OeNB Seminar

Check against delivery.

Just how difficult EU enlargement can be for others to understand was brought home in remarks attributed to the Israeli Foreign Minister, Silvan Sharom, in his recent talks with George Papandreou, Greek Foreign Minister and current holder of the EU’s rotating presidency. According to the FT, Sharom asked: ’Now tell me, how many EU countries are there? 30?’ Papandreou was not quite sure how to respond without embarrassing his host. Then came the real clincher: Shalom said that these must be difficult times for the EU now that Turkey was a member. This reminds me of one occasion when a first-year student asked me whether Britain was a member of the EU. After initial shock I felt forgiving: after all, if on a daily basis one listened to and read British political and media debates, this might seem a reasonable question to ask. 

Before addressing the more serious – and much more difficult -questions that have been put to this Session, I would like to make some preliminary remarks. First, economic governance has to deal with two challenges of enlargement, not one. The first is to complete the enlargement of the Euro-Zone to the existing 12 member states through the entry of Britain, Denmark and Sweden; the second is the challenge of the entry of the 10 new member states after 2004. Both are bound up with new pressures to change how the Euro-Zone is governed, and it is by no means certain what will be the temporal ordering of enlargement: in short, whether, for instance, Hungary will join before Britain. Secondly, even without either of these enlargements – and without a European Convention – there would be powerful pressures to change economic governance. These pressures come from changes in the policy problems that are presented to us by the international economy. Irrespective of enlargements, we may be at a watershed in the international political economy that will require a new willingness to redesign European economic governance. And, even if we are not now at a watershed between an era of inflation and one of deflation, we should be learning how European economic governance needs to be adapted to deal with future risks of deflation as well as inflation. In the words of the British economist Wynne Godley, ’one-club golf is for losers.’ Thirdly, central bankers are expected to be conservative and cautious. This means that they are not natural policy entrepreneurs, pursuing agenda change. Hence I do not expect that what I say will meet with universal approval. Finally, the European Convention is to be judged by the boldness with which it tackles the central problem confronting the EU: its weak connection to the voters. Because of the specific attributes of monetary policy (like securing credibility with financial markets) EMU is not the most central element in any process of democratic renewal. But, as I shall argue, greater transparency within EMU, and not least in monetary policy, is critical to the wider process of reconnection to voters and the legitimacy of the EU. 

My starting point is that European economic governance has a basic design fault. This fault derives from the historical circumstances in which it was founded, combined with a preference – driven principally by German ordo-liberal thinking and the desire to placate German public opinion – for detailed Treaty regulation of the monetary pillar and for a rules-based fiscal policy co-ordination for the purposes of safeguarding the credibility of the new ECB, promoting sustained budgetary consolidation, and managing externalities. Quite rightly, European policy makers saw in the threat of inflation the greatest policy risk facing EMU and responsibly sought to protect against this risk. Without it the new euro – lacking the benefit of a track-record – would have lacked credibility both with markets and with citizens. The result is an asymmetrical EMU that is well designed for the purpose of preventing inflation via a powerful independent ECB with a clear mandate, flanked by a set of fiscal rules to reinforce a disinflationary policy stance. The ECB’s pursuit of its policy mandate has locked in a set of powerful gains for the European economy as a whole. But, as I shall argue, it by no means clear that its policies contribute to an efficient European policy co-ordination and to a sense of ownership of European economic governance by member states. This sense of ownership matters because – without it – national governments are less likely to honour their commitments, notably to supply-side reforms. To pursue this argument we need, first, to unpack what we mean by ’efficient’ co-ordination and then to go on to ask whether efficient co-ordination is itself enough to secure a deepening of the European integration process. 

