a year on average and the German economy picking up and doing even better than the rest, commentators were quick to praise the European Central Bank (ECB) for its sound and wise management of the single currency: by raising interest rates soon enough, the ECB was said to have supported the external value of the euro, thus dampening inflation without noticeably slowing exports growth. Thus the EU wished to believe that the black years are over, that the efficient management of the single currency, the structural reforms, the re-launch of the “Lisbon Strategy” in 2005 with the virtually concurrent reform of the Stability Pact have put the European economy back on tracks and all that is currently needed is simply to keep up with the effort already accomplished. Germany, the paragon of this regained virtue because it has constantly supported the European monetary institutions, their independence and their wise choices, is cited as an example. Germany’s moderate wage policy and its “bold” reforms of the labour and social protection markets are given credit for renewed growth. As it is enjoying better days again, Germany has become fiscal discipline’s most stalwart supporter, after being the country that most largely drifted away from it for many years. As Germany is again the world’s largest exporting country and is piling up huge trade surpluses, the French prompt as they are to indulge in illusion and idolatry, are once more struck 21

22

Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

dumb with admiration for the “German model,” attributing it with every virtue while they cannot fail to notice that this model does not seem to give a fig for the European currency’s strength on exchange rate markets. What would be called for is not to change anything but simply carry on with reforms and slightly speed up fiscal consolidation in the countries like France and Italy where it is deemed insufficient. The European currency’s strong appreciation in value on exchange rate markets, the ambiguous signals of an economic slowdown across the Atlantic in the aftermath of the financial crisis, tensions on financial markets as well as sustained oil price increases represent as many factors which, regardless of a subsequent tightening of monetary policy aiming to fight overeagerly against inflationary pressure which is mostly due to import prices, has unfortunately put a premature end to Europe’s encouraging economic recovery. Without further delay, one must examine the real reasons for the European economy’s long-standing weakness. This chapter offers to look into this by emphasising the shortcomings of the EU’s macro economic policies, more especially those of the euro area, that have been developed over the last decade, first in preparation for the introduction of the single currency and then to carry out the currency’s proper management. If the first policies—and the subsequent sacrifices in terms of growth and employment—could be justified by the investment needed to put a new currency in place and set up a common currency area, the measly size of the fruits harvested since the launch of the euro is likely to jeopardise the support of the euro area’s populations for their new currency and for the institutions in charge of its management. Actually, confidence in a currency, especially when it is new and shared among several Nation-States, cannot only be subsumed, in spite of what many economists tend to believe, into the sole factor of monetary stability. In order that a whole set of economic agents have long-term trust in fiduciary money, in all the rules about its management and the economic governance that this implies, they must surely first believe in its perpetuity value—the purchasing power of that currency, that is, they need to be convinced that the official measure offered for it is credible. Yet, in addition, economic performance in the monetary zone thus constituted, regarding growth and employment among others, must be judged satisfactory enough so that the constraints from its operation on the national economies that are part of the system are not deemed excessive. In support of our argument, we first provide an outline of the euro area macro economic performance and compare it with that of the world’s other regions. Then we move on to show that, since the introduction of the euro, monetary policy has tended to focus on the monetary stability

Euro Area Policies and Macro Economic Performance 23

objective, in accordance with the ECB’s mission. Yet, one side effect has been increased constraints on national governments’ fiscal policies. These are examined in the following section that underlines the biases derived from the fiscal policy rules—the Stability and Growth Pact (SGP)—the incentives brought about by euro area institutions and the lack of a common economic policy. In the next section, we stress more generally the implications of these incentives for national governments’ strategies. In conclusion, we explore the dangers for the EU and the euro area of continuing further with the current strategies.

3.1 Prologue: Weak performance, yet the institutions are sound? “How come the euro area’s performance is so weak, if the Economic and Monetary Union is so wonderful?” This question by M. Wolf (2006), although economically incorrect, is probably the most concise way of formulating the problem that this chapter intends to clarify. The euro area is indeed an institutional paradox. Nowhere else in the developed world have greater efforts been made to build efficient institutions in the past 15 years, and yet nowhere else in the developed world either has economic performance been as disappointing over the last 15 years. “When the facts change, I change my mind” (Keynes). “Never change losing institutions,” the European leaders seem to retort. Or else, in a more sophisticated version, “the institutions are sound, it is the policies that are flawed.” But let us first turn to the facts. The euro area’s growth performance has been, since its inception, the topic of countless theoretical, empirical and ideological studies. So, we do not wish to bore the reader with yet another review of the question.1 We would rather concentrate on a more fundamental issue, namely the decoupling of the euro area economies’ per capita GDP from that of all other advanced economies in the world—including the EU 15, outside the euro area—since the monetary convergence strategy’s implementation by the Maastricht Treaty. What is even more alarming is that the decoupling has widened with the end of the monetary unification process and the introduction of the euro in 1999. Figure 3.1 shows that in terms of living standards, the euro area is down 6 percentage points relative to the United States over nearly 15 years, whereas the EU 15 countries which did not join the euro area have progressed slightly, Australia and Canada have made great progress, while Asia’s “little dragons” have caught up over 15 percentage points and have thereby overtaken the euro area in recent years.

24 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

Furthermore, the gap has widened after the introduction of the euro, even though one could have rightly expected that, once the period of efforts and sacrifices was over, the time to reap the dividends from the monetary union had arrived. Figure 3.2 shows in this respect the contrasted results between the euro area and the United

85 U.K., Sweden, Denmark (average) 80

Canada and Australia (average) 75 (%)

Euro zone 70

65

60

South Korea, Hong Kong, Singapore (average)

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 3.1

Per capita GDP as a % of that of the US, 1991–2005 (in PPP)

Source: OECD.

84 82 80 78 (%) 76 74 72

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

70

Euro area (except Finland and Luxembourg)

Figure 3.2

United Kingdom

Per capita GDP as a % of that of the US, 1970–2005 (in PPP)

Source: OECD.

Euro Area Policies and Macro Economic Performance 25

Kingdom, whose living standards were fairly similar in the early 1980s. That was still the case in the early 1990s but they began to diverge after 2000. This is worrying from an objective standpoint. It can be nuanced and interpreted in two plausible ways. First, one can show that once the inequalities in national income distribution are included, the gap between the euro area and the United States comes down by 25%. Table 3.1 indeed illustrates that the spectacular increase in U.S. income inequality since the mid-1980s narrows the gap in living standards with the euro area if the income proportion for the first two deciles is taken out—a proportion which was reaching nearly 46% in the United States in 2004. Thus considered, the lag in living standards goes down to 18% for France, 11% for Finland. It becomes virtually nil for Austria and even negative for Ireland. The overall gap with the euro zone falls from 28% to 21%. It must then be observed that this development gap still stems, and probably even more today than before, from the difference in the degree of labour utilisation rather than to a technological lag caused by an unsatisfactory per hour productivity—on the contrary, the figure is actually higher in France and Germany than in the United States2 —which makes the euro area different from other world regions. Put differently, that is, in Krugman’s words, the euro area does not suffer so much from an “inspiration” than from a “transpiration lag” when compared to the U.S. 3 Table 3.2 shows in that respect that the “manpower effect” is more significant than the “productivity effect” in the explanation of the living standard gaps, whereas the reverse situation prevails in all other groups of advanced economies. On this point, great disparities nevertheless exist among euro area countries, as shown in Figure 3.3. These differences obviously have an impact on the European monetary policy’s expected efficiency, and therefore on the possibility of carrying out a counter-cyclical policy. Countries essentially located in the south of the euro area undeniably lag behind in productivity and are hit by strong potential inflationary pressure compared to others in the area like Belgium, the Netherlands and France. The euro area’s hampered development actually appears to be due to two factors that become enhanced once one starts thinking within an integrated short-term/long-term theoretical framework. First, we can see that apparent productivity gains are held back, most particularly in larger European countries, while the United States managed to find out a new

Table 3.1

Income gap and income inequality between the United States and the euro area in 2004 Income Average proportion per capita PPP GDP for the PPP GDP in billion Population wealthiest in US$ US$ in million 10%

Belgium Germany Ireland Greece Spain France Italy The Netherlands Austria Portugal Finland United States Euro area (weighted by population size)

Income Per Per proportion inhabitant inhabitant Income Income for the GDP for GDP for gap for gap for wealthiest 90% of the 80% of the 100% of 90% of 20% population population GDP GDP

Income gap for 80% of GDP

31163 28275 38537 22117 25101 29340 27972

324.1 2335.5 158 245.5 1069.3 1769.2 1622.4

10.4 82.6 4.1 11.1 42.6 60.3 58.0

28.1 22.1 27.2 26.0 26.6 25.1 26.8

41.4 36.9 42.0 41.5 42.0 40.2 42.0

24896 24473 31172 18185 20471 24417 22751

22827 22302 27939 16173 18198 21932 20280

0.21 0.28 0.02 0.44 0.36 0.26 0.29

0.19 0.20 −0.01 0.41 0.33 0.21 0.26

0.15 0.17 −0.05 0.39 0.32 0.18 0.24

31951 32171 19817 30115 39442

517.6 263.8 206.1 156.6 11651.1

16.2 8.2 10.4 5.2 295.4

22.9 23.0 29.8 22.6 29.9

38.7 37.8 45.9 36.7 45.8

27371 27524 15458 25899 30721

24482 25013 13401 23829 26722

0.19 0.18 0.50 0.24 0

0.11 0.10 0.50 0.16 0

0.08 0.06 0.50 0.11 0

0.28

0.23

0.21

Sources: World Bank, authors’ own calculations.

Euro Area Policies and Macro Economic Performance 27 Table 3.2

Breakdown of the per capita income gap (2005) Per capita GDP (in % of that of the US)

Per capita GDP gap in %

Manpower effect in %*

Productivity effect in %**

OECD G7 OECD-Europe OECD-EU

69.6 84.2 67.3 66.6

−30.4 −15.8 −32.7 −33.4

−5.8 −5.5 −12.6 −12.8

−24.6 −10.3 −20.1 −20.6

Euro area

71.4

−28.6

−15.3

−13.3

Notes: * Gap from hours worked per inhabitant. ** Gap from GDP per worked hour. Source: OECD.

Spain Portugal Netherlands Luxembourg Italy Ireland Greece Germany France Finland Belgium Austria –100

–50 Manpower effect

0 (%)

50

100

Productivity effect

Figure 3.3 Breakdown of the living standard lag between Euro area countries relative to the United States in 2005 Source: OECD.

28

Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

growth path in the mid-1990s.4 Second, we have the cumulated result of a structural inability to transform potential growth into real growth. According to OECD figures, the euro area indeed grew by 2% a year between 1990 and 2006 but the United States by 3%, and emerging and developed Asia (China, India, Singapore, South Korea, Taiwan and Hong Kong) by 6.4%. So, in terms of cumulated real growth over the period, the euro area lags 15% behind the United States and 50% behind Asia. The launch of the euro in 1999 did not improve the trend but rather had the opposite effect. If we exclude Japan and Switzerland, the euro area placed at the bottom among all other OECD countries, the EU15 and the EU 10 for real growth from 1996 to 2006 (Figure 3.4). In a world which, according to the IMF, has witnessed since 2001 its strongest sustained period of growth since 1945 (around 4% per year), the euro area’s economy, although it has finally started to take off, albeit rather unimpressively, looks a sorry sight. To finish with, it must be noted that Europe’s weakness is coupled with strong heterogeneity. The economic institutions on which monetary union depends have not brought euro area’s countries closer together, as had been propounded in the theoretical model on which rested the reasons for introducing the euro. This renders regional macro economic management most difficult. Figure 3.5 indicates that growth rate dispersion (which, to a large extent, determines inflation rates) narrowed only marginally since the launch of the single currency with standard deviation in real growth rates decreasing from 1.55 down to ... 1.50!

6 5 4 3 2

Figure 3.4

Real GDP annual growth rates from 1999 to 2006

Source: OECD.

Luxembourg

South Korea

Iceland

Hungary

Slovakia

Spain

Turkey

Poland

Tcheck Rep.

Canada

New Zealand

Australia

Mexico

Sweden

U.K.

USA

OECD

Norway

Denmark

Euro area

Japan

0

Switzerland

1

Euro Area Policies and Macro Economic Performance 29 12 11 10 9 8 7 6 5 4 3 2 1 0 -1 1998

1999

2000

Belgium Greece Italy Austria Standard deviation

2001

2002 Germany Spain Luxembourg Portugal

2003

2004

2005

2006

Ireland France Netherlands Finland

Figure 3.5 Euro area countries’ real GDP annual growth rates (1998–2006) Source: Eurostat.

3.2 Europe’s macro economic policies: Organisation, trends and developments 3.2.1 Monetary policy as “the Lord of the euros” In order to dodge the trap of political horse-trading about monetary and fiscal policies in the euro area to be, namely between the ECB and national governments, which could have led with the former to a policy all the more restrictive as that of the latter was too expansionary and vice versa,5 the rules of the economic policy game were defined beforehand so that the strategic game play that was bound to take place between the different authorities could bring about a sustainable solution to the problem. In a game of chicken6 between the fiscal and monetary authorities, two types of stable equilibria can be reached. The first gives priority to “social” balance, that is, to the national governments’ growth objectives and to fighting against unemployment, while the second favours a “conservative” balance that gives priority to the central bank’s price stability objective. By granting independence to the ECB and entrusting it with the primary objective of fighting inflation, the Maastricht Treaty writers accorded the

30 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

European monetary authority the power to act on the euro area’s global economic activity, a responsibility which the fiscal authorities cannot assume since the euro area does not have an economic government. This choice, partly dictated by the German authorities—both the Federal government and the Bundesbank—which could rightfully claim that this monetary policy model, namely the one they have used, had proved more efficient than any other was most convincing at the time when the Treaty was being written. With the remarkable exception of Germany, Europe was painfully emerging from a period of relatively high inflation—we must not forget that inflation reached a two-digit figure in a large number of European countries in the late 1980s and even topped 20% in some of them, like Italy for example— and inflation eradication—the well-known disinflation period of the 1980s—cost lots of jobs and caused large growth losses (Fitoussi, 1995). Besides, the international monetary system had effectively ended the Gold Exchange Standard, in practice since 1971 and then officially with the 1976 Jamaica agreement. Confidence in a currency from economic agents, for example investors in financial markets, now has to rely exclusively on its managing authority’s credibility. Besides, as the euro was a totally new currency with no history and because it was managed by a central back lacking a long-standing reputation, the situation had to be impeccably handled. This probably implied that priority be given to the monetary stability objective. Nevertheless, giving price stability such exclusive priority presupposes that inflation involves high costs. It has however become known for a long time there is no definite evidence that inflation does involve high costs, at least when kept at moderate levels. As early as in the 1950s, Milton Friedman and the monetarists found it rather difficult to evaluate those costs in any precise manner as it seemed that the only proven though grotesque link was the increase in shoes’ wear and tear caused by the need for more frequent trips to the bank. Yet in modern economies in which means of payment are totally dematerialised and the large majority of investments made on free and reactive financial open markets, on what basis can these costs really be assessed? Starting from a standard welfare maximisation model in keeping with the Bellman principle and with the assumption that the representative agent’s utility function includes real balance assets, Lucas (2000) estimated, in the Friedman tradition, that, for example, a 5 point inflation increase reduced welfare by 1 point, and by 1.5 points when inflation went up 10 points, as inflation forces economic agents to rebuild their reserves and rethink their optimum consumption plans.

Euro Area Policies and Macro Economic Performance 31

As for Romer (2001), he supplies a long list of all the costs associated with inflation: the higher opportunity cost of holding cash— economic agents substitute it for equities at a higher cost for issuers who have to pay an interest on them—then, menu costs, that is, the cost induced by more frequent price adjustments—this brings more rigidities into the economic system and consequently higher transaction costs—and distortions in capital gains taxation or in received interests which are taxed on nominal value—this changes economic agents’ investment motivations—and changes in relative prices when all agents cannot modify their prices at the same time, which is the case for example with contracts staggered over time—this disturbs the supplier/customer relationship and may bear down on investment and consumption—and finally, the confused perception of the long-term effects of inflation, even if moderate and yet long-standing, on prices within a system in which all contracts are not inflation-adjusted. The last two types of costs—relative price changes and the confused perception of inflation—may cause distribution effects which can produce greater instability and wider inequality between those who know how to protect themselves against inflation (e.g., well-informed and wealthy savers, investors, entrepreneurs and trade unions) and those who do not. All of these different situations affect behaviour and may take the economy away from its equilibrium path. What is striking in this list, to which we wish to add the welfare loss worked out by Lucas (2000), is that its relevance is an exact proportion of the inflation rate in the economy, and is therefore all the more consistent when the economy undergoes hyperinflation. In addition, the higher the inflation level, the more vulnerable the financial system becomes. The system has partly developed to counterbalance price rises, as economic agents use an ever larger part of their cash resources and make up for the erosion in their monetary assets’ real value by buying securities. The higher the inflation level, the more endangered the currency’s nominal anchor and the greater the possibility that the payments system may become illiquid or even insolvent and a financial crisis may then occur. Fortunately, the euro area’s situation is far remote from that described above since the inflation rate achieved since the 1990s cannot by any means be compared to the scourge of hyperinflation. It must be recalled that, conversely, moderate inflation levels help to speed up companies’ adjustment to an economy confronted with a negative shock. The temporary decrease in real wages (in keeping with J.M. Keynes’s work first and then J. Tobin’s) or in real interest rates

32 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

(in keeping with L. Summers’s work and P. Krugman’s) are two ways of reinforcing either supply or demand growth. It is also possible to show (Akerlof et al., 1996) that moderate inflation levels make it easier for prices and relative wages to adjust in a decentralised economy undergoing constant changes. One must also remember that in the event of deflation risk, that is, therefore of an overall decrease in prices, the ability for the central bank to cause inflation anticipation is the only way to remedy the crisis, as in Japan’s case (Ito and Mishkin, 2004; Svensson, 2006). By selecting an historically low inflation rate target, the European Central Bank (ECB) has given up an adjustment tool that could otherwise have been be used in times of economic turmoil and the ECB’s decision could even make automatic micro economic adjustments on the goods and services markets as well as in the labour market more costly. Inflation costs’ empirical assessment attempts usually make the distinction between high and low inflation environments.7 In the first situation, it was shown that the inflation increase was associated with a fall in productivity and in GDP growth (see Anderson and Gruen, 1995, for a synthesis). However Bruno and Easterly (1998) consider that only in times of crises—namely when inflation’s yearly average tops 40%, that is, in the case of hyperinflation—can one state that there exists a negative link between growth and inflation. In the second situation, provided that inflation remains low enough, slightly higher inflation does not affect economic growth. It can therefore be concluded that there might exist a non-linear link between inflation and growth (e.g., Sorel, 1996; Groshen and Schweitzer, 1997; Wyplosz, 2001; Huh and Lee, 2002, Schiavo and Vaona, 2007). The ECB’s price stability objective has caused much ink to flow. Included in the European Union Treaty (aka, the Maastricht Treaty), the objective was translated into a figure by the European System of Central Banks (ESCB) which eventually decided that price stability was to be understood as a medium-term inflation rate of less than 2%. The ECB has therefore independent means of action, just like the US Federal Reserve Board, the Bank of Japan or the Bundesbank (Table 3.3). It is also independent in its choice of a price stability objective. The difference is quite important. In the first instance, monetary policy is considered as a merely technical activity which therefore requires much expertise. In the second instance, monetary policy is viewed as a political activity which demands a higher degree of democratic responsibility on the part of an institution made up of men and women who are appointed by Heads of State and governments, yet not elected by the people.

Euro Area Policies and Macro Economic Performance 33 Table 3.3

Comparison of the status of large central banks European Central US Federal Bank of Bank Reserve England

Instructions from governments

No

No

Length of office term Irrevocable term of office Credit available to the public sector Democratic responsibility Free to decide its own strategy

8 yrs

Bank of Japan

Bundesbank

14 yrs

Yes Yes (inflation (exchange target) rate) 5 yrs 5 yrs

8 yrs

Yes

Yes

Yes

Yes

No Weak

With a ceiling Average

Strong

Weak

Average

Yes

Yes

No

Yes

Yes

Yes

No

No

Source: Artus and Wyplosz (2002).

The independent decision of target setting suggests between the lines a biased attitude towards the optimum functioning of European economies. In a totally perfect world, economic policy is reduced to the meanest share and holds virtually no responsibility. In entirely freemarket economies with perfect flexibility of wages and prices, there is no political choice to make regarding macro economic management, since it is in essence purposeless. The statement can be extended to optimum resource allocation policies, as it is up to the “market” to take charge of the issue. Economic policy choices would then probably be limited to define the outlines of a fiscal redistribution policy. The inconsistency between this free-market economy’s view and the obsession with inflation is striking, since inflation is nothing but a temporary adjustment problem between supply and demand. In contrast, regulation policies regain legitimacy in an imperfect world in which information is asymmetrical, some prices rigid, where competition does not always exist nor is applied everywhere and some markets are incomplete. Overall inflation and changes in relative prices may reflect these imperfections and show that stabilising policies must be put in place. Unfortunately, even in that context, it has yet to be proven that monetary policy brings about price stability. This probably also makes up the second inconsistency in the European economic policies’ institutional organisation. While there is some consensus that monetary

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Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

policy must fight against inflation, Arestis and Sawyer (2007) remind us that the macro economic models used at the ESCB conclude that an 100 base point increase in the ECB reference interest rate would lead to a −0.1 point inflation decrease over 12 months and −0.3 point after three years. Thus, not only does monetary policy take a long time to have any impact but its efficiency also seems to be most marginal. So should one simply ignore monetary policy or does its limited impact only reflect the characteristics of the models used and, more importantly, the euro area’s high heterogeneity? In contrast, the assumption that monetary policy remains a key factor in economic success—through its impact on credit, stock exchange capitalisation, in sum, on public finances and on how investment and consumption are financed—is widely supported through the macro economic models used by the U.S. Federal reserve Boards which find that in U.S. states, the effects are virtually four times as high as those in the ESCB national central banks (Arestis and Sawyer, 2007). In that case, how can such large differences be accounted for? The persistence of such heterogeneity in consumption price changes between euro area Member States (Figure 3.6) is undoubtedly one of the major problems facing the ECB. It could probably explain why any specific policy has so little impact on average inflation because the figure poorly reflects the differences in price changes across Europe. Even though the divergence seems to have narrowed since 2002, it still remains large. In 2005–2006, the euro area’s average annual inflation,

Year on year changes in % 6

5 AUS BELG GERM SPAIN FIN FRA GRC IRL ITA LUX NLD PORT

4

3

2

1

0 1999

Figure 3.6

2000

2001

2002

2003

2004

2005

Euro area’s consumer price index (1999–2006)

Source: OECD.

2006

Euro Area Policies and Macro Economic Performance 35

within 1 standard deviation, ranged between 1.5% and 3.2%, whereas it used to be spread between 1.6% and 3.9% (Table 3.4). Given this heterogeneity, the ECB’s monetary policy eventually benefits only a minority of Member States, namely those whose inflation rate is near to the European average. Besides and as shown in Table 3.4, the list of those Member States tends to vary over time. Among the euro area’s first 12 Member States, only Italy’s inflation was always within the EU’s average upper and lower limits, with 1 standard deviation. Such a result could seem paradoxical with regards to Italy’s GDP and for a country that still runs a very high public debt, among other things. In fact, it proves that the assumption of a mechanic link between public debt and inflation is simply flawed. To become convinced of this, it will suffice to observe that Belgium’s inflation was outside the limits one year only during the euro’s nine years of existence, and moreover that occurred in 2002, a year in which Belgian inflation was even lower than the European average’s lower limit, including standard deviation. The Netherlands and Portugal—although the latter is regularly blacklisted for the rather unsatisfactory state of its public deficit—are in a situation comparable to that of Belgium, as except for one exception, their inflation remained within the European average. By contrast, Germany and Finland on the one hand, Spain and Ireland on the other, lay outside the limits more than half of the time, below the lower limit for the first two and above the upper limit for the last two. It hence implies that, over those five years, the ECB’s monetary policy was too tight for the first group of countries—this also applies to Austria and France, yet to a lesser extent—and too loose for the second group. Greece, which remained at the top of the European nations’ league only before adopting the euro, always benefited from too loose a monetary policy with regard to its consumption price changes. In view of these results, it becomes less surprising that over nearly ten years, the ECB reached only once its inflation target of below 2% and that the achieved objective was often closer to 2.5% than 2%. It must be added that, except for the “average” countries, the ECB’s monetary policy most frequently proved pro-cyclical. That was the case for Germany for example between 1999 and 2003. Tight monetary policy allowed Germany, thanks to low inflation, to exert downward pressure on nominal wages and subsequently to develop the competitiveness policy deliberately launched from 2000 (see below). In addition to this relative inefficiency for the monetary policy to meet the needs of all Member States, or at least of a stable majority among them, it must also be noted that the ECB’s policy is also characterised by

Table 3.4

Average annual inflation rate per country, euro area, 1999–2007

The Standard Lower Upper Austria Belgium Germany Spain Finland France Greece Ireland Italy Luxembourg Netherlands Portugal Average deviation limit limit 1999 2000 2001 2002 2003 2004 2005 2006 2007*

0.5 2.0 2.3 1.7 1.3 2.0 2.1 1.8 1.7

Note: * Forecast. Source: OECD.

1.1 2.7 2.4 1.6 1.5 1.9 2.5 2.2 1.9

0.6 1.4 1.9 1.4 1.0 1.8 1.9 1.6 2.1

2.2 3.5 2.8 3.6 3.1 3.1 3.4 3.6 2.7

1.3 2.9 2.7 2.0 1.3 0.1 0.8 1.0 1.4

0.6 1.8 1.8 1.9 2.2 2.3 1.9 1.7 1.4

2.1 2.9 3.7 3.9 3.4 3.0 3.5 3.3 3.0

2.5 5.3 4.0 4.7 4.0 2.3 2.2 2.5 3.0

1.7 2.6 2.3 2.6 2.8 2.3 2.2 2.4 2.1

1.0 3.8 2.4 2.1 2.5 3.2 3.8 3.5 2.8

2.0 2.3 5.1 3.9 2.2 1.4 1.5 1.7 1.8

2.2 2.8 4.4 3.7 3.3 2.5 2.1 2.7 2.1

1.5 2.8 3.0 2.7 2.4 2.2 2.3 2.3 2.2

0.7 1.0 1.1 1.1 1.0 0.8 0.9 0.8 0.6

0.8 1.8 1.9 1.6 1.4 1.3 1.5 1.5 1.6

2.2 3.8 4.0 3.9 3.4 3.0 3.2 3.2 2.8

Euro Area Policies and Macro Economic Performance 37

a certain number of asymmetries that stem from its statutes or from the economic view conveyed by its authorities and which, in turn, affect its ability to react to macro economic shocks. Because of its price stability primary objective as well as the strong aversion for inflation that such a goal induces, the ECB tends to underestimate potential output, and consequently probably overreacts whenever it witnesses that growth is accelerating while it bothers about the changes in the euro’s international parity only when the euro’s value goes down. Potential GDP is the GDP level that is compatible with an inflation rate that is steady or that does not accelerate. More particularly, it concerns “the sustainable aggregate supply capabilities of an economy, as determined by the structure of production, the state of technology and the available inputs” (ECB, 2000). These three components do not all progress at the same pace over time, so to assess the state of potential GDP, the temporal horizon must be first defined. In the short-term, potential output indeed crucially depends on the maximum use of the production factors, that is, on how far it is possible to push the use rate without creating inflationary pressure. The pressure subsequently results from the reduction in the gap between the effective and maximum use of the capabilities. In the mid-term, potential GDP depends on capital accumulation speed and its final accumulation level. It is then necessary to assess the dynamics of capital accumulation and the determinants of technological progress. Therefore measuring the tensions between short-term potential GDP and effective GDP as well as measuring technological progress are tricky exercises whose results need to be handled carefully. In the short-term, it must be assumed that the acceptation level of the tensions is known beforehand and invariant. In the mid-term, the characteristics of the production function must be determined, that is, the production structure and the state of technology. It is far from certain that the effective usual production functions, of Cobb-Douglas-type, will reflect those characteristics in any precise manner. It is most obvious that this type of function has difficulty capturing the ruptures introduced by productivity shocks and by technological innovation. The difficulties in assessing potential GDP also stem from the fact that the same gap between the effective and maximum use rates bears different consequences in cases when economic agents have either low or high aversion to inflation (Passet, Rifflard and Sterdyniak, 1997). A country with strong aversion to inflation will implement antiinflationary policies earlier than a country with low aversion to it and the possibility that the first economy’s capability may see its effective

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GDP getting closer to or even topping potential GDP is therefore limited. Even worse, in the country of the first type, the authorities will be tempted to underestimate potential GDP, as this reduces the risk of increased inflation. A similar effect may have been caused by the objective of price stability imposed on the ECB. The euro area’s mediocre growth results since 1994 (Figure 3.4) have allowed annual inflation to stabilise around 2.5% but also translated into mediocre potential growth, although the euro area does not generally seem to be lagging behind any other OECD countries, more particularly the United States, but rather suffers from the under-underutilisation of its current production capabilities (Table 3.2). The OECD indeed estimates that between 1999 and 2006, the euro area’s average potential GDP grew by 2% a year compared to 2.9% in the United States. The ECB’s forecast model for the euro area (AWM model, Fagan et al., 2005) uses an equation of potential growth derived from the OECD’s production function and it can be advanced that the ECB’s estimates for growth are similar to that of the OECD. The ECB most probably underestimates potential growth, while it reacts too quickly when effective growth improves. Conversely, when effective growth is low, the ECB tends to respond less actively than the US Federal Reserve Board (Creel and Fayolle, 2002). Another sort of aversion explains the ECB’s relative inertia. It is partly due to the changes in social norms Europe is currently undergoing, an evolution that has already occurred in the United States (Fitoussi and Le Cacheux, 2005). So, aversion against inequality is now becoming gradually less pronounced in Europe. Therefore, consciously or unconsciously, European authorities now condone that the “natural” unemployment rate may be higher than was deemed acceptable in the past, and consequently potential growth is becoming lower. The ECB’s asymmetric behaviour concerning the gap between effective and potential growth also translates into the ECB’s attitude towards the euro’s exchange rate. We do not wish to expand here on the cruel lack of a European exchange rate policy (see Chapter 5). It will suffice to recall that it is by all means possible for Europe to run its own exchange rate policy, in practice as well as from an institutional standpoint. In praxis, the drop in the euro in the course of 2000 led to a coordinated intervention by G7 countries’ central banks. It was unsuccessful mainly because of the intra-European tensions between the French Finance minister, the Euro group’s President and the ECB’s President.

Euro Area Policies and Macro Economic Performance 39

At the institutional level, it is up to the ECB to make sure the changes in the euro’s exchange rate do not jeopardise its objective. The Council for its part exerts full discretionary power over how it wishes to manage the euro on exchange markets. When inflation is under control and prices are stable, nothing prevents the ECB to fight against an increasing euro in order to support economic activity without putting its primary objective at risk. In fact, the European Union Treaty does specify what the ECB’s statutes and assignments are and yet that leaves room enough to infer that it is at possible to conduct a real exchange policy strategy in Europe, provided that price stability is achieved. Up to now, and despite the fact that inflation has been kept low, at a level closely matching the 2% official target, the increased value in the euro against the US dollar has not given rise to any real attempt or reaction on the part of the ECB. It is true that a high euro makes it easier to curb inflation through low imported inflation and it forces industrialists to keep their prices down to make up for the induced loss in competitiveness. In this respect, the German example (see below) is an edifying illustration. Finally, the decision to assign the objective of price stability to monetary policy presupposes that monetary policy is particularly efficient and superior to the other economic policy instruments. This is not too obvious however. We may remember what O. Blanchard (2006) had to say on the topic: “I refuse to launch [my discussion] with the assumption that the aim of monetary policy is to control and stabilise inflation [...] It may be the result (of a welfare maximisation process), yet it cannot be a hypothesis”. In any case, the objective of monetary policy ought not to be dissociated from that of fiscal policy. 3.2.2 The ill-timing and wrong priority order of fiscal policies Still under national governments’ responsibility, fiscal policies have often been blamed for not delivering the efficiency to be expected from a monetary union, in which, let us not forget, the impact of this policy instrument is theoretically stronger, in so far as the country resorting to it no longer has to worry about interest rate constraints, or the possible currency fluctuations that result—in the case of a small open economy with its own national currency—from fiscal policy manipulations as we learn from Mundell-Fleming’s (1962–1963) analysis. They were also accused of not being flexible enough to adapt to the new rules of the game after the new currency’s introduction, of relying on budget deficits too frequently, more especially in larger countries, of causing “excessive” public debt and of increasing cyclical fluctuations, because the national authorities that control them would tend to use them the pro-cyclical

40 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

way. Then again, the opinion shared by the majority of European economists and undoubtedly of the economists at the European Commission, is that the institutions implemented by the Treaties of Maastricht (1992) and Amsterdam (1997) are basically sound. It is national governments, and more significantly that of the euro area’s larger countries, that have used them badly and made mistakes which eventually condemned them to immobility. Logically enough, some even draw the conclusion that it would be better to restrict the national governments’ room for manoeuvre in fiscal policy even further, to strengthen the rules and the sanctions against those who do not abide by them. So, why not entrust this policy instrument with an independent body, as is already the case with the Union’s monetary policy? 3.2.2.1 A few lessons from the theory of optimum currency areas (OCAs) First introduced by R. Mundell (1961), then extended and altered by many other authors in the 1960s, the theory of optimum currency areas came back into fashion in the 1990s with the planned creation of the European monetary union. It provides a convenient analytical framework to ponder on the part played by macro economic policies within a monetary union. Rather expectedly, the studies on the issue8 come to the conclusion that the euro area is not an optimum currency area by whatever criterion, which is not as such, neither particularly surprising nor worrying. The same would undoubtedly apply to other existing large currency areas that have been working satisfactorily for a long time, and as time goes by, it is likely that the criteria retained will eventually converge (Frankel and Rose, 1996). However, the most interesting implications of those analyses concern fiscal policies. In the event of asymmetric shocks—that is, shocks hitting only one country in the Union or a sub-group of countries—national fiscal policies must be resorted to by national governments to ease adjustment in so far as they no longer have any other economic instrument, in particular those of monetary and exchange rate policies. In the event of a shock affecting all countries in the area (called “symmetric”), monetary policy can then be used, as it is common to all euro area countries. Yet it is preferable to give it an overall bias that is in keeping with national fiscal policies, so that a policy mix encouraging adjustment can emerge. This implies that national fiscal policies should be widely autonomous and that coordinated action can be used, whenever necessary.

Euro Area Policies and Macro Economic Performance 41

3.2.2.2 The Stability and Growth Pact (SGP) and the incentives it gives rise to9 In fact, the rules for the EU’s national fiscal policies happen not to match these prescriptions at all, or very little. It is actually the reverse as they give rise to incentives in the Member States’ national governments that make them play an often destabilising part. In continuation of the Maastricht criteria which were meant to prepare the Member States for monetary union by organising economic convergence— somewhat successfully since national inflation and long-term interest rates had indeed most widely converged on the eve of the euro’s launch at the end of 1998—the Stability and Growth Pact (SGP) included in the Treaty of Amsterdam (1997) aimed to limit the national governments’ discretionary powers, more especially those of the countries taking part in the monetary union.10 It was justified by the fear that monetary union might bring about even looser fiscal policies. The harmful consequences of budget deficits—among other things, higher interest rates and the loss of confidence in the currency from the financial markets and the subsequent fall in the currency’s value—would then no longer be only restricted to the country that originated the deficit, but affect all the other countries in the area. It therefore appeared necessary that there ought to be rules limiting the national fiscal authorities’ room for manoeuvre, all the more so as deviant behaviour by some of these authorities, if they persisted to the point of piling up unsustainable public debt, could force the common central bank (the ECB) to bail them out or to resort to inflation, the cost of which would be high for all the other euro area’s Member States. One may well agree that rules are needed, yet there remains to find out which are suitable. In fact, it soon became clear that the Pact generated high costs, partly due to the 1999 conditions of entry into the euro area for Member States. The GSP whose mission, in principle, is to make sure that the Member States’ public finances are sustainable, indeed became in practice too constraining an iron collar, since the condition regarding “excessive deficits” proved most restrictive, more especially for the area’s larger countries. At the time when the decision was made about the specific figure for that rule, namely a 3% ceiling of GDP for public deficits—probably the most commonly known condition in those rules—it was not meant to be constraining for Germany and France, the area’s two biggest counties. However, over the following ten years new events occurred that changed the original deal. The decade started with

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Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

German reunification at so huge fiscal costs that it gave rise to great inflationary pressure in Germany itself. Naturally, the Bundesbank reacted by setting interest rates at very high levels, which, in turn, caused a severe recession that deeply deteriorated French public finances for a long time (Atkinson et al, 1994). Therefore, France and Germany, as well as Italy, entered the euro area with public deficits very close to the allowed ceiling, despite the fact that Europe had witnessed excellent economic activity in the late 1990s. Hence, the room for manoeuvre thought of by the Pact’s writers in the event of a recession simply proved inexistent. Consequently, the 2001 economic slowdown and the very low growth in the subsequent years—most significantly in Germany—as a basic result of the automatic stabilizer effect, prompted the area’s two largest countries to disobey the rules. Portugal, whose entry terms and conditions were unfavourable, must be included too. The Spring 2005 European Council reformed the Pact to redress some of its most flagrant flaws. Romano Prodi, former European Commission President, had called the Pact “stupid.” Its shortcomings incited Germany and France not to accept the Commission’s condemnation for “excessive deficits.” The Pact now comprises a much wider definition of “exceptional circumstances” that allows a country to get away with the deficit ceiling constraint and in a very wise move, the list also includes significant slowdowns as opposed to just “severe” recessions. However, while the SGP’s repressive part was made more flexible, its preventive part was also strengthened. On the one hand, the need to balance public accounts—or even better, put them in surplus—in the mid-term was reaffirmed, yet each country must now commit itself to a specific agenda. The public debt ratio must be below the 60% ceiling and be gradually brought down. On the other hand, the Commission’s surveillance is now explicitly based on structural deficits, that is public deficit adjusted for cyclical fluctuations that will have in principle to come down 0.5 point of GDP per year so the mid-term objectives can be achieved. This change, based on the follow up control of structural deficits, makes up, in theory, a huge improvement on the rule’s relevance. By recognising the economic cycle’s automatic consequences on the rule, its implementation becomes easier while cancelling out its pro-cyclical bias. Yet, the evaluation of structural deficits rests on a potential GDP’s estimate, a factor that is full of uncertainty as seen before with monetary policy which besides, is more than likely to influence its evolution. The 2006–2007 situation was most enlightening in this respect. While unemployment rates remained high in several European countries—most

Euro Area Policies and Macro Economic Performance 43

significantly in France and Germany (over 8%)—the estimates from most institutions like the European Commission, the ECB, the OECD and the IMF, showed the GDP observed close to its potential, which justified the ECB’s cautious attitude and the subsequent tightening of monetary policy, as well as the European Commission’s recommendation to speed up fiscal consolidation. Yet, pressing the monetary and fiscal brake pedals as soon as growth goes over the allowed and somewhat moderate yearly 2% threshold may well contribute to keeping potential growth below that threshold. The American example, more especially in the second half of the 1990s, suggests that, in some circumstances at any rate, running an accommodating monetary policy allows the authorities to boost potential growth by encouraging investment by firms and reducing the borrowing agents’ indebtedness, more especially that of the State and households but of firms too. Naturally, it is likely that pumping liquidity into the economy, at national and world levels—or keeping credit costs low, which is basically the same—may eventually cause inflationary pressure or imbalances somewhere in the economic circuit. But for long, this type of context was more likely to create speculative bubbles on the assets, financial and housing markets rather than in the consumption goods market because the latter was subject to globalisation’s competitive and deflationary pressure. There remains, however, a long-standing positive effect that improves the potential growth path. Finally, it must be recalled that the Spring 2005 Pact’s reform, although it indeed took account of all sorts of specific national circumstances, including the probable cost of reforms anyway deemed otherwise necessary and rightfully laid the emphasis back on the objective of national public finance sustainability, clearly rejected the adoption of any British-type “golden rule.” Yet, therein lies one the Pact’s most serious flaws whose consequences probably bears down heaviest on the euro area’s long-term growth. Because it is politically easier to be cut down when the deficit ceiling must be abode by, public spending on investment, infrastructure, but also on R&D, was the greatest loser of the years of fiscal consolidation set out on Europe’s agenda during the preparation for the introduction of the euro. And it still is, every time a government feels restrained by the Pact. Investment spending ought not to be included in the ceiling because, according to sound economic logic, it is investment and not current spending and can therefore rightfully be financed by borrowing. This would circumvent the Stability Pact’s negative effect on potential growth, and hence eventually, on the Member States’ public finance sustainability that it is meant to promote in the name of the common interest.

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3.2.2.3 The policy mix It henceforth appears that the whole set of rules about the euro area’s macro economic policies is probably biased and detrimental to high growth rates, while it does not either produce the degree of monetary and financial stability or of public finance sustainability that can justify its implementation. Despite their intention of avoiding to playing at the “chicken” game, all that those who conceived Europe’s monetary union have really managed to do is simply to reintroduce the game’s very ingredients into the system by granting the ECB much too narrow a mission assignment. So far, at least, it has indeed led to a policy mix that is likely to be ill-adapted and hardly sustainable. Firstly, monetary policy was probably too tight. At any rate, it was not accommodating enough in times of low growth during which the ECB could have cut its key rate further down and over longer periods. In times of economic recovery, the ECB could have avoided to put up its rate so quickly and so sharply. Secondly, national fiscal policies were excessively loose overall, especially at times when the economy was picking up. A more balanced mix and better coordination between the two instruments is needed. It could be achieved through the creation of a euro area’s “economic government” in charge of deciding collectively the overall stance of fiscal and taxation policies. This would prevent national governments to adopt national opportunistic policies and it would help to promote real exchanges and more balanced power with the ECB. This would undoubtedly also promote both higher growth and sounder, as well as more sustainable, public finances.

