Giancarlo Corsetti

Gilles Saint-Paul

Hans-Werner Sinn

John Flemming

Seppo Honkapohja

Willi Leibfritz

Xavier Vives

English

Research Papers in Economics

The European Economic Advisory Group at
CESifo was born out of the need to look at policy
issues from a European rather than a national per-
spective. Europe is growing, and growing together,
integration is accelerating, Eastern expansion is
imminent. The establishment of a European cen-
tral bank and the introduction of a common cur-
rency have joined the Continental countries with
one monetary policy and the common need to
establish the internal and external stability of the
euro.At the same time,national fiscal policies must
operate within the boundaries of the Stability Pact.
Many problems in Europe are shared problems
like unemployment and overburdened social sys-
tems, others are more idiosyncratic. Solutions are
needed in all cases,and they may emerge from the-
oretical analyses, practical experiments and inter-
national institutional comparisons. The European
Economic Advisory Group discusses the options
and reports on the experience in the member coun-
tries and elsewhere. The Group also comments on
economic activity in the European countries.
The European Economic Advisory Group was set
up in 2001 by CESifo, a joint initiative of the Ifo
Institute for Economic Research and the Center
for Economic Studies (CES) of the University of
Munich. CESifo’s international network of 350
academic economists provides a valuable source of
information behind the report, Ifo’s macroeco-
nomic department makes the basic forecasts, Ifo’s
Data Base for Institutional Comparisons in
Europe (DICE) serves as a useful tool for policy
evaluation, and Ifo’s quarterly World Economic
Climate (WEC) indicators, based on polls in 80
countries, ensure an up-to-date overview of the
state of the business cycle in different parts of the
world.
This is the Group’s first report. It was prepared by
a team of seven economists from six European
countries, chaired by John Flemming, Warden of
Waldam College, Oxford and former Executive
Director of the Bank of England. The group also
includes Giancarlo Corsetti (University of Rome
III), Seppo Honkapohja (University of Helsinki),
Willi Leibfritz (OECD), Gilles Saint-Paul (Uni-
versity of Toulouse), Xavier Vives (INSEAD) and
Hans-Werner Sinn (Ifo Institute for Economic
Research). The group plans to deliver similar
reports on an annual basis, assuming as a group
responsibility for the content.
I wish to thank the members of the group for in-
vesting their time in a challenging project and I also
gratefully acknowledge valuable assistance provid-
ed by Wolfgang Ochel, Frank Westermann, Wolf-
gang Nierhaus, and Wolfgang Meister (content),
Heidemarie C. Sherman and Paul Kremmel (edit-
ing), Sascha O. Becker (secretariat) as well as Elsita
Walter (statistics and graphics) and Elisabeth Will
(typesetting and layout).
Hans-Werner Sinn
President, Ifo Institute and CESifo
Professor of Economics and Public Finance
Munich, 5 February 2002
CESifo Forum Special 2
IntroductionCESifo Forum Special 3
Summary
EXECUTIVE SUMMARY
This is the first annual report by the European
Economic Advisory group at CESifo that brings
together economists from different European
countries with the goal of contributing analyses
and proposals to the process of policy making and
reform. Each year, the report presents a selection
of emerging policy issues.
This report is in seven sections,each focused on a key
policy issue in the euro area. After assessing the
growth prospects for the current year,the 2002 report
discusses the external value of the euro, the appro-
priate fiscal and monetary policy mix,price and infla-
tion divergences across member states, factors
enhancing or hampering European growth in the
long run, an employment-friendly reform of welfare,
and a reform of the Common Agricultural Policy.
The first section is an assessment of the economic
situation of Europe, with some concentration on
those countries which have adopted the euro in
2001 and 2002 drawing on a wide variety of sources
including Ifo survey data.
At 1.6% in 2001 and 1.3% in 2002, these GDP
growth rates are both, lower than earlier forecasts
as a result of information since September 11, 2001
and lower than most forecasts by national govern-
ments (which may be biased upwards to present
projections of imminent fiscal stabilisation) and
one percentage point lower than the growth of
potential output. Prospective European growth
exceeds that of the United States in 2001 and, like