’Efficient co-ordination’ begs the question – ’efficient for what?’ Despite the well-known problems that have arisen with the Stability and Growth Pact (which I shall not go into here), co-ordination has proved reasonably efficient in containing inflation and securing important credibility gains. As I have stressed, this achievement in anchoring expectations of low inflation should not be underestimated. But is co-ordination efficient in delivering what Europe’s citizens repeatedly tell us in opinion polls that they most want – job creation and economic growth? The answer is no; we have not created parallel expectations of high growth and employment. This answer must fill us all with very great worry about the prospects for deepening the integration project. Failure in this respect provides ammunition to those who advocate a politics of national populism that breads hatred and intolerance and that Europe cannot afford to see again. In addition, it does nothing to increase the sense of ownership of European economic governance by member states and hence the prospects that they will be bold about structural reforms. I am not disposed to take up a position in favour of one side or the other in the dispute about whether the problem of inadequate growth and job creation is excessive supply-side rigidities or deficient aggregate demand in the European economy. The problem seems to me to be falsely stated. It is how to co-ordinate micro- and macro-economic policies so that – in a reciprocal manner – a stimulus to aggregate demand acts to unblock and ease supply-side reforms and a willingness to tackle supply-side problems creates the confidence to stimulate demand. My position is based on the straightforward political point that painful and costly supply-side reforms are easier to implement in expansive economic policy conditions. A ’win-win’ outcome in policy co-ordination is always easier to implement than a ’win-lose’ outcome that is all too implicit in present policy positions like ’first structural reforms, and then monetary and fiscal easing’. This policy prescription contains of course its own ’free-rider’ problem that it is the task of economic policy co-ordination to tackle, namely that there is an incentive for some governments to renege on their commitments to supply-side reform. It is not beyond the wit of European policy makers to address this issue (as they did over the Stability and Growth Pact), especially when the stakes and gains are so very high. Equally, it seems to me that if the purpose of policy co-ordination is to combine expansion of aggregate demand with accelerated supply-side reforms, problems have to be tackled on two interdependent levels. Both the ECB and national governments need to share in a leadership role in agenda setting. The ECB has to boldly set a clear symmetrical inflation target that identifies the twin policy risks of inflation and deflation. National governments – indispensably led by Germany – have to boldly present structural reforms to take advantage of this transformed macro-economic context. Appropriate signaling needs to come from both sides in a co-ordinated fashion. The message of ’trust’ must be made infectious. Anyone in or close to the ECB or to national governments – like the German – knows what a tall order that will be. But ultimately European economic governance will not connect to the concerns of its citizens – and improve ownership by member states – without bold policy leadership and the will to build trust and spread it like a virus. This kind of strategic leadership to transform the policy agenda – not least by reframing the problem – is prior to, and far more important than reflecting on the details of, institutional frameworks of co-ordination. A system of economic governance that rediscovered that economic policy must encompass many different objectives, not just the control of inflation, would make enlargement to include Britain, Denmark and Sweden and later the 10 new applicant states very much easier. For the former three states this kind of policy regime is more consistent with their own domestic regimes and policy preoccupations; for the latter it promises enhanced opportunities of being able to combine nominal and real convergence by the flexible use of all the dimensions of fiscal and monetary policy. 

’Efficient co-ordination’ also begs the question – ’efficient for whom?’ Is policy co-ordination efficient for the existing 12 Euro-Zone members? This question is being addressed by the European Convention. There are proposals for a more permanent chair of the Euro Group (Mr Euro), to represent its common interests externally as well as internally, as well as for more powers for the Euro Group to take decisions on its own. As the EU grows in size, there are arguments for hardening the core in economic policy, especially in budgetary policy. It has the additional advantage of strengthening the domestic political argument in ’out-states’ that there is a real political advantage in influence and power over policy that comes from euro membership and a major lack of influence from being on the outside. Is policy co-ordination likely to be efficient for a Euro-Zone that includes Britain, Denmark and Sweden? The debate about Euro-Zone membership within these three states suggests answers varying from no to a very qualified yes. Though the reasons for doubt and rejection are by no means always the same, Keynesian concerns about aggregate demand management represent a common theme. They lead, most notably in Britain and Sweden, to a preference for more flexible fiscal policy rules that treat public investment as different from other state spending and for a symmetric inflation target. Is policy co-ordination likely to be efficient for a Euro-Zone that includes the 10 new member states? Again there are reasons to think that the answers vary from a no to a very qualified yes. The yes comes from the incentives for nominal convergence and the better prospects for sustainable economic growth if the long-term disciplines of the Maastricht entry criteria and of the Stability and Growth Pact are respected. The hesitations follow from doubts about whether European economic governance will be compatible with ensuring the speedy real convergence that is necessary to persuade our new fellow citizens that membership is in their interests. An efficient policy co-ordination from their perspective is one that secures sustained growth in their main markets by a combination of supply-side reforms with reflation, whose fiscal rules better reconcile long-run discipline with short-term flexibility and treat public investment differently, and that builds a recognition of the Belassa-Samuelson effect into its policy formulas. A system of European economic governance of this type would, above all, encourage a domestic political context in which supply-side reforms are easier to implement. From the perspective of existing members – worried about enlargement – one test of an efficient policy co-ordination might be whether it avoids mounting political pressures from new member states to externalize their costs of adjustment by new fiscal transfer mechanisms. In short, there might be a common interest in redesigning European economic governance to meet the interests of new economies. What underpins this ideationally is a change in our conception of the European economy at the point at which the majority of its member states are ’transition’ economies. There is a need for reflection on what this means for European economic governance. 