3.3 Non-cooperative strategies, among which competitive disinflation and fiscal competition are mere variants11 In fact, by choosing to join the monetary union and thus entrusting the monetary instrument with an independent supranational authority, national governments voluntarily agreed to be divested from their monetary sovereignty. Whenever they meet constraints on their fiscal policy management—which may even force them to counter, at least partly, the workings of automatic stabilisers—national governments will be tempted to resort to the instruments remaining under their control every time they are confronted with problems that cannot be solved through common or coordinated policies. The temptation of noncooperative strategies, so irresistible and widely used in the 1980s in the context of the European Monetary System (EMS)12 did indeed not

Euro Area Policies and Macro Economic Performance 45

simply vanish after the introduction of the single currency. Only the operational modes and the incentives that bear on the various national economic policy agents—national governments in particular—changed, as the institutions and the rules of the game were deeply modified. The best illustration of such permanence is “competitive disinflation” which replaced within the EMS the “competitive devaluations” that the system aimed to prevent. In the second half of the 1980s and in the early 1990s, France tried to restore its competitiveness and then gain market share over its European partners in the export markets by pursuing a policy of very low inflation and fairly low wage increases. That translated into a real depreciation the French currency, while the French franc’s nominal value remained stable against the deutschmark (Atkinson et al, 1994). The temptation of such an opportunistic strategy was made all the more attractive because all EMS currencies were overvalued against other currencies, mostly the dollar and the yen at the time. In the euro area’s new institutional context, national opportunistic strategies take new shapes and the value they have for national governments depend on the conditions specific to each member country as well as on the whole area’s macro economic situation, more especially in its exchanges with the rest of the world. As regards the more specifically national aspects, the clear distinction to be made varies with country size and with the degree of economic openness, particularly openness to international trade. It has indeed been known for a long time that the various instruments at a government’s disposal do not carry the same effect, as this depends on the country’s relative size and on whether it has a more or less open economy, financially as well as trade wise. Traditional policies in support of internal demand growth can only work with large countries relatively little open to trade. In contrast, competitiveness policies—be they low-wage policies, policies lowering wage costs through cuts in taxes and in other social security contributions or policies enhancing national attractiveness through a reduction in the tax burden—are much more efficient with very small open economies, both because the negative effects on internal demand matter less to national producers, subsequently to economic growth. It is also because the positive effects are markedly higher given the exports and capital flow elasticity to differential changes in costs and economic returns. Henceforth it is easy to understand why smaller countries’ national governments will be more attracted to “competitive disinflation” policies than those of larger countries; however this type of policy is non-cooperative in so far as success is made, at least partly, in the detriment of other countries. Conversely, larger countries’

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governments will be keener on policies supporting domestic demand, or that are at least not harmful to it. This latter sort of policy has usually induced positive effects for partner countries. It is well-known that the composition of the EU and that of the euro area have changed tremendously over the recent years, with the relative proportion of larger countries shrinking. Among the 15 countries the euro area comprised in 2008, three of them were large countries (Germany, France and Italy), one of average size (Spain) and the remaining 11 were of small or very small size and this remains true whether size is considered in demographic or in economic terms (Laurent and Le Cacheux, 2006). It is also common knowledge since Olson’s (1965) seminal work that, when collective action is needed in the whole group’s interest, the decision-making process becomes all the more arduous as the group is bigger and more heterogeneous, especially sidewise. The smaller countries will usually tend to take advantage of their small size and adopt opportunistic and free rider strategies. Those trends are getting even stronger within the current EU and euro area’s institutional framework, because of such decision-making process rules as unanimity and the thresholds adopted for qualified majority voting, or the “open method of coordination” whose different variants—more especially those on employment policy, social protection and even more importantly, those on the implementation of the reformed “Lisbon Strategy”—encourage competition between Member States and tend to make collective decision-making difficult, if not impossible. The ECB contributes to this overall trend by urging national governments to keep control over wage increases. It argues that this is essential, if the euro area is to retain its external competitiveness and keep up the fight against inflationary pressures. The consequences of the haunting and long-standing increase in the euro’s value against other major currencies, more especially the yen and the dollar, yet also against all the currencies that are more or less directly pegged on the dollar—which includes most Asian currencies— provides an illustration of how adjustments work in the current context. The euro’s appreciation is naturally positive for monetary stability as it helps to contain price increases in euro-denominated imports. It also tends to put a serious strain on European producers relative to their foreign competitors. So, entrepreneurs and national governments are tempted to react in dispersed order to the strengthening of their constraints. Firms cut down on manpower, delocalise part or all of their production so that they can manage to set margin rates at the high levels demanded by financial markets. National governments put in

Euro Area Policies and Macro Economic Performance 47

place competitive strategies which have lower social protection costs or that contain lesser redistribution ambitions. A more accommodating monetary policy—as well as a genuine European exchange policy in accordance with the Treaties which give shared responsibility for it to the European Council (that probably means the Euro group, in practice) and to the ECB (see Chapter 5 in this volume)—would allow the euro to achieve a more favourable exchange rate and subsequently improve the area’s competitiveness. By contrast, giving priority to the euro’s appreciation—or showing benign neglect—may, in the long-term, well give rise to valuable specialisation in high value-added products, yet there is no guarantee that this will happen. It might also produce the reverse effect and trigger a downward spiral because policies regarding the reduction in unit production costs through low wages or the gradual dismantling of social protection can by no means compete with those of low-wage countries in a world in which capital, firms and technologies are footloose.

3.4 Epilogue: From the race to the top to the race to the bottom The fiscal and social competition that is currently spreading in the euro area is an objective obstacle to the redistribution policies pursued by Member States, even though some distinctions must be drawn as to its effects among the various European social models (Laurent, 2006). In fact as shown by all “value” surveys like the European Social Survey, European citizens, more especially those of the euro area, feel more attached than others to the government’s redistributive role. Fiscal and social competition thus runs against European collective preferences. Furthermore, this economic dynamics does not seem to be evidently grounded in history, as it is in total contradiction with the preceding globalisation period (and with Europeanisation) that took place in the late nineteenth century and in the early twentieth century. On the basis of some previous work of his,13 Williamson (2002), in his empirical exploration of Hecksher and Ohlin’s (Ohlin, 1933) analysis shows that the first wave of globalisation brought about a reduction in living standards as well as in the income gap between the old and the new world and even within the European continent itself. In particular, he argues that massive migrations of workers can account for up to 70% by per capita income of the convergence that occurred in industrialised countries. He shows cogently how social (and protectionist)

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policies were put in place in European industrialised countries so as to safeguard living standards from the international and intra-national redistribution dynamics of economic opening. Atkinson (2004) also propounds the idea that the Welfare State was Europe’s response to the international market integration that took place between 1870 and 1914.14 He writes that “It was concern about the distributional impact of expanding trade and factor mobility that contributed to the setting in place of social security.” Economic integration has given rise to the need to “compensate the globalisation losers” through increased protection of their income thanks to the setting up of permanent economic security, namely the Welfare State. This type of analysis gets close to the “compensation hypothesis” according to which economic opening most often induces the development of public social protection in democratic societies (Cameron, 1978; Rodrik, 1998; Tanzi, 2006). Finally, Berger (2003) showed how labour mobility played a part in spreading new social ideas across Europe thanks to trade unions, among others. This “yardstick competition”15 can also help to explain how a “social race to the top” developed during the first globalisation. Berger thus notes that “by limiting oneself to political speeches only, it is possible to find much evidence of the international emulation and mutual learning that appears to have led to the creation of a virtuous circle in the field of social protection.” The 1884 industrial injury legislation in Bismarckian Germany was indeed followed in France by similar legislation in 1898. It seems that a hundred years later when the euro area became confronted with the same problem of social instability from economic integration, it decided to give in rather than try to contain it. European institutional Darwinism’s supporters believe that competition between social models leads to the natural selection of the fittest. They obviously suffer from amnesia. Beyond the Welfare State’s fundamental social justice dimension, they simply overlook its economic role. Social protection has largely contributed to the stabilisation of the economic system and to the consolidation of democracy in Europe after 1945. In actual fact, the Welfare State is the only fair way for advanced economies to set off the volatility effects induced by trade opening when they are confronted to the harmful effects of trade and financial protectionism. If euro area’s Member States are to thrive in a world of globalisation, they ought not to become low-wage countries to each other but they must consolidate their shared sovereignty in a common effort, in other words their power.

Euro Area Policies and Macro Economic Performance 49

Notes Translated from French by Bernard Offerle. 1. A useful reference is the introduction and chapter 1 of the work by Aghion, Cohen and Pisani-Ferry (2006). 2. Since the mid-1980s in France’s case and the mid-1990s for Germany. See Timbeau, Heyer and Plane (2007). 3. According to the OECD, the population’s annual growth rate came up to 1.12% on average for the United States over the 1992–2005 period against 0.55% for the euro area, that is, twice as high as in the euro area and four times as high relative to France, Germany or Italy’s averages which came up to only 0.27% over the same period. 4. See Timbeau, Heyer and Plane (2007) on this particular point. 5. See Alesina and Tabellini (1987) and Capoen, Sterdyniak and Villa (1994). 6. See Fitoussi (1999, pp. 129–30). 7. For a summary, see Temple (2000). 8. There are very many studies on this. For synthetic presentations of the main conclusions, see, Creel and Farvaque (2004), Baldwin and Wyplosz (2004), De Grauwe (2007) among others, and also the round table discussions published in Revue de l’OFCE (“the OFCE Review”), n°99, 2006. 9. For a more thorough analysis of the Pact’s many flaws, see more particularly Creel, Latreille and Le Cacheux (2002), Fitoussi and Le Cacheux, eds. (2005), Le Cacheux (2007). 10. In principle, the SGP applies to all EU Member States, be they euro area members or not. Yet, in practice, for the countries that wish to enter the monetary union, SGP rules are merely a subdivision of the Maastricht criteria with which applicant countries must comply. And for the other countries like the United Kingdom for example, the GSP is not considered as really constraining, since the British government also adopted its own “golden rule” for public finance in 1997 (see below). 11. This section is a summary of the analyses developed by the authors in several other articles, more especially Creel and Le Cacheux (2006), Creel, Laurent and Le Cacheux (2006). It is based on previous work on national non-cooperative strategies, more particularly Le Cacheux (2005), and on “The European economic constitution,” more specifically Laurent and Le Cacheux (2006). 12. See more especially Atkinson et al. (1994). 13. Thus, in 2002, there was only an average of 2.5% of people to say they disagreed with the statement that “the government must take measures to narrow income gaps.” 14. See O’Rourke and Williamson (1999) in particular. 15. See Salmon (2005) and below.

References Aghion, Ph., E. Cohen and J. Pisani-Ferry (2006), Politique Économique et Croissance en Europe, Rapport du Conseil d’Analyse Economique n° 59, Paris, la Documentation française, 2006.

50 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux Akerlof, G.A., W.T. Dickens and G.L. Perry (1996), “The macroeconomics of low inflation”, Brookings Papers on Economic Activity 1: 1–59. Alesina, A. and G. Tabellini (1987), “Rules and discretion with non coordinated monetary and fiscal policies”, Economic Inquiry, 25. Andersen, P. and D. Gruen (1995), “Macroeconomic policies and growth”, in Andersen P., J. Dwyer and D. Gruen (eds.), Productivity and Growth, Sydney: Reserve Bank of Australia, pp. 279–319. Arestis, P. and M. Sawyer (2007), “Can monetary policy affect the real economy?” mimeo. Artus, P. and C. Wyplosz (2002), “La Banque centrale européenne”, Rapport du Conseil d’Analyse Economique, (“The European Central Bank”, Report of the Council of Economic Analysis of the Prime Minister's Office), La Documentation française, October. Atkinson, A. (2004), “The future of social protection in a unifying Europe”, 1st Kela Lecture, Helsinki, 5 November. Atkinson, A., O.J. Blanchard, J-P. Fitoussi, J.S. Flemming, E. Malinvaud, E.S. Phelps and R.S. Solow (1994), Competitive Disinflation, the Deutschmarl, and Budgetary Policies in Europe, London: Palgrave. Baldwin, R. and C. Wyplosz (2004), The Economics of European Integration, Berckshire: MacGrawHill Education. Berger, S. (2003), Notre Première Mondialisation-Leçons d’un Echec Oublié, Paris: Seuil. Blanchard, O.J. (2006), “Monetary policy; science or art?” panel discussion at the conference on “Monetary policy: a journey from theory to practice”, ECB, March. Bruno, M. and W. Easterly (1998), “Inflation crises and long-run growth”, Journal of Monetary Economics 41(1): 3–26. Cameron, D.R. (1978), “The expansion of the public economy”, American Political Science Review 72: 1243–61. Capoen, F., H. Sterdyniak and P. Villa (1994), “Indépendance des banques centrales, politique monétaire, politiques budgétaires: une approche stratégique”, Revue de l’OFCE, 50, July. Creel, J. and E. Farvaque (2004), Construction européenne et politique économique, Dyna’sup, Paris: Vuibert. Creel, J. and J. Fayolle (2002), “La Banque centrale européenne, ou le Seigneur des euros”, Revue de l’OFCE, Hors-série, March. Creel, J., Th. Latreille and J. Le Cacheux (2002), “Le Pacte de stabilité et les politiques budgétaires dans l’Union européenne”, Revue de l’OFCE, Special issue, March. Creel, J., E. Laurent and J. Le Cacheux (2006), “Ouverte pour travaux: la présidence allemande de l’UE et la réunification européenne”, Lettre de l’OFCE, 277, 5 December. Creel, J. and J. Le Cacheux (2006), “La nouvelle désinflation compétitive européenne”, Revue de l’OFCE, 98, July. De Grauwe, P. (2007), Economics of the European Union, 7th edition, London: Oxford University Press. ECB (2000), “Potential Output Growth and Output Gaps: Concepts, Measures and Estimates”, ECB Monthly Bulletin, October.

Euro Area Policies and Macro Economic Performance 51 Fagan, G., Henry J. and Mestre R. (2005), “An area-wide model (AWM) for the euro area”, Economic Modelling, January, 22(1): 39–59. Fitoussi, J.-P. (1995), Le débat interdit; monnaie, Europe, pauvreté. Paris: Arléa (Points économie, Paris: Le Seuil, 2000). Fitoussi, J.-P. (ed.) (1999), Rapport sur l’état de l’Union européenne, Paris: Fayard and Presses de Sciences Po. Fitoussi, J.-P. and J. Le Cacheux, eds, (2005), L’État de l’Union européenne 2005. Paris: Fayard and Presses de Sciences Po. Fleming, J.M. (1962), “Domestic Financial Policies under Fixed and under Floating Exchange Rates”, IMF Staff Papers, 9 (3). Frankel, J. and A. Rose (1996), “The Endogeneity of Optimum Currency Area Criteria”, NBER Working Paper, 5700, August. Groshen, E.L. and M.E. Schweitzer (1997), “Identifying inflation’s greeze and sand effects in the labor market”, NBER Working Paper 6061, June. Huh, H. and H. Lee (2002), “Asymmetric output cost of lowering inflation: empirical evidence for Canada”, Canadian Journal of Economics, May, 35(2): 218–38. Ito, T. and F.S. Mishkin (2004), “Monetary policy in Japan: Problems and solutions”, presented at the US-Japan Conference on the Solutions for the Japanese Economy, University of Tokyo, 19–21 June. Laurent, E. (2006), “From competition to constitution: Races to bottoms and the rise of ‘shadow’ social Europe”, CES Working Paper Series n°137, Center for European Studies, Harvard University, http://www.ces.fas.harvard.edu/ publications/docs/abs/Laurent_abst.html. Laurent, E. and J. Le Cacheux (2006), “Integrity and efficiency in the EU: The case against the European Economic Constitution”, Centre for European Studies Working Paper Series, n°130, Harvard University, http://www.ces.fas.harvard. edu/pulications/docs./abs/Laurent_LeCacheux_abst.html. Le Cacheux, J. (2005), “Politiques de croissance en Europe : un problème d’action collective”, Revue économique, 56(3): May. Le Cacheux, J. (2007), “To co-rodinate or not to co-ordinate: An economist's perspective”, in Linsenmann, I., C. O. Meyer and W. Wessels, eds. Economic Government of the EU: A balance sheet of new modes of policy co-ordination, Basingstoke: Palgrave MacMillan. Lucas, R.E. (2000), “Inflation and welfare”, Econometrica, March, 68(2). Mundell, R. (1961), “A theory of optimum currency areas”, American Economic Review, 51(4): November. Mundell, R. (1962), “The Appropriate Use of Monetary and Fiscal Policy i for Internal and External Stability”, IMF Staff Papers, 9, March. OFCE (1999), Revue de l’OFCE, n°99. Ohlin, B. (1933), Interregional and International Trade, Cambridge, MA: Harvard University Press. Olson, M. (1965), The Logic of Collective Action, Cambridge, MA: Harvard University Press. O’Rourke, K. and J.G. Williamson (1999), Globalization and History. Cambridge, MA: MIT Press. Passet, O., C. Rifflart and H. Sterdyniak (1997), “Ralentissement de la croissance potentielle et hausse du chômage”, Revue de l’OFCE, January, 60.

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Rodrik, D. (1998), “Why do more open economies have bigger governments?” Journal of Political Economy 106: 997–1032. Romer, D. (2001), Advanced Macroeconomics, 2nd edition, McGrawHill Higher Education. Salmon, P. (2005), “Horizontal competition among governments”, LEG— Document de travail—Economie 2005–02, Université de Bourgogne. Schiavo, S. and A. Vaona (2007), “Nonparametric ans semiparametric evidence on the long run effect of inflation on growth”, Economics Letters, 94(3): 452–58. Sorel, M. (1996), “Nonlinear effects of inflation on economic growth”, IMF Staff Papers 43, pp.199–215, March. Svensson, L.E.O. (2006), “Monetary policy and Japan’s liquidity trap”, presented at the ESRI International Conference on Policy Options for Sustainable Economic Growth in Japan, 14 September 2005, revised version. Tanzi, V. (2006), “Making social policy under efficiency pressures from globalization”, in Kaul I. and P. Conceição (eds.), The New Public Finance-Responding to Global Challenges, Oxford: Oxford University Press. Temple, J. (2000), “Inflation and growth: Stories short and tall”, Journal of Economic Surveys, September, 14(4): 395–432. Timbeau, X., E. Heyer and M. Plane (2007), “Les Français sont-ils toujours productifs?” in Fitoussi, Jean-Paul and Éloi Laurent (eds.), France 2012. E-book de campagne à l’usage des citoyens, OFCE, 2007. http://www.ofce.sciences-po.fr/ ebook.htm Williamson, J.G. (2002), “Winners and losers over two centuries of globalization”, NBER Working Paper 9161, September. Wolf, M. (2006), “Comment on C. Wyplosz”, Economic Policy, April, pp. 253–56. Wyplosz, C. (2001), “Do we know how low inflation should be?” CEPR DP 2722, March.

4 Peer Pressure and Fiscal Rules Jean-Paul Fitoussi and Francesco Saraceno

4.1

Introduction

In a seminal contribution on fair wages and unemployment, Akerlof (1980) showed that social norms can persist, even when costly to follow for individuals, if disobedience entails a loss of reputation. This chapter extends to public behaviour the argument developed by Akerlof. We maintain that public social norms may limit the ability of national governments to manoeuvre when building and managing an economic and monetary union, and yet survive because of reputation considerations. More specifically, the public social norm we consider in this chapter is the Stability and Growth Pact (SGP), signed in 1997 by the countries participating in the European Monetary Union. Social norms and their effect on economic behaviour and outcomes have been investigated at length. The essays collected by Hechter and Opp (2001a) show the variety of definitions of social norms, and the disagreement among scholars about their emergence and persistence. We do not intend to enter this debate, but since we claim that the Stability Pact is, in fact, a social norm, we need to clarify some of their general features. At the core of the literature on norms is the observation that the need for social acceptance contributes to determine individual behaviour. Social psychologists have long studied group behaviour, and the tendency to conformity. In a series of experiments Asch (1951) shows that members of a group, even when capable of making the right choice when deciding in isolation, tend to conform to group decisions regardless of whether they are correct or not. One of the explanations for group conformity (e.g., Buchanan and Huczynski, 1997) may be that groups establish social norms, and punish deviation. This set of findings 53

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serves as a justification for Harsanyi’s (1969) postulate that social recognition plays a role along with economic gain in determining the behaviour of economic agents. In other words, “persons want to be rich and famous—the and-famous part of the expression not being redundant” (Akerlof 1980, p. 753). Harsanyi’s postulate underlies Pettit’s (1990) classic definition of norms: regularity in behaviour is a norm if: first, members of the society generally conform to it; second, deviance is disapproved; third, the fact that most people conform to the norm helps enforcing it. This definition has two important consequences. The first is that agents may follow the social norm even when it is against their own economic interest, if the gain in reputation or social esteem is sufficiently large.1 What matters is a concern for reputation rather than an immediate impact on private (or social) welfare. The second and related consequence is that the norm does not necessarily originate within the sphere of investigation of economics: scholars seem to agree on the fact that the emergence of social norms depends on socio-historical conditions and, as such, is case specific (Hechter and Opp, 2001b). Thus, when discussing the norm Stability Pact below, we will give some reasons that may explain why that specific norm emerged in the first place. Akerlof’s model fits in this discussion. Firms, fearing a loss of reputation, are willing to pay a wage perceived as fair and higher than the market clearing one, thus obtaining suboptimal profits; on aggregate, this causes involuntary unemployment. In other words he shows how freely obeyed social norms may result in constraints on individual behaviour as well as in departures from the optimal equilibrium. The presence of reputation in the utility function could of course be seen as the result of a meta-maximization problem in which reputation serves as a means towards other ends (Becker, 1976). Thus, in Akerlof’s analysis, firms could be induced to offer fair wages by the fear of losing skilled workers and hence incurring in lower profits. The economic and reputation incentives would thus be impossible to disentangle. Nevertheless, Elster (1989) warns against the temptation to think that norms can always be treated as any other element in the utility maximization process. He gives examples of norms, hard to reconcile with self or common interest, that are nevertheless obeyed.2 Elster argues forcefully that to accept social norms as a motivational mechanism is not to deny the importance of rational choice. “[...] Actions typically are influenced both by rationality and by norm. Sometimes, the outcome is a compromise between what the norm prescribes and what

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rationality dictates. [...] At other times rationality acts as a constraint on social norms. [...] Conversely social norm can act as a constraint on rationality.” (Elster 1989, p. 102).3 The transition towards the European Monetary Union was dominated by the Maastricht criteria (in particular limits to deficit and debt, later crystallized in the SGP constraints). These were accepted even by governments which were opposed to their design; many countries encountered serious problems conforming to the criteria, and the only immediately visible benefit was the increased reputation of their governments among their peers (but not necessarily with their electorate). This is why we argue that the current fiscal setting has the features of a social norm, in that governments follow its prescriptions primarily because the others are following it. We make this working hypothesis because it is difficult to be convinced by the rationale underlying the European economic government. We will show that the theoretical debate on the need of supranational fiscal rules, as well as the empirical evidence, is inconclusive, so that some other explanation for the persistence of the SGP deserves at least to be explored. The question of why governments have accepted such a constraining fiscal rule is all the more important because in a monetary union national governments lose their control on interest and exchange rates, and fiscal policy is one of the few instruments left. Furthermore, the single EMU interest rate has differentiated effects on the dynamics of public debt: countries enjoying the lowest rate of inflation will suffer from the highest level of real interest rate. The reputation argument is not as odd as it may look at first glance. The design of European institutions is such that decisions in most fields are the outcome of a bargaining process between the different governments. Thus, credibility and the bargaining power of each government may depend on reputation among its peers (the meta-maximization problem defined above). If a government wants to earn or maintain a good reputation, for example in order to use it in other negotiation venues, then it may be valuable to obey a norm that is not directly beneficial, simply because it is followed by the other governments. We argue in other words that the European Council resembles a Club where members obey a social norm to earn social acceptance. In light of these considerations, the enlargement that took place in May 2004 is a major source of concern (see also Buiter and Grafe, 2004). It is plausible that, with the increase of heterogeneity, the need

56 Jean-Paul Fitoussi & Francesco Saraceno

of stabilization policies to cushion asymmetric shocks will increase, as will do the cost of obeying a norm that limits such policies. If the norm is strong enough to resist the increased pressure, then the negative welfare consequences for the EU may be substantial. The rest of the chapter is structured as follows: the next section briefly describes the provisions of the Stability and Growth Pact, discusses the theoretical arguments underlying the Pact, and argues for their inconclusiveness. In section 4.3 we highlight a number of features of the SGP that corroborate our interpretation as a social norm. Our model, a simple extension of Akerlof (1980) in which obedience to the norm is induced by reputation considerations, will be presented in sections 4.4 and 4.5, where we also show the effects of enlargement when a norm like the Pact is in place. Section 4.6 concludes and suggests themes for further research.

4.2

The debate on fiscal rules and on the Stability Pact

The institutions of Europe, in their actual design, stem from two main sources. The first is the founding Treaty signed in Maastricht in 1991, and the second is the Stability and Growth Pact4 that, negotiated together with the Amsterdam Treaty in 1997, completes the setup for fiscal policy. The Maastricht Treaty defined the convergence criteria that countries had to fulfil in order to be admitted to the single currency area. In particular, it required a deficit to GDP ratio of no more than 3%, and a public debt below 60% of GDP, or approaching that level at a satisfactory pace. The vagueness of the latter requirement allowed to overlook it for high debt countries as Italy, Belgium and Greece. The SGP contains further provisions regarding fiscal policy that have the objective of increasing transparency and control on public finances. Each year member countries present a Stability and Convergence Programme, to be examined by the European Commission and the Council. The programmes have to contain a medium term objective for the budgetary position of close to balance or in surplus, together with an account of the adjustment path towards the objective. The Excessive Deficit Procedure (EDP) states what deviations from the 3% budget deficit ceiling are acceptable, and gives the Council the right to sanction (by qualified majority) the infringers. The EDP has first been invoked for Portugal (for the 2001 deficit). In November 2003 the Council decision to forgive France and Germany triggered an unprecedented clash with the Commission, which had recommended sanctions to be imposed. The Commission sought a judgement by European Court of Justice,

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that ruled against the Council in July 2004. In the spring 2004 the Excessive Deficit Procedure was also invoked for The Netherlands, Greece, and six newly admitted countries, while for Italy the Council and the Commission waited June 2005. As of today (October 2009), no country has been sanctioned. The requirement to attain a position of close to balance or surplus in the medium term is an important innovation with respect to the Maastricht Treaty. In fact, it implies the strong consequence that public debt as a ratio to GDP should tend asymptotically to zero (De Grauwe, 2003), a position hard to justify per se. First, very much like private agents, governments may be willing to spread the cost of investment projects over time, in order to match the expected future pattern of returns (no private firm would find it rational to finance investment projects exclusively out of current revenues; so why ask it to governments?). Second, and specific to public finances, debt may be a tool for transferring resources across generations and/or social groups, or to finance public spending investments whose social return is larger than expected profitability. This inconsistency of the SGP has been at the root of reform proposals excluding public investment from deficit limits (the golden rule of public finances). A recent paper by Creel et al. (2007) analyses the effects of public investment on growth, and discusses the application of the golden rule to the U.K., where it has been successfully implemented since 1997. The fiscal requirements of the Maastricht criteria and of the SGP had a deep influence on the pattern of public finances in European countries. Figure 4.1 shows the fiscal impulse for a number of countries, computed as the negative of year on year changes in cyclically adjusted government net lending, and averaged over different periods. Such an indicator measures the discretionary fiscal stance of the country, a positive number being an expansionary stance. All the Euro zone countries included in the figure, be they large or small, virtuous (Austria, Finland) or less so (France, Italy, Germany, The Netherlands, Portugal), had an overall restrictive stance since the early 1990s. The heterogeneity of the countries considered leads to link this restrictive stance to the efforts for entry in the EMU in the 1990s, and for trying to respect the SGP constraints since 1997. The pattern is particularly striking if we take the subperiod 2000– 2006: in spite of sluggish growth, the orientation of fiscal policy did not change, and remained restrictive. This contrasts with the United States and with the United Kingdom, where fiscal policy was more reactive to economic conditions. Figure 4.2 shows the scatter plot of changes in

58 Jean-Paul Fitoussi & Francesco Saraceno

0.6

1992–2007 1997–2007 2000–2006

% of GDP 0.4

US

0.2

0

IT

GER

EU12

U.K.

FR

NL

AU

PT

FN

−0.2

−0.4

−0.6

Figure 4.1

Fiscal impulses

Source: OECD Economic Outlook—Authors’ calculations.

I

Fiscal impulse

US 01-03

II

1.7

1.2

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US 07 −1.2

−1

−0.8

−0.6 EU12 01-05

−0.4

0.2 Change in output gap

−0.2

0 −0.3

III

IV −0.8

Figure 4.2

0.2

Output gaps and fiscal impulses

Source: OECD Economic Outlook—Authors’ calculations.

0.4

0.6 0.8 EU12 94-00

US 04-06

EU12 06-07 US 94-00

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the output gap against the fiscal impulse for the US and the Euro zone. In the US fiscal policy has been countercyclical (expansionary in 2001– 2003 and in 2007, contractionary during the expansion of the 1990s and in 2004–2006). This pattern shows that fiscal policy has constantly been in the policy maker toolbox, regardless of the administration (the sample spans the two Clinton terms, and the Bush years till 2006). In the Euro zone, the consistently restrictive fiscal stance happened to be countercyclical in the second half of the 1990s. But it was slightly procyclical during the difficult years at the beginning of this decade. The prolonged period of soft growth experienced by most Euro zone countries (especially the largest ones), and the increasing number of countries struggling to maintain their deficits within the limits set by the Pact, have triggered a debate on the flaws of the current fiscal framework, and on possible reforms aimed at a better functioning of fiscal policy in Europe (for detailed accounts of the debate on reforming the Pact see Buti et al. 2005, and Monperrus-Veroni and Saraceno, 2006). The constitutional Treaty signed in Rome in October 2004 had left substantially unchanged the provisions regarding fiscal and monetary policy, but the long political process has finally yielded a first result in the reform adopted by the European Council in March 2005: the 3% and 60% limits remain unchanged, and no automatic mechanism (such as a golden rule or a debt related rule) is put in place. Nevertheless, on one side the medium term objective of a zero structural deficit is slightly relaxed for countries with low debt and/or with high potential growth; and on the other the new Pact contemplates a number of circumstances (e.g., a strong engagement in costly structural reforms) allowing temporary deviations from the deficit ceiling, and longer delays for correcting them. When discussing fiscal policy one should clearly separate the issue of whether there exists a deficit bias requiring rules to constrain fiscal policy, from the issue of whether a supranational norm like the SGP is needed. This crucial distinction has unfortunately often been neglected in the debate on the SGP. Several arguments point to the existence of a deficit bias, for example voter myopia, opportunistic behaviour and dynamic inconsistency, or intergenerational conflicts. Nevertheless, the mere existence of a deficit bias is not enough to justify a supranational rule in a monetary union. In fact, economic commonsense and the principle of subsidiarity would require rules to be country-specific and left to the choice of national governments, unless it were argued convincingly that the effects of suboptimal fiscal policy spill over to the other members of a monetary union. Thus, for our purposes we need to focus on arguments entailing some sort of spillover between countries, that

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would justify such a rule. In the remainder of this section we will outline strengths and weaknesses of these arguments; a detailed account of the more general debate on the utility of fiscal rules can be found in Fitoussi and Saraceno (2007) and in Le Cacheux (2007). The main theoretical foundation of the Stability Pact is a simple externality argument: a government running a budget deficit has to borrow; in a monetary union this is supposed to raise the common interest rate, and to have restrictive effects both on public expenditure (the areawide increased interest payments reduce government consumption and investment possibilities), and on private consumption and investment in the other countries. This negative externality would induce national governments—free from the control of foreign exchange markets—to run excessive budget deficits, allowing them to make the other countries pay part of the bill. The empirical evidence in favour of this claim rests on several contributions concluding that expansionary fiscal policy has a positive effect on interest rates.5 Nevertheless, a closer look reveals that this literature cannot be invoked to support the externality argument. In fact, none of these papers looks at the effects on the rates of partner countries, but only on own rates. The need for a common rule has to originate from common effects of government behaviour, domestic effects having to be taken care of by national policies and/or rules. As the evidence on domestic interest rates is not terribly robust, it would be extremely surprising if a study gave empirical arguments in favour of common rules, by finding important effects of fiscal policy on interest rates at the European level.6 More importantly, from a theoretical viewpoint, the externality argument can be reversed. Suppose that a country implemented an unwarranted expansionary fiscal policy, while close to full employment; this would result in inflationary pressure, and hence in reduced competitiveness. If on the other hand the deficit responded to a slump in production, it would sustain demand and hence income and imports. In both cases, the increased demand for the other countries’ production would yield larger fiscal revenues and lower deficits. Models with either negative or positive fiscal policy spillovers have flourished in the recent literature;7 but nothing, from a theoretical point of view, may induce one to think that the negative externality would be larger in size than the positive one. Indeed simple reasoning leads to believe the contrary: generally, a fiscal expansion in a region does not have negative effects on other regions of the same country. Given the short life of the EMU, we will have to wait some more time for empirical work to help shed some light on this debate.

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Interest rate spillovers may also operate through a different channel. Detken et al. (2004) show that bond substitutability in a monetary union widens the savings pool at which governments can draw to finance deficits, thus weakening the interest rate costs of excessive deficits. Governments can thus free ride in a monetary union. This mechanism, (that incidentally runs against the one described above, and may explain why empirically the effects of deficit on interest rates are not robust) would call for a national rule, as the interest rate costs are paid by the country itself, and no spillovers appear. A second argument in favour of a supranational rule is credibility: excessive deficits may end up in insolvency, forcing the European Central Bank to intervene (against its own statute) to bail out the country involved; otherwise, banks owning the debt would see their financial soundness hampered, and face the risk of depositors runs (Artis and Winkler, 1999). The moral hazard aspect of excessive deficits could hence undermine the central bank’s credibility in its commitment to fight inflation. Furthermore, as the costs of an ECB bailout would be sustained by all EMU citizens, this would encourage irresponsible behaviour of governments. A constraint on deficits can avoid this risk. This argument may be dismissed on several grounds. First, a debt crisis seems scarcely plausible in the present context. Since 1945, even in far more turbulent times, European countries never seriously risked default on their debt. Furthermore, a study on OECD countries by Alesina et al. (1992) showed that markets are capable of monitoring fiscal performance and exerting pressure on governments through interest rate spreads. Bernoth et al. (2004) show more specifically that this capacity was not weakened by the inception of EMU. Eichengreen and Wyplosz (1998) further notice that in contrast to Mexico and East Asia during the crises of the 1990s, the European banking system exposure and the term structure of public debt seem more solid, so that the bailout risk is not particularly important. They also argue that such a risk would be better dealt with by improving public debt management and bank regulation, an argument that was strengthened by the recent subprime crisis. The credibility argument is also less robust than it may appear. The Pact was designed assuming that governments would accumulate surpluses in good times to allow the operation of automatic stabilizers in bad times.8 This ideal scenario though, did not take into account at least two complications: the first, correctly predicted by Eichengreen and Wyplosz (1998), is that this symmetry would only be attained after a long transition; during this transition, which is still happening,

62 Jean-Paul Fitoussi & Francesco Saraceno

governments are being forced to restrictive fiscal policies irrespective of the business cycle phase. To make things worse, the Pact was signed at the end of a long phase of convergence to the Maastricht criteria, that for some countries involved restrictive, and generally procyclical fiscal policies.9 When growth later resumed, they could not continue to be restrictive. For all these reasons the Euro area economy has experienced, especially since the end of the US expansion of the 1990s, an explosive combination of depressed growth and procyclical (or at best neutral) fiscal policy induced by the convergence to Maastricht criteria first, and by the Stability Pact after. Mainly because of high debt service, the three largest countries—Germany, France and Italy—do not have room for the automatic stabilizers to play, so that fiscal policy is ineffective even facing transitory shocks. This extremely difficult situation is already resulting in creative accounting experiments, and in increasing pressure to revise, soften, or simply ignore the Pact. Even worse, the impossibility of using the fiscal instrument is inducing governments and economists to put pressure on the ECB for a more expansionary monetary stance, undermining the support for the fight against inflation. Finally, the repeated violations of the Pact, and the recent legal controversies between the Commission and the Council have further reinforced the belief that the current institutional setting is inappropriate. These phenomena seem far more threatening, for the credibility of the European institutional system as a whole, than the bailout risk. To sum up, while the theoretical debate on the existence of deficit biases and the ensuing need for some kind of fiscal rule seem to have become consensual, the empirical foundations for such rules, and for supranational measures like the Stability Pact do not look nearly as solid. Such mixed results may explain why, in spite of the consensus in the academic profession, the instances where fiscal rules have been adopted in practice are quite rare.

4.3

Fiscal discipline or social acceptance?

The inconclusiveness of economic arguments in favour of the SGP is at the basis of our claim that other factors, namely reputation, may be used to explain why most countries of the EMU have adopted strict and often procyclical fiscal policies even when suffering from low growth, and lack of policy instruments. This claim also rests on a number of features of the Pact that remind characteristics of social norms recalled in the introduction. First, the circumstances that led to the Stability Pact.

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Stark (2001) or Heipertz and Verdun (2004) give accurate accounts of its genesis, that could explain why reputation in the European club is founded on a sound fiscal position, and not on more sensible measures of public welfare, like low unemployment or high GDP growth. As happens for other social norms (e.g., what determines a fair wage?) the answer seems to lie in a mix of historical, social and political factors: Germany’s historically strong aversion to inflation that made its government give up its monetary sovereignty only in exchange for an insurance of prudent fiscal behaviour. Alternatively it could be, as many argue, the desire of core countries to keep out of the union the so-called Club Med nations (Greece, Italy, Portugal and Spain). Furthermore, the rule persisted even after the special circumstances that originated it have disappeared (to the point that Germany was, between 2003 and 2006, one defaulting member of the club), a sort of hysteresis that is also common among other social norms. A second element in favour of our interpretation is the sanctioning scheme associated with the Pact; we will argue in what follows that the sanctions are not likely to be imposed, because too heavy and delayed. In fact until now sanctions for deviating countries have simply taken the form of a public reprimand (i.e., the starting of an Excessive Deficit Procedure). If this is the case then, it appears that the efforts of most countries to respect the provisions of the Pact are dictated by the need for social recognition rather than by the fear of actual costs. Whatever its origins may be, we are interested in the effects that the social norm Stability Pact has on government behaviour and social welfare. One point should nevertheless be stressed: most private social norms have their origin in a notion of fairness, implying that agents behave in such a way as to refrain from taking full advantage of a (possibly temporary) dominant position (Hicks, 1974). Social norms of this type may even been considered as a way to address the so-called zero contribution problem, namely that unless the number of individuals in a group is quite small, or unless there is coercion or some other special device to make individuals act in their common interest, rational, self interested individuals will not act to achieve their common or group interests. (Olson 1965, p. 2). Norms constraining public behaviour may also have the same origin, the quest for common interest. But by definition—because they are written at a particular moment—they cannot reflect the outcome of a repeated game. For this reason they are often entrenched in some doctrine representing the current economic paradigm, and may survive after it disappears (the political economy explanation). The threat of social sanctions is enough to make it rational to obey the norms.

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While we outlined a number of reasons why the SGP has the features of a social norm, there may be other reasons for the emergence of a suboptimal arrangement in Europe. For instance, an anti-inflationary coalition would benefit from a rule constraining demand side interventions and making supply side interventions (structural reforms) inevitable.10 Such a political economy interpretation is certainly convincing in explaining why the Stability Pact emerged in its current form. Nevertheless, it presupposes an ideological homogeneity of European governments and vested interests that does not seem to be observed in practice. Once we need to explain why more interventionist governments ended up accepting an agenda that ran contrary to the interest of their constituencies, reputation appears again as a plausible and appealing explanation. The Stability Pact is not the only instance of a social norm constraining public behaviour in recent European history. In the early 1990s, the obedience to the theoretically dubious requirement of maintaining exchange rate parities vis-à-vis the German mark had most of the features of a social norm. In fact some governments believed these parities to be crucial for their reputation. Adherence to that norm led to a strongly procyclical monetary policy, similar in many respects to the widely studied (e.g., Clarke, 1967) British experience of the 1920s. As a result, Europe entered a period of slow growth and mounting unemployment that lasted almost six years. In the next section we present a simple model derived from Akerlof (1980), in which we show that an inefficient equilibrium caused by a social norm can be sustained, if deviation from the norm causes a loss of reputation. The existence of a social norm may therefore result in a lower level of income for the area as a whole.

4.4

The model

This section introduces a static, very stylized model of public choice and reputation. In general terms, the government’s objective function has two arguments, welfare of the population, and reputation among its peers. This general setting may be applied to various problems; in this chapter we assume that the welfare measure is the output gap,11 whereas reputation stems from obeying the Stability Pact, and giving up income stabilization. Consistently with our previous discussion, we assume that positive and negative externalities linked to budget deficits wash out, so that they do not play a role in the model. Suppose we have an economic union of mass 2 (the reason for this choice will be clear shortly below). Each country belonging to the union

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65

(indexed by i) is very broadly described by an aggregate demand relationship, and by a stochastic process describing private demand: y i ci g i ci yn i Total income in country i is simply the sum of private (ci) and public (gi) expenditure, that for sake of simplicity can be viewed as deficit spending. The natural or potential level of income (yn) is given by the deterministic part of private consumption, and it is assumed to be equal across countries. We assume that the shock has a uniform distribution with zero mean: i ~U(a, a).12 Government expenditure gi can be decomposed into a discretionary part, gd,i and an automatic stabilization ga,i, that is assumed to partially stabilize output (g 1): gi ⬅ ga,i gd,i ga,i gi The government objective is to set gd,i in order to minimize deviations from the natural rate of income (the output gap). We assume that it acts after the shock is realized. Suppose nevertheless that a social norm is in place, call it “Stability Pact”. This norm stems from a political process, and has no clear economic justification; it considers values of gi larger than a threshold , that is excessive deficits, as “bad”. Each government knows that, by breaking the norm, it will gain the undesired reputation of a “naughty boy”. The objective function is a loss minimization min ᑦ i = a( yi _ y n )2 + Ri g d ,i

Notice that our formalization rules out any deficit bias, as governments do not try to push output above its natural level; this has the important implication that no conflict with the central bank arises, and we can avoid modelling monetary policy.13 Ri is the loss linked to a bad reputation. We assume that the loss of reputation is proportional to the fraction of governments that believe in the norm, m and that it does not depend on the magnitude of gi.  Ri = 0 if g i ≤ g  2  Ri = b m if g i > g

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Jean-Paul Fitoussi & Francesco Saraceno

Obviously, for positive shocks the government faces no choice, and it stabilizes the economy. A government facing a negative shock faces a two step problem: (1) decide whether to break the norm and stabilize (gi ⇒ Ri 0) which it will do if the shock is large enough; and (2) if the norm is broken, what level of gd,i to choose. The problem can be tackled backwards, remembering that if the code is broken the reputation loss is not linked to the size of stabilization. Substituting equations (economy) and (gi) within equation (lossgov), we obtain 2

min a  g d ,i + (1 −g )e i  + Ri g d ,i

whose solution is  g i = −ei g d , i = −(1 −g )ei ⇒   yi = y n If the government chooses to use discretionary policy to complement automatic stabilization, income remains at its natural level. On the other hand, if the government opts for obedience to the norm, total expenditure will be limited by the threshold , and yi yn ei. This implies that regarding the choice of whether to stabilize, the loss in the two cases (S/F, stabilize/follow the norm) will be ᑦSi = Ri = b2 m  F 2 ᑦ i = a[ g + ei ] The norm will be followed only if ᑦFi < ᑦSi that is if |ei | ≤ e = b

m +g a

Thus, as intuitive, the threshold ˉe, that is the shock governments will endure without intervening to stabilize, will be higher if the reputation loss b is high, and if the weight given to the output gap a is low. On the other hand, if the rule were made less stringent (larger ), more governments would follow the norm (larger ˉe ). For computational simplicity, and without any loss of generality, from now on we will assume that = 0, meaning that any deficit will be sanctioned by a reputation loss. Furthermore, when referring to the “union”

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or the “area”, we will focus on the part of governments faced with negative shocks, that has unit mass, and a distribution of shocks i ~U(a, 0). 4.4.1 Short term equilibrium In the short term the fraction m of believers in the norm is given. As the shock has a uniform distribution, the fraction of governments following the norm, that is those for which the absolute value of the shock is small enough, is m=

4.4.2

b a

m a

Long term equilibria

In the long run, the number of believers in the norm changes according to their number with respect to the followers. m = w( m −m ) w > 0 where w is a positive multiplicative constant. Thus, if more governments believe in the norm than follow it, the number of believers will decrease; and if the opposite holds, the number will increase. The following prop. osition characterizes the long run, or steady state equilibrium (m = 0): Proposition 1 Suppose that b 0; then (a) Two equilibria may exist, one in which nobody follows the rule, and one in which a positive fraction 0 m** 1 of governments follows the rule: m∗ = 0  b2  m∗∗ = min  1, 2   a a (b) The equilibrium m* is unstable, whereas the equilibrium m** is globally stable Proof See Appendix. m* corresponds to the equilibrium without reputation (nobody believes in the norm, nobody follows it and nobody is sanctioned for that). The other equilibrium is characterized by a positive fraction of governments following the rule and hence not stabilizing.14 m** is inversely related to the parameters a and a: both a higher weight given to stabilization, and a more unstable macroeconomic environment, make the rule less

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Jean-Paul Fitoussi & Francesco Saraceno

sustainable. In particular the role of the latter parameter may be worth investigation in further research. Notice that if the sanctions are weak enough (0 b2 a2 a ⇒ m** 1) there is coexistence, in steady state, of governments stabilizing and governments abiding by the rule. In the following we will assume to be in such a situation. Substituting back in equation threshold, we obtain the long term value for the threshold: e= 4.4.3

b2 aa Aggregate income and welfare

At the m* = 0 equilibrium all governments stabilize, and aggregate income is Y* = yn (the countries hit by negative shocks have unit mass). Accordingly, aggregate loss is ᑦ* = 0 , as Ri is equal to zero for every i. The equilibrium with some countries following the rule will on the other hand be characterized by lower aggregate income and larger aggregate loss. Proposition 2 Suppose b2 僆(0, a2 a); then (a) The m** equilibrium, with a positive number of followers of the norm, is characterized by a lower level of production than the m* equilibrium: Y ∗ = y n > Y ∗∗ = y n −

b4 2a3 a2

(b) The m** equilibrium is inferior: ᑦ∗ = 0 < ᑦ∗∗ =

m∗∗ b2 a 3 (a − e ) + e . 3a a

Proof See Appendix. In this section we proved in the general case that the emergence of a social norm whose violation involves a reputation loss may yield two equilibria, one in which the norm is neglected, and the other in which it is followed by a positive fraction of agents. The latter equilibrium is globally stable, and it involves both a lower aggregate welfare and a lower average income. To keep the algebra of the model tractable, in the following we normalize the shock and the weight to a = a = 1. As a consequence, m∗∗ = e = b2 ᑦ∗∗ = b4 (1 −

2 2 b4 b ) Y ∗∗ = y n − 3 2

From now on we will focus on the only stable equilibrium (m = m**).

Peer Pressure and Fiscal Rules

4.5

69

Enlarging the club: New members and reputation

In this section we explore the effects of the norm in the case of an enlargement of the union. To do so, we introduce heterogeneity in a peculiar way: we assume that for exogenous reasons (e.g., past history) not all countries suffer from the same reputation loss in case they break the code. To keep things simple, they are divided in two groups, (b)ad and (g)ood, of mass n and 1 n respectively. We further assume that countries belonging to the two groups face the same shocks, have the same natural income, and the same weight for output stabilization. The only difference is that reputation loss is larger for bad countries (bg bb). For each group we can compute the threshold and the fraction of followers (see eqs. threshold and xf, remembering that here a = a = 1): ej = mj = b j m

j = b, g

The total number of norm-followers is then m =n mb + (1 − n )mg = (nbb +(1 −n )b g ) m = b m where we define b ⬅ nbb (1 n)bg. The steady state equation and its nonzero solution (eqs. dyn and equilmu) are (nbb + (1 −n )b g ) m −m = 0 m∗∗ = (nbb +(1 −n )b g )2 = b2

Accordingly, the values for the thresholds are ej = b j b= b j (nbb + (1 −n )b g )

j = b, g

where bg < bb ⇒ ˉeg ˉeb. Average income for the area can be written as Y ∗∗ =

∫

yn − eb

∫

yn

∫

yn − e g

y n dy + y dy + (n y + (1 −n )y n ) dy yn −1 yn − e g yn − eb

A

B

C

70 Jean-Paul Fitoussi & Francesco Saraceno

The integral A collects the countries that do stabilize, because (the absolute value of) the negative shock is above all the thresholds. B represents countries whose shock is so small that they do not stabilize whatever their group is. Finally, integral C represents the group of countries for which the behaviour depends on the group. If they are bad (n of them), they do not stabilize, whereas if they are good, they will find it convenient to stabilize. Equation avheter yields Y ∗∗ = y n −

1 (neb2 +(1 −n )eg2 ) 2

that is the equivalent of equation (incomvalue). Notice that, as fewer countries will stabilize, average income in the “b” group will be lower than in the “g” group: Yb∗∗ = y n −

1 2 1 eb < y n − eg2 = Yg∗∗ 2 2

Hence, even assuming that the natural level of income is the same, the mere existence of the norm may generate income inequality. Newly admitted members are usually closely scrutinized to verify whether they abide by the rules. The ten countries that joined the European Union in May 2004 are no exception, and though not formally, their public finances will most probably be subject to stricter controls from the old member states. In fact, in May 2004 the European Commission issued early warnings for six of the ten new member states, namely Cyprus, the Czech Republic, Hungary, Malta, Poland and Slovakia. Even more plausibly, the newcomers themselves will do whatever is within their capabilities to show the other participants of the club that they deserve to be part of it. In terms of our model, this means that the ratio of governments for which deviations from the norm imply a higher reputation loss has increased with the enlargement. Assume that the reputation loss of good countries is a fraction of the reputation loss of bad countries, bg = xbb, x 僆 (0, 1). The following proposition relates average income, and its variability, with the ratio of bad governments on the total. Proposition 3 Assume that 0 < bg = xbb < bb < 1. Then, as the ratio of bad governments n increases: (a) Average income for the area as a whole decreases. (b) Income variability for the area as a whole, V(Y), increases, for values of x sufficiently low: x < x ˉ (n) (c) The threshold x ˉ (n) is increasing in n: x ˉ (n) > 0

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Proof See Appendix. Figure 4.3 shows the shape of the threshold as a function of n. If the difference between good and bad countries in terms of reputation loss is large enough (x < 2/3) then, income volatility will increase even if the number of bad members of the club is low. Similarly, if the number of bad countries is large enough (n > 1/2), then income volatility will increase even if the penalty is similar for the two groups. Only the combination of similar penalties (large x) and a large majority of good countries (low n) could yield a decreased variability of income; in such a case, the decreased income variability of good countries would more than compensate the increased income variability of the bad countries. The model gives thus an insight on the possible effects of enlargement in presence of a constraining rule on stabilization policies. If the intuitive assumption that entrants will have to be more rigorous than the old members of the union proves correct, then the norm will become more binding, with the effect of generally increasing income variability, and reducing the average income and welfare of the area. We believe that such a risk should be taken into account when discussing the future institutional setup of the EMU, and especially when

x 0.9 0.8 x(ν) 0.7 x(0) = 2⁄3

∂V > 0 ∂ν

0.6 0.5 0.4 0.3 0.2 0.1 0 0

Figure 4.3

0.1

0.2

0.3

0.4

0.5

Threshold value as a function of n

0.6

0.7

0.8

0.9

ν

72 Jean-Paul Fitoussi & Francesco Saraceno

coming to the issue of deepening vs. enlarging the union. Notice furthermore that this result is derived in the most unfavourable case, given that besides reputation countries are all alike; the negative effects of the norm would be even more evident if we had allowed for heterogeneity.

4.6

Conclusion: Enlargement and the Pact

This chapter developed the consequences of a strong but plausible premise, namely that the Stability and Growth Pact has uncertain theoretical justifications, and that its raison d’être is mainly a reputation issue. In this sense it may be considered a social norm of the type discussed in the introduction. The model we presented was willingly kept abstract and simple, in particular assuming that the system, as described by equations economy, was static; and more importantly that positive and negative externalities washed out. At the price of more cumbersome algebra, we could express the model in terms of growth rates, keeping the main conclusions unaltered: ●

●

In spite of its lack of economic justification, the norm generates a stable equilibrium with lower income and welfare. Furthermore, the higher the weight attached to reputation loss, the lower the equilibrium income level. Further making the plausible assumption that in case they broke the Pact, new members would suffer a higher loss in reputation than the others, we showed that the enlargement would further decrease the area-wide average income level, and increase its dispersion. This conclusion seems to suggest that enlargement may help break the bad equilibrium and help the EU out of the suboptimal social norm.

A few extensions might add to the insights of model. Some would intuitively strengthen our results, for example if the model was complicated in order to keep track of long term variations in potential income. If we consider that, especially in periods of fast technological change, potential output is plausibly affected (via investment) by protracted periods of low growth, the dynamics would probably result in even stronger long run negative effects of a social norm depressing output in the short run. Another extension that would highlight the negative effects of the Pact is the consideration of common (instead of independent) shocks, and of interdependence between countries.

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If business cycles are synchronized, then the number of countries breaking the code would be higher in recession times (something we are observing nowadays). The effect of this extension on the norm itself (could it be that if a common shock is severe enough the norm simply breaks down?) would be particularly interesting to study. On the other hand, the explicit consideration of negative externalities of budget deficits would soften our conclusion; showing how do externalities interact with the reputation issue tackled in this chapter would certainly be interesting. Finally, in this chapter we overlooked an important source of heterogeneity in the European Union, the size of the economy. Small countries have had very different patterns: some of them, Austria, Finland, Luxembourg, have made fiscal discipline their trademark, while others, like Portugal, Greece and The Netherlands had problems conforming with the provisions of the Pact. On the other hand, the three large countries, regardless of their government and policies, struggled to remain within the fiscal constraints. Le Cacheux and Saraceno (2007) show with a simple model of monetary union that in small open economies the weight of domestic demand is less important, and as a consequence constraints to fiscal policy do not significantly affect aggregate demand and output. This implies that for these countries structural reforms are a preferred way to solve their problems, while fiscal policy is harder to give up for larger ones (Le Cacheux, 2005; Fitoussi, 2006). In terms of our framework this would imply that small countries are able to acquire good reputation with a lower cost. Furthermore, this reputation is consistently used in negotiation venues, to counterbalance the economic power of large countries. This explains why smaller countries tend to oppose any attempt at reforming the Pact. Thus, the introduction of size heterogeneity in our framework would be expected to affect both the sanctioning scheme, and the influence of deficits on reputation.

Appendix: Proof of propositions Proof Proposition 1 (a) . Equation (dyn), together with the steady state condition m = 0 implies m = m that is (using eq. xf) m=

b a

m a

74 Jean-Paul Fitoussi & Francesco Saraceno

the two solutions are given in equation (equilmu), and repeated here for convenience: m∗ = 0  b2  m∗∗ = min  1, 2   a a where the formulation for m** stems from the fact that m 僆 [0, 1]. (b) For notational convenience, define K =

b a a

, implying that m** = K2.

In order to study stability, we substitute (xf) inside (dyn), to obtain the following: m = F( m ) = w( K m −m ) Notice that F(0) = F(m**) = 0. Furthermore, notice that lim F ′( m ) = lim m →0

m →0

1 −1> 0 2 m

so that the m* = 0 equilibrium in unstable. Global stability of m** requires F(m) > 0 ∀m < m** = K2, and F(m) < 0 ∀m > m** = K2, exactly what we have (remember that w > 0): K m −m > 0 ⇔ m < K 2 = m∗∗ K m − m < 0 ⇔ m > K 2 = m∗∗ so that m** is globally stable. Proof Proposition 2 (a) If ei ~ U(a, 0) it follows that yi = yn + ei ~ U(yn a, yn). Aggregate (and average) income of the area, when m = m**, can then be written as

Y

∗∗

  yn 1  yn − e  =  y n dy + ydy  a y −a yn − e   n  A B

∫

∫

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75

where A denotes the “extreme” countries, whose shock is large, whereas B is the income of countries which do not stabilize, and consequently produce yi = yn + ei. Changing from yi to ei, and collecting the yn term, equation aggy1 can be rewritten as Y ∗∗ =

1 yn a 

∫

0

de +

−a

∫

 e d e =  −e

0

= yn −

1 2 e 2a

= yn −

b4 < yn 2a3 a2

(b) Governments stabilizing will face a reputation loss of b2m, Countries following the rule will suffer a loss of ae2i Aggregate loss can be written as ᑦ∗∗ =

1 a 

∫

−e

m∗∗ b2 d e +

−a

∫

0 −e

 ae2 d e 

=

m∗∗ b2 a 3 (a − e ) + e a 3a

=

b4  2 b2  1− >0 2  a a 3 a2 a 

given that b2 僆 (0,a2 a). Thus, ᑦ** > ᑦ* = 0 Proof Proposition 3 First of all notice that bb > b g ⇒ eb > eg , that is that the threshold value is different for countries belonging to the two groups (a) Recall that average income is (from equation avincsolved) Y ∗∗ = y n −

1 (neb2 + (1 − n ) eg2 ) 2

76 Jean-Paul Fitoussi & Francesco Saraceno

whose derivative is ∂e   ∂Y ∗∗ 1  ∂e = −  eb2 − eg2 + 2n b  eb b − eg g   < 0  ∂n ∂n ∂n   2 given that ∂ eb = ∂ eb ∂ b = bb ( bb − b g ) > ∂ eg = b g ( bb − b g ) by the assumption ∂n ∂ b ∂n ∂n bb bg > 0 which guarantees that the term within square brackets is positive. (b) The variance of income can be written, similarly to the mean, as V (Y ) =

∫ +

yn − eb yn −1

∫

( y n − Y ∗∗ )2 dy +

yn − e g yn − eb

(n y + (1 −n )y

∫

yn yn − e g

( y − Y ∗∗ )2 dy +

)

2

n

− Y ∗∗ dy

Tedious algebra, and substitution of Y** with the value from equation (avincsolved), yields 1 1 1 1 1 1 V (Y ) =n 2 eb3 ( − eb ) + (1 −n )2 eg3 ( − eg ) + 2n(1 −n )eg2 ( eg − eb2 ) 3 4 3 4 3 4 Given that bg = xbb, we can write b ⬅ (1 n)bg + nbb = ((1 n)x + n)bb. Further remembering that with a = a = 1, we have eˉj = bbj (j = b, g). Furthermore, take the derivative with respect to n, divide throughout for b6b, and for notational ease, define b = b2b: C=

3 ∂V 1 2 6 = − ( x + 1) ( x − 1) bn 5 2 ∂n b6b

1 4 1  +5  x ( x + 1) (3x + 2 ) ( x − 1) b + x2 + x + 1  ( x − 1) n 4 2  3

(

)

3  1  +4  − x 15x2 + 20 x + 6 ( x − 1) b − x2 + x + 1  ( x − 1) xn 3  4 

(

)

(

)

1 2   +3  x 5x2 + 5x + 1 ( x − 1) b + 2 x2 + 4 x + 3  ( x − 1) x2 n 2   3

(

)

(

)

1  1  +2  − x 15x2 + 1 + 10 x ( x − 1) b + 2 x2 − 4x − 1  x3 ( x − 1) n  4  3

(

)

1  +  x (3x + 1) b − 1 x5 ( x − 1) 2 

(

)

Peer Pressure and Fiscal Rules

77

We want to show that ∂V >0 ∂n

∀x < x

We notice that if b → 0, considering that x, n 僆 (0,1), C b→0 =

(

)

1 (1 − x) 2 xn(1 + x + x2 ) + 3x3 + 5n 2 (1 − x3 ) ( x(n −1) −n )2 > 0, 3

and that the derivative of C with respect to b is negative: 3 ∂C = − (1 − x) x2 (1 −n ) + n 3x2 (n − 1) − x − 3n ( x(n − 1) −n ) < 0 ∂b

(

)(

)

Thus, there will be a threshold level of b, such that C = 0: C b=b = 0 ⇒ b=

(

)

5n 2 (1 − x3 ) + 2 x2 n(1 + x) + 2 xn + 3x3 2 3 x2 (1 − n ) + n 3x2 (1 − n ) + 3n + x ( x(1 − n ) + n )

(

)(

)

For values lower than the threshold we have that C > 0, so that when ˉb is equal or larger than one, then the derivative of income variance with respect to n will be positive. Unfortunately this is not true for any pair (n, x) 僆 (0,1), and we need to define a threshold xˉ for which the variance is positive, given the other parameters. An explicit relationship between x and n is impossible to find, but we can study the function at its extremes. When n → 0, the threshold is b

n→ 0

=

2 3x2 + x

so that x ≤

2 = x ⇒ b ≥ n . In other words, whenever 3

x<x=

2 , the 3

variance of income will be increasing in n. If x → 1, then we have b

x→1

=

1 +n, 2

78

Jean-Paul Fitoussi & Francesco Saraceno

so that b ≥ 1 ⇒ n ≥

1 2

=n

In the (x ˉ, 1) and (0,nˉ ) range we have to use numerical simulations to solve for the relationship between the threshold x ˉ and the proportion of bad countries n.15 The results of the simulation allow us to draw Figure 4.3 in the text, that shows a positive relationship between x and n.

Notes We thank Robert Solow for his thorough reading of a previous draft. We also benefited of comments by two referees, as well as Philippe Aghion, Alberto Alesina, Pierfederico Asdrubali, Giorgio Basevi, James Forder, Anton Granik, Roberto Perotti, and participants in the Third Lectures on Macroeconomic Governance in the EMU, Siena, May 2006. The comments of two anonymous referees also helped improve the chapter. 1. Contrary to the game theoretic literature, that defines reputation as the coherence between ex ante and ex post behaviour (reputation is equivalent to credibility), the literature on social norms defines reputation in more general terms, as the positive effect on welfare coming from the acceptance by other members of the community. 2. A trivial, and yet forceful, example is that bus riders do not pick their nose. They want others to think that they “know how to behave”, even if they will never meet again. 3. Elster echoes a tradition on social norms rejecting the utilitarian (or functional) approach that we describe in the text. For authors like Habermas and Rawls the social norm emerges when individuals accept limitations to their behaviour in order to form a community. Thus, norms mark the passage from the state of nature to civil society (Forsé and Parodi, 2005). This approach, dominant in sociology, is a minority view in economics. 4. The SGP consists of a Resolution of the European Council (OJ 1997, C 236/1), and two Council Regulations (1466/97 and 1467/97). 5. To cite just the most recent ones, Laubach (2003), Ardagna et al. (2004), Canzoneri et al. (2004). These results nevertheless are not extremely robust, as other studies are inconclusive (Mehra, 1992; Cunningham and Vilasuso, 1994), or find negative correlation (Caporale and Williams, 2002). 6. Landon and Smith (2000) find some effect of provincial debt in Canada on the creditworthiness of the other provinces. These effects are nevertheless small, and the authors do not clearly take position between a market based and a rule based approach to fiscal discipline. 7. Examples of negative spillovers are in Andersen and Sorensen (1995), Jensen (1996), and Catenaro and Tirelli (2000). Some rely on the adverse effect of interest rate increases described in the text, while others focus on negative terms of trade effects. The classic book by Mundell (1968) assumed positive demand spillovers, that also emerge in Dixon and Santorini (1997), and Beetsma et al. (2001). Levine and Brociner (1994) present a model in which

Peer Pressure and Fiscal Rules

8.

9. 10. 11.

12.

13.

14.

15.

79

all these externalities play a role, and argue that the negative ones probably dominate the positive ones. Allsopp et al. (1995) also discuss at length the different effects at work in a monetary union, and reach the conclusion that decentralization of fiscal policy is likely to provide insufficient stabilization. “Nevertheless, the problem, with the Pact as presently framed is that it is all tick and no carrot; rewarding good fiscal behaviour in booms rather than, or in addition to, punishing bad behaviour in slumps, would certainly make better sense” (Bean 1998, p. 106). For example, France Germany and Italy all conducted restrictive fiscal policies in 1996 (a negative fiscal impulse), while the output gap was widening. In a similar vein Fitoussi (2006) speaks of an “hidden agenda” that the current European institutions help to push. By targeting the output gap, on one side the government reduces variability of income, therefore reducing uncertainty for its citizens; on the other, it sustains employment and per capita income, both linked to individual welfare. Given the assumption of mass 2, the density function is f(x) = 1/a. Notice that this assumption about the shocks rules out ex ante correlation between income in the countries. A deficit bias would simply shift towards a positive average deficit the equilibrium of the economy, thus leaving unaltered the logic of our argument. By ruling out deficit biases, we are not concerned by strong empirical results like those of Fatás and Mihov (2003). As we are only concerned by the welfare effects of the norm, and as m** is the only stable equilibrium, we don’t deal with the emergence of the rule, nor with its robustness with respect to parameter changes. The matlab code is available from the authors upon request.

References Akerlof, G.A. (1980), “A theory of social custom, of which unemployment may be one consequence”, The Quarterly Journal of Economics 94(4): 749–75. Alesina, A., M. De Broeck, A. Prati and G. Tabellini (1992), “Default risk on government debt in OECD countries”, Economic Policy: A European Forum 15: 427–51. Allsopp, C., G. Davies and D. Vines (1995), “Regional macroeconomic policy, fiscal federalism, and European integration”, Oxford Review of Economic Policy 11(2): 126–44. Andersen, T. and J. Sorensen (1995), “Unemployment and fiscal policy in an economic and monetary union”, European Journal of Political Economy 11: 27–43. Ardagna, S., F. Caselli and T. Lane (2004), “Fiscal discipline and the cost of public debt service: Some estimates for OECD countries”, NBER Working Paper 10788, September. Artis, M.J. and B. Winkler (1999), “The stability pact: Trading off flexibility for credibility?” in Hughes Hallett, A., M.M. Hutchison and S.E. Hougaard, and H. Jensen (eds), Fiscal Aspects of European Monetary Integration, Cambridge: Cambridge University Press, pp. 157–88. Asch, S.E. (1951), “Effects of group pressure upon the modification and distortion of judgement”, in Guetzkow, H. (ed.), Groups, Leadership and Men, Pittsburgh, PA: Carnegie Press, pp. 177–90.

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Bean, C. (1998), “The stability pact: More than a minor nuisance? Discussion”, Economic Policy 13: 104–07. Becker, G. (1976), The Economic Approach to Human Behavior. Chicago: Chicago University of Press. Beetsma, R., X. Debrun and F. Klaassen (2001), “Is fiscal policy coordination in the EMU desirable?” HEI Working Paper 04/2001, Geneva, Institut Universitaire de Hautes Etudes Internationales. Bernoth, K., L. Schuknecht and J. Von hagen (2004), “Sovereign risk premia in the European bond market”, CEPR Discussion Papers 4465, July. Buchanan, D. and A. Huczynski (1997), Organizational Behaviour. London: Prentice-Hall. Buiter, W.H. and C. Grafe (2004), “Patching up the pact: Suggestions for enhancing fiscal sustainability and macroeconomic stability in an enlarged European Union”, Economics of Transition 12(1): 67–102. Buti, M., S. Eijffinger and D. Franco (2005), “The stability pact pains: A forward-looking assessment of the reform debate”, CEPR Discussion Papers 5216, September. Canzoneri, M.B., R.E. Cumby and B.T. Diba (2004), “Should the European Central Bank and the Federal Reserve be concerned about fiscal policy?” in Rethinking Stabilization Policy, A Symposium sponsored by the Federal Reserve Bank of Kansas City. Caporale G.M. and G. Williams (2002), “Long-term nominal interest rates and domestic fundamentals”, Review of Financial Economics 11: 119–30. Catenaro, M. and P. Tirelli (2000), “Reconsidering the pros and cons of fiscal policy co-ordination in a monetary union: Should we set public expenditures targets?, Working Paper Series 30, Dipartimento di Economia Politica Milano-Bicocca. Clarke, S. (1967), Central Bank Cooperation: 1924–31. New York: Federal Reserve Bank of New York. Creel, J., P. Monperrus-Veroni and F. Saraceno (2007), “Has the golden rule of public finance made a difference in the UK?” Observatoire Français des Conjonctures Économiques Document de Travail (OFCE Working Papers), 13. Cunningham, S.R. and J. Vilasuso (1994), “Is Keynesian demand management policy still viable?” Journal of Post Keynesian Economics 17(2): 187–210. De Grauwe, P. (2003), The Stability and Growth Pact in Need of Reform, Mimeo, University of Leuven. Detken, C., V. Gaspar and B. Winkler (2004), “On prosperity and posterity: The need for fiscal discipline in a monetary union”, ECB Working Paper 420, December. Dixon, H. and M. Santoni (1997), “Fiscal policy coordination with demand spillovers and unionised labour markets”, Economic Journal 107: 403–17. Eichengreen, B. and C. Wyplosz (1998), “The stability pact: More than a minor nuisance?” Economic Policy 28: 65–104. Elster, J. (1989), “Social norms and economic theory”, Journal of Economic Perspectives 3(4): 99–117. Fatás, A. and I. Mihov (2003), “The case for restricting fiscal policy discretion”, The Quarterly Journal of Economics 118(4): 1419–47. Fitoussi, J.P. (2006), “Macroeconomic policies and institutions”, Documents de Travail de l’OFCE, 6, March.

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Fitoussi, J.P. and F. Saraceno (2007), “Fiscal discipline as a social norm: The European stability pact”, Observatoire Français des Conjonctures Économiques, Document de Travail (OFCE Working Papers), 22, July. Forsé, M. and M. Parodi (2005), The Priority of Justice. Elements for a Sociology of Moral Choices. Bern: Peter Lang. Harsanyi, J. (1969), “Rational-choice models of political behavior vs. functionalist and conformist theories”, World Politics 21(4): 513–38. Hechter, M. and K.-D. Opp, eds (2001a), Social Norms. New York: Russel Sage Foundation. Hechter, M. and K.-D. Opp (2001b), “What have we learned about the emergence of social norms”, in Hechter and Opp (2001a), pp. 394–415. Heipertz, M. and A. Verdun (2004), “The dog that would never bite? What we can learn from the origins of the stability and growth pact”, Journal of European Public Policy 11(5): 765–80. Hicks, J.R. (1974), The Crisis in Keynesian Economics. Oxford: Basil Blackwell. Jensen, H. (1996), “The advantage of international fiscal cooperation under alternative monetary regimes”, European Journal of Political Economy 12: 485–504. Landon, S. and C.E. Smith (2000), “Government debt spillovers and creditworthiness in a federation”, Canadian Journal of Economics 33(3): 634–61. Laubach, T. (2003), “New evidence on the interest rate effects of budget deficits and debt”, Board of Governors of the Federal Reserve System, Finance and Economics Discussion Series, 12, April. Le Cacheux, J. (2005), “Politiques de croissance en Europe: Un problème d’action collective”, Revue économique, 56 (3): May. Le Cacheux, J. (2007), “To co-ordinate or not to co-ordinate: An economist’s perspective”, in Linsenmann, I., C.O. Meyer and W. Wessels (eds), Economic Government of the EU: A Balance Sheet of New Modes of Policy Co-ordination, Basingstoke: Palgrave MacMillan. Le Cacheux, J. and F. Saraceno (2007), “Fiscal stabilization and the SGP constraints: Why size matters”, in Farina, F. and R. Tamborini (eds), Macroeconomic Policy in the European Monetary Union: From the Old to the New Stability and Growth Pact, Routledge, pp. 147–60. Levine, P. and A. Brociner (1994), “Fiscal policy coordination and EMU”, Journal of Economic Dynamics and Control 18(3/4): 699–729. Monperrus-Veroni, P. and F. Saraceno (2006), “Whither stability pact? An assessment of reform proposals”, in Mitchell, W., J. Muysken and T. van Veen (eds), Growth and Cohesion in the European Union. The Impact of Macroeconomic Policy, London: Edward Elgar, pp. 32–56. Mehra, Y.P. (1992), “Deficits and long-term interest rates: An empirical note”, Federal Reserve Bank of Richmond Working Paper, 2 July. Mundell, R. (1968), International Economics. New York: McMillan. Olson, M. (1965), The Logic of Collective Action: Public Goods and the Theory of Groups. Cambridge: Harvard University Press. Pettit, P. (1990), “Virtus normativa: Rational choice perspectives”, Ethics 100(4): 725–55. Stark, J. (2001), “Genesis of a pact”, in Brunila, A., M. Buti and D. Franco (eds), The Stability and Growth Pact, The Architecture of Fiscal Policy in EMU, Basingstoke: Palgrave, pp. 77–105.

5 The ECB’s Quiet Hijacking of the Euro Area’s Exchange Rate1 Jérôme Creel, Éloi Laurent and Jacques Le Cacheux

“My name’s Mr. Euro!” Wim Duisenberg “I am Mr. Euro” Jean Claude Trichet

5.1 Prologue: A mere symbol deprived of all sovereignty The choice of an exchange rate regime inevitably becomes important when national economies have to compete with each other to gain market share in their own part or in the rest of a world that is becoming increasingly more integrated. Over the last few years, China and Germany have become convincing illustrations of this basic truth. The Chinese authorities still undervalue the yuan’s value against the U.S. dollar despite strong American pressure for a free-floating Chinese currency. Similarly, market share in European cross border trade is what governs the real exchange rate strategy unremittingly pursued by the Germany since 2000 which led to wage stagnation and low growth in that country.2 The exchange rate is therefore essential to euro area countries. The fact that European national currencies were officially replaced by the euro in 1999 when the final parity rates were irrevocably decided upon should not mask two other factors. First of all, the euro floats freely against the world’s other currencies, particularly the yen and the U.S. dollar and therefore it influences the volume and the value of the zone’s imports and exports. Secondly, euro area countries can 82

The ECB’s Quiet Hijacking 83

always set up social competition strategies which can really improve their competitive advantage within EU borders since intra-EU trade represents about two-thirds of all EU member states’ external trade. Exchange rate management, that is, the exchange rate policy, is consequently of primary macro-economic importance in the euro zone because of its direct impact on inflation, growth and regional cohesion. However this chapter does not aim to establish a mechanical relationship between the value of the euro and the macro economic performance of countries taking part in the single currency, although some sort of link between the two does exist as we shall see later. We would rather focus on the exchange rate policy’s institutional status within the euro area and on its consequences for Europe’s dynamism and the stability of its historic, economic and political heart. We mainly wish to argue that the one-way de facto responsibility for the European exchange rate policy has been counter-productive. This is all the more harmful as the painful structural transformations caused by current globalisation call for more efficient economic policies and there is no need for any added obstacle thrown in the way. Europe combines the lack of a common growth strategy, the absence of macroeconomic coordination instruments with the self-inflicted punishment of an exchange rate policy that is mesmerised by price stability. This has created the need for social policies whose consequences on competition have been detrimental to internal growth and regional stability. The euro is not just a stateless currency, it is also deprived of all sovereignty. Because of the absence of any proper European government, the euro does not enhance the European project. It rather proves heteronymous for currency exchange markets since its value can be viewed as the result of the rest of the world’s overall imbalance. This heteronomy is mainly due to its institutional status. The euro has been the victim of a virtually unnoticed3 quiet hold-up4 by an independent monetary authority that propounds that any exchange policy is totally useless and even dangerous in a world of floating currencies. In fact, this thesis rests on an unconvincing theoretical and empirical basis, since the floating currency regime, quite contrarily, frees the monetary instrument and most of the world’s currencies of many constraints and boosts national economies. We shall then argue that the euro area has the economic need for an exchange rate policy and that it is legally entitled to one.

84 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

5.2 The lessons from theory: A conflict between potential objectives 5.2.1 What sort of stability? Price stability objectives5 and exchange rate nominal stability are closely interrelated which often brings them into conflict. This is more particularly the case in the euro area since it has a dual exchange rate regime: it is irrevocably fixed within the euro zone while the euro freely floats again the rest of the world’s currencies. Price stability however can be achieved via an astute monetary policy that manipulates interest rates. It is common knowledge that the interest rate is one of the factors that determine exchange rate fluctuations. It can be the result of the direct mobilisation of the non-covered parity which is the link between the anticipated appreciation rate of a currency and the difference in the levels of national and foreign interest rates. One can also act indirectly through the impact of interest changes on capital flows, even if the interest rate parity is then not satisfactorily covered. This happens when people are risk averse or if they have a marked national preference, according to the “habit at preference” principle. Portfolio effects then occur, yet interest rates may still affect the composition of portfolios. In structurally weak economies, high interest rates may cause exchange rate crises. A lower value in financial and bank assets combined with higher economic uncertainty may lead to an exchange rate collapse. Currency devaluation may in turn, bring more price instability. Conversely, exchange rate stability objectives limit monetary policy independence in keeping with Mundell’s incompatibility triangle—also known as the impossible trinity. In a situation where world capital markets are highly integrated, countries with a fixed exchange rate have to harmonise their monetary policy with their amount of foreign currency reserves, which hampers monetary policy. Krugman (1998) refined this analysis by integrating the new elements that make up the contemporary international monetary system. His “eternal triangle” links up adjustment, confidence and liquidity. The top angle of the triangle concerns the ability of public authorities to bring macro economic stabilisation. Confidence has to do with dealing and solving speculative attacks on the exchange rate which can be achieved by either joining a monetary union or restricting capital flows. And finally, liquidity refers to short-term capital movements. According to this triangle, one country may effectively respond to recessions or economic slowdowns in the liquidity context. By contrast, the same

The ECB’s Quiet Hijacking 85

country cannot resort to confidence unless it joins a single currency or sets up a currency board. The opposite situation, like that of the EMS for example, would bring about endless fights to defend national currencies against speculation. Krugman propounds that the United States, the euro area, and Japan do not really have to worry about confidence as long as they belong to an exchange rate floating regime. It allows these countries to concentrate entirely on their macro economic stabilisation policy while allowing them to make the most of free capital movements. This benign neglect for the exchange rate is made possible by the limited openness of their economy, their low respective foreign debt in foreign currencies and international investors’ confidence in the robustness of their economies. When applied to the U.S. dollar in the current period, this analysis presents some limitations mainly because of the Chinese authorities’ attitude with their own currency and the American authorities’ mounting pressure for a revaluation of the yuan, which seems to be having some success. This shows that the period of U.S. benign neglect for its exchange rate is coming to an end. Even though the openness of the American economy remains limited, U.S. authorities have made it clear since the mid 1980s that they have opted for an undervalued dollar policy (Eichengreen, 1998). Therefore, if the United States does not seem to care about a “weak” dollar, despite all the claims by all successive U.S. secretaries of the Treasury in the past 20 years, they certainly do all they can to stop the dollar going up—it is the opposite with the euro. This can partly be explained by the fact that an undervalued currency induces low costs in the atomised interests of consumers. It still remains true however that Mundell’s and Krugman’s approaches shed light on the inconsistency of European priority for price stability. A floating exchange rate regime should allow for a discretionary monetary policy that leads to growth and full employment—“reflation” policies in Krugman’s words, while the European monetary union has only managed to put an end to the risks of currency speculation within the euro zone. The ECB which is de facto the only authority in charge of the euro area’s exchange rate policy (see below) is all for price stability:6 ●

“The main objective of the single monetary policy is to maintain price stability. Monetary policy will always be about achieving this aim. Consequently, the Eurosystem’s monetary policy does not have an either implicit or explicit exchange rate target simply because monetary policy decisions about meeting an exchange

86

Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

●

●

rate target could, in some circumstances, come into conflict with the price stability objective. Therefore, the ECB believes that exchange rates result more from present and anticipated monetary, fiscal, structural policies and cyclical trends than from the objective or target of that monetary policy. The distortions and the excessive instability of exchange rates often reflect macro economic imbalances and/or market uncertainty. Consequently, macro economic policies resting on stability and carried out transparently are the best contribution that the leaders in charge of economic policy can bring to the reinforcement of exchange rate stability.”7

5.2.2 Which instruments? The adoption of a floating exchange rate regime does not necessarily imply that a country or its central bank will have no exchange rate policy at all. First of all, “dirty floating” or managed floating are all part of a Central banker’s tool box. Managed floating is usually understood as a Central bank’s intervention on the Forex market with no exante or ex-post warning and without any specific targeting. The Bank of Japan is most familiar with this type of intervention which it has resorted to 340 times between 1991 and 2007, compared with 22 for the Federal Reserve and four for the ECB.8 It is therefore false to believe that the Japanese and American economies pursue no exchange rate policies. More generally speaking, there are several tools that monetary policy can use in theory to intervene in financial markets. Apart from direct intervention on the currency exchange market, they can change short-term interest rates or resort to what is called “openmouth operations,” in reference to open market operations (Guthrie and Wright, 2000). In the euro area, these three instruments lay in the European Central Bank’s sole hands and serve the purpose of price stability. Open-mouth operations are virtually unknown in Europe, since the ECB considers that the exchange rate policy is just one element in the macro economic context (see below). The ECB’s governor however happened to declare in autumn 2000 and 2001 that he was worried about the euro’s external value at times when the depreciation of the euro against the dollar threatened to cause imported inflation. Yet, this type of preoccupation is not symmetrical.

The ECB’s Quiet Hijacking 87

Direct interventions have also been limited in number. They essentially took place in September–November 2000, again to contain the euro’s devaluation and the subsequent risk of imported inflation and then in September 2001 in an attempt to bring down the risk of financial panic. In both cases, the interventions were uncoordinated at international level, except in September 2000 and did not last for long. They only served as complementary measures in support of the major instrument mobilised, namely the short-term interest rate which is strictly committed to the objective of price stability according to Article 105 of the EC Treaty (see below). These open-mouth and direct interventions which Cartapanis (2005) describes as “sporadic” must be put into perspective with the world’s large economies’ doctrine. As Cartapanis reminds us, “the situation is very different for the United States, Japan and obviously China, the three major protagonists on the financial stage. These countries have exchange rate targets and do not hesitate to inform the markets about them. In the recent past, they never shied away from either carrying out large scale policies, or making many official public interventions and speeches explaining their official position so as to influence financial operators and investors. Their macro economic strategies always include exchange rate targets. This is most obvious today in the United States and in China, although it can also apply to Japan, Australia and Canada ....” Regarding open-mouth interventions, Fratzsher (2004) shows for his part how efficient such operations usually are. They indeed have an impact on the evolution of the exchange rates between large countries’ currencies, like the euro to the dollar or the yen to the dollar, and they do manage to smooth away some of their volatility. It becomes therefore obvious when one looks into the euro area’s exchange rate policy – or observes that it is non existent—that the ECB has given priority to price stability over exchange rate stability, since the exchange rate has widely fluctuated since 1999 whereas the inflation rate has been remarkably contained within the fluctuation band of the Bank’s own choosing. The ECB starts to pursue an exchange rate policy only when the evolution of the exchange rate threatens to fuel inflation, which is in fact nothing more than the pursuit of a monetary policy by other means. Under the ECB, the euro zone’s exchange rate policy has hence become one-way, residual and asymmetric. And yet, the European Treaties establish that its responsibility is to be shared and that its objectives ought to be defined by the political authorities.

88 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

5.3

The Treaties say it is a shared field of competence

5.3.1 The European Economic Constitution’s obscure clarity A careful reading of the European Economic Constitution (Laurent and Le Cacheux, 2006) namely of the explicit rules about economic policy in the European Treaties shows that Article 105 and Article 111 of the Treaty establishing the European community may contradict each other. Let us quote the two articles in full so as to assess the possibility of this contradiction: Article 105 1. The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in article 4. 2. The basic tasks to be carried out through the ESCB shall be: —to define and implement the monetary policy of the Community; —to conduct foreign exchange operations consistent with the provisions of Article 111; —to hold and manage the official foreign reserves of the Member States; —to promote the smooth operation of payment systems. Article 111 1. By way of derogation from article 300, the Council may, acting unanimously on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with objective of price stability, after consulting the European Parliament, in accordance with the procedure in paragraph 3 for determining the arrangements, conclude formal agreements on an exchange-rate system for the ECU in relation to non-Community currencies. The Council may, acting by a qualified majority on a recommendation from the ECB or from the Commission and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, adopt, adjust or abandon the central rates of the ECU within the

The ECB’s Quiet Hijacking 89

exchange-rate system. The President of the Council shall inform the European Parliament of the adoption or abandonment of the ECU central rates. 2. In the absence of an exchange-rate system in relation to one or more non-Community currencies as referred to in paragraph 1, the Council, acting by a qualified majority either on a recommendation from the Commission and after consulting the ECB or on a recommendation from the ECB, may formulate general orientations for exchange-rate policy in relation to these currencies. The general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability.9 There is a dual legal ambiguity. The Council may issue “general orientations for exchange-rate policy” in respect with the European lexicographic economic order—first price stability and when this is established, the other economic policy objectives, Article 111. However, as the ECB is also subject to this order, it must, after being consulted, carry them out (Article 105). Exchange rate policy therefore definitely seems to be a shared field of competence and as a result, this also becomes the case for the appreciation of effective price stability. 5.3.2 Independent means with interdependent aims According to European law, in the event of a compatibility conflict between the exchange rate general orientations and the primary objective of price stability, the Council and the ECB must indeed discuss it and consequently they must also discuss how the price stability objective must be reached which includes discussing the definition of the objective. More specifically, the ECB’s role can be explained through the distinction between the independence of means and of objectives. The ECB is independent on how to reach the orientations decided by the Council, but these orientations must be discussed between the Council and the ECB so they remain compatible with the price stability objective. Henceforth, from a legal viewpoint, the exchange rate policy is indeed, even though in a rather twisted way, a field of competence shared between the Council and the ECB. For these reasons, the euro area is in no different situation than that of the United States, Japan, the United Kingdom or Australia, although it may appear at first that its position is more akin to that of the Swedish model with its hyper-independent Central bank.