The questions ’efficient for what, and efficient for whom?’ are import ant but do not go to the heart of the question of how to deepen the European integration process. Engaging the hearts and minds of Europe’s citizens is about more than just improved policy outcomes in job creation and growth. It is about cultivating the trust and confidence that comes from transparent and accountable processes of decision making. Only in this way can the ownership of European economic governance by member states and citizens be secured over the longer term. This issue came to a head in the early public debate between Otmar Issing and Wilhelm Buiter about the appropriate institutional arrangements to ensure that European economic governance contributed to the wider legitimacy of the EU. At the cost of some simplification, the argument is between a technocratic and a democratic conception of EMU. In the technocratic (and ordo-liberal) view what matters is policy outcomes, and good outcomes – in fighting inflation – are to be secured by a depoliticization of monetary policy and tough, clear and enforceable rules for fiscal policies. Legitimacy is about fulfilling the terms of the Treaty, and the Treaty is about economic stability. In the democratic view – represented strongly by the British and Swedish – what matters is process, which must engender trust and confidence through transparency and accountability. The institutional arrangements of the Bank of England have been seen as a model of transparent and accountable process. The context of this argument is changing with enlargement. In part, this has to do with reforms of the ECB that the British and Swedes would like to see before they enter. It is also bound up with the implications of the principle of rotation in the ECB’s reformed decision rules, and perhaps at a later stage the principle of delegation, in order to make decision making more efficient in an enlarged Euro-Zone. With rotation of voting in the Governing Council, transparency and accountability become more serious issues. Why should citizens trust that those national central bank governors that are currently voting members of the Governing Council are representing Euro-Zone-wide and not their own national interests? How can they be reassured that they are not disadvantaged when their national central bank governor – perhaps for many years – is not a voting member? These questions will be increasingly serious, and will need a new approach by the ECB. 

What I hope has been clear from my presentation is that I do not believe, and am not arguing, that European economic governance should regard inflation as dead and abandon an obsession with it. My argument is that its design must pay attention to policy instruments for avoiding deflation as well as inflation, notably ’post-asset-price-bubble’ contractions. In such phases provision is needed for much closer co-ordination between national governments and the ECB (which may prove more difficult to organize than within a national economy). This includes such measures as slashing interest rates, Keynesian fiscal loosening, manipulating the yield curve, providing general debt bail-outs, and creating inflationary expectations. Indeed, a potential high price of early complacency about ’post-bubble’ contractions is a later inflationary ’blow-out’ from excessively delayed and dramatic policy responses. I do not make this point simply because I believe that we may now be tipping into deflation (though this fear helps to establish my point). In fact, I made it in my book The Politics of the Euro-Zone (OUP) in 2000. My firm belief is that we need to be armed for more than one battle; when a particular battle needs to be joined is a matter for delicate professional judgement about the stage of the business cycle that we are in. To vary the metaphor, ’one-club golf is for losers’.