90 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

Originally, even the ECB subscribed to that interpretation of the European economic constitution: The Maastricht Treaty provides that the ECOFIN Council can formulate exchange-rate general orientations. These orientations – in keeping with my previous observations—do not affect the Eurosystem’s main objective, namely maintaining price stability. Consequently, EU Finance ministers who are ultimately in charge of the euro area’s exchange-rate policy have agreed in December 1997 to formulate general orientations about the exchange rate in exceptional circumstances only, for example, if the euro’s exchange rate is subject to manifest and long-lasting misalignment.10 The reference to the conclusions of the Luxembourg European Council of 12 and 13 December 1997, deserves a mention as it gives more detail on the meaning of Article 111: As regards the implementation of the provisions on exchange policy, it is understood that general exchange policy guidelines vis-à-vis one or more non-Community currencies will be formulated only in exceptional circumstances in the light of the principles and policies defined in the Treaty.11 But, this is only one interpretation without any constitutional value. Yet, Henning (2006) explains that at the advent of the monetary union there were two models as to what respective role the Council and the Eurosystem should play in the euro’s exchange rate policy. The German interpretation of the Treaties was in favour of the prevalence of the Eurosystem, while the French wished greater power for the Council. Henning observes that “the door had been kept open to exchange rate activism” at the launch of the euro area. 5.3.3 The Eurogroup’s programmed weakness The choice of this somewhat tortuous institutional strategy for implementing the European economic constitution’s provisions for the euro area’s exchange policy has resulted in getting round European law. During the course of the December 1997 Council, rather than setting up a formal body where the ECB and the Council could debate over exchange policy, European governments opted for the creation of the

The ECB’s Quiet Hijacking 91

Eurogroup, a non-institution viewed as an informal subdivision of the ECOFIN Council: By virtue of the Treaty, the ECOFIN Council is the centre for the coordination of the Member States’ economic policies and is empowered to act in the relevant areas. In particular, the ECOFIN Council is the only body empowered to formulate and adopt the Broad Economic Policy Guidelines which constitute the main instrument of economic coordination. The defining position of the ECOFIN Council at the centre of the economic coordination and decision-making process affirms the unity and cohesion of the Community. —The ministers of the States participating in the euro area may meet informally among themselves to discuss issues connected with their shared specific responsibilities for the single currency. The Commission, and the European central bank when appropriate, will be invited to take part in the meetings. —Whenever matters of common interest are concerned they will be discussed by Ministers of all member States — Decisions will in all cases be taken by the ECOFIN Council in accordance with the procedures laid down in the treaty.12 The Eurogroup is undoubtedly an excellent illustration of the two shortcomings about the euro area since its inception. It lacks autonomy within the European Union, holds no sovereign power since that authority has stealthily been handed over to the ECB. At any rate, European law cannot be held responsible for this twin deficit, the blame for the ECB’s admittedly quiet hold-up of the euro area’s exchange policy lies with European governments which cannot bring themselves round to abiding by the letter of the European economic constitution.

5.4 The actual cost of a non-policy 5.4.1 The quiet hijacking The bickering over who is in charge of exchange policy in Spring 2006 between the “two Jean-Claudes”—Juncker, the Eurogroup President who has been returned for a new term and Trichet, the ECB’s Governor— only shows too well that the dialogue the first is trying hard to establish, even with the help a huge “megaphone,” is a mere chimera within the present institutional framework.13

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What is paradoxical is that this dialogue would be perfectly legal if only it was organised. As there is no will, logically enough, the ECB keeps the exchange policy to itself to subject it to monetary policy: I have said often enough that I am Mr. Euro. There is no doubt: we issue the currency and I sign the banknotes. My signature is on the notes.14 We highly recommend reading Henning’s (2006) paper15 which describes how the ECB seized power over exchange policy matters in the course of year 2000. The ECB’s takeover was made possible then by the deep divergences in opinion among Euro member states and within the ECB’s governing Council over the value of the euro against the dollar. Those conflicting views were confusing the financial markets – it was believed that this “cacophony” was bringing down the euro’s value—and euro area’s international financial partners. For example, the U.S. Treasury which usually finds it important to communicate with its foreign counterparts, gradually gave preference to direct links with the ECB, the highest point in the process being the September 2000 multilateral intervention. One may remember that the French authorities were behind the turning point in favour of this move which was meant to stop the euro depreciating further against the dollar. Before such an intervention could take place, it was first necessary to clarify how it was to be organised. Henning goes on explaining that the European authorities and their representatives were fully aware that their “declaratory cacophony” was having a catastrophic effect on the euro area’s “credibility.” Pragmatic questions needed solving urgently, so the Treaties had to be left aside because they were simply too vague. Thus, as early as in the second quarter of 1999, conversations between the various European authorities dealt with who would be in charge of public relations regarding the value of the euro, who would formally decide on the principle of an intervention and who would implement and negotiate it with partner countries. All Eurogroup representatives, as well as all those of ECOFIN and the ESCB managed to reach an agreement on a modus operandi at the September 1999 informal Council of Turku, Finland. The situation was later clarified, although still kept secret, at a Eurogroup meeting in Luxembourg in June 2000. It took only a couple of hours after the 22 September 2000 multilateral intervention on the exchange markets for the consensus between the Eurogroup and the ECB to start to fall apart. This incited the authorities in Frankfurt to ignore European political authorities, but we are not quite there yet.

The ECB’s Quiet Hijacking 93

The Turku consensus comprised four points. First of all, the ESBC would decide on the date, the level and the amounts of reserves for the intervention. Secondly, intervention would take place under an understanding with the Eurogroup on action in principle arrived at in advance, in other words, the ESCB did not need to seek explicit permission from the Eurogroup before taking action. Thirdly, the ECB had to notify the Finance ministers once the intervention was in progress. Finally, an official joint declaration was to be prepared by the ECB, the Economic and Financial Council and the Eurogroup. The ECB Governor was now fully entitled to call himself “Mr. Euro.” As Henning puts it: “Finance ministers appear to accept the ‘sole competence’ of the Eurosystem as a practical matter (de facto) rather than as a legal right laid down in the Treaty (de jure).” Unfortunately the success of the September 2000 intervention did not last for long. Among the various reasons for the failure, we can mention here the verbal sparring matches between the Eurogroup President of the time, Laurent Fabius, the French Minister for the Economy and Finance, and Wim Duisenberg, the ECB Governor. When Laurent Fabius declared that the intervention “follows the position expressed by the Finance ministers of the euro area in Versailles on September 8th,” Wim Duisemberg lashed back at him: We [the ECB’s Governing Council] did not ask for [finance ministers’] permission because we do not need permission. While ministers had a role in the overall orientation of exchange rate policy, the management of the foreign exchange markets was a matter for the ECB.16 After stating on 24 September 2000 that interventions would start when deemed necessary, the ECB intervened again on 6, 3 and 9 September 2000, although unilaterally this time. The United States, the United Kingdom, Canada and Japan had taken part in the previous action. In this case, the Eurogroup President was informed only about ten minutes before the intervention, while the ECB’s Governor notified Finance ministers in the evening of 6 November. The Turku consensus had been dealt a serious blow and the ECB’s hold-up had become manifest. Even though this last point cannot be refuted from 2003, the ECB’s quiet hold-up of the exchange policy has had and continue to have a large impact at regional level, but it also affects Europe’s role and responsibilities within the international monetary system.

94 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux

5.4.2 Pro-cyclical regional policy It can hardly be denied that the EMS progressed chaotically between 1979 and 1998, and that it had negative consequences on the economies of euro area countries to be (Fitoussi, 2004). This can be explained by the teething problems of European monetary convergence. The trouble is that the maladjustment of interest rate levels went on after the introduction of the single currency and even worsened later on (Figure 5.1). This misynchronisation is the most blatant sign of the absence of European economic sovereignty. So the euro does not boost growth in the euro area. Since 1999, its value has gone down when economic activity was up and has increased when growth slowed down (Figure 5.1). The euro is entirely dependent on the ECB’s anti inflationary stance. The price to be paid for perfect price stability is high exchange rate volatility. An in-depth study of the euro to dollar parity from 1999 till 2005 is an excellent illustration of the euro’s pro-cyclical evolution (Figures 5.2 and 5.3). The average yearly growth rate was 2.7% in the euro area from the first quarter of 1999 to the third quarter of 2001. Growth then sharply slowed down and became virtually negative in the last quarter of 2001. While economic activity began to slow down, the euro began to go up. This came to an end in 2004, when economic activity went back to a more satisfactory level. The euro increased again when growth slowed down in mid 2004. The 2005 economic rebound came to 0.75% in the first quarter

5

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Figure 5.1

Real growth rate

Effective change rate (straight scale)

The pro-cyclical evolution in the euro’s exchange rate (%)

Source: OECD.

Sources: Datastream and OECD.

Figure 5.3 The euro area’s real growth rate (%)

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The ECB’s Quiet Hijacking 95

1.60 US $ to 1 euro

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Figure 5.2 The euro to dollar exchange rate

Source: ECB.

%

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to reach 1.5% in the fourth along with a depreciation in the euro’s value. All in all, the euro’s pro-cyclical evolution is strikingly regular. Again, this is not new. Since at least the mid 1980s, the euro to dollar parity has followed a pro-cyclical pattern (Figure 5.4): the dollar’s deep depreciation, partly uncontrolled, started in 1985 and actually took place long before Europe’s economy had really picked up in the period of the disinflation strategy’s implementation. In 1992–1993, during the last recession across Europe, the ECU reached a peak against the dollar. The euro was set up, among other reasons, to put an end to this heteronomy on the exchange markets of European currencies, yet the same heteronomy has occurred since the euro’s introduction in 1999 and is still with us today. Conversely, it can also be noted (Figure 5.5) that the U.S. dollar has benefited from a stabilising factor since 1992, with the brief exception of the 2001 shock. Until 2000, the dollar’s appreciation occurred in a period of high growth, while from 2002 onwards, the U.S. currency’s depreciation has sustained the upturn in the economy. Other monetary areas have been served well by their currencies (Figures 5.6 to 5.8). The periods of currency appreciation persisted as long as growth rates in volume topped 3% in annual rate for countries like the United Kingdom, for example. The counter-cyclical patterns of the yen and the Australian dollar also appear clearly, although this no longer applies to Australia since 2002.

US $ to 1 euro (ECU prior to 1999)

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Figure 5.4

Euro/dollar parity in the long-term euro to dollar parity

Sources: Datastream and ECB.

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Figure 5.5 The U.S. exchange policy, 1992–2005 (%) Source: OECD.

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Figure 5.6

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75

Effective exchange rate (straight scale)

The U.K.’s exchange policy, 1992–2005 (%)

Source: OECD.

Sweden’s case is particularly enlightening (Figure 5.9). Even though the Swedish krona may well have remained stable against the euro, this does not change the fact that the country has pursued a countercyclical exchange policy, which is a wise move for a small economy like Sweden’s since it is currently wide open to the outside world. Its economic openness rate—that is, the ratio of total exports and imports to GDP—tops 100% (see Touzé, 2007). Moreover, Sweden is outside the

98 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux 4 105 3 95

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Source: OECD. 6

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Figure 5.8 Australia’s exchange policy, 1992–2005 (%) Source: OECD. 6

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Real growth rate

Effective exchange rate (straight scale)

Figure 5.9 Sweden’s exchange policy, 1992–2005 (%) Source: OECD.

80

The ECB’s Quiet Hijacking 99

euro area, which means it has potentially more room for manoeuvre over it exchange and monetary policies than euro zone members. Thus, unlike its euro area counterparts, the Swedish Central bank has led an exchange policy resulting in a counter-cyclical evolution in its exchange rate since 2001. The Swedish krona was at its lowest point in 2001 at a time when its GDP in volume was increasing by just over 1% a year. Then the currency’s value went up, essentially against the dollar, which astutely supported the economy’s recovery. Therefore, the Swedish krona’s relative stability against the euro, especially since the Swedes decided not to adopt the euro, does not show that Sweden has stopped using its exchange rate to promote, or simply to defend, economic growth. 5.4.3 The risky games of real exchange rates and social-tax competition Yet, the consequences of the absence of a common economic strategy in Europe—of which the euro’s evolution is only the symptom—is even more harmful within the Community because EU intra-European trade makes up two-thirds of all exchanges in goods and services. European countries first set up competitive “social devaluation strategies” for conquering EU markets within the Bismarckian continental model (Creel and Le Cacheux, 2006; Laurent, 2006). Germany was the first to open the Pandora’s Box by manipulating the real exchange rate through the social model. It behaved as if it was a small country (Le Cacheux, 2005; Laurent and Le Cacheux, 2006) which has translated since 2000 into “deep-freezing” wages and adopting a strategy of high economic openness (see also Chapter 6). Paradoxically, the nominal appreciation of the euro against the dollar brings only advantages to Germany. Unsurprisingly, it reduces the cost in euros of extra-European imports, which make up 60% of all German imports. This subsequently encourages a drop in inflation which allows German firms to maintain, if not increase, their profit margins. More perniciously, this encourages German firms to convince their workers they ought to accept a wage freeze so as to keep prices competitive in export markets. Although the result of this against nature growth strategy has so far proved most unconvincing regarding growth and unemployment, it is most efficient in terms of competitiveness, as shown in Figure 5.10. The relative difference between Germany and Italy is absolutely spectacular and will remain that way for many years to come, unless Italy firmly engages in the same strategy. Relative prices will gradually come

100 Jérôme Creel, Éloi Laurent & Jacques Le Cacheux 125

Germany

120 115 France

110 105

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Figure 5.10

1999

2000

2001

2002

2003

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2005

Work unit costs in large continental European economies

Source: OECD.

down on condition that the strategy loses its efficiency in Germany and that country may then decide to quit the euro area so it can go back to traditional competitive devaluation. By leading such a policy of non-cooperation, Germany takes the risk of making the euro zone implode. Social-tax competition is developing within the EU, as illustrated by the three point increase in German VAT on 1 January 2007 and the cut in social contributions along with a decrease from 38.7% down to 29% in corporate tax. The establishment of the euro’s sovereignty has now become essential for regional cohesion.

5.5 Epilogue: The euro area as a globalisation bystander The euro is the interface between Europe and globalisation. Because it is not sovereign, it is only logical that the euro cannot take part in “Bretton Woods II,” the informal monetary system which has built up again in the transpacific region following the U.S. current account deficit (Dooley, Folkerts-Landau and Garber, 2004). The euro serves as some sort of adjustment variable for the world’s imbalances. Let’s imagine an optimistic scenario in which the timid start in the appreciation of Asian currencies, more particularly the yuan, persists as desired by the U.S. authorities. The appreciation in the euro’s value would then be due not to the needs of cooling down an overheating economy but to Asian Central banks’ portfolio reallocation. This would kill in the bud a recovery originally pulled by exports. European governments could do nothing but stand by and witness the worsening of a situation fuelled by the rate increase engineered

The ECB’s Quiet Hijacking 101

by the ECB. In a catastrophe scenario, Asian investors would heavily sell U.S. dollars because they have fears about the U.S. economy. The impact would be much worse in the euro area, because the lack of a common exchange policy would cause an unprecedented political crisis. The ultimate paradox in this situation of European helplessness is that monetary union and globalisation can provide the opportunity of regaining full control over monetary and exchange policies, namely the instruments needed to achieve higher growth and get to full employment. A monetary union helps to fend off speculative attacks, while globalisation helps to support low inflation. Both seem much more effective than Central bankers in achieving these goals (Rogoff, 2006). If these two analyses are correct, then the euro area is simply missing an historic opportunity to decide on the institutional modalities for an exchange policy matching its political ambitions. Then, the ECB’s hijacking of the European exchange policy, quiet as it has been, may well not remain so for very long.

Notes Translated from French by Bernard Offerle. 1. A first draft of this chapter was presented on 26 October 2006 at a conference on: “Independence and accountability: the case of the European Central bank.” It was organised by the Centre for European Studies and OFCE within the CONNEX European excellence network. We wish to thank all the participants for all their valuable comments and more particularly Iain Begg, Hubert Kempf and Jim Rollo. 2. See Creel, Laurent and Le Cacheux (2006). 3. More on this later. 4. Cartapanis (2005) for his part, says that the exchange rate policy has been “confiscated” by the European Central Bank. 5. As we wish to stick to the ECB status, we will not examine here, although it is essential, the link between monetary policy and asset prices. We shall also leave aside the problem of finance surveillance in the euro area. 6. See Kaltenhaler (2003) for a demonstration based on ECB exchange rate decisions between 1999 and 2001. 7. “The euro, the dollar and national policies: what room for manoeuvre?”, Willem F. Duisenberg’s intervention at the “Euroj+80” Paris conference on 25 March 1999. http://www.ecb.int/press/key/date/1999/html/sp990325_2. fr.html 8. “La politique de change japonaise en 2005” (“Japan’s exchange rate policy in 2005”), French Embassy in Japan, Economic Department, Minefi. 9. Consolidated version of the Treaty establishing the European Community, http://europa.eu/eur-lex/en/treaties/dat/EC_consol.html

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10. Willem F. Duisenberg’s intervention, op. cit. 11. European Council meeting in Luxembourg of 12 and 13 December 1997, Presidency Conclusions. http://www.consilium.europa.eu/ueDocs/cms_Data/ docs/pressData/en/ec/032a0008.htm 12. See note 11. 13. Éloi Laurent, “Euro: la guerre des deux Jean-Claude n’aura pas lieu” (“The Jean-Claudes’ war will not take place”), Les Echos, 25 July 2006. 14. Jean-Claude Trichet, Madrid Press conference, 8 June 2006. http://www.ecb. int/press/pressconf/2006/html/is060608.en.html 15. http://www.petersoninstitute.org/publications/wp/wp06–4.pdf 16. Quoted by Henning (2007).

References Cartapanis, A. (2005), “Pour une politique de change contra-cyclique de l’euro”, paper presented at Rencontres économiques d’Aix-en-Provence, L’Europe et les Etats-Unis, Cercle des économistes, July. Creel, J., E. Laurent and J. Le Cacheux (2006), “Ouverte pour travaux: La Présidence allemande de l’UE et la réunification européenne”, Lettre de l’OFCE, 4 December. Creel, J. and J. Le Cacheux (2006), “La nouvelle désinflation compétitive européenne”, Revue de l’OFCE n°98, July. Dooley, M.P., D. Folkerts-Landau and P. Garber (2004), “The revised Bretton Woods system”, International Journal of Finance and Economics, October, 9(4): 307–13. Eichengreen, B. (1998), Globalizing Capital: A History of the International Monetary System. Princeton, NJ: Princeton University Press. Fitoussi, J.-P. (2004), “La question du taux de change de l’euro”, Lettre de l’OFCE n°247, 2 April. Fratzscher, M. (2004), “Communication and exchange rate policy”, Working Paper Series n°363, European Central Bank, May. Guthrie, G. and J. Wright (2000), “Open mouth operations”, Journal of Monetary Economics, October, 46(2). Henning, C.R. (2007), “Organizing for foreign exchange intervention”, Journal of Common Market Studies, 45(2): 315–42. Kaltenthaler, K. (2003), “Managing the euro”, European Union Politics 4(3). Krugman, P., “The Eternal Triangle, explaining international financial perplexity”, mimeo, MIT, 13 October 1998, http://web.mit.edu/krugman/www/ triangle.html. Laurent, E. (2006), “From competition to constitution: Races to bottoms and the rise of ‘shadow’ social Europe”, Working Paper Series n°137, Center for European Studies, Harvard University. Laurent, E. and J. Le Cacheux (2006), “Integrity and efficiency in the EU: The case against the European Economic Constitution”, CES Working Paper n°130, Harvard University. Le Cacheux, J. (2005), “Politiques de croissance en Europe : un problème d’action collective”, Revue économique, 56(3): May.

The ECB’s Quiet Hijacking 103 Rogoff, K. (2006), “Impact of globalization on monetary policy”, “The new economic geography: Effects and policy implications”, Jackson Hole, Wyoming, 24–26 August, http://www.kc.frb.org/PUBLICAT/SYMPOS/2006/pdf/rogoff. paper.0829.pdf Touzé, V. (2007), “Les performances économiques de la Suède : quelques éléments d’évaluation”, Revue de l’OFCE n°100, January.

6 The Irish Tiger and the German Frog: A Tale of Size and Growth in the Euro Area Éloi Laurent and Jacques Le Cacheux

Today, Europe consists solely of small countries. The only relevant distinction that remains is that some countries understand this, while others still refuse to acknowledge it. Paul-Henri Spaak

6.1 Macroeconomic performance and country size in the Euro area: The importance of being small The overall growth performance of the Euro area since the inception of monetary union in what had become a booming world has been disappointing, to put it mildly. If efficiency measures the ratio of results compared to efforts, then the efficiency of EMU is quite low: nowhere in the developed and emergent world for the last 15 years have efforts been deployed harder to build strong economic institutions and nowhere has economic performance, measured by real growth rate of GDP, been so feeble.1 Yet, this weak performance can not be fully captured without understanding that member states diverge a great deal in their macroeconomic scoreboard. The reasons for this divergence are very complex, even if it has often been reduced in the literature to the issue of flexibility and rigidity of social models in general and labour markets in particular (see Sapir, 2006 for a recent attempt). In this chapter, we propose another type of explanation, the theoretical foundations of which can be found in Laurent & Le Cacheux (2006). To put it simply, we argued that country size plays a major role in macroeconomic performance, especially in the case of a monetary union. In the present chapter, we focus our attention on Germany and Ireland, respectively the biggest and the second smallest Euro area 104

The Irish Tiger and the German Frog

105

economy. Their belonging to the Euro area is crucial for our argument, given the constraints that the EMU puts on the use of macroeconomic policies and the incentives its institutions shape for national growth strategies. A basic national breakdown of growth and unemployment performance between 1995 and 2005 (we will have something to say in the conclusion about the year 2006) makes Ireland and Germany stand out, for the best and the worst (Figures 6.1, 6.2 and 6.3).

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Figure 6.1 Real GDP growth in the Euro area, 1995–2005 Source: OECD.

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Figure 6.2 Long term unemployment, 1995–2005 in % Source: Eurostat.

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Éloi Laurent & Jacques Le Cacheux Greece Germany Belgium France Italy Portugal Finland Spain Netherlands Ireland Austria Luxembourg 0

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5

Figure 6.3 Long term unemployment in the Euro area, 2005 Source: Eurostat.

6.2 Why should size matter for countries’ economic performances? Is size really an important determinant of economic performance in the Euro area and how? The relationship between country size and economic policy has been an essential feature of economic policy theory until the end of the 1970s (see Robinson, 1960) before it gradually gave way to a de-territorialised approach to national models often exclusively characterised by their social compact. To quote Robinson in the Introduction of the 1960 volume, the economics of the size of nations (that can be traced at least to J.S. Mill) is “a subject that well deserves more attention.” The flaws of an approach to economic policy that would posit the “death of size” in a similar way than the “death of distance” has been postulated should be obvious. Yet, on the basis of the last two decades literature on economic policy, it seemed as though increasingly integrated Nation-States have been implementing various combinations of macroeconomic and structural policies regardless of their size. This minimization of the role played by country size in growth strategies is likely to be related to the growing importance of globalisation and regional integration but also to the focus (at times exclusive) put on supply-side economics.

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Whatever the cause, the issue of country size is hopefully again the object of theoretical and empirical attention. The fertile cross-over between the new economic geography and the new trade theory, combining concepts such as integration, competition and agglomeration, enables to rediscover the crucial notions of borders, proximity and country size. New literature following McCallum (1995) thus seeks to shed light on the relation between the existence of borders (i.e., geographic proximity between two jurisdictions) and the intensity of trade. The “death of distance” posited by some authors (see for instance Cairncross, 1997) appears more symbolic than empirical in the light of this line of economic analysis and empirical investigation. More specifically, a recent literature intends on exhuming the fundamental role of country size in the definition of growth strategies but also on highlighting how this role is evolving in the context of contemporary globalisation. 6.2.1 Country size in recent literature The most recent works (see Alesina and Spolaore, 2003; Alesina, Spolaore and Warcziarg, 2005) attempt to determine endogenously national preferences using size as a causal factor. Country size itself is seen as resulting from a trade-off between citizens’ preferences heterogeneity costs and economies of scale in the provision of public goods. This latter literature thus constitutes a good starting point for new research and investigation on the relation not only between country size, economic performance government size but also institutional, and political dynamics and international relations strategic interactions. However promising, the new country size literature suffers from two important limitations that partly determine the interest of this project. First, it concentrates almost exclusively on the case of small open economies. In doing so, it finds itself in coherence with the seminal contemporary literature on country size (see Kuznets, 1960; Demas, 1965 and Katzenstein, 1985), but neglects to study the issue of size symmetrically. We believe that country size plays a role for small and large countries (by definition less open) alike, although in different ways. Because of this asymmetric bias, this literature does not depart entirely from the “country model” one that tends to compare social compacts without reference to the “size of nations.” What is more, this literature does not deal with the role played by country size within inter-governmental entities and regional integration dynamics. It offers an interesting absolute approach to size and formulates problems and solutions related to the “optimal size” of political and economic federations or unions. But it does not offer much

108 Éloi Laurent & Jacques Le Cacheux

insight on the comparative effect of size. An analysis of economic and political interactions between countries of different size and of the way country size shapes constraints and preferences in terms of macroeconomic policies and structural reforms thus appears necessary, especially given the dual current context of globalisation and regional integration. In this theoretical context, we are even more inclined to (re)investigate the relation between country size and growth strategy. The EU, and more specifically the Euro area, is a natural case study of an inquiry into the effect of country size on growth strategy. The choice of regional and national economic policies as well as the efficiency of federal rules or even the justification of their very existence crucially depends on both national and regional size. Tensions are indeed mounting in the contemporary period between large and small countries of a more than ever numerous and heterogeneous EU and Euro area (see Laurent and Le Cacheux, 2006). The implementation of monetary and fiscal rules and more generally the very nature of economic integration modalities are at stake. What is more, small European countries have for long appeared much more economically successful than large ones and shown a much better capacity to grow and reform their economic and institutional structures. This is why we are inclined to shed more light on a possible “size nexus” in the Euro area. The conditionality of the link between size and economic growth noted by many authors is indeed crucial to understand. Alesina and Spolaore (2003), for instance, show that country size matters for economic prosperity to the extent that the country is not integrated with the rest of the world. The more a country is globalised, the less its size will be an advantage. The fact that small countries have prospered more than large ones in the Euro area can thus be related to the fact that benefits of country size decrease as economic integration increases. To put it differently, the benefits of trade openness and economic integration are larger for smaller countries: GDP per capita and real GDP growth are positively associated with size, but when openness is introduced in the equation, both indicators become negatively correlated with size, giving small open economies a comparative advantage in a globalised world. Whatever the validity of this line of reasoning in the long term, there does not seem to be a link between country size and economic growth for OECD countries between 1995 and 2005. This is shown in Figure 6.4: outside the Euro area, large and small countries equally display good and bad performance. The cases of Sweden and the U.K. are especially interesting exhibits for instance a very similar performance while they are obviously very different in terms of size.

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Real GDP growth average 1995–2005, in %

The fact that the European economic constitution (the common market and policy rules of EU member states) gives small countries the advantage of trade while not allowing large countries belonging to the Euro area to compensate their handicap by an active use of macroeconomic policies may therefore explain part of the divergence in their performance in the recent period (shown in Figure 6.5).

6 5

Slovak Rep.

Turkey

4 Canada

US

3 Sweden

y = –2.5154x + 3.4486 R2= 0.0242

U.K.

2 Switzerland

Japan

1 0 0

5

10

15

20

25

30

Size of population 2004, in % of OECD total

Figure 6.4 Real GDP growth among OECD large and small countries, excluding Euro area members, 1995–2005

Average real growth of GDP, 1995–2005

Source: OECD.

8

Ireland

y = –0.1088x + 3.9016

7

R2 = 0.322

6 5 Luxembourg 4

Greece

3

Finland Portugal

2

Austria

France

Netherlands

Germany

Belgium

Italy

1 0

5

10

15

20

25

30

Population 1993 in % of the total

Figure 6.5 Real GDP growth among large and small members of the Euro area, 1995–2005 Source: OECD.

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6.2.2 A strategic approach to country size What is specific about belonging in the Euro area? Obviously, institutions and rules of the game differ from what applies in the rest of the world. In order to give substance to our reasoning in terms of political economy of growth policies, let us be more explicit about assumptions and analytical framework. Two analytical issues would seem to deserve some elaboration, before we move on to examining the cases of Ireland and Germany, as emblematic of two polar cases amongst Euro area members: one is the notion of a country’s strategy; the other is the assumptions to be made with regard to preferences in strategic contexts. When analysing the national economic policy choices facing a small country in the global economy, the natural assumption to make is, indeed, that of the small open economy, which is the most commonly made in such contexts. This assumption has the great advantage of eliminating all strategic considerations from the analysis: the small, open economy is the exact equivalent, on the international scene, of the private agent in a perfect competition environment; it is a pricetaker on all relevant markets. The notion of atomicity, common to the perfect competition and to the small, open economy analytical frameworks, implies that the small economy’s authorities can safely ignore any induced consequences of its own actions on the rest of the world. Or, to put it in other words, the small country’s situation in this case is not strategic. This is so both because of atomicity, and because the small country’s authorities are assumed to exert full control over their own economic policy instruments: there are, therefore, no sources of interdependencies. Things are different for large countries in the global context: they can no longer be assumed to be price takers. Hence they are usually treated as having some market power, but still supposing they decide on their policy moves in a passive environment, with no feedback or reaction from other players. However, these simple assumptions regarding each country’s environment and situation when having to decide on economic policy options are not appropriate in the Euro area context. For one thing, the small, open economy assumption is no longer warranted, and one has to recognise the strategic characteristics of member states’ decisions when it comes to growth policies, and more generally economic and social policies. The reason is fundamentally that countries, small and large, are no longer playing against a passive environment, but are in strategic conditions: there are interdependencies, arising from

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the existence of shared policy instruments, that are managed in common according to specific rules of the game, as well as from the presence of spillover effects of all kinds in the context of a single market operating with a single currency. Hence, national policy-makers are not facing the same constraints and the same payoffs as in the global context, and, when making policy decisions, they usually have to take other countries’ decision makers’ expected reactions into account, a dimension that profoundly alters the nature of the games they will want to play. But how to specify these games, and the countries’ strategic choices? In line with the classic literature on international policy making, economic policy coordination, and world public goods2 —that is, all contexts in which there exist interdependencies, hence strategic interactions—, we assume that a country’s government, namely those who have power to decide and mobilise economic policy instruments that are under the country’s control, and to partake in collective decision-making processes over regional, common policy instruments, may be treated as a rational actor, in the traditional way of standard economic analysis. In addition, it is supposed that domestic considerations dominate in their preferences, which implicitly assumes that “borders matter” (McCallum, 1995), so that it is possible and meaningful to distinguish between “inside” and “outside” the domestic economy, and that national governments care mostly about their residents’ welfare. The latter assumption may be regarded as excessively idealistic; but it may be justified as a simple reflection of the national dimensions of democratic processes: voters elect national decisionmakers, who are, in the current institutional context of the EU and the Euro area, the players in domestic as well as European economic policy games. From this perspective, what matters are the rules of the game, the instruments in the various players’ hands, and the constraints they are facing. Hence, we will not assume that national governments’ preferences are different in the Euro area context from what they were before its creation, that they are different in large and in small countries, or indeed different from governments’ preferences in other, non-Euro, European countries, in other regions of the world, or other regional groupings: they may, or may not be. But we argue that they chose different strategies because they face different constraints and different policy options; in other words, given their preferences, the cost-benefit analysis of their policy choices is different, so that their rational choices will be different too.

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6.2.3 Constraints and policy options of countries: Small and large, the games they play Let us apply all this to macroeconomic policies for stabilization and growth of the domestic economy.3 Neither within nor outside monetary unions, can small open economies easily resort to traditional, demand-management instruments. But whereas those not belonging in a monetary union can control their monetary policy and can manipulate their external, nominal exchange rate in case of necessity, small countries in a monetary union cannot do so, and, just as large ones, have to live with the common interest rates and the common external exchange rate. One way of looking at the problem is to argue that a small country does not need macroeconomic stabilization instruments the way a large one does.4 For a small open economy, traditional fiscal policy of the Keynesian kind will usually be of little efficiency, whereas all policies that improve the competitiveness of the national economy by lowering production costs of firms located in the domestic economy are relatively more powerful: this may explain why fiscal consolidations in small countries have been found to have “non-Keynesian” effects in the EU; it also suggests that tax competition, “structural reforms” and wage moderation policies will all have very powerful, positive effects for a small open economy, both because domestic demand represents only a fraction of demand to domestic firms and because the elasticity of the supply of external capital—in particular foreign direct investments—is higher, the smaller and the more open the economy is. In addition, policies that lower production costs in a small economy do not harm domestic demand much, and they have little incidence on domestic inflation, so that they do not raise real interest rates, as nominal rates in a monetary union tend to be uniform across countries and to be relatively less influenced by the policies of a single, small country. For large countries on the contrary, free riding is impossible and the various policies reviewed above tend to be more costly, or even counterproductive for the economic system. Keynesian-style demandmanagement policies, especially fiscal policies, are more efficient for large relatively closed economies than for small open economies. On the other hand, all policies tending to lower production costs are less effective, and they all tend to lead to a lower domestic inflation, which, in a monetary union, then results in a higher real interest rate, so that they tend to be costly in terms of economic activity and growth. This is where the rules constraining the use of stabilization policies in the Euro area are paramount: they are much more painful for large

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countries than for small nations. This is how country size plays into economic performance in the Euro area. In Laurent and Le Cacheux (2006), we have gathered evidence of the existence of a “Millian growth,” that is a growth systematically biased in favour of small states of the Euro area given the European economic constitution. In quantitative terms, the systematic divergence between small states and large states amounts to 2.3 percentage points in real growth, 0.73 percentage point in inflation and 3.12 percentage points in public finance balance. We also find that the gap between small and large countries in terms of unemployment and long term unemployment is respectively of 3.9 and 2.2 percentage points. The “size nexus,” both for growth and unemployment, seems stronger than any “social nexus” (highlighting the role of labour market and social policies), in the Euro area. We should now look more closely at Ireland and Germany to find confirmation of our approach.

6.3

The “Irish Tiger”: A wonder of globalisation?

Many factors have been mobilised to account for the Irish miracle, but oddly enough, European integration is barely part of it.5 Yet, a careful study of the economic history of Ireland shows that the beginning of the economic “miracle” coincides with Ireland’s integration in the EU (1973), strengthens with the Single Act (1986) and accelerates with the launch of the EMU (1992). What is more, while the features of the Irish “liberal”

25000

U.K.

Ireland

12 West European countries

20000

15000

10000

2000

1997

1994

1991

1988

1985

1982

1979

1976

1973

1970

1967

1964

1961

1958

1955

1952

1949

1946

1946

1943

1940

1937

1934

1931

1928

1925

1922

1870

5000

Figure 6.6 GDP per capita in Ireland, U.K. and Western Europe, 1870–2000, in 1990 international Geary-Khamis dollars Source: Maddisson (2003).

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model of welfare state is put forward in the explanation of the stellar Irish growth performance before the 2008 recession, it is often forgotten that the U.K., which shares much of the same features, has not benefited as much from the European integration (Figure 6.6). A “small country effect” must have played a role in the European Irish success. The “Irish tiger,” which has become economically bigger than it was, is not a happy by-product of global economy but a result of the European economic constitution and the type of growth regime it favours and encourages. The result of the Irish catch-up was in 2005 nothing short of spectacular: three decades after having entered the EEC as its poorest member state, Ireland is now the second richest member state of the EU (Table 6.1). Table 6.1 GDP per capita index, 2005 for EU countries Luxembourg Ireland Denmark Austria Netherlands U.K. Belgium Sweden Finland France Germany Euro-zone Italy EU25 Spain Greece Cyprus Slovenia Portugal Malta Czech Rep. Hungary Slovakia Estonia Lithuania Poland Latvia Croatia Romania Bulgaria Source: Eurostat.

223 139 122 122 120 119 119 116 115 111 109 107 105 100 98 82 82 78 73 72 72 61 52 50 48 47 43 46 32 30

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Precisely because Ireland is such a small economy, one has yet to question the relevance of GDP as an accurate indicator of its real wealth. Actually, it may be expected that, for very open economies, GDP is not an accurate measure of residents’ standards of living, because a significant fraction of domestic production may be transferred abroad through factor income outflows, or because of the practice of “profit shifting” that tends to artificially increase GDP for countries having favourable corporate tax regimes. GNP or GNI might thus be better to capture the true level and rate of economic growth6 (see OECD, 2006, for alternative measures that “place Ireland around or slightly above the euro area average”. See also Stiglitz et al, 2009). This empirical issue leads naturally to the question of the nature of the Irish growth strategy. There is indeed a difference between two concepts put forward by Delmas (1965): “structural openness” and “functional openness.” A small country is structurally open economically because it has limited resources. But it can develop a functional openness, that is a growth strategy that aims to take advantage of its size. In the case of Ireland, the logic of functional openness has been pushed very far. One can estimate the difference between structural openness and functional openness by comparing Ireland openness evolution in the most recent period to other OECD countries. The Irish trade to GDP ratio has increased by almost 40 points in just one decade, from 55% in 1991 to 92.1% in 2001 (before decreasing to 74.9% in 2005, see conclusion). Ireland was in 2005 the fifth most opened economy of the OECD, far ahead of many small open economies (Table 6.2). Structural openness is therefore not enough to explain Ireland economic extraversion. This openness is the result of the development of the Irish export sector that led to a gradual improvement of its trade balance, exactly correlated with the development of the Single market, as shown in Figure 6.7. Hence, it can be said that the Single market for goods and services (62% of Irish trade in 2003) has been instrumental in the Irish success. The other pillar of the Irish “functional openness” has been the choice of tax competition, as early as 1981 (Figure 6.8). It has to be said that this strategy worked: United Nations data reveal that the stock of incoming FDI represented in 2004 126% of Irish GDP, compared to only 31.7% for the EU, 20.5% for large developed countries and 21.7% for the world economies.7 The two pillars of the Irish “miracle,” trade and tax competition, would not have been that successful outside of the European economic constitution. The European economic constitution is asymmetric: it allows integration of capital markets but not the harmonisation of tax

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Éloi Laurent & Jacques Le Cacheux Table 6.2

Trade to GDP in 2005 for OECD countries

United States Japan Australia Greece Italy France Spain United Kingdom New Zealand Mexico Turkey Portugal Canada Norway Poland Germany Iceland Finland Korea Switzerland Sweden OECD average Denmark EU15 average Austria Netherlands Hungary Czech Republic Ireland Slovak Republic Belgium Slovenia Luxembourg

13.4 13.6 21 22 26.3 26.6 28.2 28.3 29.1 30.7 30.7 32.9 36 36.7 37.2 38.1 38.3 39 41.2 44.5 44.9 45 46.2 50.7 51.9 66.1 67.1 70.8 74.9 79.8 86 129.7 148.6

Source: OECD.

policies. In this context, tax competition by small economies is bound to prosper. Because of its smallness, Ireland felt inclined to lower its tax rate more than other countries without having to fear retaliation. The final important ingredient to add to the Irish recipe is the European budget, which has shown to be very efficient in small countries, with fewer regional disparities than large ones. The Irish Ministry of Finance calculates a total of 40,176.6 million euros net receipts from the EU budget 1973 to 2005, or 3.3% of GDP per year on average over the period. During the period between 2000–2006, while Ireland

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100000 90000

Exports

Imports

80000 70000 60000 50000 40000 30000 20000 10000 2005

2004

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1992

1991

1990

1989

1988

1987

1986

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1983

1982

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1981

1979

1978

1977

0

Figure 6.7 Irish export and imports, 1977–2005, in million euros Source: Irish Ministry of Finance.

60 48%

50

40 32% (%) 30

20 20.60% 10 13%

10% 0 1979

1981

1983

1985 1987

Ireland

1989

1991

1993

1995

1997 1999

Average EU 15 (12 countries)

2001

2003

2005

EU 10

Figure 6.8 Corporate taxation in Ireland, the EU 15 and the EU 10, nominal tax rates on profit (%) 1979–2005 Source: Devereux, M.P., R. Griffith and A. Klemm (2002) and Eurostat.

had become one of the richest European nations, structural funds still amounted to 3.35 billion euros, or 25% of the financing of the “national development plan.”8 For all its brilliance, Ireland performance is not guaranteed to last forever as Figure 6.8 suggests. Even before the 2008 deep recession, some concerns have indeed been expressed about the viability of the functional openness growth strategy, while new Eastern member states can

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also play the tax competition game, and in a not so distant future, the trade one also. But does an “Irish model” exist, or was it more something of a prototype? Can the Irish success be replicated by others or was it only possible because Ireland was the only country playing this game? In any event, under-investment in human capital in particular is a concern for the Irish economy if it is to change the nature of its growth strategy (see OECD, 2006).

6.4

The German frog: How to shrink a large country

Katzenstein (1985) remarked that States were shrinking as they gradually became more open to foreign trade in an integrating world. But large states remain fundamentally dependent on their domestic market for growth. The German economic paradox lies at the intersection of those two assertions: Germany is the largest European state (34% of Euro area GDP and 26% of EU GDP) and, at the same time, the world leading exporter (cf. infra). First, the obvious fact is that Germany is a large economy. As such, its domestic demand plays the dominant role in the use of its GDP: private consumption alone represented almost 60% of German GDP in 2005 (see Table 6.3). Given this structure, coherent with the country’s economic nature, the dynamics of German use of GDP from 1995 to 2005 was disturbing (Figure 6.9). While private consumption and consumption expenditure of government remained more or less stable, gross capital formation 100 90 80 70 60 50 40 30 20 10 0

1995

1996

1997

1998

1999

2000

Private consumption expenditure Consumption expenditure of government

2001

Figure 6.9 Use of German GDP, 1995–2005, in % Source: Destatis and authors calculations.

2002

2003

2004

Gross capital formation Net exports

2005

Table 6.3

2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995

Germany’s GDP use from 1995 to 2005 at current prices, billion euros Gross domestic product

Private consumption expenditure

Consumption expenditure of government

Gross capital formation

Exports

Imports

Net exports

2241.00 2207.20 2161.50 2143.18 2113.16 2062.50 2012.00 1965.38 1915.58 1876.18 1848.45

1321.06 1302.94 1281.76 1263.46 1258.57 1214.16 1175.01 1137.51 1115.78 1091.50 1067.19

419.64 415.06 417.23 411.8 400.23 391.91 387.24 376.36 371.47 371.75 361.82

384.29 378.32 376.99 370.2 411.85 449.18 432.31 424.69 404.42 396.06 410.77

912.27 844.12 770.74 765.7 735.6 688.39 591.49 563.24 526.25 467.09 442.79

796.26 733.24 685.22 667.98 693.09 681.14 574.05 536.42 502.34 450.22 434.12

116.01 110.88 85.52 97.72 42.51 7.25 17.44 26.82 23.91 16.87 8.67

Source: Destatis.

120 Éloi Laurent & Jacques Le Cacheux

had shrunk for the benefit of net exports. The share of exports in GDP had skyrocketed from 25.7% in 1995 to 40.1% in 2005, while that of investment went from 23.9% in 1995 to 17.2% in 2005. The openness dynamic is indeed the most important phenomena to occur in Germany’s economic history in the last 15 years. The OECD calculates that the trade to GDP ratio of Germany went from 23.7% in 1995 (it was 25% for Italy, 22.2% for France, 28.6% for the U.K.) to 38.1% in 2005 (26.6% for France, 26.3% for Italy and 28.3% for the U.K.). Consequently, Figure 6.10 shows that, judging on this criterion, Germany has left the group of large European countries to join the group of small European countries. As a result of this impressive external effort, in 2003, Germany regained its rank of leading global exporter lost in 1992, at least for goods. The WTO data show that in 2005, Germany exports amounted to 971 billion dollars in merchandise (with a 12% yearly growth between 2000 and 2005) and 143 billion dollars in services (with the same growth rate), compared to 353 billion dollars in services for the U.S. (with a 5% growth) and 904 billion dollars in merchandise (with a 3% growth). Of course, this has to be put in the perspective of Germany’s reunification. In 1990, for the GFR, the GDP was 1306 billion euros and exports 421 billion (already 32% of GDP). In 1991, GDP for the whole country amounted to 1534 billion euros with exports falling to 395 billion (27% of GDP). But while the German domestic market has been enlarged, the export-led growth strategy was pushed further and not moderated. The share of exports in GDP was almost stable from 1991 to 1999 55 50 Austria

45

Denmark Finland

40

France 35

Germany Italy

30

Portugal Sweden

25

UK 20 15 1995

Figure 6.10

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Trade to GDP ratio for selected EU member states, 1991–2005 (%)

Source: OECD.

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(it increased from 25% to 29%) but climbed by 10 points from 1999 to 2005. How did Germany achieve this performance? Mostly thanks to an aggressive competitiveness strategy. Figure 6.11 shows how, between 2000 and 20005, German wages under-performed those of OECD economies, Euro area member states and the two other large EMU countries. The explanation of the German performance given by Sinn (2007) appears odd in this respect: while he denounces rightly “a pathological export boom” and “landslide sector shift towards export industries with excessive destruction of the domestic sectors,” he attributes this to a “rigidity of wages” (pp. 47–48). Figure 6.11 shows how much on the contrary wages have been flexible. As with Ireland, one can wonder if the German performance was mostly due to specifically European factors or more generally to globalisation. One interesting point to look at in this respect is the evolution of the euro exchange rate, which in effective terms has appreciated since 2002. How to make sense of an exports boom with a currency appreciation? One has to distinguish two elements for Germany: the real exchange rate with Euro area main trade partners and the nominal exchange rate with main trade partners outside the Euro area. The European component of the German success then appears prominent. Table 6.4 lists the 15 first trade partners of Germany in 2005, for exports and imports. Not surprisingly, 4 out of the first 5 and 8 out of 15 belong to the EU, 3 out of the first 5 and 6 out of 15 to the Euro

Germany France & Italy Euro area without Germany UE 15 outside Euro area OECD

6 5 4 3 2 1 0

2000

2001

2002

2003

2004

2005

Figure 6.11 Annual growth rates of nominal compensation per employee in the private sector, 2000–2005 Source: OECD.

122 Éloi Laurent & Jacques Le Cacheux

area (the Single market represented 65% of German external trade in 2003). If competitiveness was achieved, it was thus within the Single market and compared to Euro area trade partners. In this latter case, the exchange rate that matters is not of course the nominal rate of the euro, but the real exchange rate, that is relative labour costs. Table 6.5 shows the dramatic evolution of unit labour costs between Germany and Euro area trade partners. The gap with the Euro area has almost been multiplied by a factor 5 between 1999 and 2005. What about the other trading partners outside the Euro area? Table 6.6 shows the evolution of nominal exchange rates between

Table 6.4 First 15 trade partners of Germany in 2005 Exports France US U.K. Italy Netherlands Belgium Austria Spain Swiss Poland China Russia Tch. Rep. Sweden Hungary

912.2

%

Imports

796.2

%

79 69.3 60.4 53.9 49 43.6 43.3 40 29.6 22.3 21.2 17.3 19.2 17.2 13.6

8.7 7.6 6.6 5.9 5.4 4.8 4.7 4.4 3.2 2.4 2.3 1.9 2.1 1.9 1.5

France Netherlands US China U.K. Italy Belgium Austria Swiss Russia Japan Spain Tch.Rep. Poland Norway

53.7 51.8 41.8 40.8 39.1 36.3 28.8 26 22.6 22.3 21.8 18.1 17.7 16.8 15.1

6.7 6.5 5.2 5.1 4.9 4.6 3.6 3.3 2.8 2.8 2.7 2.3 2.2 2.1 1.9

Source: Destatis and authors calculations.

Table 6.5 Gap with Germany in unit labour costs growth (whole economy) from 1999 to 2005, % points

France Italy Netherlands Belgium Austria Spain Euro area

1999

2000

2001

2002

2003

2004

2005

0.5 0.7 1.2 0.9 −0.4 1.4 0.4

0.3 −0.1 2.2 −0.4 −0.9 2.1 0.4

1.4 2.3 4.1 3.4 0.1 2.3 1.3

2 2.8 3.9 1.2 0.1 2 1.5

0.8 3.3 1.7 −0.4 0.1 2 1

1.2 2.6 0.5 −0.1 −0.2 2.7 1.1

2.8 3.4 0.6 3.2 1.8 3.1 1.9

Source: ECB and authors calculations.

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Table 6.6 Nominal exchange rate of Germany (euro) with main trade partners outside the Euro area from 1999 to 2005 1999 US U.K. Poland China Russia Tch. Rep. Hungary

1.16 0.7 4.1 26.6 35.7 250.7

2000

2001

2002

2003

2004

2005

1.01 0.61 4.16 8.13 28.6 36 254.9

0.93 0.63 3.85 7.76 26.6 35.1 265

0.88 0.61 3.59 7.31 27.01 32 243.8

1.06 0.65 4.07 8.79 33.8 31.4 240.3

1.26 0.69 4.71 10.43 36.3 32.7 264.3

1.31 0.69 4.07 10.85 36.6 30.3 246.4

Source: Eurostat, OECD.

Germany and its main trading partners outside the Euro area. Here also, the evolution is favourable, with the U.S. of course but also with China and Russia while Germany’s competitiveness has been stable with the U.K., Poland or Hungary. There is no denying that the German competitiveness effort has been a huge success in terms of net exports growth. But is it compatible with the fact that Germany is a large country? It appears that the “shrinking” of Germany was, at least until 2009 (with the exception of 2006, cf. infra), a counter-productive small country growth strategy. In his famous fable, “The Frog who Aspired to Become as Big as the Ox,” La Fontaine warned courtesans of the vital danger of trying to become, blinded by ambition, what they were not. The frog that wants to be as big as the ox by filling itself with air ends up exploding. The German ox wants the opposite: it wants to let go with domestic demand and focus on external competitiveness. On the road to becoming the “German frog,” it risks the same peril: by investing abroad and depressing wages, it puts a severe constraint on domestic consumption and investment, and eventually on growth. The results of this strategy so far are eloquently feeble (with 2006 as the exception that confirms the rule or the turning point, see infra). Table 6.7 shows how Germany has fared in the most recent period, where the small country strategy has been the most intensively pursued (the share of exports in GDP jumping more than 10 points form 1999 to 2005), in terms of real GDP growth, real domestic demand, unemployment rate and long term unemployment rate. The comparison between France and Germany, the two largest Euro area countries, in terms of real growth and domestic demand is enlightening (Figures 6.12 and 6.13).

124 Éloi Laurent & Jacques Le Cacheux Table 6.7 German growth, domestic demand, share of exports in GDP, unemployment and long term unemployment, 1999–2005 Share of exports in GDP 1999 2000 2001 2002 2003 2004 2005

29.4 33.4 34.8 35.7 35.7 38.0 40.2

Real GDP growth 1.9 3.5 1.4 0.1 −0.2 1.1 1.1

Real domestic demand growth

Long term Unemployment unemployment rate rate

2.5 2.4 −0.4 −1.9 0.6 0.1 0.3

7.9 7.2 7.4 8.2 9.1 9.5 9.5

4.1 3.7 3.7 3.9 4.5 5.4 5

Source: ECB.

4.5 4

France

Germany

3.5 3 2.5 2 1.5 1 0.5 0 – 0.5 1995

Figure 6.12

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Real GDP growth among the “big two,” (%) 1995–2005

Source: OECD.

Why did Germany choose that strategy? The answer lies in the incentives system devised by the European economic constitution and especially the Euro area constrains on stabilization policies: large countries are encouraged to behave like small ones, and thus to compete using real “social disinflation” rather than nominal exchange rate policy, that is to adopt competitiveness policies focused on labour cost reduction and welfare state roll-back policies. Since they are not small, the results are not as good for them and, worse even, they trigger strategic reaction from other large countries, who in turn will engage in the social race to the bottom. Some elements of this worst-case scenario for Euro area social models have already appeared (see Laurent, 2006).

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5 France

Germany

4 3 2 1 0 –1 –2 –3 1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Figure 6.13 Real domestic demand growth among the “big two,” (%) 1995–2005 Source: OECD.

6.5 A turning point in 2006? Weighting the future 6.5.1 Is Ireland growing up? The Irish strategy was extremely effective until the 2004 enlargement, but the integration of a number of small Eastern European countries now forced Ireland to revise its growth strategy. Domestic demand appears to progressively play a greater role in the Irish growth. Figure 6.14 shows that the degree of openness of Ireland was reduced from 2001 to 2005 by 15 points. Table 6.8 shows that in 2005 and 2006, real domestic demand and private consumption have been buoyant while imports and exports have cooled. One is thus entitled to wonder if Ireland was not growing up economically, that is, shifting away from an aggressive small economy strategy to a more balanced growth. 6.5.2 Is Germany gaining weight? Germany appeared to develop its domestic market again in 2006 (consumption remains weak but investment had certainly picked up), but the exports performance was still a major part of national growth (Table 6.9). The strength of the recovery was thus more than ever in question, and the issue of the evolution of wages was to be crucial in this perspective. If Germany continues its economic extraversion, it is possible that its recovery would be short-lived, and at risk of a downturn in global demand.

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95 90 85 80 75 70 65 60 55 50 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Figure 6.14

Trade to GDP ratio, 1991–2005

Source: OECD.

Table 6.8

Domestic and trade indicators for Ireland, 2004–2006, in % growth

Private consumption Real total domestic demand Exports Imports

2004

2005

2006

3.8 3.6 7.3 8.6

6.6 8 3.9 6.5

6.2 6.3 5 5.4

Source: OECD.

Table 6.9 Main economic indicators for Germany in 2005 and 2006, in % growth

GDP at market prices Total domestic demand Private consumption Gross fixed investment Exports Imports Net exports Compensation per employee Unit labour cost Unemployment (rate) Employment Labour productivity Source: OECD.

2005

2006

1.1 0.6 0.3 1 7.1 6.7 0.5 −0.6 −0.9 9.1 −0.1 1.2

3 1.9 1 6.4 12.9 11.5 1.2 1.4 −1.6 8.1 0.7 2.2

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The exports performance can once again be detailed. The two phenomena already noted, the real depreciation of the German “currency” in the Euro area and the nominal depreciation of the euro against Germany’s main EU Eastern trading partners have intensified. If there is some truth to the idea of the “Bazaar economy” (Sinn, 2007), it is in the fact that Germany has become something of a “Mittleconomy”: it competes eastward with appreciating currencies in nominal terms for buying, and westwards with appreciating currencies in real terms for selling. While the trade with Eastern Europe increased (Table 6.10), real depreciation in the Euro area (Table 6.11) and nominal depreciation with Eastern European countries (Figure 6.15) have continued.

Table 6.10 Imports variation from 2005 to 2006 for Germany’s main trade partners, in % 35.4 24.9 23.1 23 19.4 18.2 16.8 16.1 14.8 11.4 10.9 9.6 8

Russia Tch. Rep. Belgium Poland China France Netherlands US Austria Swiss Italy U.K. Spain

Source: Destatis.

Table 6.11 Unit labour costs variation from 2005 to 2006 for Germany and its main trade partners in the Euro area Germany Euro area France Italy Spain Netherlands Austria Belgium Source: ECB.

–0.9 1 1.9 2.5 2.2 –0.3 0.9 2.3

−1.6 0.9 1.9 2.6 2.5 0.2 0.6 0.7

128 Éloi Laurent & Jacques Le Cacheux 31

4.2

30

4.15 4.1

29

4.05

28

4 27 3.95 26 3.9 25

3.85

24

3.8

23

3.75

22 2005Jan 2005Apr 2005Jul 2005Oct 2006Jan 2006Apr 2006Jul 2006Oct 2007Jan 2007Apr

3.7

Czech koruna

Hungarian forint /10

Polish zloty (right scale)

Figure 6.15 Exchange rate variations between the euro and Germany’s main Eastern EU trade partners, 2005–2007 Source: ECB.

6.6 Epilogue: Is the Euro area becoming a competitive large country or a collection of competing small economies? The German and Irish case studies show how much country size matters in the Euro area. Taken together, they also point to a concerning evolution: if all Euro area countries start behaving like small economies, social and tax competition is bound to prosper, but not the Euro area. The Euro area is fundamentally a large closed economy: its degree of openness is close to that of the largest of its members. This means that it should allow for macroeconomic policies in order to make the most of its domestic market if it wants to stimulate its economic growth, like many large countries in the developed world (US, U.K., Australia, Canada ...). Otherwise, in applying economic rules made for small economies while it is truly a large economy, it runs the risk of structurally jeopardising its growth and pitting against one another its largest economies. The recent evolution of tax competition on corporate taxation is a striking example of how not only small countries compete against large ones, but large ones compete against other large economies. Germany announced in May 2007 that it would lower its global corporate taxation (local and federal) from 38.9% today to 29.8% on

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45 40 35 30 25 20 15 10 5 0 EU

Latin OECD Asia Germany U.K. America Pacific 2008

Italy

France Spain Germany USA 2006

Japan

Figure 6.16 Corporate taxation in the world in 2006 (nominal tax rates on profits, in %) Source: OECD and KPMG.

January 1, 2008. This move targeted the other large economies of the EU (see Figure 6.16), and the U.K. soon announced that it would lower its own tax rate from 30% to 28%, exactly below the new German level. France (34.4%) and Italy (33%) are bound to follow suit. The EU is already the region of the world were corporate taxation is the lowest (see Figure 6.16). Because of economic rules that do not take enough into account country size, European countries today find themselves in the opposite movement of building the welfare state in the context of the first globalisation (1870–1914). A century after Bismarck, the French law on labour accidents (1898) or the institution of the income tax, they rival not to build but to dismantle their welfare state. And yet, social compacts remain the only efficient way to balance globalisation.

Notes Éloi Laurent thanks the Department of economics of Columbia University, where elements of this chapter have been assembled, for its hospitality. The usual disclaimer applies. This chapter is part of a research project on country size, that has benefited from the financial support of the ANR (French National Research Agency). 1. For a detailed assessment and some nuances, see Creel, Laurent and Le Cacheux (2007).

130 Éloi Laurent & Jacques Le Cacheux 2. Early illustrations of such analytical endeavours are, in particular, Hamada (1976) and in a more formal analytical setting, Oudiz and Sachs (1985). 3. For a modern rehabilitation of stabilization policies, and for an analysis of the interrelations between these two types of policies, see Aghion and Marinescu (2007). 4. See Le Cacheux (2005). 5. For recent examples of such underestimation, see “The luck of the Irish: A survey of Ireland”, The Economist, London, 14 October 2004, OECD Economic Surveys, Ireland, 2006 (see box 1.1, “What caused the Irish miracle”, p. 24) and IMF Country Report, Ireland, 2005. 6. The Irish Ministry of Finance calculates that in 2005 the GNP at constant prices was 131071 euros (compared to a GDP at constant prices of 155723 euros) and that the GNP at current market prices was 136055 euros (compared to a GDP at current market prices of 161163 euros). Yet, if the gap in term of growth of both indicators was 3.2 points high in 2002, it was only of 0.1 point in 2005. 7. Source: UNCTAD, World Investment Report 2005, www.unctad.org/wir 8. Cf. The European social funds in Ireland, http://www.esf.ie/en/homepage. aspx

References Aghion, P. and Marinescu, I. (2007), “Cyclical budgetary policy and economic growth: What do we learn from OECD panel data?” mimeo, http://www. marinescu.eu/AghionMarinescu2007.pdf Alesina, A. and E. Spolaore (2003), The Size of Nations. Cambridge, MA: MIT Press. Alesina, A., E. Spolaore and R. Warcziarg (2005), “Trade, growth and the size of countries”, in Aghion P. and S. Durlauf (eds), Handbook of Economic Growth, Amsterdam: North Holland, http://www.stanford.edu/~wacziarg/ Cairncross, F. (1997), The Death of Distance. How the Communications Revolution is Changing Our Lives. Boston: Harvard Business School Press. Creel, J., Laurent, É. and Le Cacheux, J. (2007), “Politiques et performances macroéconomiques de la zone euro: Institutions, incitations, stratégies”, OFCE Working Paper n°2007–23, September, http://www.ofce.sciences-po.fr/pdf/ dtravail/WP2007–23.pdf Demas, W. (1965), The Economics of Development in Small Countries. Montreal: McGill University Press. Devereux, M.P., R. Griffith and A. Klemm (2002), “Corporate income tax reform and international tax competition”, Economic Policy, 35: 451–95, http//:www. ifs.org.uk/publication.php?publication_id=3210 Hamada, K. (1976), “A strategic analysis of monetary interdependence”, Journal of Political Economy, August, 84: 677–700. Katzenstein, P.J. (1985), Small States in Global Markets. Ithaca: Cornell University Press. Kuznets, S. (1960), “Economic growth of small nations”, in Robinson, E.A.G. (ed.), Economic Consequences of the Size of Nations: Proceedings of a Conference held by the International Economic Association, New York: St Martin’s Press.

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Laurent, E. (2006), “From competition to constitution: Races to bottoms and the rise of ‘shadow’ social Europe”, CES Working Paper Series, Entre for European Studies, Harvard University, http://www.ces.fas.harvard.edu/publications/ docs/abs/Laurent_abst.html Laurent, E. and Le Cacheux, J. (2006), “Integrity and efficiency in the EU: The case against the European economic constitution”, Centre for European Studies Working Papers Series 130, Harvard University, http://www.ces.fas.harvard.edu/ publications/docs/abs/Laurent_LeCacheux_abst.html Le Cacheux, J. (2005), “Politiques de croissance en Europe: un problème d’action collective”, Revue économique 56: 230–45. Maddison, A. (2003) The World Economy: A Millennium Perspective, Paris: OECD. McCallum, J. (1995), “National borders matter: Canada-US regional trade patterns”, American Economic Review, June, 615–23. Mill, J.S. (1844), ] Essays on Some Unsettled Questions of Political Economy. London: Longmans, http://www.econlib.org/library/Mill OECD (2006), Economic Survey: Ireland. Paris: OECD. Oudiz, G. and Sachs, J. (1985), “International policy co-ordination in dynamic macromodels”, in Buiter, W and R. Marston (eds), International Economic Policy Co-ordination, Cambridge: CUP. Robinson, E.A.G. (dir.) (1960), The Economic Consequences of the Size of Nations. London: Macmillan. Sapir, A. (2006), “Globalization and the reform of European social models”, Journal of Common Market Studies, June, 44(2): 369–90. Sinn, H-W. (2007), Can Germany Be Saved? The Malaise of the Worlds First Welfare State. MIT Press. Stiglitz, J.E., A. Sen, and J.-P. Fitoussi (eds) (2009), Report of the Commission on the measurement of economic performance and social progress, Report to the President of the French Republic, September, http://www.commission-stiglitz-senfitoussi.fr

7 Funding the EU Budget with a Genuine Own Resource: The Case for a European Tax Jacques Le Cacheux

7.1

Introduction

The EU budget is a reflection of the general state of the European integration process. Widespread dissatisfaction with its current mechanisms and achievements is therefore to be taken seriously. The protracted negotiations on the 2007–2013 EU medium-term financial perspectives, and the almost unanimous, bi-partisan rejection in January 2006 by the European Parliament of the final December 2005 compromise painstakingly built by the EU Council have clearly provided ample evidence of the highly unsatisfactory character of the EU budgetary procedure and its outcomes. Indeed, while reporting on the “success” of the budget negotiations and on the happy end of a stalemate that had started with the failure of the June 2005 Council to agree on the financial perspectives, the December 2005 Council conclusions immediately called for a mid-term review in 2008–2009 and asked the Commission to prepare proposals for a reform of the EU budget resource system. Similarly, while eventually adopting a slightly amended budget proposal after a tri-institutional compromise in April 2006, the European Parliament decided to harden the mandate of the Commission for proposing the creation of a genuine own resource for the EU budget. In its June 2006 Report on the Council decision on the system of the European Communities’ own resources (EU Parliament, 2006), the Parliament explicitly makes the current system of national contributions responsible, at least in part, for what it regards as the unsatisfactory functioning and outcome of the recent European budgetary negotiations: “... the aim of such review should be to reach agreement on a new, comprehensive 132

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financial system ..., and pointed out that, in particular, the system of own resources as well as the expenditure side needed to be reformed urgently in order to avoid the same painful experience of national bargaining for the next financial framework.” (Amendment to Article 5, italics added). That the European Parliament expressed such a strong position on the necessity to reform the budget and its funding should not come as a surprise: indeed, the long tradition of Western representative democracy has been built on the principle that the power to tax is an essential ingredient of democracy, and should be exercised by the elected Parliament. This chapter has the limited ambition of exploring only one aspect of the EU budget, namely the financing issue, in order to contribute to the upcoming debate. The aim is not to add new proposals to those already put forward by the Commission (2004) and extensively discussed in other studies (see especially: Cattoir, 2004; SGES, 2005), but rather to provide a systematic and synthetic review of the main options. This will shed light on the trade-offs that will have to be faced when making decisions. After recalling the major features of the current EU budget procedures and financing mechanisms and showing the numerous problems they give rise to and objections they raise (Section 7.2), Section 7.3 offers a brief analysis of the criteria that should reasonably be taken into account when selecting a tax instrument for financing the EU budget: it is shown that the list of such criteria does not exactly match the one that could be established for a national budget, according to standard public finance theory, due to the specific character of the EU and its peculiar brand of federalism. Section 7.4 goes on to review the main tax instruments that have been proposed and tries to assess how well each of them would fare according to the various criteria proposed in the previous section. Section 7.5 reports the results of an attempt at roughly estimating the amounts that might be raised with the various tax instruments discussed above, based on implicit tax rates calculated from macroeconomic and tax receipt data. Section 7.6 offers a brief discussion of some of the difficulties facing the introduction of a European tax, and explores some of the possible avenues for practically implementing the most promising proposals. The final section contains a summary and concluding remarks.

7.2 Major shortcomings and flaws in the current budgetary elaboration and decision-making procedures Dissatisfaction about the outcome of the recent budget negotiations, and hence general discontent with the main features of the 2007–2013

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medium-term financial perspectives, even before applied, are mostly due to the decision-making process, in which decisions concerning the expenditures and those concerning funding are made simultaneously for a long period of time. On the one hand, the way financing obligations are distributed amongst member states has increasingly been itself the object of negotiations, national governments trying to minimise national contributions. On the other hand, the rules and mores governing the elaboration of the budget financial framework are intrinsically conducive to biases that almost inevitably result in collectively inefficient outcomes. 7.2.1 A brief history of the EU budget and its financing In theory, the financing mechanisms of the EU budget have been based on a system of “own resources” since the early 1970s. In practice though, the so-called “traditional own resources” (TOR)—that is the receipts from the common external tariff on extra-European imports and the levy on agricultural imports—have been progressively dwarfed by the growing size of the EU budget and, more importantly still, the shrinking amounts derived from tariffs. This sharp and continuing decrease was itself engineered by the developments in the common trade policy, leading, in the global framework of the GATT agreements and, more recently, of the World Trade Organisation (WTO) negotiations, to a drastic reduction in external tariffs and agricultural import levies (converted into a fixed tariff since 1995). It also resulted from self-sufficiency in agriculture production and from the preferential treatment granted to many of the less-developed countries from which agricultural imports enter the EU internal market. These weaknesses were already apparent in the late 1970s, when it was decided, in 1979, to add a new “own resource,” a levy on national VAT receipts, with, initially, a uniform call rate. The VAT had then just been generalised to all European Community member states, with its adoption by then new comers, including the U.K., and the 1977 VAT directive had broadly harmonised the conditions under which it was being levied in all member states; in addition, it was widely regarded as a fairly neutral and buoyant tax instrument that would provide ample resources for the then rapidly inflating EU budget, eaten up by market support expenditures in the framework of the Common agricultural policy (CAP) and having to face growing demands on the newly introduced structural funds. Though convenient and, in many respects, satisfactory, the VAT own resource soon became insufficient for financing growing expenditure needs. It also became unpopular among some EU

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national governments, mostly because it was regarded as unfair, given the wide differences existing in tax bases. The 1988 Brussels summit introduced a new “own resource,” namely the now dominant GNP/GNI resource (see Figure 7.1). Although the latter presented the clear advantage of providing a source of financing whose receipts would automatically grow along with the economies of member states, it also soon proved “too buoyant” and was increasingly regarded as unfair, feeding the then mounting controversies on “fairness” and “net national contributions.”1 This led many national governments to call for a cap on the overall size of the budget, also introduced at the 1988 Brussels summit. This limit was later to be raised to the current 1.27% of GDP (1.25% of GNI) ceiling by the Edinburgh agreement of December 1992. Even though the current funding system, essentially fed by GNIbased national contributions, may be regarded as relatively satisfactory, because it is, at least apparently, simple and seems to provide adequate financing for EU expenditures, it has the major inconvenience of focusing the attention of national governments and national parliaments—who then have to vote every year on the national contribution, treated as an expenditure item in the national budgetary

100

GNI

80

60

VAT

(%) 40 Duties 20

Figure 7.1

Agricultural levies

Customs duties

GNI

Miscellaneous

VAT

European budget 1971–2005: Breakdown of revenue (%)

Source: European Commission.

2005

2003

2001

1999

1997

1995

1993

1991

1989

1987

1985

1983

1981

1979

1977

1975

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0

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processes. It is therefore tempting to regard this contribution as a fee for membership in the EU “club,” and to compare it to an evaluation of the (private) benefits derived from being a member. Hence the domination, in the last two rounds of negotiations over the medium-term financial frameworks—that of “Agenda 2000,” covering the period 2000–2006 and painstakingly adopted in Berlin in April 1999, and the one covering the 2007–2013 period, whose elaboration and final adoption have taken more than two years and given rise to so many difficulties, both in the Council and in the EU Parliament—of what may be called an “accounting logic” (Fayolle and Le Cacheux, 1999) almost exclusively guided by the—largely meaningless and flawed—notions of “net national contributions” and “fair return” (Le Cacheux, 2005b). More damaging still are the problems of visibility and legitimacy that are inherent in the current funding scheme. Indeed the European citizens are fully ignorant of the European budget: they do not have the slightest idea of the total amount it represents, of what it does, of how it is funded. And the almost exclusive reliance on national contributions makes it look like the financing of any international organisation, such as the UN, or even of faraway empires. 7.2.2 Multi-annual budgeting and unanimity Though initially designed with reasonable, and in some cases even commendable, objectives, the procedures for deciding over the EU budget have increasingly shown stark weaknesses and flaws in the recent episodes of negotiations over medium-term financial perspectives. At least three features of the budgetary decision-making process, none of which was included in the initial institutional arrangements of the Rome treaty, may be regarded as sources of trouble, especially when taken together: the binding medium-term financial planning, the unanimity rule, and the almost exclusive reliance on national contributions for financing the EU budget. 7.2.2.1 Planning for the medium-term Initially conceived to provide visibility and stability to the process of expenditure planning, especially in such areas as public infrastructures, where the rule of “additionality” applies to EU financing, as well as to avoid annual stalemates resulting from recurrent conflicts between the European Parliament and the Council, the medium-term financial perspectives, first introduced by the then-president of the Commission Jacques Delors in 1988, have indeed had the effect of making budget decisions, hence also conflicts between EU institutions, less

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frequent. But as a counterpart, it has introduced considerable inertia in the budgetary process, which may be deemed damaging from at least two points of view. One is efficiency, in the sense of adequacy of means with current goals and declared priorities. This first drawback may be simply illustrated by referring to the often-mentioned lack of adequate financing for the “Lisbon strategy” (see, e.g., Sapir et al., 2003). The sequence of decisions is in itself telling: the 2000–2006 medium-term financial framework (“Agenda 2000”) was elaborated by the Santer Commission, even before the actual launching of the euro and the conclusion of the enlargement negotiations with Central and Eastern European candidate countries, then negotiated by national representatives over the winter 1998–1999, to be finally adopted, with great difficulties, in the Berlin summit of April 1999, precisely at a time when, in the aftermath of the Russian financial crisis, some European economies, and especially Germany, were experiencing a marked slowdown in economic activity, which luckily appears, in retrospect, to have been very short and probably overestimated. Exactly one year later, in a context of euphoria about the “new economy” and booming economic activity all over Europe, while the first signs of a recession were being felt in the US, the Lisbon Council meeting, elated by the good economic performance of the EU and the success of the new currency, then widely believed to function as a shield protecting Europe from the negative effects of US recessions, adopted the ambitious objectives of the “Lisbon strategy.” But the structure of the EU budget had been frozen for seven years the year before ... The second major drawback of a medium-term financial framework that is actually binding, leaving almost no margin of manoeuvre for reallocations of resources in case of changing circumstances or objectives, and that covers such a long time span,2 may be regarded as yet another illustration of the problematic character of imposing “rules rather than discretion,”3 and hence of what is sometimes referred to as the “democratic deficit” of the EU decision-making process. Indeed, using again the case of the 2000–2006 financial framework, it was initially conceived by the Santer Commission, then adopted by the Council and the European Parliament in 1999, before the European elections. Then it went into application in 2000, under the Prodi Commission and with a newly elected Parliament, but ran well into the mandates of, and hence was also binding for the Parliament elected in 2004 and the Barroso Commission, until 2006. Not to mention the changes affecting the composition of the Council in the meantime. The next financial framework, elaborated by the Prodi Commission in 2003–2004,

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eventually adopted by the Council in December 2005 and by the European Parliament in April 2006, started being implemented in 2007, by the Barroso Commission. But, barring major changes following the mid-term review it will also constrain the choices of the Parliament to be elected in 2009 and of the next Commission, who will then have to elaborate the next financial perspectives, for 2014–2020, to be implemented by two other legislatures in Parliament, as well as the next two Commissions. Thus, the people in power in the major EU institutions when the budget is conceived and elaborated are almost never those who will execute the decisions. In most instances, they are led to make decisions that effectively bind their successors, which clearly is a problem, and does not contribute to make clear and transparent the stakes of the democratic debate for European citizens. The most serious drawbacks of the multi-annual budgetary procedure stem from the difference in length between the mandate of the Parliament and the Commission, on the one hand, and the budget’s medium-term financial framework, on the other. And the problem would be made more acute in the case of a “genuine own resource”— that is a European tax—that would have been voted by the European Parliament: then, the lack of synchronicity between European elections and the major decisions on taxation and financing the EU budget would indeed appear in stark contradiction with the fundamental democratic principle of “no taxation without representation”—a simple solution would be to keep the multi-annual procedure, that has many advantages, and switch back to the initial, five-year periodicity. 7.2.2.2 Unanimity and national contributions: The deadly cocktail Submitting EU budgetary decisions to unanimity was not in the Rome treaty. It came later, in 1966, as part of the Luxembourg compromise, as a way out of the long crisis between the French government and the Commission over budget priorities. The unanimity decision rule was, in effect, imposed by France as a means of protecting its own agricultural interests, then regarded as vital. Since then, decisions over the budget in the Council have been submitted to the unanimity rule. Starting with Wicksell (1896), economists have advocated the merits of unanimity rules when it comes to preserving what may be called individual “integrity” (Laurent and Le Cacheux, 2006), that is to ensure that collective decision-making does not violate individual preferences of the members of the group. But it is precisely because each member then has a veto power that recourse to this decision rule should be strictly limited to contexts in which violating one member’s preferences

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is deemed very damaging. This is so, in particular, when adopting constitutional rules (Buchanan and Tullock, 1962; Laurent and Le Cacheux, 2006). Wicksell himself advocated the unanimity decision rule in public finance; but he was well aware of the restrictive bias thus introduced and his rationale was precisely to prevent public infringements onto the private domain by strictly limiting public finance to the provision of what was later defined as “pure public good” (Samuelson, 1954; Buchanan, 1968). When analysing the respective merits and flaws of various collective decision rules, modern economic theory has generally recognised that outside this ideal and highly unlikely case, unanimity voting rules will be inefficient, because they prevent any collective action (Olson, 1965; Phelps, 1985), especially in large and heterogeneous groups.4 One reason is that in large groups, individual members, especially small ones, will be tempted by opportunistic, “free-rider” strategies. The other reason is that most collective goods are not “pure,” in the classical sense of the term, nor are they financed by lump-sum taxes levied on individual members: in many cases, the benefits from their consumption are unevenly distributed, and they are financed by taxes related to members’ economic situation; and many items of public expenditure are explicitly designed for redistribution purposes. In the EU budget context, the combination of unanimity and national contributions may be regarded as a major source of trouble in collective decision-making, especially because decisions are made simultaneously on expenditures, many of which are easily located in one or the other member state, and their financing by member states’ contributions (Le Cacheux, 2005b and 2005c). Minimising the overall size of the budget in order to minimise “net national contributions” is inevitably the most tempting strategy for “net contributors,” whereas “net beneficiaries” will try to get the largest possible overall budget and individual transfers. Moreover, it tends to encourage petty bargaining and “pork-barrel” politics, as clearly demonstrated by the contents of the list of individual projects and expenditure items included in the annex of the December 2005 Council conclusions.

7.3

Criteria for selecting an EU tax instrument

In its proposed amendments to the December 2005 Council decision on the reform of the own resource system, the EU Parliament (2006) writes: “agreement on a new, comprehensive financial system which is fair, buoyant, progressive and transparent and which equips the European

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Union with the ability to match its aspirations with own resources rather than contributions by the Member States ...” (Amendment to Article 5, italics added). The Parliament first emphasises the need for any such system to be transparent and simple, while stressing the lack of such qualities in the most recent decisions of the Council itself regarding EU budget funding, in particular with respect to the change in the uniform VAT call rate enacted by the Council on the same day. Before reviewing the various tax instruments that have been proposed to finance the EU budget, it seems appropriate to discuss the criteria that will have to be used in the assessment of the candidates. The traditional literature on public finance in national contexts offers some guidance, by suggesting simple criteria that any tax system should fulfil; but in the current EU context, given the peculiar brand of federalism that has evolved over the years and the, sometimes contradictory, requirements of “integrity” and “efficiency” (Laurent and Le Cacheux, 2006), as well as specific views of “fairness,” that are to be imposed on the budgetary procedures, additional criteria should probably be considered, making the selection process even more demanding and complex. The choice of a tax instrument for a given level of government is a political choice, in the sense of necessitating a multi-dimensional trade-off amongst a fairly large number of criteria, some of which may be regarded as “universal,” others that specifically apply to federal, or multilevel governmental contexts. 7.3.1 Generally agreed requisites for a tax system in a democracy with a free-market economy Any mechanism designed to provide resources to a public budget in order to fund some collectively defined expenditures, should fulfil a number of general criteria, some of which appear to be common sense, other being derived from economic efficiency considerations. 7.3.1.1

General criteria

Simplicity and transparency are traditionally regarded as overriding criteria for any budget financing system, especially in a democracy, where citizens, or their representatives, are supposed to express their willingness to pay taxes, the famous “consent” (Buchanan and Tullock, 1962). Though self-evident virtues of any tax system, these two requisites always have to be mitigated by other considerations, so that in general tax systems, even those that have been carefully designed to match these two criteria, end up being more complex and less transparent than initially planned.

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Buoyancy also appears in most preambles and tax law textbooks as a needed characteristic of tax systems. It refers to the potential of a tax instrument to raise revenue, in a static framework, but also to the dynamism of tax revenues, in response to changing economic conditions. The underlying reasoning is that the public agent should be equipped with a revenue-raising instrument that allows it to keep in line with the private sector, that is revenues should not fall behind the incomes of private agents, so that the financial means of government are at least effectively maintained in relative terms without having to change the parameters of the tax system. This argument is all the more important in contemporary economies, in which economic agents have to plan their decisions over a long time span, and hence need to form expectations about the future, on the basis of reliable perspectives on tax burdens, implying that stability of the tax system is a major ingredient of long-term visibility, itself a necessary condition for capital accumulation, investment and saving, hence economic growth. 7.3.1.2 Criteria derived from economic efficiency and equity considerations Economic analysis of the effects of taxation on incentives, hence on private sector choices to supply work, to save and consume, to invest, etc., points to additional criteria that tax instruments should aim at fulfilling, or at least that should be taken into account in the trade-offs made when designing such instruments. It is well known that, barring politically unacceptable lump-sum taxes, all forms of taxation introduce relative price distortions that generate inefficiencies in the allocation of resources by the private sector and deadweight losses. Hence, it is impossible to conceive a tax system that is costless. But economic analysis also demonstrates that this inefficiency is related to the magnitude of the price distortion, itself dependent on the marginal effective rate of taxation. Therefore, a tax system that aims at minimising inefficiency should be characterised by broad bases and low marginal rates. In addition, as was demonstrated long ago by Ramsey (1927), the more price-inelastic the tax base is—that is the less it changes in reaction to relative price or tax rate modifications—, the less inefficient the tax instrument. In the current European context, characterised by internally mobile tax bases, but also by international mobility of some of them, this Ramsey criterion has to be extended and interpreted broadly to include considerations about mobility of tax bases. In a number of well-defined circumstances, efficiency may imply deliberately introducing price distortions: whenever there are negative

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external effects, market prices do not properly reflect social costs, and the Pigouvian solution to restore efficiency consists in introducing distortionary taxation in order to correct externalities and produce the right incentives; this is the well-known case for eco taxation. But of course, efficiency is not the only criterion for a “good” tax system. It should also fulfil some “equity” requirement. The latter may have two distinct meanings: either “horizontal equity” (the equivalent in matters of taxation of the principle of “equal treatment of equals”); or “vertical equity” (traditionally understood to refer to ability to pay, and often also to some form of progressiveness in individual tax burdens). Whereas the former requirement is usually considered straightforward, it raises specific difficulties in federal or pseudo-federal systems such as the EU (see below). And the former, though explicitly mentioned in all declarations of intentions for tax reforms—including the amendment from the EU Parliament cited above—, is particularly elusive in practice. Indeed, the unavoidable trade-off between “efficiency” and “equity,” understood mostly as “vertical equity,” is at the heart of the economic analysis in terms of optimal taxation.5 Although not easily transposed onto EU taxation choices, this central trade-off will have to be faced when discussing the various options. 7.3.2 Specific criteria for a pre-federal EU Whereas the criteria briefly presented above are of general application, the EU context, with its pseudo-federal, or pre-federal,6 features, imposes to add other considerations, both in terms of efficiency and equity of tax instrument assignments in multilevel governmental frameworks, and in terms of a possible use of EU tax instruments as incentives on national or sub-national entities. 7.3.2.1 Horizontal and vertical tax competition Whether or not tax competition amongst national governments within the EU to attract mobile tax bases—that is horizontal tax competition—is regarded as a serious problem in the current institutional setting of the EU,7 the introduction of an EU tax will almost certainly modify the incentives of national governments to engage in such strategies. If the tax instrument chosen for the EU budget own resource is one that is currently subject to intense tax competition among member states—that is horizontal tax competition, which seems to be particularly the case of the corporate income tax and of taxes on income from private financial asset holdings—, then it is likely to mitigate the tendency to undertax: according to economic analysis (see, e.g., Touya, 2006), having a

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supranational authority levy a tax—which would thus introduce vertical tax competition, that is public authorities of different levels competing to tax the same tax base—would somewhat alleviate the pressure resulting from horizontal tax competition to reduce tax burdens on mobile factors and to produce a “race to the bottom” in tax rates. The introduction of a European tax may even be regarded, from this point of view, as a way of fostering some beneficial forms of tax cooperation. 7.3.2.2 Fairness in the EU context In theory, horizontal equity means the equal treatment of equals, referring to individuals. In multilevel governmental settings and in particular in federations or pseudo-federal contexts, however, this notion is complicated by the consideration of another notion of “fairness” which refers to the component constituencies: ability to pay is often appreciated at the level of member states, not of individuals. And of course, the two usually differ immensely, insofar as income distributions within member states are different. Any supranational tax therefore has to result from a compromise between at least two notions of “fairness,” not to mention the regional component, which is so central in structural policies funded by the EU budget. In the case of the EU budget, the initial situation is one in which the second meaning of “fairness” has been given considerable attention. The previous reform of the “own resource system” in effect exclusively emphasised this meaning by choosing the GNI-based national contribution formula.8 And the protracted intergovernmental negotiations over the latest medium-term financial perspectives have shown that an exacerbated— and largely unfounded (Le Cacheux, 2005b)—measure of “fair” national contributions, understood as “net national contributions,” leads to an almost impossible compromise and to a distribution of financial burdens that give no weight to individual horizontal equity, and indeed not much to regional horizontal equity. But of course, the fact that a wrong measure of the “fairness amongst member states” has been used so far by no means implies that this notion is irrelevant or ill-founded. Indeed, some acceptable burden sharing for the financing of the EU budget will have to be found if a European tax is to be deemed acceptable by all. 7.3.2.3 A Pigouvian brand of fiscal federalism? While the overall objectives of non-distortionary and neutral taxes are almost always set forth in any list of criteria that a “good” tax system should fulfil, there are also cases in which economic analysis pleads for the introduction of deliberate distortions in the price system in order to

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induce some behaviours and discourage others. As already mentioned above, this Pigouvian logic calls for manipulating relative prices: in cases in which there are (positive or negative) external effects of private (or indeed governmental) decisions, then subsidies and taxes may be used to correct the “wrong” incentives that are present in the decentralised price mechanism.9 But this logic may be broadened to apply to the EU brand of federalism, where a high degree of decentralisation and a small central budget are regarded, at least presently, as essential ingredients of any legitimate institutional arrangement. Indeed, applying the Pigouvian logic would mean using the tax and expenditure items of the EU budget as incentive mechanisms for national governments, in order to induce them to carry out the common policies that have been deemed desirable by EU decision-making bodies. In both cases though, whether the Pigouvian logic is applied at the level of individual, private economic agents or at the level of member states, it would entail a departure from equity considerations, much in the same way as taxing tobacco or fossil fuels is orthogonal to personal income distribution considerations, and indeed often anti-redistributive.10

7.4 A list of possible EU tax instruments The need to reform the EU budget own resource system and the quest for genuine tax instruments to equip the EU with sufficient and, according to some criteria, satisfactory sources of funds in order to pursue common policies and objectives has long been recognised and has given rise to an already long list of candidates, inspired by current practices in existing federations and/or by the current situation of tax structures within the EU itself. Some proposals date back to the immediate aftermath of the Single European Act of 1986, when it was becoming increasingly clear that tax competition would likely intensify, that harmonisation of national tax systems would not easily be forthcoming, and that granting a tax instrument to the EU budget might appear as an attractive way out of the dangers of unfettered tax competition (see, for instance, Sterdyniak et al. 1991; Le Cacheux, 2000). More recently, the European Commission (2004b and Cattoir, 2004; see also Begg et al., 2008) and the European Parliament (SGES, 2005; European Parliament, 2006) have provided more extensive and systematic analyses of the most serious candidates for becoming a European tax instrument. This section reviews and summarises these studies and their major conclusions. It also ranks the proposals according to the criteria discussed in the previous section.

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An EU indirect tax: European VAT or an excise duty?

Consumption taxes are currently a major source of tax revenues in all member states, and they are increasingly popular amongst OECD governments. In many countries, they are already shared in some way among various levels of governments. Broadly speaking, they are of two varieties: general consumption tax, the archetype of which is the Value Added Tax (VAT), but also sales tax; and specific consumption taxes, mostly excise duties (on fuels, tobacco, alcohol, pollutants, etc.). Each of these two categories may be considered a possible choice for a European tax instrument, with pros and cons on each choice. 7.4.1.1

A European VAT

VAT has been generalised to all EU countries in the course of the 1970s, and adopted by all new members during their transformation into market economies in the early 1990s. Two European directives, in 1977 and 1991, have imposed relatively uniform taxation practices; the latter has also made some progress in the direction of harmonising tax bases, and imposed floors on the two major national rates—16% for the “normal” rate, 5% for the “reduced” rate. In a number of member countries, VAT is shared by the central and sub-national government levels. But VAT has retained the “destination principle,” so that it maintains a distinction between intra-European trade and domestic sales, hence some form of distortion in the Single market.11 Being a general tax on consumption, with a large base and relatively low rates, VAT may be regarded as one of the most neutral forms of taxation, also insofar as it does not tax savings: it corresponds to the ideal general consumption tax that many analysts12 and policymakers have been advocating, even to replace personal income taxes, in the US in particular. But VAT is also often deemed unfair, as it taxes low-income individuals, who tend to consume a larger fraction of their income and save less, relative to high-income individuals. This vertical inequity of VAT is mitigated by the existence of a reduced rate on staples and other basic consumption goods. In addition, in a world of low inflation and barring complete indexation of wages of consumer prices, a VAT obeying the “destination principle”—hence exonerating exports—is an instrument for indirectly taxing imports, therefore also a substitute for tariffs, that tend to be banned by international agreements on trade in the framework of WTO, and for currency devaluations, that are no longer possible within the euro zone, and are currently not being used in the context of monetary relations between the euro zone and the rest of the world. Such a

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tax can therefore be regarded as an instrument of intra-EU tax competition when used by one national government,13 which would constitute yet another argument in favour of some (minor actually) centralisation: the “vertical competition” thus introduced by allowing different government levels to tax the same base would mitigate the effects of existing “horizontal” tax competition. Transferring a “slice” of VAT to the EU budget would be relatively easy, technically. It would not, initially, translate into any change in the overall rates of VAT taxation, so that EU taxpayers would barely notice it. The EU Parliament would then be responsible for voting the rate for this EU VAT. Apart from these advantages in terms of simplicity and transparency, the adoption of such an instrument would introduce a clear and relatively neutral principle of taxation, based on resident consumption expenditures, with distribution of the national tax burdens being determined by a simple, non manipulable mechanism. Moreover, the yield from VAT taxation is directly related to economic growth and less fluctuating than that from other taxes. 7.4.1.2 Excise duties and eco-taxation Rather than using a general, broad-based consumption tax, it may be tempting to endow the EU budget with a specific consumption tax instrument, precisely because it would induce distortions of a kind that the EU authorities may actually want, or because it would allow the EU to tax activities that are seen as benefiting most from the existence of a European single market. The first rationale would correspond to the case with any of the major excise duties that are presently collected by national governments on alcohol, tobacco, and fuels in all EU countries, with the double—and partly contradictory—objective of raising revenue and increasing the relative price of the good being taxed in order to discourage its consumption. The same principles apply to the—so far relatively limited—eco-taxation, that is the taxation of activities damaging the environment. The second rationale applies to proposals in favour of taxing SMS or mobile phone communications, for instance: these activities are fast expanding and seem to benefit, through economies of scale, from the existence of a large market; because their absolute price is falling, thanks to technical progress and scale economies, imposing a (small) tax on these consumptions, or on the cash flows generated by them, would be relatively painless and yield buoyant revenues. For other excises duties, there would, obviously, be clear advantages in using specific consumption taxation at the EU level. In the same way as VAT, it would help mitigate the current existing problems of horizontal

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tax competition amongst national governments, and may also help reduce fraud. In addition to raising revenue, it would flag the priorities of the EU and produce warranted price distortions—what is sometimes called the “double dividend” in the literature on eco-taxation. An EU excise duty on motor fuels or fossil fuels in general, or on kerosene (plane fuels, that presently bear almost no tax), or on green-house gas emissions would combine reliable yield—at least in the short-run—, a relatively low administration cost and a price incentive to induce a general reduction in the taxed consumption or activity. Moreover, because such fuels are for the most part imported in the EU from the rest of the world, it would have an incidence partly on the rest of the world: in other words, exporters of fuels to the EU would bear part of the tax burden, which then acts as an import duty.14 7.4.2 A European corporate income tax The idea of using corporate income tax (CIT) as the major, or indeed even single, instrument to finance the EU budget has long been contemplated or advocated (Sterdyniak et al., 1991; EU Commission, 2002). It is attractive in many respects, including some of the criteria discussed in the previous section. One major argument in favour of making (part of) the corporate income a European tax is that differences in current national corporate tax systems, both in the definition of the tax base and in rates, are a major source of distortions in location decisions of firms within the internal market and/or of profit-shifting within EU multinational corporations. For these reasons, the corporate income tax is currently an important instrument of tax competition among national governments in the EU, that has clearly resulted in a “race to the bottom” in statutory rates as well as in marginal and average effective tax rates on corporate profits, bringing EU national tax rates below those observed in the rest of OECD countries (see, e.g., Devereux and Sorensen, 2005; Laurent, 2006 and Chapter 6). Some analysts may find that having to compete to attract tax bases is a welcomed incentive for national governments to manage public finances in an efficient way and not to indulge in Leviathan strategies.15 It is however also widely recognised that compliance costs and other induced distortions for private firms may be very high. Many also stress the dangers of tax competition that is likely to yield sub-optimal levels of taxation and public goods provision, as well as unwanted distributions of tax burdens among different categories of taxpayers (see, e.g., Le Cacheux, 2000). In addition to eliminating many of the above-mentioned distortions and difficulties, a European corporate income tax would not raise

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major issues of horizontal equity, and would make it very difficult, if not impossible, to ascertain the amounts paid by the various member countries, as a significant portion of the total tax yield would be paid by multinational corporations. Moreover, the costs of administration of such a European tax would likely be relatively small, given the fairly small number of taxpayers. It could even become minute if, in the meantime, the Commission’s proposal to harmonise the corporate income tax base16 has been adopted by all or at least by many member states.17 And, the political acceptability of such a tax on businesses is probably higher, in most EU countries, than that of most other candidates. If, in the coming years, the corporate income tax in the EU were to evolve into a broad-based,18 fairly low rate19 tax on companies’ profits, then making it, or part of it, a European tax would endow the EU budget with a resource instrument that would induce relatively little distortion, either in the owners of capital’s decisions to save and invest in the EU economy, or in the economic decisions to invest, to produce, to hire workers, to locate in one EU country rather than another, etc. In addition, the definition of the tax base at the EU level, especially with regard to interest deductibility, depreciation allowances and other types of provisions allowed, would give EU tax policy the possibility of conducting a genuine industrial policy, making choices that would direct EU-based corporations towards certain types of investments—research, environmental protection, green-house gas emission limitations, etc. In recent years, the receipts derived from corporate income taxation have, in most EU countries, and indeed in almost all OECD countries, been quite buoyant, so that the assignment of (part of) the corporate income tax to the EU budget would pass this criterion. A difficulty would however be that business cycles induce relatively large fluctuations in the annual yield of the corporate income tax, which may conflict with the deficit ban on the EU budget. This argument against this instrument may be mitigated in at least two respects: first, the fluctuations in CIT annual receipts have, at least until 2009, been much smaller over recent years than in the past (EU Commission and Eurostat, 2006); second, such fluctuations would not necessarily generate deficits, provided the initial scaling of the tax were chosen in such a way as to provide some excessive yield in “good times,” that could be saved in a “buffer stock,” or “rainy day” stabilization fund. 7.4.3

Other tax instruments?

Other taxes have, at one stage or another of the debate on the EU budget’s own resources, been considered as possible candidates. Among

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these, a European personal income tax on EU residents’ private incomes has sometimes been advocated (e.g., Gil-Robles, 1998). The major advantages of such a solution would be that it would replace part of an existing, national tax instrument, would be broad-based and low rate, hence not very distortionary, and that it would make EU citizens aware of their financial participation in the functioning of the Union, an argument often found in discussions on the democratic character of EU institutions. But it is very likely that such a tax would fail to gain political support. It would also be objectionable from the point of view of equity, both horizontal and vertical: unless a thorough harmonisation of the tax base were agreed, a simple addition of an “EU surcharge” on existing national income taxes would make individual tax bills highly unequal for citizens in similar economic conditions, simply because of large differences in the definition of personal taxable income;20 and given the significant dispersion of living standards among EU countries, a flat-rate income tax might well be judged highly unfair from a vertical equity point of view, as it would hardly reflect ability to pay. However, rather than a general income tax, a possibility may be to introduce a European tax on income from personal financial assets. Of course, many economists—and others—would object to an instrument that is often seen as penalising a “virtuous” choice on the part of individuals, and that is sometimes presented as “double taxation.” But income from private asset holdings is currently taxed in all EU countries. The “savings directive” (2000) has to some extent harmonised the conditions in which non-residents’ incomes from savings should be treated. And it seems that the implementation of the directive is highly problematic, especially with respect to the obligation for information exchanges among national tax authorities. As is well known, the directive offers the countries that, for reasons of bank secrecy, do not want to comply with information exchange obligations, the option of applying a 15%,21 flat-rate taxation on non-residents’ incomes from savings invested in the country. Thus, there already is the premise of a single rate, acting as a floor on national tax rates, which could then be used as an EU tax instrument, which may be popular in some quarters, but the yield of which is, however, difficult to ascertain with existing data.

7.5 Assessing the potential receipts from various EU taxes Given the current size of the EU budget—about 1.1% of EU GNI, that is about €130 billion in 2009—and the very modest increase that has been decided in the next medium-term financial framework for the period

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2007–2013 (the total budget is planned to end the period just below 1% of GNI), any EU tax instrument that is meant to cover the full cost, or a significant fraction of, total expenditure would not have to have a very high rate anyway. For some of the previously discussed potential instruments, an assessment is relatively straightforward; for others, such as VAT, given the large differences in national rates and bases, an empirical estimate is less easy to obtain. Although a detailed assessment of each potential tax instrument’s yield would require complex calculations to take account of specific characteristics of each national tax base and current rate, it is, in most cases, possible to get a rough idea of the required rate by using aggregate tax data from official (Eurostat) sources. Thus, total receipts from VAT amounted to almost 7% of GDP in the EU25 in 2004, meaning that if it were decided to fund the EU budget entirely out of this resource, the European rate would have to be about 1/7 of the average current national rates. The average normal rate being around 20%, this would mean at least 2.5 percentage points of the normal VAT. However, this average hides a good deal of heterogeneity in national rates and bases, hence also in yields: the gap between the highest and the lowest share in GDP was a little less than 4 points of GDP in 2004. Other types of indirect taxes on consumption or environmental taxes yield much lower receipts: the average yields of excises and environmental taxes are very similar, at about 2.7% of GDP in 2004, with again a very marked heterogeneity amongst national situations. Based on averages, it would be sufficient to set a European tax rate at about half of the current national rate to yield receipts of the order of magnitude of the EU budget size. The average yield of corporate income taxation in EU member states was in 2007 also close to double the size of the EU budget—at 2.1% of GDP. Since the average statutory tax rate in the EU25 was then about 20%—but, of course, with wide differences in nationally defined tax bases—, this suggests that a European corporate income tax rate at about 10%, that is at about the minimum level currently observed amongst national tax rates on corporate income in the EU, would suffice to fund the European budget. Just as is currently the case in the US, for instance, it would therefore be easy to introduce a European corporate income tax rate—after having harmonised the tax basis (cf. supra)—, then to leave national governments free to add up national corporate income taxation to this common tax rate, provided national governments all agree on some form of formula apportionment for the distribution of EU-wide tax base amongst national jurisdictions.

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With regard to other mentioned tax instruments, evaluating the potential yield is even less straightforward, even approximately, insofar as there are no generally comparable data on the yield of corresponding national tax instruments. Because tax bases are highly dissimilar, a uniform EU rate would yield extremely uneven receipts, making these solutions much less attractive than the previous ones.

7.6 Practical aspects, political obstacles and feasibility issues Opting for the introduction of a European tax, voted by the EU Parliament, would obviously imply solving a number of political and practical issues, some very important, others minor. In this section, only four such issues will be briefly mentioned: the number of tax instruments to be introduced at the EU level; the opportunities opened to national governments and parliaments by switching from the current funding mechanism based on national contributions to the European tax as an exclusive—or almost exclusive—own resource; the distributional issues involved; and the EU Balanced-budget rule. Concerning the number of European tax instruments, it should be clear that the introduction of such a revolutionary move is politically so difficult as to avoid making the move more complicated by having several instruments: a single European tax is therefore probably advisable, at least so long as the European budget is small and unique. Obviously, having more than one instrument would make it easier to reach several objectives simultaneously; it would also mitigate the problem of receipt volatility (see below); but political feasibility clearly pleads in favour of simplicity. However, if the current split between the euro zone and the rest of the EU were to last for significantly longer than originally planned in the Maastricht treaty, then it may make sense to have two distinct budgets, fulfilling different functions and financed with separate tax instruments: hence, for instance, if the idea of creating a “European Community of Environment, Energy, and Research (ECEER)” (Fitoussi and Le Cacheux, 2007) were to materialise for the EU27, it would make sense for it to have a separate budget—just as the late European Coal and Steel Community (ECSC) had its own budget—financed by some variant of an eco-tax, while the euro zone would be better off with a budget of its own, that would serve other goals—in particular aiming at tighter financial solidarity, better cyclical stabilization, and possibly at a lesser intensity of tax competition—funded with the proceeds of, say, a European corporate income tax. Though this dual organisation of the

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budget and its financing may look too complex, it would help clarify the different stakes of emerging forms of “enhanced co-operations.” In practice, switching from the current funding scheme to a genuine own resource system, whatever the precise choice made, will mean that national budgets are immediately ridded of a significant expenditure item, so that national governments and Parliaments can instantaneously reduce total tax receipts by the same amount. But whether they effectively do it, rather than reducing national budget deficits, or indeed increasing expenditures on other items, should clearly be left to the sovereign choice of nationally elected, legitimate authorities. And if they choose to cut the national tax burden by an amount equivalent to the reduced expenditure, they may of course exactly compensate the new European tax by cutting the corresponding national tax rate—say in the case of corporate income taxation, for instance, the sum of the new national rate and the European rate being then equal to the previous national rate; but here again, they should be left free to choose to do otherwise, especially in the case where the new European tax is an ecotax, for instance, or more generally a tax that many national governments would want to increase if economically and politically feasible. Funding the EU budget with a European tax will, in almost all cases, change the distribution of financing burdens across member states compared to the current one, based on GDP contributions, which is likely to be a significant obstacle in the way of adopting such a genuine own resource system for the EU budget. A few examples may help understand the nature and extent of the problem. Consider, first, a tax on carbon emissions: obviously, it would impose a heavier burden on national economies relying on fossil fuels as major sources of energy, and a lesser one on countries, such as France, relying at least in part on nuclear energy. This feature may seem unfair; but it is no different in nature from what results from the use of such taxes within national economies: after all, the objective is indeed to make the use of carbon-emitting sources of energy more expensive. A possible solution would be to set up a mechanism for giving back part of the revenue, in the form of a lump-sum transfer, to the countries that are deemed to bear an excessive burden. The same mechanism could indeed be implemented in most of the cases considered above: indeed, a generalised correction mechanism, similar to the one proposed by the Commission in its 2004 budget proposal, but applying to gross, not net national contributions, could be envisaged to overcome the distributional consequences of adopting a European tax. The switch to a funding scheme exclusively relying on a single European tax instrument will also undoubtedly pose a problem for

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the balanced-budget rule currently imposed on the European budget: indeed, the yield of the various tax instruments discussed above is likely to vary with business conditions, and this is especially true for corporate income tax yields, that are especially volatile. On the other hand, it is not advisable to have expenditures vary in the same way according to business conditions; indeed, it is often argued by economists that precisely the opposite is an important mechanism of automatic stabilization introduced by the functioning of the budget. But then, what would be the solution? The obvious one would be to authorise budget deficits, hence borrowing, at the EU level; but of course such a possibility may not be welcomed by national governments and Parliaments at a time when they have been subjected to the discipline of the Stability and Growth Pact which imposes ceilings on national budget deficits and advocates budget balance in the medium run. An alternative would be to opt for a slightly “too high” tax rate at the EU level, in order to accumulate budgetary reserves—the kind of “rainy-day fund” advocated by some economists for national budgets—that would be decumulated in cases when the yield of the EU tax would not cover expenditures. Yet another possibility would be to retain the GNI resource as a residual resource, to be called upon to complete the receipts derived from the EU tax instrument (Begg et al., 2008).

7.7

Concluding remarks

Given the dissatisfaction about the recent budgetary decisions at the EU level, and more generally about the kind of policies that the current budgetary procedures and funding mechanisms allow EU authorities to pursue, there is a need to advance thinking on the issues raised by the EU budget and its funding scheme is all the more. If the mid-term review that has been programmed in the conclusions of the December 2005 summit that adopted the medium-term financial perspectives for 2007–2013 is ever coming, it seems important to equip all decisionmakers, at the national and at the European levels, with elements of analysis that can shed light on the choices they will be facing. Clearly, and unsurprisingly, the EU Parliament is currently the political institution that has expressed the strongest interest in a move to a genuine own resource-funding scheme, based on a European tax. But the issue is also of paramount importance for national governments and Parliaments. Introducing a European tax would be a major milestone in the European integration, as it would bring more substance to the political dimension of the process, possibly leading to a clearer sharing of

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competences between EU authorities and between government levels, but also to more legitimacy of the European Parliament. Coming after a few other papers on this issue, this chapter has tried to shed light on the economic considerations that will have to be brought to bear on the choice of an adequate tax instrument to finance EU expenditures, without passing judgment on the opportunity of increasing the size of the budget or of changing the relative weights of various expenditure items. Our analysis shows that there exists an array of tax instruments that could be considered for funding the EU budget. None is obvious; each has advantages and drawbacks, and each one scores better on some criteria than on others. Of course, some instruments, such as corporate income taxation, have a clear advantage on purely economic grounds, while others, such as eco-taxes, would seem to be better tools to promote common goals and to be in a better position to win broad political support. In such a situation, the choice will have to weigh and trade-off the various criteria.

Notes This paper was written for Notre Europe. It has greatly benefited from comments on early drafts by Teresa Bomba, Stephen Boucher and Eulalia Rubio, of Notre Europe. The author is also grateful to participants in a seminar held in Brussels on 14 March 2007 for their many constructive remarks and encouragements. The usual disclaimer applies. This chapter has benefited from the financial support of Notre Europe, and is published with its authorisation. 1. For a critical analysis of the notion of “net national contributions” and of the way EU budget negotiations have been dominated by requirements of “juste retour,” see Le Cacheux, 2004a and 2005b. 2. Initially, financial planning covered only five years (the so-called “Delors Package I,” 1989–1993), then six (“Delors Package II,” 1994–1999), and now seven. 3. This is, of course, a well-known and long-standing debate in economic policymaking. For a thorough analysis of this debate in the context of EU economic policies, see Fitoussi, 2002 . For an application to the EU budget process, see Le Cacheux, 2005c. 4. The consequences of heterogeneity in preferences are well known. Those of heterogeneity in size are analysed in Le Cacheux (2005a) and Laurent and Le Cacheux (2006). 5. Mirrlees (1971). See also Saint-Etienne and Le Cacheux (2005) for an application in the context of a reform proposal for the French tax system in response to tax competition. 6. Strictly speaking, the advocacy of a genuine EU budget, funded by a genuine own resource voted by the EU Parliament implies that the EU moves closer to a federal system. In the tradition of the economic analysis of “Fiscal

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14.

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federalism,” the use of this term is rather loose. The term “pre-federal” is borrowed from the proposals of the MacDougall Report (EU Commission, 1977) where it was used to refer to a stage in which the central (European) budget is autonomous but still much smaller than in existing federations: the authors of the report mentioned a budget representing initially 2% of GDP, then growing to an intermediate size of 5–7% of GDP. By their standards, the current stage of the EU would have to be labelled “pre-pre-federal” ... It is well known that tax competition may have good and bad effects on the behaviours and choices of national governments: on the one hand, competition forces governments to be efficient and not to indulge in wasteful activities, thus “taming the Leviathan”; on the other hand, it sets a “race to the bottom” in motion and will often result in under-provision of collective goods and services, as well as in over-taxation of immobile tax bases. There is a vast literature, both theoretical and empirical (in particular applied to the EU), on tax competition. For surveys, see Le Cacheux (2000), Laurent (2006). There is also mounting evidence of the use of this notion in European states that are not explicitly federal, but have been engaging in ambitious devolution programs. Hence, in Spain and in Italy, for instance, the debate over inter-regional “fairness,” sometimes even framed in the (erroneous) notion of “net contributions,” has gained momentum. For a recent advocacy of these Pigouvian principles, see the Commission’s report on the eco-taxes (EU Commission, 2007). In principle though, they could be made compatible, insofar as the Pigouvian logic is based on relative, marginal costs, whereas redistribution is concerned with averages. Hence the effects of Pigouvian taxes on income distribution could, in theory, be compensated by lump-sum transfers. Failure to agree on an “origin principle,” for good reasons—it would have made VAT a tax on production, rather than a consumption tax, with related problems of competitiveness—, has also induced a high level of tax evasion and fraud: estimates of missing receipts run at about 10% to 15% of the total yield. According to a recent Commission estimate (EU Commission, 2006), total EU tax fraud may amount to as much as €200 billion, that is 2% to 2.5% of EU GDP, which is significant and much higher than the total EU budget. While bearing in mind that there is a large margin of uncertainty. One of the first economists to speak in favour of adopting such an instrument as the single, or at least major, source of revenue for governments was the late British economist Nicholas Kaldor, in 1955. See also the recent critical survey by Hines (2007). See Creel and Le Cacheux, 2006 , for an analysis of national strategies of “competitive disinflation” using tax instruments, in particular hikes in VAT rates, with special reference to Germany. For a more general analysis of incentives for national governments to embark on such non cooperative strategies, see Fitoussi and Le Cacheux, eds., 2007. See the recent Commission report on eco-taxation (EU Commission, 2007) as well as Hines (2007).

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15. See Brennan and Buchanan (1980) for a classic exposition of arguments in favour of tax decentralisation in order to “ tame the Leviathan.” 16. Since 2003, the Commission has been trying to push a proposal, called the Common Consolidated Corporate Harmonised Tax Base (CCCHTB). See, EU Commission, 2002. 17. Commissioner Kovacks, in charge of the Tax and Customs Union portfolio, has often advocated recourse to the enhanced cooperation procedure in the—highly likely—case in which the CCCTHB proposal would not gain unanimous support from member state governments. 18. See Devereux and Sorensen (2005) for an exhaustive analysis of the respective merits of various reform proposals for the corporate income tax. 19. It is argued in Saint-Etienne and Le Cacheux (2005) that the current trends in corporate income tax in the EU will probably lead to a statutory rate that, in most small EU member states will be around 12% to 15%. 20. Among many other differences, one may point to the many ways in which dependent children are taken into account in personal income tax calculations in the various EU countries (see, e.g., Marini, ed., 1999, for a review of current national practices). 21. The directive also includes the obligation for those countries to raise the rate to 20%, then to 25% in the next ten years, the idea being to induce non-information-exchanging countries to switch to information exchanges.

References Ambrosiano, F. and M. Bordignon (2006),” Normative versus positive theories of revenue assignments in federations”, Handbook of Fiscal Federalism. Begg, I. (2004), “The EU budget: Common future or stuck in the past?” CER Paper, London, January. Begg, I. (2005), “Funding the European Union. Making sense of the EU budget”, A Federal Trust Report on the Union’s Budget, The Federal Trust, London. Begg, I., H. Enderlein, J. Le Cacheux and M. Mrak (2008), Financing of the European Union Budget: Study for European Commission, Directorate General for Budget: Final Report, http://ec.europa.eu/budget/reform/library/issue_paper/ study_financingEU_de_en_fr.pdf Brennan, G. and J.M. Buchanan (1980), The Power to Tax. Cambridge, MA: Cambridge University Press. Buchanan, J.M. (1968), The Demand and Supply of Public Goods, Chicago: Rand McNally. Buchanan, J.M. and G. Tullock (1962), The Calculus of Consent. Ann Arbor, MI: University of Michigan Press. Buti, M. and M. Nava (2003), “Towards a European budgetary system”, EUI Working Paper 2003/8, Florence (Italy). Cattoir, P. (2004), “Tax-based EU own resources: An assessment”, Working Paper n°1/2004, EU Commission Directorate-General Taxation and Customs Union. Collignon, S. (2004), “Le fédéralisme budgétaire dans la zone euro”, in Lefebvre, ed., 2004.

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Conseil économique et social (2005), Les perspectives financières de l’Union européenne, Rapport de la Section des finances, Georges de la Loyère, rapporteur, 27 April. Creel, J. and J. Le Cacheux (2006), “La nouvelle désinflation compétitive européenne”, Revue de l’OFCE, 98, July. Devereux, M.P. and P.B. Sorensen (2005), “The corporate income tax: International trends and options for fundamental reform”, paper prepared for the Working Party n°2 of the Committee on Fiscal Affairs, OECD, Paris, October. EU Commission (1977), The role of public finances in the process of European integration, McDougall Report, Brussels. EU Commission (2002), Company Taxation in the European Single Market. Brussels. EU Commission (2004a), Building our common future: Policy challenges and budgetary means of the enlarged Union 2007–2013, COM (2004) 101, Brussels, 10 February. EU Commission (2004b), Financing the European Union: Commission report on the operation of the own resources system, Schreyer Report, Brussels, 14 July. EU Commission (2006), EU coherent strategy against fiscal fraud: Frequently asked questions, EC Memo/06/221, 31 May. EU Commission (TAXUD) and Eurostat (2006), Structures of the Taxation Systems in the European Union. 2006 edition, May. EU Commission (2007), Green paper on market-based instruments for environment and energy related policy purposes, COM (2007) 140 final, 28 March. European Parliament (2006), Report on the proposal for a Council decision on the system of the European Communities’ own resources, Committee on Budget, Alain Lamassoure, rapporteur, A6–0223/2006, 23 June. Fayolle, J. and J. Le Cacheux (1999), “Budget européen: Triomphe de la logique comptable”, Lettre de l’OFCE n°185, 30 April. Fitoussi, J.-P. (2002), La règle et le choix, La République des idées, Paris: Seuil. Fitoussi, J.-P. and J. Le Cacheux, eds (2003), Rapport sur l’état de l’Union européenne 2004. Fayard and Presses de Sciences-Po. Fitoussi, J.-P. and J. Le Cacheux, eds (2007), L’état de l’Union européenne 2007. Fayard and Presses de Sciences-Po. Gil-Robles, J.M. (1998), Interview to the Daily Telegraph, October 25. Hines, J.R. Jr. (2007), “Taxing consumption and other sins”, Economic Perspectives Winter 21(1). Kaldor, N., (1955), An Expenditure Tax, London: George Allen & Unwin. Laurent, E. (2006), “From competition to constitution: Races to the bottom and the rise of ‘shadow’ social Europe”, Harvard CES Working Paper Series n°137, Centre for European Studies, Harvard University, July. Laurent, E. and J. Le Cacheux (2004), “L’Europe ‘Boucles d’or’: Trois maximes pour sortir d’une impasse”, Lettre de l’OFCE n°246, 30 January. Laurent, E. and J. Le Cacheux (2006), “Integrity and efficiency in the EU: The case against the European economic constitution”, Harvard CES Working Paper Series n°130, Centre for European Studies, Harvard University, February. Le Cacheux, J., ed. (1996), Europe: La nouvelle vague. Perspectives macroéconomiques de l’élargissement. Presses de Sciences Po.

158 Jacques Le Cacheux Le Cacheux, J. (2000), “Les dangers de la concurrence fiscale et sociale en Europe”, in “Questions européennes”, Rapports du Conseil d’analyse économique n°27, La Documentation française, September. Le Cacheux, J. (2004a), “Negotiating the medium-term financial perspectives in the enlarged EU: The future of the European budget”, Special issue “EU enlargement”, Revue de l’OFCE n°89, April. Le Cacheux, J. (2004b), “L’avenir du budget européen et le financement des politiques communes”, in Lefebvre, ed., 2004. Le Cacheux, J. (2005a), “Politiques de croissance en Europe: Un problème d’action collective”, Revue économique, Papers and Proceedings of the Annual Congress of AFSE, May. Le Cacheux, J. (2005b), “European budget: The poisonous budget rebate debate”, Notre Europe Study n°47, www.notre-europe.eu, June. Le Cacheux, J. (2005c), “Budget européen: le futur conjugué au passé”, Lettre de l’OFCE n°265, www.ofce.sciences-po.fr/pdf/lettres/265.pdf, July. Le Cacheux, J. and H. Sterdyniak (2003), “Comment améliorer les performances économiques de l’Europe ?”, Critical review article on the “Sapir Report”, Revue de l’OFCE n°87, October. Lefebvre, M., ed. (2004), Quel Budget européen à l’horizon 2013? Moyens et politiques d’une Union élargie, CEES/IFRI, La Documentation française. Marini, H., eds, (1999), La concurrence fiscale en Europe, Report for the French Senate, Paris: Sénat, June. McLure, C. (2005), “The European Commission’s proposals for corporate tax harmonization”, CESifo Forum, Spring, l.6(1). McLure, C. (2006), “Legislative, judicial, and soft-law approaches to harmonizing corporate income taxes in the US and the EU”, paper presented at the International Conference National Fiscal Sovereignty: Integration and Decentralization, Ravenna, October 13–14. Mirrlees, J. (1971), “An exploration into the theory of optimal income taxation”, Review of Economic Studies 38(2). Oates, W.E. (1972), Fiscal Federalism. New York: Harcourt Brace Jovanovich. Oates, W.E. (1999), “An essay on fiscal federalism”, Journal of Economic Literature 37. Olson, M. (1965), The Logic of Collective Action. Cambridge, MA: Harvard University Press. Phelps, E.S. (1985), Political Economy: An Introductory Text, New York and London: Norton & Co. Ramsey, F. (1927), “A contribution to the theory of taxation”, Economic Journal, 37: 47–61. Rawls, J. (1971), A Theory of Justice. Princeton University Press. Saint-Etienne, Ch. and J. Le Cacheux (2005), Croissance équitable et concurrence fiscale, Rapport du Conseil d’analyse économique, n°56, Paris: La Documentation française, October. Salmon, P. (2003), “The assignment of powers in an open-ended European Union”, CESifo Working Paper Series n°993, Munich. Samuelson, P.A. (1954), “A pure theory of public expenditure”, Review of Economics and Statistics, 36(4), November: 387–89.

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Sapir, A., et al. (2003), An agenda for a growing Europe, Sapir Report, Report of an independent expert panel to the President of the EU Commission, Official Publications Office of the EU, Luxemburg. SGES (Study Group for European Studies) (2005), Own resources: The evolution of the system in a EU of 25, Report for the European Parliament, 30 June. Sterdyniak, H., M.-H. Blonde, G. Cornilleau, J. Le Cacheux and J. Le Dem (1991), Vers une fiscalité européenne?, Economica. Touya, F. (2006), Les interactions fiscales verticales dans les systèmes à plusieurs niveaux de gouvernement, PhD Dissertation, UPPA, Pau, September. Wicksell, K. (1896), “A new principle of just taxation”, in R. Musgrave and A. Peacock (eds., 1958), Classics in the Theory of Public Finance, New York: MacMillan, pp. 72–118.

8 The EU Environmental Strategy Jean-Paul Fitoussi, Éloi Laurent and Jacques Le Cacheux

8.1

Malthus or the Apocalypse?

As Hotelling (1931) wittily pointed out “the economics of exhaustible assets presents a whole forest of intriguing problems.” Environment economics indeed combines many issues relating to the economy as well as to the political economy that prove most complex in theory and most wily in praxis: inter-generational justice, the production and preservation of public goods, the management of externalities at both national and international levels, the time consistency of public policies and also collective action at both regional and global levels. It is therefore no surprise that what is at stake has often been caricatured and that public debate has been infected with a false alternative that was already formulated more than 30 years ago in the well-known Meadows Report (1972): the end of growth or the end of the world. Along with simplistic economism—which often subsumes the environmental issue into the comparative static of a cost-benefit analysis—radical environmentalism brings the economic system down to destructive productivism and advocates lowering living standards, although one is never too sure whether the ultimate goal is the survival of the human species or rather the protection of nature. These two extreme streams of thought actually merge into one as they are merely the result of Rev. Malthus’s funereal arithmetics which concludes that there may not to be enough seats reserved at the “great banquet of nature.”1 Yet, attempting to arbitrate between economic growth and the preservation of natural resources seems a rather naïve way to formulate the problem if one considers that, for the most part, tools were created by man so he can transform nature. Real arbitrage involves the different 160

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modes of sustainable development—put forward in the Brundtland Report (1987) as “[Development that] meets the needs of the present without compromising the ability of future generations to meet their own needs.”— and the practical means of putting them into practice. Environmental policy is indeed an art of execution: much of it comes down to finding the proper ways and means, on the prime condition that a broad consensus on what the general objectives are often exists. In March 2007, European States managed to agree—without too much difficulty thanks to the vigorous impulsion of the German Presidency— that greenhouse gas (GHG) emissions should be reduced unilaterally by 20% compared to 1990 levels by 2020. Yet this does not solve the question of how this can be achieved. How best to avoid that the sustainable European project becomes yet another “Lisbon Agenda,” that is, a grand ambition with very limited means? Environmental economics’ major issue may therefore be defined as both the search for a new growth mode and the conversion of the consensus on the objectives into practical means of political action. The European Union is the world’s region with the widest consensus and the highest developed means of collective action. Therefore the efficiency of the EU’s environmental strategy does matter, if only because it serves as an example to the rest of the world. “European environmental strategy” must be understood here restrictively as the EU’s strategy against climate change. Even if this stance fails to embrace all aspects of the environment issue (e.g., water and soil pollution, sanitary hygiene etc.), it still presents a systemic challenge. If the situation is to persist, climate change is bound to eventually affect all the parameters of Europe’s (and the entire world’s) environment. If one specifically considers climate change, economic analysis can hardly help at the primary stage of the issue, namely to validate the scientific consensus that built around climate change, and even less, at the other end, on the engineering resolution, that is, the technological merits of the various methods to limit GHG emissions. Economic analysis however, can lend its expertise to assess the relevance of the models used to calculate the mid and long-term impact of climate change on people’s life modes. It can also help with the potential effectiveness of the incentive systems that have been envisaged for some given environmental goals. This chapter will focus on this last point and attempt to address the following question: Does the EU have the best institutional system so it can carry its environmental strategy through to a successful conclusion? We will first show why we do not believe that this is the case and will

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then suggest improvements by setting up a “European Community for the Environment, Energy and Research.” We finally provide details as to what the Community’s objectives and instruments should imply.

8.2

Why react to climate change at the European level?

8.2.1 The state of the world’s environment and the difficult assessment of the cost of its degradation 8.2.1.1 The work by IPCC and the scientific consensus The remarkable work done by the Intergovernmental Panel on Climate Change (IPCC), has finally found its appropriate place in the public debate after the fourth wave2 of its assessment reports was published in early 2007. Climate change issues have currently become common knowledge: everyone now knows that we all know about it. The IPCC’s fundamental scientific findings that the earth’s climate is being altered by the greenhouse effect caused by human activity3 dates back to the early 2000s. In the 2001 report—the third assessment wave—human responsibility in the climate deterioration process was estimated at 66%. The figure went up to 90% in their latest report (IPCC, 2007c). In spite of the large consensus among academics,4 a minority of scientists still questions the fact that climate change is due to human activity. Quite a few among them doubt the magnitude of its effects and the reality of the catastrophic impact already forecast. Richard Lindzen5 (MIT), for example does not dispute that climate changed in the twentieth century, neither does he deny that CO2 concentration has increased in the atmosphere or that this may take temperature levels on earth even higher in the future. He is however strongly opposed to the idea that the single major cause of climate change should be attributed to human activity and therefore rejects the supposed impact6 of climate change on the propagation of hurricanes and epidemics. But the fact of the matter still remains that climate change is having and will have a huge impact on the world’s ecosystems and economy. 8.2.1.2

The Stern Review: The issue with the economic cost approach

The Stern Review (2006) offered a straight evaluation of the economic consequences due to climate change by estimating that it would cost 1% of world GDP every year so as to stabilise GHG CO2 emissions between 500 ppm and 550 ppm by 2050, although the IPCC believes that such levels would probably not be enough to keep climate warming back to the 2°C mark that has been considered tolerable

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for the pre-industrial era. The potential cost of inaction would range between 5% and 20% of world GDP every year. So doing nothing seems the costliest course of action. Nick Stern’s model has attracted numerous and various criticisms from environmental economists.7 The Stern Review’s core assessment rests on the normative measurement of social actualisation that depends on three main parameters: the rate of preference for the present—namely the measure of intergenerational altruism—the per capita consumption rate and finally the utility variation induced by consumption variation, which is just another way of measuring consumption’s marginal utility. Assessing those rates and their components adequately remains most essential for public policy. The lower the time preference rate, the more beneficial for the upcoming generations, as today’s incurred costs will bear on those to be met in the future. It therefore becomes all the more urgent to react firmly now, even though that may generate very high short-term costs. However, the Stern team’s evaluation of the social actualisation rate and its components seem to vary widely from the assessments of the existing literature. Tol (2006) is most critical: he feels the report’s findings are “alarmist,” if not totally “incompetent.” In contrast, Weitzman (2007) attempts to validate the Review’s results by claiming that there is indeed wide scientific uncertainty as to the magnitude and effects of climate change, in so far as unknown probability exists whose impact can be extreme. He therefore thinks that it is justified, as sound economic theory propounds, to go along with the overweighting of the report’s findings, simply because of the apparently too low actualisation reference rate—namely 0.1, which corresponds to a good balance between today’s generations and the next, even though one may expect the latter to become somewhat wealthier. The two parameters at the centre of this not quite always neutral debate over the social actualisation rate comprise the measure of intergenerational altruism and that of marginal utility consumption. To some economists, the weighting accorded to future generations would be too high and consequently the assessment of (uncertain) future risk is also overestimated (Nordhaus, 2006). Others however consider that the weighting for the poorest is too low (Dasgupta, 2006) and that the two parameters are merely too inconsistent when put together. It remains most difficult to decide who is right. As long as the arithmetic of inter-temporal and spatial justice rests on proofs transparent as well as falsifiable, all manner of conclusions may be brought to the attention of policy makers (see also Stiglitz et al., 2009).

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Beside the major interest of the Stern Review in spreading knowledge about the likely risks and costs of climate change, over-evaluation of some parameters8 may take into account the difficulty inherent in international action. It remains to be seen whether the states’ action can be altered by the powerful influence of public debate. Stern tends to adopt a slightly catastrophic outlook on the situation, probably because politicians tend to shy away from what is really at stake. 8.2.2 The limits to global collective action9 However much instructive and salutary Stern’s work may be, one cannot fail to note some lack of inner consistency: The undertones are alarming—this was probably the original idea and may be quite appropriate—yet Stern omits to conduct a thorough analysis of the feasibility of the measures he recommends. If one accepts to go along with his reasoning, where does one learn how to impose a carbon dioxide tax on the entire planet? Which organisations ought to be in charge of implementing such regulations? Is action at world level really the best way to resolve the most serious collective problem of trying to set up an active policy against climate change? On all of these crucial points, Stern does not offer any in-depth analysis or operational proposals, and therein lies its greatest shortcoming. One of the first problems about global collective action concerns the on-going scientific uncertainty about the details of climate change whose actual consequences remain mostly unknown for the time being. Some countries still hide behind this uncertainty and simply do not react in the hope they will eventually benefit from the efforts of other nations, in the classic tradition of the free riding under imperfect information (Aldy, Orszag and Stiglitz, 2001). However, the Bush Administration’s spectacular U-turn in Spring 2007 indicates that this position has become increasingly more untenable. The second problem has to do with all the different countries’ current and future responsibility in the emission of greenhouse gases. Table 8.1 shows that OECD members were still the largest world polluters in 2004. Yet, emerging and developing countries are forecast to take over as of 2010 and, according to the International Energy Agency, China has surpassed the US as the world’s largest polluter as early as 2007. According to the IPCC, with 20% of the world’s total population, developing countries represented 46.5% of all GGE in 2004, whereas developing and less developed countries were responsible for 73% of GGE growth also in 2004, yet of only 41% of global emissions and of 23% of all the emissions cumulated since the eighteenth century (Raupach et al., 2007).

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Table 8.1 The top 20 biggest GHG polluters, 1990–2004 Total (in millions of tonnes of C02) 1990

2004

USA

4818.3

6045.8

China

2398.9

Russia

Annual growth, 1990–2004 (in%)

Share of global emissions (in%) 1990

2004

1.8

21.2

20.9

5007.1

7.8

10.6

17.3

1984.1

1524.1

−1.9

8.8

5.3

India

681.7

1342.1

6.9

3.0

4.6

Japan

1070.7

1257.2

1.2

4.7

4.3

Germany

980.4

808.3

−1.3

4.3

2.8

Canada

415.8

639.0

3.8

1.8

2.2

U.K.

579.4

586.9

0.1

2.6

2.0

South Korea

241.2

465.4

6.6

1.1

1.6

Italy

389.7

449.7

1.1

1.7

1.6

Mexico

413.3

437.8

0.4

1.8

1.5

South Africa

331.8

436.8

2.3

1.5

1.5

Iran

218.3

433.3

7.0

1.0

1.5

Indonesia

213.8

378.0

5.5

0.9

1.3

France

363.8

373.5

0.2

1.6

1.3

Brazil

209.5

331.6

4.2

0.9

1.1

Spain

212.1

330.3

4.0

0.9

1.1

Ukraine

600.0

329.8

−3.8

2.6

1.1

Australia

278.5

326.6

1.2

1.2

1.1

Saudi Arabia

254.8

308.2

1.5

1.1

1.1

Source: United Nations.

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Thirdly, the IPCC (2007b) estimates that the geographic impact of climate change will vary much from country to country. More precisely, it is likely that those which will suffer from the nastiest effects of climate change are the less advanced countries, mostly situated in Africa, although these countries only contribute for a relatively minor part in global climate warming. By contrast, Western countries, currently the major GHG producers, along with emerging countries, tomorrow’s polluters to be, will only be marginally affected in regard with their actual responsibility. It is therefore arduous to translate the moral consensus on the challenges of climate change into social or even economic policy at world level. The climate of planet earth is undoubtedly a global public good, yet all countries can feel the change on a long-term basis only. It could thus be merely overlooked in the short-term and accorded only slight consideration in the mid-term. Besides, the organisations likely to make the world’s nations realise that they put their populations at risk are few. The major efforts towards this aim include the 1992 United Nations Framework Convention on Climate Change (UNFCCC) and the Kyoto Protocol, adopted on 11 December 1997. Both have unfortunately been only partly successful. Although 84 countries initially signed the Kyoto Protocol and 175 have ratified or approved it to date—including China and India—this covers only 60% of all GHG: The US have refused to ratify it, whereas China and India, as “outside Annex 1” countries, do not wish to commit themselves to the legal objectives that will constrain them as individual countries. Furthermore, Kyoto aims at a 5.2% decrease on GHG by 2011 compared to 1990 levels, which is way off the ICCP’s target that planned a four-fold reduction of all GHG emissions by 2050. This puts serious limits on the effectiveness of collective global action and it has led certain authors to contend that the urgency of dealing with climate change is fairly limited. Bjorn Lomborg’s Copenhagen Consensus Centre argues that climate change should not be considered as the most pressing issue of our time. He puts a particular stress on the practical side of the unsurmontable problems raised by such solutions like levying a carbon dioxide tax at world level. He suggests politicians should instead concentrate their environmental effort on more prominent issues that may be more surely solved like fighting against AIDS or malaria. In 2006, Lomborg’s panel of experts therefore ranked the global application of the Kyoto Protocol 27 out of 40 among the most pressing environmental issues. The various provisions for an international carbon dioxide tax came bottom three.10 In view of these serious limitations and the paucity of international cooperation at this stage, as was confirmed by the semi-failure of the G8

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summit of June 2007 and of the Bali Conference in December 2007, it must be noted that the European Union (EU) fares much better. Fighting against climate change has gradually gathered momentum in the EU over the last few years and even culminated at the European Council of 8–9 March 2007. The 2007 Council resolutions comprise two parts which strictly follow the European Commission’s recommendations. The first is an international part that requires Member States to commit themselves to reducing their emissions by 30% before 2020 compared to 1990 levels through a multilateral accord. The second part is unilateral and implies a 20% reduction by 2020, which shows only too well how much more advanced and effective the EU’s environmental strategy is when compared to the rest of the world’s public collective action. 8.2.3 The European “preference for the environment” The European Union is now indeed at the forefront of the fight against climate change. Actually, it is directly concerned by its effects. A report by the European Agency for the Environment published in August 2004 found that on average, Europe was warming up faster than the rest of the world. The IPCC (2007b) for his part, concludes that “virtually all European regions will be affected negatively by climate change,” the effects being worse in the South and East than in the North. These effects will increase inequality in the distribution of natural resources and besides, the IPCC forecasts risks of sea submersion, flooding, erosion, as well as huge damage to ecosystems, including the possible up to 60% extinction for some species. The EU’s commitment to environmental issues is deep. It must be observed that the reference to sustainable development, introduced as early as 1997 in the Amsterdam treaty has constitutional status. The Göteborg council (2001) added up an environmental pillar to the Lisbon strategy which paves the way for a common position in favour of sustainable development. In actual fact, the European “preference for the environment” translates into the comparison of GHG emissions throughout the world since 1984 (Table 8.2). Europe is the only developed bloc that managed to increase its level of atmospheric pollution only very moderately. The comparison since the early 1990s between all Annex I countries of the Kyoto Protocol, the countries for which a binding target has been assigned clearly shows how divergent evolutions have been and how the EU countries have done better than their developed counterparts (Figure 8.1).11 It is possible to specify the measures of the EU’s environmental performance by referring to Kaya’s work (1990).12 “Kaya’s identity” subdivides the GHG growth effects into four factors: population, per capita GDP, per capita GDP energy intensity—namely primary

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Table 8.2 Distribution of GHG due to energy consumption among countries and regions, in CO2 million tonnes

Countries & regions Canada

1984

2004

Variation % of between 1984 emissions and 2004, in % in 2004

425.2

588.0

38.3

2.2

United States

4597.8

5912.2

28.6

21.9

North America

5289.9

6886.9

30.2

25.5

Brazil

175.7

336.7

91.7

1.2

Central and South America

613.6

1041.4

69.7

3.9

France

393.1

405.7

3.2

1.5

U.K.

566.9

579.7

2.3

2.1

Italy

359.7

485.0

34.8

1.8

Germany

1052.0

862.2

−18.0

3.2

Europe

4450.1

4653.4

4.6

17.2

Russia

2010.0

1684.8

−16.2

6.2

Ukraine

560.8

363.5

−35.2

1.3

Eurasia

3380.2

2550.8

−24.5

9.4

Saudi Arabia

181.2

365.1

101.5

1.3

Middle East

565.3

1319.7

133.5

4.9

South Africa

294.5

429.6

45.9

1.6

Africa

625.7

986.6

57.7

3.6

India

400.5

1041.9

160.1

3.9

China

1707.9

4707.3

175.6

17.4

Japan

895.6

1262.1

40.9

4.7

Australia

215.6

386.2

79.1

1.4

101.3

307.7

203.8

1.1

4004.8

9604.8

139.8

35.5

18929.7 27043.6

42.9

100.0

Indonesia Asia & Oceania All world

Note: The growth rate of GHG emissions between 1990 and 1999 was 1.1% against 3.3% (i.e., a threefold increase) between 2000 and 2004 (source: Raupach et al., 2007). According to the 2007 AEE preliminary report, emissions have gone down by 0.8% between 2004 and 2005 for the EU 15. Source: Energy Information Administration, http://www.eia.doe.gov/

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1995

2000

2004

2005

169

+16.3

Kyoto target

7 6 Millions

5

–1.5

4 –28.7 3 2 1

+25.6

–1.6

–14.8

+25.3

–18.4

+ 6.9

0 Australia

France

U.K.

Canada Germany

Japan

Russia

EU 15

USA

Figure 8.1 GHG emissions in billion tonnes of CO2, according to the Kyoto Protocol reference years (1990 or 1995) Source: United Nations.

energy consumption per GDP unit—and carbon dioxide intensity— that is, the GHG emission level per primary energy consumption unit. On that basis, the IPCC estimates that the 1.9% annual growth in GHG emissions throughout the world from 1970 to 2004 stems from the 1.6% yearly population increase, the 1.8% annual per capita growth, the 1.2% yearly decrease in energy intensity and the 0.2% drop in carbon dioxide intensity. The global impetus is that of a world that develops faster than energy efficiency and energy decarbonisation can allow, so the decrease in the last two factors cannot offset the increase in the first two. In contrast, the European Union benefits from a low population growth along with a carbon dioxide intensity that markedly came down and which thus makes up for growth in per head GDP (see Table 8.3). The EU naturally intends to pursue and intensify its efforts against climate change, yet it also hopes to attract the rest of the world in its wake. Hence there is no contradiction between a firm regional policy and resolute international engagement. It is by acting at regional level that the European Union can pave the way for an international consensus and create a knock-on effect. It is within the regional institutional framework that the EU must set up the practical resolutions it believes the international community ought to adopt. First, the progression rate of GHG emissions has been markedly lower in the European Union than anywhere else in the developed world since the early 1990s and besides, there seems to be a deep consensus both on the urgency of addressing climate change and on the legitimacy of taking political action at European level (Figures 8.2 and 8.3).

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Table 8.3 Kaya’s Breakdown (1990) for the EU 15 (1990–2004) and the rest of the world (1970–2004) Rest of the world 1970–2004 (in yearly growth %)

EU 15 1990–2004 (in yearly growth %) Population

+0.4

+1.6

GDP per head

+1.7

+1.8

Energy intensity

−0.9

−1.2

Carbon dioxide intensity

−1.04 (emissions weighted average)

−0.2

−0.06

+1.9

Net effect

Source: IPCC, OECD, EAA, EIA and the authors’ own calculations.

% of people who consider that climate change is a “very serious” issue 80

70

60

50

40 2003 2006

30

20

10

0 China

USA

Italy

U.K.

France

Germany

Figure 8.2 The European consensus on climate change Source: Globescan 2006, http://www.pipa.org/OnlineReports/ClimateChange/ClimateChange_Apr06/Climate Change_Apr06_quaire.pdf

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“According to you which is the most efficient institutional level for making decisions concerning the protection of the environment?” 35

30

25

2002 2004

20 (%) 15

10

5

0 EU

National government

United Nations

Figure 8.3 Environmental legitimacy in the EU Source: Eurobarometer http://ec.europa.eu/environment/barometer/pdf/report_ebenv_2005_04_22_en.pdf

8.3 The state of Europe’s environmental strategy How can this European “preference for the environment” be converted into effective action against climate change? The European environmental strategy in the terms of this chapter deals with the reduction of GHG in the EU—which means that the issue of adaptation to climate change is not considered here, but only that of mitigation. What are the objectives and the means to achieve them? 8.3.1

The EU’s objectives

The European commitment to fighting climate change goes back to 1995 when Heads of State and Government decided to limit the earth’s warming by a further 2°C compared to what it was in the pre-industrial period. It was later reaffirmed by the European Commission in January 2007. The European effort is part of the Kyoto Protocol which has been in force in the EU since February 2005. Within this legal framework, the Union has the set objective of an 8% GHG reduction in 2012 and then since March 2007, of 20% in 2020 compared to 1990

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levels. The EU 15 have agreed in April 2002 to share out this effort among themselves according to the levels and dynamics of each country’s own emissions (see below). The new Member States had either to meet the objective of a 6% reduction in 2012—like Poland—or of 8%, with the exception of Malta and Cyprus which did not ratify the Kyoto Protocol. 8.3.2 The theoretical instruments: The Coasian and Pigouvian solutions The economic analysis of environmental issues rests for its basic part on the under evaluation by the economic system of the use of natural resources compared to their social costs. In theory, the reason for this under evaluation is threefold (Arrow et al., 2004): property rights are ill-defined, externalities poorly understood and public subsidies wrongly targeted. A two-pronged approach can be considered so public policy may solve this under evaluation: the Coasian or the Pigouvian solutions (only economic instruments are taken account of here, which leaves aside regulation tools and information policies). The Coasian solution (Coase, 1960) states that when a market exists, it can manage to allocate productive resources efficiently and that the State’s environmental policy should be limited to the definition of property rights. This theory is in continuation of that of Hotelling (1931) which attempted to discredit the American “conservationism” movement by arguing that there was no economic justification for public intervention if the aim was to restrain too fast public exploitation of a non-renewable resource. It would suffice that the State put an efficient emissions quotas market in place, which is exactly what the United States did regarding sulphur dioxide in 1990. In contrast, the Pigovian solution (Pigou, 1920) recommends to resort to tax and fiscal policy so as to modify relative prices and thus incite economic agents to better integrate environment conservation into their consumption and production plans. It comes down to knowing how best to lead the economic system to “internalise externalities” and subsequently put the use of environmental resources on a par with its social price (Solow, 1974). A problem due to market failure could not be solved by merely creating a new market. The Netherlands, Denmark, Sweden and Norway, for instance, adopted an ambitious ecological taxation policy in the early 1990s. In the specific case of the fight against climate change, the fundamental challenge is how to determine carbon’s social price. With the

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objective of stabilising GHG emissions to a level acceptable to humankind and its environment—that is, a CO2 concentration lower than 550 ppm for a 2°C temperature increase compared to the pre-industrial era—IPCC (2007a) estimates vary from $20 to $50 per tonne of carbon by 2030. For Richard Newell (Duke University), and according to various models, if carbon was to meet these objectives, its price per tonne would range from $5 to $30 in 2025 and between $20 and $80 in 2050.13 What tools should be used to make sure that carbon be valued at “the right price”? On this point, the EU’s environmental strategy is currently somewhat paradoxical. It both leans clearly towards the Coasian solution—which seems unsatisfactory in the present circumstances— while at the same time, it refuses to adopt the Pigovian solution— whose implementation is perfectly feasible. The combination of both approaches is probably the most effective solution. 8.3.3 The EU’s environmental strategy’s tools and their limits The European preference for the Coasian over the Pigovian solution is a direct result of the Kyoto Protocol by which the EU was granted the right to conclude a “bubble” agreement that allowed EU Member States to meet their obligations jointly.14 Kyoto indeed provides for three so-called institutional “flexibility” agreements. The setting up of a market (associating States and/ or firms) for GHG emissions permits; “joint implementation” which allows for the exchange of environmental investments and pollution credits between Annex 1 countries subject to legally-binding individual objectives. Finally, the Clean Development Mechanism that associates developing countries to the efforts of advanced countries on the same principle of environmental investments against pollution credits. In sum, Kyoto is entirely Coasian. Under the aegis of the European Environment Agency and the European Commission, the EU has indeed set up in January 2005 the first world system for the exchange of “emissions permits,” the European Union Greenhouse Gas Emission Trading Scheme (EU ETS), which is a free market, yet with a fixed ceiling covering 11.000 installations. The market comprises three institutional phases that correspond to the series of national allocation plans gradually approved—or rejected—by the European Commission for the 2005–2007 period (presented in Spring 2004), 2008–2012 (presented in Spring 2006) and beyond 2013 (adopted in April 2009).

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EU governments grant emissions quotas to companies in the industrial and energy sectors. This allows the firms to produce carbon dioxide emissions up to certain ceiling. The companies that have not used up all of their quotas can sell their surplus to the firms that wish to avoid paying the very heavy fines on those which have gone over quota. Although rather attractive in theory, the system shows very serious teething problems in its current form. First of all, national governments tend to be over-generous when assessing their own needs for emissions quotas, the proof of which being that virtually all national plans presented for the 2008–2012 period were turned down by the European Commission and had to be reviewed down before they could be accepted. Consequently, the emissions rights market is skewed and can no longer set the right price. Thus, in 2006, the amount of quotas put on the market was so large that it caused a structural surplus which in turn, caused a price collapse that subsequently destroyed all incentives to cut down on emissions. As permits are not transferable from one period to the next, emissions prices were doomed to a slow death until December 2007. As for the second phase, in 2008, emissions permits prices remained satisfactory, but collapsed again in early 2009. Secondly, even though the market may prove efficient in allocating quotas to firms on the basis of their effectiveness in reducing pollution, it is also most volatile because of high speculative behaviour which tends to send confusing signals. Besides, the mechanisms that have thus been set up only cover part, the smallest part actually, of human activity responsible for GHG emissions. Others, like transport or heating etc. are in no way taken into account. Finally, this market system does not produce any public revenue since emissions quotas are given out to companies for free. Reforming this market implies to combine the Coasian and the Pigouvian solutions15 by selling emissions rights on auction, as will progressively be the case starting in 2009. The funds thus generated could be paid into the European budget or be used to reduce national taxation and social contributions, in keeping with the “double dividend” logic which is often referred to when advocating the need for “ecological” taxes.16 In addition, all the European instruments available should be used in a Pigovian perspective into a European environmental strategy both more ambitious and more coherent. At any rate, it is probably necessary to review and increase the objectives and instruments needed to reach the goals the EU set for itself in March 2007. In its October 2006 Report, the European Environment

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Agency (2006) warned that, with the present measures, only two countries among the EU 15, namely Sweden and the U.K., would manage to reach their Kyoto targets. The EU 15 results in 2004 give only a 0.9% GHG reduction. Even though the new Member States fare much better, the overall performance for the EU 25 is no higher than the goal for the EU 15. All in all, if no further measures are taken, and if carbon pits17 are excluded, the EU15 would reach in 2010 only half of its planned objectives. (see Table 8.4). Furthermore, the March 2007 Council decision decided to increase the targets, even though they undoubtedly still remain lower than the IPCC’s recommended levels. The European environmental strategy appears all the weaker as there also exists a collective action problem at EU level, even though it less serious than the issue at world level. As shown in Figure 8.4, the distribution of GHG emissions levels is most uneven among the EU 25, since the five largest European economies produce over two-thirds of all GHGs. To finish with, the pace of emissions reductions in the EU shows that, if the performance has been pretty good from 1990 to 2000, the trend is since then worrisome, as emissions increase for all countries, “old” and “new” of the EU (Figure 8.5). As is worrisome the dynamic of the transports sector over the last 15 years (Table 8.5). A new impetus is therefore certainly needed for the European environmental strategy, if the Union is prepared to take on full responsibility for its claimed preference for the environment and if it wishes to contribute greatly, as it may well afford to do, to world action against climate change. To get the right picture of what shape this new ambition could take, one must briefly go back to the nature of the economic development process in which the knowledge economy and the consumption of natural resources compete with each other.

Table 8.4 GHG emissions reduction forecast for 2010 compared to the Kyoto commitments in the EU 15 Policies & measures currently available outside the Kyoto provisions Extension of Kyoto mechanisms to all EU 15 countries Carbon pits use Total Kyoto commitment Source: European Environment Agency.

−0.6% −2.6% −0.8% −4 % −8 %

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New member states without Poland and Czech Rep. 4 Czech Rep. 3 Poland 8 Germany 20

Luxembourg 0 Ireland 1 Denmark 1

UK 13

Sweden 1 Finland 2 Portugal 2 Austria 2 Greece 3

Italy 12 Belgium 3 Netherlands 4 Spain 9

France 11

Figure 8.4 Distribution of GHG emissions among the EU 25 in 2004 (%) Source: European Environment Agency.

100

97.8%

95

96.7%

90

90.8%

EU 15 92.6% EU 27

(%) 85 80

New member states

75.8%

75 71.7% 70 1990 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Figure 8.5 GHG Emissions in the EU, 1990–2006 (1990 = 100%) Source: EAA

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Table 8.5 GHG sources in the EU Share in GHG total emissions in 2005 (%)

Growth between 1990 and 2005 (%)

Energy without transports

59

−3

Transports

21

+25

Industrial processes

8

−16

Agriculture

9

−11

Wastes

3

−38

Other

0.2

—

Source: European Environment Agency.

8.4 The European Community for the environment, energy and research18 8.4.1 A new political ecology The wealthier our societies get, and the greater the care for the environment, same as in the past, the demand for luxury products (namely those other than basic needs products) kept on growing. As mentioned in the introduction, a common error of judgment is to believe that caring for the environment means a decrease in growth. Quite the opposite: it is the engine for a new type of growth. The European commission thus estimates at €1000 billion the world market value in environmental goods and services and it forecasts a yearly 5% growth increase for that sector. Besides, the economy is not a closed universe, totally disconnected from all reality that only lives by its own rules.19 This comes out most clearly with the ecological issue. The economic process naturally appears as engaged in a mutual exchange with its environment. The specificity of this exchange is that it is not run by some timeless mechanic rules but obeys those of thermodynamics, and more particularly the law of entropy. Issued from work by Sadi Carnot (1824), the law of thermodynamics establishes that, in the universe, the amount of free energy—which may be turned into mechanical work—goes down as time goes by. It is then all about a law that takes us back to the measure of evolution in a finite world. Yet, it never lets you know when “heat will die out,” as the theory’s primary formulation used to say.

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Nicholas Georgescu-Roegen (1906–1994) was a pioneer in the relations between physics and the economic process and helped us understand that the economic process has no autonomy and because of its multiple interactions with nature, produces irreversible consequences. We dig up at random the stocks of non-renewable natural resources (oil, raw materials and commodities etc.) and downgrade or modify the quality of our environmental heritage because we impose on it an exploitation rate that cannot allow for its natural renewal (rural land, water, sea resources etc.). The law of entropy is here to remind us that time is pointing only one way, so we will pass on to the next generations a diminished heritage—most probably ill-adapted to their needs—compared to the one we inherited ourselves from our elders. Furthermore, because the exploitation of non-renewable resources frees up the ecological pace of economic “speed” (i.e., growth), it contributes to natural resource degradation like, for example, of the biosphere and may have a longstanding impact on climate change (IPCC, 2007c). As mentioned at the beginning of this chapter, decline or simply stagnation in growth are no solution to this problem because that would imply one either accepts to put up with current inequality or that one is prepared to adopt a redistribution system in which all resources would be shared out equally. The first proposition is simply untenable and the second sheer totalitarian utopia. However, the law of entropy is not the only time pointer running our lives. The knowledge economy is another essential part, although of a more subtle nature. Human evolution seems therefore affected by a dual process of irreversibility: on the one hand knowledge accumulation and technical progress, and on the other, the decrease in nonrenewable resources or the similarly irreversible degradation process of some environment stocks. For these reasons, the direction of economic time cannot but include these two factors. It is entropic as far as resources are concerned, but governed by history regarding production, organisation and the advance of knowledge. The evolution perspectives of the system partly depend on the place accorded to these two dynamic processes that somehow work like the blades of a pair of scissors, linked and yet separate. Hence there is no specific limit to growth provided that the level of progress available manages to ensure the whole system’s survival. But both nature and knowledge are public goods that cannot be “produced” in sufficient quantities without State intervention. The only solution to the problems of our finite world is to try to keep the scissors blades open wide apart by investing in education and research—more

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particularly in renewable resources and in any field that helps to keep down the energy costs of our standard of living—and in nature conservation by finding out the ways that may slow down natural resource degradation. 8.4.2 New environmental and energy technologies as engines for the European model and project Same as the European environmental strategy needs a new impetus, it has also become clear that the European project requires a new ambition. Reshaping Europe is an adventure that calls for both new and original ideas, a vision that can meet today’s challenges by relying on its past successes. Building up a political union between sovereign States is a most arduous task. Yet at some points in history, this becomes possible because of the obvious negative effects of disunity. The way towards union can then but be political in substance, even though the original justification may appear merely technical. Europe’s founding fathers were well aware of those demands when they decided to set up the European Coal and Steel Community (ECSC). When former enemies choose to share out some of the most fundamental commodities needed to wage war against each other for supposedly economic reasons, that is proof of intelligence at its best. We are living through similar times. Successfully taking up the challenge of new energy and environmental technologies (NEET) is just as essential. The European Community for the Environment, Energy and research (ECEER) could be the right institution to set this up. Although this may sound basically technical, it remains very political in essence, since it relates to Europe’s geopolitical influence, its energetic independence and the understandable ecological worries of EU citizens. ECEER would actually represent a pragmatic application of the Lisbon agenda (2000), because it only follows up two closely correlated objectives. First, Europe’s energetic independence could benefit from the energy and environment’s new technologies and then it could find itself in a better negotiating position in world forums on matters like the conservation and the improvement of our ecosystem thanks to more effective action against climate change. The European Union is the right scale and has the proper institutional framework to make this a viable plan. Its socio-cultural model is partly inspired by its concern about the environment. This project would allow the renewal of the European social contract, same as when in 1950 the ECSC served as the research laboratory for the later Treaties of Rome.

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The ECSC aimed to make of war’s commodities a mutual resource so that a war could never happen again. ECEER would put all economic development resources in common so they can never be exhausted and subsequently relaunch European growth for years to come. Coal production lay at the centre of the ECSC, carbon intensity reduction would be ECEER’s heart. The ECSC treaty was originally meant to run for 50 years. It expired in July 2002 and was not renewed. The ECSC’s €1.6 billion assets were transferred to the European Commission. This fund’s annual net income is €45 million and goes towards research on coal and steel. This money might be used to start what could become the financial core of ECEER’s most ambitious development. More specifically, the European Pigovian instruments have to be used to promote this new project. ECEER could primarily be based on tax incentives common to all Member States. In other words, it could rest on coordinated subsidies, namely and in contrast with ECSC, on positive rather than negative integration. The setting up of ECEER could offer the opportunity to redress the previous mistake of entrusting an independent authority with a political assignment—in this specific case, the High Authority, later to become the European Commission. ECEER could be financed by the European budget for instance, and could come under an ad hoc European parliamentary commission—a practice that goes back to the 1951 Assembly. From this could be derived the core of the ECEER’s new democratic power in the European Union. In that way, Europe could become the world’s production centre of clean technologies. These could then be sold to competitors and be passed on at low cost to developing countries. In his 9 May 1950 statement, did not Robert Schuman recommend that ECSC’s European production of coal and steel be used for “the development of the African continent?” 8.4.3

The ECEER’s instruments

8.4.3.1 The European budget and European tax policy as tools to fight against climate change The European budget is the standard institutional way of financing “European public goods.” Yet the current proceedings are far from satisfactory, and the near future is bound to bring further evidence of its shortcomings.20 The major problem has to do with the amounts involved. A mere 130 billion euros for about 500 million European citizens, namely hardly over 1% of the EU’s total GDP, compared to the between 35% and over 50% of the GDP figure for the Member States’

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national budgets. The central budgets’ figure for existing federations come up to between 15% and 25% of GDP. Another weakness is the current financing mode based mainly on national contributions calculated on the Member States’ gross national income (GNI) ratio. This leaves little room for financing the other EU’s common policies since the Common Agricultural Policy (CAP) already gobbles up almost half of the cash available for such projects, even though the CAP is arousing much criticism. Last but even more fundamental, is that this type of financial decision-making process cannot but produce the lowest of priorities for the funding of European public goods. In contrast with the current decision-making process that is based on a seven-year plan term, it is essential to increase the role of Parliament and to grant it wider control power. The present system only encourages fiscal inertia and jeopardise democracy by having staggered budget decisions and election times. Its unanimity procedure can only lead to haggling and enhance national selfishness through the strict application of the “fair share” rule. This system only puts unjustified limits on the European budget and subsequently, on the possibilities of financing public goods or common policies. The role of Parliament must therefore be reinforced and its control be made more frequent, which includes the adoption of qualified majority voting within the Council on budget matters. This does not exclude that the distinction must be made between euro zone countries and other members for each institution, given that the Euroland is a more closely-knit union and has different needs, for example, in matters of economic stabilisation and fiscal policy coordination. In addition, it would be necessary to give the budget proper financial resources. The EU should be granted taxing power as this would contribute to give each of the separate entities their own tax “resources.”21 Once the decision, both political and economic in nature, is eventually made, fundamental reform would consist in letting the European Assemblies set the tax base and tax rate, independently from the decisions on spending level and its breakdown, as is currently the case in all democracies. Even if EU budgets remain limited in size, it would then become possible to put a Pigovian-like federalism in place whereby budgets would have the same incentive as that played in the Pigovian approach by subventions and taxes on common goods and collective pollution, according to the classic “polluter-payer” principle. Although national governments’ budgets would remain larger than European ones, the latter could then be used, at least partly, to subsidise spending or penalise any type of wrong behaviour.

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8.4.3.2

The CAP

Agriculture plays much more than a minor role in climate change (see Table 8.5). Article 3 of the 1782/2003 regulation taken by the EU Council of 29 September 2003 undoubtedly establishes common rules as regards direct CAP support, which constitutes at least the starting point of some sort of eco-conditionality since it provides for cutting or even ending payments in case of a breach of Community rules. Yet, the environment is far from being the CAP’s first priority. Difficult decisions will have to be made to remedy these problems. For example, wider use of biofuels and more generally of biomass energy may be encouraged. They provide renewable energy resources that produce fewer GHGs than fossil fuels, although they may also tend to lead to higher specialisation for large agricultural firms. They obviously feed on polluting inputs like chemical fertilisers and pesticides, among others, all of which are harmful to biodiversity and affect landscape beauty. There could also exist an impact on the price of staple commodities as such activity takes up its share of the supply available for feeding humankind. It is high time all of these issues came under discussion. 8.4.3.3 The Stability and Sustainable Growth Pact The Stability Pact must make up the European environmental strategy’s third pillar. Public investment in new environment and energy technologies ought to be excluded from budget deficit calculations. It should be up to the European Council to decide what must be included in this type of spending. The Council would then have means powerful enough to urge national governments to invest in the future. This looks much more attractive than mere co-ordination which is always difficult to achieve and time consuming. The new system would contribute to the emergence of a proper European environment policy. It would give the European Council the urging power needed for Europe’s planned priorities and would allow Europe to use its huge wealth for developing effective European public goods. 8.4.4

The intellectual climate change

The environmental question’s comeback is well-timed: it reshuffles the cards of an economic globalisation game in which players had started to doze off. The State is now reinstated in its market regulation role while the invisible hand seems more prone to amplifying market failure

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than correcting it. Even the fundamentalists who strongly believe that only competition can produce more modern technologies must admit that the State’s role remains central since it holds the only key to incentives.22 In this context, the European environmental strategy is still incomplete, yet it is most promising and holds the answer to the most serious challenges facing the construction of contemporary Europe, namely democracy and growth. The climate change issue offers Europe a great historical opportunity to show its citizens and the rest of the world that it is about a much grander idea than the mere creation of a huge market.

Notes Translated from French by Bernard Offerle. The authors wish to thank Amanda Mitchell of Stanford University for her excellent research assistance with some of the data presented in this chapter. 1. Malthus, An Essay on the Principle of Population, 1798. 2. The first IPCC studies were published in 1990 (and updated in 1992). The group was set up under the aegis of the UN. The UN framework convention on climate change and the Kyoto Protocol were directly inspired from these original documents. 3. The terms used are those of “anthropic” emissions and of “anthropogenic” climate change. 4. See among others the works published in June 2006 by the National Academy of Sciences, http://www.nasonline/site/PageServer 5. See in particular his hearing on “the Climate Change debate before the US Congress,” U.S. Senate Committee on Environment and Public Works, 2 May 2001. 6. A report published by the House of Lords in June 2005 found that there were “some positive aspects” to climate change which the IPCC reports might have overlooked. 7. For a survey of the economic issues, see for instance Geoffrey Heal, 2008. 8. The latest IPCC report (2007a) states that the measures to limit temperature increases to around +2°C would imply a 0.12% decrease in annual GDP growth as of 2030. 9. The academic reference here is naturally Olson (1965). See also Godard and Henry (1998) on similar topics. 10. See “Copenhagen Consensus 2006,” http://www.copengagenconsensus. com/. See also Lomborg (2006). 11. The difference in environmental performance between Russia and all other Annex I countries is due to the quasi coincidence of the Kyoto reference year with that of the collapse of the former USSR. 12. Kaya Y. (1990), “Impact of carbon dioxide emission control on GNP growth: Interpretation of proposed scenarios”. Paper presented to the IPCC Energy

184

13. 14.

15.

16. 17. 18. 19. 20. 21. 22.

Jean-Paul Fitoussi, Éloi Laurent & Jacques Le Cacheux and Industry Subgroup, Response Strategies Working Group, Paris, quoted by IPCC (2007a). The Economist, “The Final Cut,” 2 June 2007. The Pigovian approach had nevertheless been discussed. Yet in late 1994, the EU finally declined to adopt the energy/carbon tax proposed by the European Commission in September 1991 because of lack of international mutual recognition. See Godard and Henry (1998) for more on mixed solutions and for a theoretical discussion of the respective merits of emissions permits market in the sulphur dioxide US market. See among others, Chiroleu-Assouline (2001), Guesnerie (2003) and OFCE (2002). One talks of “net emissions” when carbon pits are included. This part draws on Fitoussi, Laurent and Le Cacheux (2007). This part draws on Fitoussi and Laurent (2008). See Chapter 7. See Chapter 7. This is exactly why neo-liberal intellectuals strongly refute the reality of climate change and its effects. They also deny the relevance and/ or the legitimacy of State intervention in the development of effective environmental strategies. This ideological school of thought rests on the (long-standing) doctrine that markets will eventually find a (technological) solution to climate change issues, so long as they are given a free rein.

References Aldy, J.E., P.R. Orszag and J.E. Stiglitz (2001), “Climate change: An agenda for global collective action”, Prepared for the conference on “The Timing of Climate Change Policies” Pew Centre on Global Climate Change, The Brookings Institution, http://www.aei.brookings.org/admin/authorpdfs/page.php?id=13 3&PHPSESSID=f7684b21f883073ccc4e671941f6af38 Arrow, K. et al. (2004), “Are we consuming too much?” Journal of Economic Perspectives 18(3): 147–72. Brundtland Commission (1987), Notre Avenir à Tous, rapport de la Commission Mondiale sur l’Environnement et le Développement, Les Editions du Fleuve, 1987, une version est accessible à http://fr.wikisource.org/wiki/Rapport_Brundtland. Chiroleu-Assouline, M. (2001), “Le double dividende—Les approches théoriques”, Revue Française d’Economie, October, XVI(2): 119–47. Coase, R. (1960), “The problem of social cost”, Journal of Law and Economics 3(1): 1–44. Dasgupta, P. (2006), “Comments on the Stern Review’s economics of climate change”, University of Cambridge, http://www.econ.cam.ac.uk/faculty/ dasgupta/STERN.pdf Eurobarometer (2005), “Attitudes des citoyens européens vis-à-vis de l’environnement”, Eurobaromètre Spécial N°217, European Commission, http:// ec.europa.eu/environment/barometer/pdf/report_ebenv_2005_04_22_fr.pdf European Commission (2007), Limiter le changement de la planète à 2 degrés celcius, http://www.europa.eu/press_room/presspacks/energy/com2fr.pdf

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European Council (2007), Conclusions of the Presidency. 9 March. European environmental agency (2006), Greenhouse gas emission trends and projections in Europe 2006, European Environmental Agency, http://reports.eea. europa.eu/eea_report_2006_9/en/eea_report_9_2006.pdf Fitoussi, J-P. and É. Laurent (2008), La nouvelle écologie politique. Paris: Le Seuil. Fitoussi, J.-P., E. Laurent and J. Le Cacheux (2007), “La Communauté européenne de l’environnement, de l’énergie et de la recherche”, in Fitoussi, Jean-Paul and Eloi Laurent (dir.), France 2012. E-book de campagne à l’usage des citoyens, OFCE, 2007. http://www.ofce.sciences-po.fr/ebook.htm Godard, O. and C. Henry (1998), “Les instruments des politiques internationales de l’environnement : la prévention du risque climatique et les mécanismes des permis négociables”, in Fiscalité de l’environnement, Rapport du CAE, La Documentation française, Paris, pp. 83–174. Guesnerie, R. (2003), Kyoto et l’économie de l’effet de serre, Rapport du Conseil d’analyse économique n°39, Paris, La Documentation française. Heal G. (2008), “Climate economics: A meta review and some suggestions”, NBER Working Paper 13927. Hotelling, H. (1931), “The economics of exhaustible resources”, The Journal of Political Economy, April, 39(2): 137–75. IPCC (2007a), Mitigation of Climate Change, May, http://www.ipcc.ch/SPM040507. pdf IPCC (2007b), Impacts, Adaptation and Vulnerability, April, http://www.ipcc.ch/ SPM13apr07.pdf IPCC (2007c), The Physical Science Basis, February, http://ipcc-wg1.ucar.edu/wg1/ wg1-report.html Le Cacheux, J. (2005), “European budget: The poisonous budget rebate debate”, Notre Europe, July, http://www.notre-europe.eu/fileadmin/IMG/pdf/Etud41en.pdf Le Cacheux, J. (2007), “Funding the European budget with a genuine own resource: The case for a European tax”, Notre Europe, http://www.notre-europe.eu/ Lomborg, B., ed. (2006), How to Spend $50 Billion to Make the World a Better Place. Cambridge: Cambridge University Press. Meadows, D.H., D.L. Meadows, J. Randers and W.W. Behrens III (The Club of Rome) (1972), The Limits to Growth, New York, NY: Universe Books. Nordhaus, W. (2006), “The Stern Review on the economics of climate change”, Yale University, http://nordhaus.econ.yale.edu/SternReviewD2.pdf OFCE (2002), Les réformes fiscales Europe 1992–2001, http://www.senat.fr/rap/ r02–343/r02–34336.html#toc426 Olson, M. (1965), The Logic of Collective Action: Public Goods and the Theory of Groups. Revised edition, Cambridge, MA: Harvard University Press. Pigou, A.C. (1920), The Economics of Welfare, Macmillan, Londres. Raupach, M.R., G. Marland, P. Ciais, C. Le Quéré, J.G. Canadell (2007), “Global and regional drivers of accelerating CO2 emissions”, PNAS, 22 May. Solow, R. (1974), “The economics of resources and the resources of economics”, American Economic Review, May: 1–14. Stern (2006), Stern Review on the economics of climate change, http://www.hm-treasury.gov.uk/ Stiglitz, J., A. Sen and J.-P. Fitoussi (eds) (2009), Report of the Commission on the measurement of economic performance and social progress, Report to the President of the French Republic, September, http://www.stiglitz-sen-fitoussi.fr

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Tol, R.S.J. (2006), “The Stern Review of the economics of climate change: A comment”, Economic and Social Research Institute, Hamburg, Vrije and Carnegie Mellon Universities, http://www.fnu.zmaw.de/fileadmin/fnu-files/reports/ sternreview.pdf Weitzman, M. (2007), “The Stern Review of the economics of climate change”, http://www.economics.harvard.edu/faculty/Weitzman/papers/JELSternReport. pdf, Journal of Economic Literature, September 45(3): 703–724.

9 If It’s Broken, Don’t Fix It: The Government of the Euro Area in the EU “Reform Treaty” Éloi Laurent

The government of the Euro area—the institutions, objectives and instruments of the regional area pooling together the monetary sovereignty of the 16 EU member states that share the euro—was obviously the blind spot in the otherwise animated negotiations of the sessions of the European Convention, and then of the Intergovernmental Conference in 2004. What seemed then a missed opportunity now looks like a major collective failure. Euro area member states in 2009 dangerously diverge in terms of inflation, growth and current accounts; economic policy choices are made separately, threatening European cohesion and monetary union in its very principle; tax and social competition is becoming the norm between neighbours and partners; an exchange rate policy able to domesticate an out-of-control euro is still missing; the short-lived European recovery has given way to a deep recession in a context of global uncertainty. Who can now doubt that an open and thorough debate on the reform of the functioning of the core of European economic integration was badly needed, and still is? True, new provisions regarding the Euro area were inscribed in the friable marble of the “European Constitution” (“The Treaty establishing a Constitution for Europe”). The text of the “Draft Treaty amending the Treaty on European Union and the Treaty establishing the European Community” in Lisbon on 18 October, called “Draft Reform Treaty” (“Reform Treaty” hereafter), reminds us that some “reforms” of the Euro area have indeed been decided when the “European Constitution” was signed. Since the 2007 Intergovernmental Conference (IGC) mandate quotes “the improvements to the governance of the Euro” among “the innovations ... agreed in the 2004 IGC” that “will be inserted into the Treaty”, one has to review the changes in question and assess if they 187

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match the challenges faced collectively by Euro area economies. The short answer: no, alas.

9.1

Will the ECB be more independent?

One can only regret that the European symbols put forward in Article I-8 of the “European Constitution” have disappeared from the “Reform Treaty”. The “euro” finally replaces the “ECU” as the official European currency, and it is also mentioned in Article 3 of the new text, but this downgrading takes some democratic value away from the euro. This feeling becomes stronger when the reader explores the new provisions regarding the European Central Bank (ECB). To start with, and this is not a minor issue, the ECB gains financial independence in the new Treaty,1 as stated in the new Article 245a: The European Central Bank shall have legal personality. It alone may authorise the issue of the euro. It shall be independent in the exercise of its powers and in the management of its finances. Union institutions, bodies, offices and agencies and the governments of the Member States shall respect that independence. This new provision had been asked by the ECB itself in its opinion of 19 September 2003 (ECB, 2003). As a matter of fact, the new section 4a is largely inspired from the ECB demands. The ECB thus logically expresses its general satisfaction with the new text in its Opinion of 5 July 2007.2 Yet, on second thought, one point has become problematic for the ECB, which even decided to publicly warn the Portuguese Presidency about it. There is no question that the ECB will be even more independent after the Reform Treaty is being implemented than before (with the consolidated version of the Nice Treaty). The text makes the ECB into an institution of the EU (Article 9), which does not change anything to its statutes, mandate, objectives or instruments but strengthens its original institutional position, since it is the only EU institution with the legal personality. Yet, the ECB expressed its opposition as soon as 20033 to this integration into the EU framework and asked for a specific treatment: Because of its specific institutional features, the ECB needs to be differentiated from the “Union’s institutions” and this justifies the fact that Art. I-18 does not list the ECB. To increase the clarity, consistency and soundness of its institutional status, if not for purely editorial reasons, the ECB would

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like to recommend that the heading of Title IV be changed to “The Institutional Framework of the Union.” The wording of the “European constitution” actually sustained the ECB claim, categorising the Bank among the “other Union’s institutions.” By reintroducing the ECB among the Union’s institutions, the Reform Treaty triggered a stiff, if delayed, reaction. In a letter to Manuel Lobo Antunes (President of the Council of the European Union) on August 2 2007, Jean-Claude Trichet, President of the ECB, writes that, while “the ECB considers that ... the changes to be introduced to the text of the current Treaties are limited to and comprise all the innovations agreed at the 2004 ICG ... this does not appear to be the case on the question of the institutional status of the ECB”. Trichet adds that the ECB would therefore like that “the reference to the ECB ... should be moved ... under the rubric, ‘The other institutions are’ and that the rubric ‘The Union’s institutions’ should be replaced by ‘The Union’s institutional framework’ ”. The ECB did not win its case in Lisbon since its legal interpretation of the new text as limiting in any way its independence did not convinced the overwhelming majority of EU member states. But it speaks volumes on the ECB conception of democracy: it does not want to be part of the European political system. As regards the ECB’s mandate, “price stability” becomes, here again following the Bank 2003 opinion, an objective of the Union. Article 3 of the “Reform Treaty” states that the Union: ... shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment. In the same vein, Article 3 of the new Title I (“Categories and areas of Union competence”) explicitly ranks monetary policy as an area of exclusive competence for the Euro area countries: 1. The Union shall have exclusive competence in the following areas: (a) customs union; (b) the establishing of the competition rules necessary for the functioning of the internal market; (c) monetary policy for the Member States whose currency is the euro;

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(d) the conservation of marine biological resources under the common fisheries policy; (e) common commercial policy. One of the many stakes of this wording is the exact scope of this competence, and in particular the problematic sharing of the exchange rate policy between the ECB and the Council.

9.2

Will Europe finally have an exchange rate policy?

The euro so far is not only a currency without a State, but a currency without sovereignty. It is not governed on the global scene because it has been de facto put under the sway of an independent authority (the ECB) whose conviction is that the Euro area should not have an exchange rate policy. This position was clearly expressed at the very beginning of the ECB by its first President the late Wim Duisenberg: On the question of exchange rates and target zones, I would like to state clearly that, in its monetary strategy, the ESCB does not have an exchange rate target. Nor do the United States and Japan. An exchange rate target for an area as large and relatively closed as that of the euro area could easily conflict with the maintenance of price stability and could, therefore, not be sustainable. According to our monetary policy strategy, the exchange rate of the euro will thus be an outcome, rather than the objective, both of the economic, monetary and other policies pursued in the euro area, and of cyclical developments in the euro area and abroad. It will be monitored as one of the indicators of monetary policy and as a source of potential changes in the price level in the euro area.4 While the consequences of the chaotic European Monetary System were logically negative for European countries between 1979 and 1999, one could reasonably hope that the creation of the single currency would give the Euro zone economy a true monetary sovereignty. Because of the ECB beliefs and the national governments passivity, it has not been the case. The priority has clearly been given since 1999 to price stability over exchange rate stability. As a result, since 1999, the euro has been “strong” when the economy was “weak” and “weak” when the economy was “strong”. In order words, the euro exchange rate has destabilised the Euro area economy instead of contributing to stabilise it. The activism

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of the European Central Bank on the Forex market has been asymmetric: it intervened when the euro depreciated (threatening price stability), but not since it has appreciated (see Chapter 5). At the global level, the Euro area is thus only an involuntary player in the international monetary system, through the risk derivation circuit played by the euro with respect to the dollar. Hence, the euro can be said to serve as the adjustment variable to global imbalances. Without an exchange rate policy of the Euro zone, movements of the exchange rate of the euro simply reflect the exchange rate policies of the rest of the world. On the contrary, one can make the argument that the Euro zone economically needs an exchange rate policy and is legally entitled to it. European law, on this point ambiguously unambiguous, gives the shared responsibility of the exchange rate policy to the ECB and the Council. The ambiguity runs both ways: the Council can formulate general orientations for the exchange rate policy but must respect the ECB lexicographic order (price stability is first, then comes the rest, Article 105 of the European Union Treaty) and the ECB, submitted to this order, must support those orientations when they are formulated (Article 111). Article 111 1. By way of derogation from Article 300, the Council may, acting unanimously on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, after consulting the European Parliament, in accordance with the procedure in paragraph 3 for determining the arrangements, conclude formal agreements on an exchange-rate system for the ecu in relation to non-Community currencies. The Council may, acting by a qualified majority on a recommendation from the ECB or from the Commission, and after consulting the ECB in an endeavour to reach a consensus consistent with the objective of price stability, adopt, adjust or abandon the central rates of the ecu within the exchangerate system. The President of the Council shall inform the European Parliament of the adoption, adjustment or abandonment of the ecu central rates. 2. In the absence of an exchange-rate system in relation to one or more non-Community currencies as referred to in paragraph 1, the Council, acting by a qualified majority either on a recommendation

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from the Commission and after consulting the ECB or on a recommendation from the ECB, may formulate general orientations for exchange rate policy in relation to these currencies. These general orientations shall be without prejudice to the primary objective of the ESCB to maintain price stability. Article 105 1. The primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2. The ESCB shall act in accordance with the principle of an open market economy with free competition, favouring an efficient allocation of resources, and in compliance with the principles set out in Article 4. 2. The basic tasks to be carried out through the ESCB shall be: —to define and implement the monetary policy of the Community, —to conduct foreign-exchange operations consistent with the provisions of Article 111, —to hold and manage the official foreign reserves of the Member States, —to promote the smooth operation of payment systems. More precisely, since, as the ECB itself puts it, the “ultimate responsibility” for the exchange rate policy lies with the member states, a distinction must be made between independence of means (also called “economic independence”) and of objectives (also called “political independence”). The ECB appears to be independent in terms of the means chosen to achieve the general objective set by the Council. But these objectives have to be discussed between the Council and the ECB. And these objectives and that of price stability have to be compatible. The exchange rate policy is thus (although somewhat tortuously) unambiguously legally a shared competence between the Council and the ECB. Instead of conforming to this institutional framework, the Euro area member states have opted for the bizarre creation of the Euro group, the informal gathering of Euro area economic and finance ministers, which has been created in 1997 with no legal basis to “dialogue” with the ECB (see infra). The Reform Treaty does nothing to pull the European exchange rate policy out of ambiguity and inertia. Consequently, the euro will

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probably continue to be submitted to the objective of price stability, in a context where the dollar, the yen and the yuan all have good reasons to continue to depreciate on the exchange rate markets against the European currency. The “informal” recognition of the Euro group (cf. infra) and the creation of the “High Representative of the Union for Foreign Affairs and Security Policy” in the Reform Treaty will not change this state of affairs. The Euro area has to rely on other macroeconomic instrument than the exchange rate.

9.3

Will the policy mix be more efficient?

So far, the only provisions aimed at coordinating macroeconomic policies in the Euro area are EU wide instruments, namely the “Broad economic policy guidelines” (BEPG) and the “Stability and growth Pact” (partly reformed in 2005). A case can be made that these rules, submitted to the price stability objective of the ECB, work against macroeconomic reactivity and a strong and sustained economic growth, but yet without insuring the degree of monetary stability or public finance sustainability that justify them (see Chapter 3). Indeed, the policy mix of the Euro area consists in juxtaposing an excessively restrictive (or at least insufficiently accommodative) monetary policy, which has the regrettable tendency to shorten recoveries and prolong downturns, and national fiscal policies that are aggregately excessively expansionist, especially in recoveries (see Laurent and Le Cacheux, 2006). A better combination and coordination of both instruments is to be sought and found. The collective determination of fiscal and tax policies in order to avoid opportunistic national policies and the development of a substantial dialogue with the ECB would for instance likely enable the Euro area to benefit from a stronger growth, sounder public finance and easier to reform social models. But, here again, the reform Treaty is mute. The punitive facet of the European coordination is the only one to be strengthened: the European Commission will now be able to directly warn a country that would not respect the BEPG, without having to wait for the Council approval. If the Council decides to address a recommendation to a country, the country will no longer be able to participate in the vote. The “excessive deficit” procedure of the SGP will also be strengthened: the Commission will now be able to bypass the Council to send a warning to a country. Finally, the Council will determine if a public deficit is excessive and if the sanction procedure is to be activated with a majority vote of countries (representing at least 65% of the Euro area population), excluding the country subject to the

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procedure. The paradox of the Reform Treaty, which gives the Euro area some much needed autonomy but only for discipline and not coordination, is further aggravated by new provisions.

9.4 Will the Euro area become more autonomous in the EU? 4. The Union shall establish an economic and monetary union whose currency is the euro. Article 4 of the Reform Treaty is, at the same time, good and bad news for the economic sovereignty of the Euro area within the EU. On the one hand, the pivotal role of the Economic and Monetary Union (EMU) is recognised. But on the other hand, the Euro area and the EU are institutionally imbricate by this wording when they should, on the contrary, be dissociated and not confused in the same institutional continuum (see Fitoussi, Laurent and Le Cacheux, 2007). It is true that the Reform Treaty, which picks up the rare innovation of the European Constitution on the chapter of economic policy, gives for the first time more autonomy to Euro area member states. But this autonomy serves coercion and not coordination. According to Article 114 of the new chapter 3a, the Euro area member states will have the ability to decide with a qualified majority to: (a) strengthen the coordination and surveillance of their budgetary discipline; (b) set out economic policy guidelines for them, while ensuring that they are compatible with those adopted for the whole of the Union and are kept under surveillance. The only true improvement regards the emergence of a new formal framework to determine the representation of the Euro area in international organisations: 1. In order to secure the euro’s place in the international monetary system, the Council, on a proposal from the Commission, shall adopt a decision establishing common positions on matters of particular interest for economic and monetary union within the competent international financial institutions and conferences. The Council shall act after consulting the European Central Bank. 2. The Council, on a proposal from the Commission, may adopt appropriate measures to ensure unified representation within the international financial institutions and conferences. The Council shall act after consulting the European Central Bank.

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But whatever its shortcomings, one has to acknowledge that new chapter 3a, because it marks for the first time the need of specific provisions and procedures for Euro area member states, is the most important progress made by the Reform Treaty regarding the government of the Euro area. The same can not be said of the new provisions that concern the Euro group.

9.5

Will the Eurogroup be institutionalised?

The Eurogroup, the informal gathering of Euro area economic and finance ministers, is a non-institution that has been created with no legal basis to “dialogue” with the ECB. This baroque setting was decided at the European Council meeting in Luxemburg on 12 and 13 December 1997, whose conclusions mark a clear distinction between formal and informal coordination: The defining position of the ECOFIN Council at the centre of the economic coordination and decision-making process affirms the unity and cohesion of the Community. The Ministers of the States participating in the euro area may meet informally among themselves to discuss issues connected with their shared specific responsibilities for the single currency. The Commission, and the European Central Bank when appropriate, will be invited to take part in the meetings Article 115 of chapter 3a of the Reform Treaty mentions the Eurogroup and states that: Arrangements for meetings between ministers of those Member States whose currency is the euro are laid down by the Protocol on the Euro Group. But these meetings clearly stay “informal”, the Council remaining the place where decisions are effectively taken. It is true that Article 115 and the Protocol n°3 recognise the existence of the Eurogroup for the first time ever in a European Treaty. What is more, the Protocol explicitly mentions the need to go further in the coordination of economic policies in the Euro area, stressing the necessity: ... to promote conditions for stronger economic growth in the European Union and, to that end, to develop ever-closer coordination of economic policies within the euro area,

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... the need to lay down special provisions for enhanced dialogue between the Member States whose currency is the euro ... But Article 1 of the Protocol reminds the reader that the role of the Eurogroup is and will remain informal: The Ministers of the Member States whose currency is the euro shall meet informally. Such meetings shall take place, when necessary, to discuss questions related to the specific responsibilities they share with regard to the single currency ... Article 2 of the Protocol simply states that: The Ministers of the Member States whose currency is the euro shall elect a president for two and a half years, by a majority of those Member States. Nowhere in the Reform Treaty is it indicated how the Eurogroup can find its place between the ECB, the Council and the Commission in the definition of the economic policies of the Euro area. The example of the 2006 most publicised spat between the “two Jean-Claude”, the ECB President, Jean-Claude Trichet, and the Eurogroup President, Jean-Claude Juncker, has shown that the legal coordination that ought to take place according to the Treaties does not exist in reality because the ECB is simply much more powerful than the Eurogroup. The dialogue between the Eurogroup and the ECB on the exchange rate thus remains virtual, a point Jean-Claude Trichet has been very clear about: I have said often enough that I am Mr. Euro. There is no doubt: we issue the currency and I sign the banknotes. My signature is on the notes ... In my understanding, the relationship that the ECB has with the executive branches, in line with the provisions of the Maastricht Treaty, is probably the best organized at the global level ... Of course, in the European tradition and in the Maastricht Treaty, this is accompanied by what I would call the inflexible independence of the monetary authority, which is in the Treaty and which forms the basis of our credibility.5 The institutional minority of the Eurogroup is even reinforced by the creation in Article 112 of the Reform Treaty of an “Economic and

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financial Committee” in lieu of the “Monetary Committee with advisory status” created by the “European Constitution”. This Committee is to gather, like the Eurogroup, member states, the Commission and the ECB to promote, just like the Eurogroup, economic policies coordination.

9.6 Will competition be a means or an objective of the EU? The final reform regarding the Euro area is not macroeconomic but microeconomic and regards the EU as a whole. The French government has asked and obtained at the June 2007 EU summit that competition no longer be an objective of European economic policies. Article 3 now merely states: 3. The Union shall establish an internal market. This reform, apparently innocuous, could be of great importance if it were to signal a shift in the conception of economic policy in the EU. One can indeed argue that competition is no longer an objective but a means of economic policy. Actually, intermediary and final objectives of economic policy tend to be confused in the EU, “competition” and “price stability” being sought at the detriment of growth and full employment (see Fitoussi, 2002). But this interpretation of the Reform Treaty is probably too optimistic. The British government has actually obtained that a new Protocol n°6 be added to the Reform Treaty, reducing the significance of the shift of competition from objective to means. ... the internal market as set out in Article 3 of the Treaty on European Union includes a syst\em ensuring that competition is not distorted ... This amendment returns very close to the abandoned wording of Article I-3 of the “European constitution”: 2. The Union shall offer its citizens an area of freedom, security and justice without internal frontiers, and an internal market where competition is free and undistorted. Overall, the Reform Treaty amounts to a conservative reform of the government of the Euro area, in the double meaning implied by the term. It will not change the current architecture of the economic policy institutions of the Euro area and thus not remedy its

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failures. But it also reasserts the restrictive bias of the present system: by reinforcing the independence of the ECB, including, by default, in the exchange rate policy domain; by strengthening fiscal discipline without allowing for a better coordination; finally, by failing to build the cohesive economic sovereignty needed to give a political consistency to the economically integrated Euro area. Is a major crisis the only way to convince the Euro area member states to govern their economy?

Annex: Exerps from the Reform Treaty Section 4a The European Central Bank Article 245a 1. The European Central Bank, together with the national central banks, shall constitute the European System of Central Banks. The European Central Bank, together with the national central banks of the Member States whose currency is the euro, which constitute the Eurosystem, shall conduct the monetary policy of the Union. 2. The European System of Central Banks shall be governed by the decision-making bodies of the European Central Bank. The primary objective of the European System of Central Banks shall be to maintain price stability. Without prejudice to that objective, it shall support the general economic policies in the Union in order to contribute to the achievement of the latter’s objectives. 3. The European Central Bank shall have legal personality. It alone may authorise the issue of the euro. It shall be independent in the exercise of its powers and in the management of its finances. Union institutions, bodies, offices and agencies and the governments of the Member States shall respect that independence. 4. The European Central Bank shall adopt such measures as are necessary to carry out its tasks in accordance with Articles 105 to 111 and Article 115a, and with the conditions laid down in the Statute of the ESCB and of the ECB. In accordance with these same Articles, those Member States whose currency is not the euro, and their central banks, shall retain their powers in monetary matters. 5. Within the areas falling within its responsibilities, the European Central Bank shall be consulted on all proposed Union acts, and all proposals for regulation at national level, and may give an opinion.”

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Chapter 3a Provisions Specific to Member States Whose Currency Is the Euro Article 114 1. In order to ensure the proper functioning of economic and monetary union, and in accordance with the relevant provisions of the Treaties, the Council shall, in accordance with the relevant procedure from among those referred to in Articles 99 and 104, with the exception of the procedure set out in Article 104(14), adopt measures specific to those Member States whose currency is the euro: (a) to strengthen the coordination and surveillance of their budgetary discipline; (b) to set out economic policy guidelines for them, while ensuring that they are compatible with those adopted for the whole of the Union and are kept under surveillance. 2. For those measures set out in paragraph 1, only members of the Council representing Member States whose currency is the euro shall take part in the vote. A qualified majority of the said members shall be defined in accordance with Article 205(3)(a). Article 115 Arrangements for meetings between ministers of those Member States whose currency is the euro are laid down by the Protocol on the Euro Group. Article 115a 1. In order to secure the euro’s place in the international monetary system, the Council, on a proposal from the Commission, shall adopt a decision establishing common positions on matters of particular interest for economic and monetary union within the competent international financial institutions and conferences. The Council shall act after consulting the European Central Bank. 2. The Council, on a proposal from the Commission, may adopt appropriate measures to ensure unified representation within the international financial institutions and conferences. The Council shall act after consulting the European Central Bank.

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3. For the measures referred to in paragraphs 1 and 2, only members of the Council representing Member States whose currency is the euro shall take part in the vote. A qualified majority of the said members shall be defined in accordance with Article 205(3)(a).”. Protocol (No 3) On the Euro Group THE HIGH CONTRACTING PARTIES, DESIRING to promote conditions for stronger economic growth in the European Union and, to that end, to develop ever-closer coordination of economic policies within the euro area, CONSCIOUS of the need to lay down special provisions for enhanced dialogue between the Member States whose currency is the euro, pending the euro becoming the currency of all Member States of the Union, HAVE AGREED UPON the following provisions, which shall be annexed to the Treaty on European Union and to the Treaty on the Functioning of the European Union: Article 1 The Ministers of the Member States whose currency is the euro shall meet informally. Such meetings shall take place, when necessary, to discuss questions related to the specific responsibilities they share with regard to the single currency. The Commission shall take part in the meetings. The European Central Bank shall be invited to take part in such meetings, which shall be prepared by the representatives of the Ministers with responsibility for finance of the Member States whose currency is the euro and of the Commission. Article 2 The Ministers of the Member States whose currency is the euro shall elect a president for two and a half years, by a majority of those Member States. Protocol (No 6) On the Internal Market and Competition THE HIGH CONTRACTING PARTIES, CONSIDERING that the internal market as set out in Article 3 of the Treaty on European Union includes a system ensuring that competition is not distorted,

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HAVE AGREED that to that end, the Union shall, if necessary, take action under the provisions of the Treaties, including under Article 308 of the Treaty on the Functioning of the European Union. This Protocol shall be annexed to the Treaty on European Union and to the Treaty on the Functioning of the European Union.

Notes 1. 2. 3. 4.

Presidency of the IGC (2007a) and (2007b). ECB (2007). ECB (2003). “The International Role of the Euro and the ESCB’s Monetary Policy”, 20 November 1998, http://www.ecb.int/press/key/date/1998/html/sp981120. en.html 5. Press conference, 8 June 2006.

References European Central Bank (2007), Opinion of the European Central Bank of 5 July 2007 at the request of the Council of the European Union on the opening of an Intergovernmental Conference to draw up a Treaty amending the existing Treaties (CON/2007/20), http://register.consilium.europa.eu/pdf/en/07/st11/ st11624.en07.pdf European Central Bank (2003), Opinion of the European Central Bank of 19 September 2003 at the request of the Council of the European Union on the draft Treaty establishing a Constitution for Europe (CON/2003/20), http:// www.ecb.int/ecb/legal/pdf/c_22920030925en00070011.pdf Fitoussi, J.-P. (2002), La règle et le choix. Paris: Seuil. Fitoussi, J.-P., E. Laurent and J. Le Cacheux (2007), “L’Europe des biens publics”, in Fitoussi, J-P. and E. aurent (eds), France 2012: E-book de campagne à l’usage des citoyens, OFCE, http://www.ofce.sciences-po.fr/ebook.htm Laurent, E. and J. Le Cacheux (2006), “Integrity and efficiency in the EU: The case against the European economic constitution”, Centre for European Studies Working Paper Series n°130, Harvard University. Presidency of the IGC (2007a) , Draft Treaty amending the Treaty on European Union and the Treaty establishing the European Community, http://www.consilium.europa.eu/uedocs/cmsUpload/cg00001re01en.pdf Presidency of the IGC (2007b), Draft Treaty amending the Treaty on European Union and the Treaty establishing the European Community—Protocols, http://www. consilium.europa.eu/uedocs/cmsUpload/cg00002re01en.pdf

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Index accounting logic see European Union (EU) budget Aghion, P. 49, 78, 130 Akerlof, G.A. 32, 50, 53–4, 56, 64, 79 Aldy, J.E. 164, 184 Alesina, A. 49–50, 61, 78–9, 107–8, 130 Allsopp, C. 79 Ambrosiano, F. 156 Amsterdam treaty 40, 41, 56, 130, 167 Andersen, P. 50 Andersen, T. 78–9 Ardagna, S. 78–9 Arestis, P. 34, 50 Arrow, K.J. 172, 184 Artis, M.J. 61, 79 Artus, P. 33, 50 Asch, S.E. 53, 79 Asdrubali, P. 78 asymmetric shocks 33, 40, 56 Atkinson, A. 42, 45, 48, 50 automatic stabilizers 42, 44, 61–2, 65–6, 153 bailout 61–2 Baldwin, R. 49, 50 Barroso, Commission 137–8 Basevi, G. 78 Bean, C. 79–80 Becker, G. 54, 80 Beetsma, R. 78, 80 Begg, I. 101, 144, 153, 156 Berger, S. 48, 50 Berlin summit 136–7 Bernoth, K. 61, 80 Blanchard, O. 39, 50 Blonde, M.H. 159 Bordignon, M. 156 ‘broad economic policy guidelines’ (BEPGs) 91, 193 see also economic policies Brennan, G. 156

Brundtland Report/Commission 161, 184 Bruno, M. 32, 50 Brussels summit 135 Buchanan, D., 53, 80 Buchanan, J.M. 139, 140, 156 budget (EU) see also European budget 6, 116, 132–59, 181 budget/public deficit/surplus 3, 35, 39, 41–3, 55, 57, 60, 62, 64, 66, 73, 79, 81, 91, 100, 148, 152–3, 182 ‘bias’ 59, 65, 79 ceiling/limit 42–3, 56, 59 “excessive”/excessive deficit procedure (EDP) 2–3, 41–2, 56–7, 61, 63, 193 structural 42, 59, 174 Buiter, W.H. 55, 80, 131 Buti, M. 59, 80–1, 156 Cairncross, F. 107, 130 Cameron, D.R. 48, 50 Canadell, J.G. 185 Canzoneri, M. 78, 80 capitalism 20 Capoen, F. 49–50 Caporale, G.M. 78, 80 carbon 7, 152, 164, 166, 169, 170, 173, 175, 183 tax 7, 152, 166, 184 see also Emission Trading Scheme (ETS) Cartapanis, A. 87, 101–2 Caselli, F. 79 Catenaro, M. 78, 80 Cattoir, P. 133, 144, 156 central and eastern European countries (CEECs) 2, 137 Chiroleu-Assouline, M. 184 Ciais, P. 185 Clarke, S.V. 64, 80 climate 18 policy 6, 7, 160–86 203

204

Index

Coase, R. 172, 184 Coasian mechanism/solution 172–3 see also ETS, market for carbon Cohen, E. 49, 51 cohesion 1, 15, 81, 83, 91, 100, 187, 195 collective action 46, 51, 81, 139, 158, 160–1, 164, 167, 175, 184–5 collective goods 139, 155 Collignon, S. 156 Commission 2–3, 9–10, 40, 42–3, 56, 62, 70, 88, 89, 91, 138, 144, 148, 155, 171, 173, 177, 180, 184, 193–200 see also EU Commission Common Agricultural Policy (CAP) 134, 181–2 competition policy 16, 197–200 competitive disinflation 6, 44–5, 50, 155 competitiveness 13, 39, 45–7, 60, 99, 112, 122–3, 155 external 46, 123 policy/strategy 35, 45, 121, 123–4 compromise 54, 143 European budget 132 ‘Luxembourg Compromise’ 138 Conseil économique et social 157 constraints 39, 46, 54, 83, 108, 111–2 on national policies 22–3, 44, 55, 57, 73, 81, 105 and Stability Pact 55, 73, 81 convergence 23, 41, 47, 94 ‘Maastricht criteria’ 56, 62 programmes 56 cooperation 12, 16, 17, 80–1, 143, 166 enhanced 156 see also non-cooperative policies/ practices/strategies coordination 1, 7, 44, 46, 80–1, 83, 91, 111, 181, 191, 193–200 open methods of 46 Constitutional treaty 59 Cornilleau, G. 159 countercyclical 59, 97 country size 45–6, 60, 81, 104–10, 113, 115, 128–9, 130 Creel, J. 21–52, 57, 80, 82–103, 129–30, 157

crises 32, 50, 61 exchange rate 84 crisis 1–2, 5, 22, 31, 32, 61, 101, 137, 198 Cumby, E. 80 Cunningham, S.R. 78, 80 Dasgupta, P. 163, 184 Davies, G. 79 De Broeck, M. 79 De Grauwe, P. 49, 50, 57, 80 Debrun, X. 80 Demas, W. 107, 130 decision-making 7, 198 collective 46, 111, 138–9 process/procedures 46, 91, 111, 195, 198 EU budget 133–4, 136–7, 139, 144, 181 deficit see budget/public deficit democracy 12, 20, 48, 133, 140, 181, 183, 189 democratic deficit 137 Detken, C. 61, 80 Devereux, M.P. 117, 130, 147, 156, 157 Diba, B.T. 80 Dickens, T. 50 Dixon, H. 78, 80 Dooley, M.P. 100, 102 Duisenberg, W. 82 Durlauf, S.N. 130 Easterly, W. 32, 50 Ecofin 90–2, 195 economic growth 5, 18, 33, 45, 52, 99, 103, 108, 115, 128, 130, 141, 146, 160, 189, 193, 195, 200 economic performance 131, 137, 185 country size and economic performance 104–13 macroeconomic performance 25–51 role of institutions in 34, 66 economic policies 8, 36, 66, 73, 171, 189, 192, 196–200 coordination 91, 193, 195 and the exchange rate 83, 86, 88, 91

Index 205 economic policies—Continued macroeconomic policies 5, 13, 22, 29–48, 105, 108, 109, 112, 128 and non-cooperative practices 6, 13, 44–5, 49 policy mix 4, 6, 40, 44, 193 see also ‘broad economic policy guidelines’ (BEPGs); fiscal policies EDP (Excessive Deficit Procedure) see budget deficit Eichengreen, B. 61, 80, 85, 132 Eijffinger, S. 80 Elster, J. 54, 55, 78, 80 Emission Trading Scheme (ETS) 173–4 Kyoto targets/commitments 169, 175, 183 See also carbon employment/unemployment 2, 5, 8, 9, 10, 22, 29, 53–54, 60, 63, 64, 79, 85, 99, 101, 105–6, 113, 126, 189, 197 long-term unemployment 105–6, 113, 123–4 ‘natural’ unemployment rate 38 Enderlein, H. 156 energy 12, 152, 168–9, 174 intensity 19, 167, 169–70 new technologies of energy and the environment (NTEE) 17, 179, 182 see also carbon enlargement 55–6, 69–70, 125, 137, 158 EU budget 137 and the Stability Pact 71–2 environmental policies 5, 7, 11–12, 14, 16–20, 160–85 biodiversity 182 greenhouse gas (GHG) emissions 7, 161–77, 185 ‘preference for the environment’ 167–73 sustainability 20, 43, 181, 193 and taxes 148, 150–1, 180–1 see also Kyoto Protocol EU Commission 147–8, 155–8

EU 10 28, 117 see also CEECs EU 12 58 EU 15 114, 150, 175, 176 EU 25 11, 150, 175, 176 EU 27 151, 176 euro 2, 4, 6, 21, 121–2, 187, 194, 196, 198–201 ‘Mr. Euro’ 82 exchange rate policy 82–103, 188–91 real exchange rate 82, 99, 121–2 euro area/zone 5–7 macroeconomic policies 21–52 see also euro Eurobarometer 171, 184 Eurogroup 6, 90–2, 191–7 President of the Eurogroup 91, 93, 196 see also Juncker European (EU) budget 6, 116, 135–6 accounting logic 136 national net balances/ contributions 135, 139, 143, 152, 154–5 unanimity rule 136–9 ‘collective/public goods’ financing 139, 147, 155 and environmental policy 180–1 and EU/European tax 139–53, 185 financial perspectives 132, 134, 136, 143, 158 funding of/resources 132–59 and the Lisbon strategy 137 own resources 132–59 size and structure of 134–5, 139, 149–50, 154–5, 181 structural funds 117, 134 European Central Bank (ECB) 4, 6, 21, 29, 32, 34–5, 37–8, 122, 124, 127, 128, 201 asymmetric policy 6, 33, 38, 87, 107, 115, 191 exchange rate of the euro 82–103, 190–3 independence 29, 101, 188–90 monetary policy 29–39, 35 President of the ECB see also Trichet 189, 196

206 Index European Commission see Commission, EU Commission and the EU budget 132–8, 144 environmental policy 171–80 and exchange rate policy 89–91, 191 SGP 3, 42, 56–7, 70, 193 European Community for the Environment, Energy and Research (ECEER) 151, 179–80 European constitutional treaty 1, 2, 6, 87, 131, 160, 188 European Council 6, 39, 42, 47 and exchange rate policy 88–93, 190–1 and EU budget 132, 136–40 and euro external representation 194–5, 199–200 and SGP 55–9, 62, 182, 193 European Economic Community (EEC) 114 European Environmental Agency (EEA) 185 European monetary system (EMS) 44–5, 85, 94, 190 European Monetary Union (EMU) 6, 40, 52–3, 55, 57, 60–2, 71, 78, 80–1, 85, 104–5, 113, 121, 194 see also euro area/zone European Parliament 88, 89, 180, 191 and euro exchange rate policy 88–9, 191 and European budget 132–3, 136–8, 144, 151, 153–4, 157–8, 181 eurozone see euro area/zone excessive deficit procedure (EDP) 2, 56–7, 63, 193 see also SGP exchange rate see euro exchange rate

‘pre-federal’/’pseudo-federal’ 142–3, 155 see also EU budget fiscal policies 6, 23, 29, 39–44, 50, 62, 79, 112, 193 see also ‘broad economic policy guidelines’ (BEPGs); economic policies, SGP Fitoussi, J.-P. 1–10, 49–3, 66, 70, 72–4, 76, 78–81, 94, 102, 157, 160–86, 194, 197, 201 Folkerts-Landau, D. 100, 102 Forder, J. 78 Forsé, M. 78, 80 Fleming, J.M. 39, 51 Flemming, J.S. 50 Franco, D. 80–1 Frankel, J. 40, 51 Fratzscher, M. 102

Fagan, G. 38, 51 Farvaque, E. 49–50 Fatas, A. 79–80 Fayolle, J. 38, 50, 138, 157 federalism/federations 5, 30, 108, 133, 140, 154, 181 fiscal federalism 143–4, 155–6, 158 ‘Pigouvian federalism’ 143

Hall, A. 190 Hamada, K. 130 Haralambides, H.E. 194 Harasty, H. 194 Harsanyi, J. 80 Heal, G. 183, 185 Hechter, M. 53–4, 81 Heipertz, M. 63, 81

game of chicken 29, 44 Garber, P. 100, 102 Gaspar, D. 80 Gil-Robles, J.M. 149, 157 globalization/global, 5, 11–20, 22, 47–8, 51–2, 106–30, 131, 191, 196 competition 43 global collective/public goods 160, 164, 166, 169, 184 Godard, O. 183–5 Grafe, C. 80 Granik, A. 78 Griffith, R. 117, 130 Groshen, E.L. 32, 51 Gross National Income (GNI) 115 See also European Budget Gruen, D. 32, 50 Guesnerie, R. 184–5 Guthrie, G. 86, 102

Index 207 Henning, C.R. 102 Henry, C. 183–5 Henry, J. 51 heterogeneity 28, 34–5, 55, 57, 72, 73, 107, 150, 154 Heyer, E. 49, 52 Hicks, J.R. 63, 81 Hines, J.R. 155, 157 Hotelling, H. 160, 172, 185 Huczynski, A. 53, 80 Huh, H. 32, 51 income tax corporate 7, 130, 142, 147–8, 150–2, 156–8 personal 129, 141–2, 145, 149, 153 inequalities 15 in distribution of incomes 25–6, 144–5, 155 inflation 2, 4, 9–10, 21–22, 28, 41, 45, 50–2, 60–4, 112–13, 145, 187 and exchange rate policy 83, 86–7, 94, 97–9, 101 monetary policy and 29–39 institutions 2–3, 5–6, 14, 104–5, 110, 130, 136, 138, 149 and economic performance 21–52 of economic policies 55–6, 79–80 Reform treaty 187–201 instruments 5–7, 14, 39, 44–5, 55, 62, 83, 86, 101, 110–2, 133, 193 for climate/environment policy 162, 172, 174, 180, 185, 187–8 tax instruments for the EU budget see EU budget funding interdependencies 72, 110–1, 130 interest rates 1, 4, 9–10, 112 monetary policy 21, 31, 34, 39, 41–2, 55, 84, 86, 94 spillovers 60–1, 78, 80–1 uneven effects 112 Inter-governmental Conference (IGC) see Presidency of the IGC IPCC (International Panel on Climate Change) 162, 164, 166–7, 170, 173, 175, 178, 183–5 Ito, T. 32, 51

Jackman, R. 190 Jennequin, H. 138–9 Jensen, H. 78–9, 81 Juncker, J.-C. 91, 102, 196 Kaldor, N. 155, 157 Katzenstein, P.J. 107, 118, 130 Klaassen, F. 80 Klemm, A. 117, 130 Krugman, P. 25, 32, 85, 102 Kyoto Protocol 166, 169, 171–5, 183, 185 labour costs 7, 122, 124, 126–7 labour markets 14, 32, 51, 80, 104, 113 and social protection 13–16, 21, 46–8, 50 Lane, T. 79 Landon, S. 78, 81 large countries 6, 17, 25, 39–42, 45–6, 48, 54, 57, 59–60, 62, 73, 87, 100–28, 190 see also size of countries Latreille, T. 49–50 Laubach, T. 78, 81 Laurent, E. 21–52, 46–7, 49–50, 52, 82–103, 104–31, 138–40, 147, 154–5, 157, 160–86, 194, 201 Le Cacheux, J. 21–52, 60, 73, 81, 82–103, 104–59, 160–86, 193, 201 Le Dem, J. 159 Le Quéré, C. 185 Lee, H. 32, 51 Lefebvre, M. 156, 158 Lisbon strategy (agenda) 21, 46, 137, 161, 179 Lisbon treaty see Reform treaty Lomborg, B. 166, 183, 185 Lucas, R.E. 30–1, 51 ‘Luxembourg Compromise’ 138 ‘Maastricht criteria’’ 41, 49, 55, 57, 62 Maastricht treaty 23, 29, 32, 40, 56–7, 90, 151, 196 Maddison, A. 131 Malinvaud, E. 50 Marinescu, I. 130

208 Index Marini, H. 156, 158 Marland, G. 185 McCallum, J. 11, 107, 131 McLure, C. 158 Meadows/Meadows Report 160, 185 Merha, Y.P. 78, 81 Mestre, R. 51 Mihov, I. 79–80 Mill, J.S. 106, 131 Mirrlees, J. 156, 158 Mishkin, F.S. 32, 51 monetary policy see European Central Bank Monperrus-Veroni, P. 59, 80–1 Mrak, M. 156 Mundell, R. 39, 40, 51, 78, 81, 84–5 national contributions 132, 134–6, 138–9, 143, 151–2, 154, 181 national fiscal policies 6, 40–1, 193 constraints on 23, 44, 54, 57, 73, 81, 105 see also SGP national parliaments 135 Newel, R. 173 Nice treaty 188 non-cooperative policies/practices/ strategies 6, 13, 44–5, 49 ‘competitive disinflation’ 6, 45, 50, 155 tax/social competition 6, 47, 83, 99–100, 112, 115–16, 118, 128, 130, 142–4, 146–7, 151, 154–5, 187 Nordhaus, W. 163, 185 Oates, W.E. 158 OECD, 7–8, 24, 27–8, 34, 36, 38, 43, 49, 58, 61, 79, 94–5, 97–8, 100, 108–9, 115–16, 118, 120–1, 123–6, 129–31, 145, 147–8, 157, 164, 170 OFCE, 49–51, 80–1, 102–3, 130, 157–8, 184–5, 201 Ohlin, B. 47, 51 oil, price of 2, 4, 18, 22, 178 Olson, M. 46, 51, 63, 81, 139, 158, 183, 185 Opp, D. 53–4, 81

O’Rourke, K. 49, 51 Orszag, P.R 164, 184 Oudiz, G. 130–1 ‘own resources’’ 132–58 see also EU budget Parodi, M. 78, 80 Passet, O. 37, 51 peer pressure 3, 53–81 see also SGP Perotti, R. 78 Perry, G.L. 50 Pettit, P. 54, 81 Phelps, E. S. 50, 139, 158 Pigou, A. 172, 185 Pigouvian logic 142–3, 145 Pigouvian solutions/taxes 155, 172, 174 Pisani-Ferry, J. 49 Plane, M. 49, 52 potential GDP/growth/income/ output 15, 28, 37–8, 42–3, 50, 59, 72 Prati, M. 79 Presidency of the IGC (Inter-governmental conference) 201 principle of subsidiarity 59 procyclical 59, 62, 64 Prodi Commission 137 Prodi, Romano 42 production costs 47, 112 productivity deficit 25 increase/gain in 25, 27 labour 8–10, 19, 25, 126 shocks 37 public debt 1, 2, 9–10, 35, 39, 55–6, 61, 79 sustainability of 41–4 see also ‘excessive deficit procedure’ (EDP) public finance 34, 41–4, 49, 52, 56–7, 70, 80, 113, 133, 139–40, 147, 157, 159, 193 ‘golden rule’ 43, 47, 57, 59, 80 rules 49, 51–86 see also ‘excessive deficit procedure’, public debt, SGP

Index 209 Ramsey, F. 141, 158 Raupach, M.R. 185 Rawls, J. 78, 158 recession/slowdown 2, 4, 6, 14, 21–2, 42, 73, 84, 96, 114, 117, 137, 187 see also crises recovery 2, 6, 22, 44, 99–100, 125, 187 Reform treaty see also Lisbon treaty 187–98 Rifflart, C. 51 Robinson, E.A.G. 106, 131 Rodrik, D. 48, 52 Rogoff, K. 101, 103 Romer, D. 31, 52 Rose, A. 40, 51 Sachs, J. 130–1 Saint-Etienne, C. 154, 156, 158 Salmon, P. 49, 52, 158 Samuelson, P.A. 139, 158 Santer Commission 137 Santoni, M. 80 Sapir, A. 104, 131, 137, 158 Sapir Report 137, 158 Saraceno, F. 54–80, 59–60, 73, 80–1 Sawyer, M. 34, 50 Schiavo, S. 32, 52 Schremmer, D.E. 194 Schuknecht, L. 80 Schuman, R. 180 Schweitzer, E. 32, 51 Second World War 2 Sen, A. 131, 185 SGES (Study Group for European Studies) 133, 144, 158 Sinn, H.W. 121, 127, 131 size of countries see country size ‘small’ countries 73, 104, 108–9, 111–2, 128, 130 see also country size Smith, C.E. 78, 81 social norms 38, 53–5, 62–3, 78, 80–1 SGP as a social norm 53–81 see also peer pressure social policies/protection 13–16, 21, 46–8, 50, 52, 83, 110, 113

solidarity 16–17, 151 Solow, R. 50, 59, 78–9, 172, 185 Sorel, M. 32, 52 Sorensen, B. 147, 156–7 Sorensen, J. 78–9 Sorensen, P.B. 147, 156–7 Spaak, P.-H. 104 Spolaore, E. 107–8, 130 Stability and Growth Pact (SGP) 2, 6, 23, 41–2, 53–82, 153, 193 as a social norm 53–82 see also fiscal policies, public finance Stark, J. 63, 81 Sterdyniak, H. 37, 49–51, 144, 147, 158–9 Stiglitz, J.E. 115, 131, 163–4, 185 Stiglitz-Sen-Fitoussi Commission 115, 131, 163, 185 structural policies 21, 59, 64, 73, 83, 86, 106, 108, 112, 143 structural funds see EU budget subsidies 144, 172, 180 summit conferences 2, 135, 137, 153, 157, 197 sustainable development/growth 6, 11, 161, 167, 182, 189 ‘sustainable utopia’ 11, 12, 16–17, 20, 29 Svensson, L.E.O. 32, 52 Austro-Hungarian customs union 97 employment subsidies 14, 62–3 monetary see European monetary system (EMS); monetary policy national contributions 110, 113 pension/retirement 132–3 qualified majority voting 13 social protection see social protection variable levy trade protection 90 Szapáry, G. 153, 154, 197–8 Székely, I. 147, 197 Tabellini, G. 49–50, 79 Tanzi, V., 48, 52 tax/social competition 47–48, 52, 83, 99–100, 112, 115, 117–18, 128, 130, 142–3, 146, 147, 151, 154–5, 187

210

Index

Temple, J. 49, 52 Timbeau, X. 49, 52 Tirelli, P. 78, 80 Tol, R.S.J. 163, 186 Touya, F. 142, 159 Touzé, V. 97, 103 trade surplus 21 Treaty of Rome 136, 138, 179 Trichet, J.-C. 82, 91, 102, 189, 196 Tullock, G. 139–40, 156 Turkey 28, 109, 116 unanimity 46, 136–9 EU budget rule of 136–9 Van Klink, A. 194 Vaona, 32, 52 Veenstra, A.W. 194 Verbeke, A. 194

Verdun, A. 63, 81 Vilasuso, J. 78, 80 Villa, P. 49–50 Vines, D. 79 Von Hagen, J. 80 Wagner’s law 19, 152 Warcziarg, R. 107, 130 weighting of Council vote 79, 162–3 Weitzman, M. 163, 186 Wicksell, K. 138–9, 159 Williams, G. 78, 80 Williamson, J.G. 47, 49, 51–2 Winkelmans, W. 194 Winkler, B. 61, 79–80 Wolf, M. 23, 52 Wright, J. 86, 102 Wyplosz, C. 32, 33, 49–50, 52, 61, 80