in the United States, recovery starts in the course
of 2002. Unlike the United States, Europe as a
whole is not expected to experience any decline in
quarterly GDP, although some member countries
are already in recession.
Slow growth is reflected in unemployment rising
by 0.25 percentage points between 2001 and 2002
(from a low point in 2001), while inflation falls by
0.75 percentage points in the Euro area.
The second section addresses the weakness of the
euro against the US dollar and the yen since its
launch in 1999. The report stresses the effects on
the euro of a dramatic decline in the demand for
base money which probably reflected a flight of
black money from within the euro countries as well
as of deutschmarks returning from Eastern Europe
and other parts of the world.As the ECB absorbed
the fall in the demand for base money at given
interest rates by changing the composition of its
broad money aggregate M3, without changing its
size, the effect on the exchange rate was very simi-
lar to a sterilised intervention of the same size.
Measured against the trend, the decline in the
demand for base money was in the order of q90
billion over the last few years until October 2001,
enough to fully explain the euro weakness in quan-
titative terms.
Apart from these changes in the demand for cur-
rency, macroeconomic factors have also con-
tributed to the weakness of the euro, which may be
seen as a reflection of dollar strength in the late
1990s. Dollar appreciation was initially driven by
high consumption and investment demand due to
expectations of a strong US advantage in growth
and productivity. After doubts about the persis-
tence of this advantage towards the end of 2000,
the euro stopped depreciating, but remained weak,
perhaps reflecting market pessimism about
Europe’s ability to sustain its own growth indepen-
dently of the United States. It was precisely in this
period that the movements in currency demand
mentioned above may have become stronger.
Chapter 3 considers the monetary and fiscal poli-
cies appropriate to Europe under the circum-
stances of an adverse international cycle and a
weak euro. Typically, governments have medium-
term plans for fiscal consolidation, “stabilisation
plans”, calling for a falling trend in budget deficits.
The European Commission has called for this
trend to be sustained and argued that the ECB
should provide the necessary value-stimulus by
cutting interest rates further. On the other hand
Euro area interest rates are already lower thanwould be expected on the basis of the evolution of
prices and output, and an indicator based on inter-
est and exchange rates also indicates considerable
easing of monetary conditions throughout 2001.
There is thus a danger that neither party will be
willing to act.
The growth and stability pact underlying national
fiscal stabilisation plans has a number of presenta-
tional weaknesses. In particular, although paths for
deficit reduction are typically presented alongside
GDP projections, they are not explicitly condition-
al on them. If GDP turns out lower than expected,
deficits will be higher than planned which may
induce the fiscal authorities to take steps that have
the effect of aggravating the downturn.There may
also be a tendency for them to have published
unrealistic GDP projections in order to show
falling budget deficits despite their failure to take
real steps towards consolidation.
We would like to see stabilisation plans made more
explicitly conditional and the projections made
more realistic. Against this background one would
be able, with much greater confidence, to allow the
built-in stabilisers to operate and also to take par-
allel self-reversing measures (such as accelerating
previously planned tax cuts).
While we cannot wait for such reforms to take
place, and the recession should not be used as an
excuse to postpone necessary reforms of the state
sector, it would be appropriate for deficits to rise
throughout Europe during the current cyclical
downturn except where stabilisation efforts have
been weakest, and debt income ratios are also
highest,and even there they should not decline.We
also believe that (especially as compared to the US
Fed) the ECB has room to cut interest rates fur-
ther – a measure which should be adopted sooner
rather than later.
It may also be appropriate to consider/propose a
contingency plan for a more radical and co-ordi-
nated policy throughout Europe.This might either
be modelled on the discretionary fiscal regulations
in the German Stability and Growth Act of 1967
(and a UK law of that era) and/or be designed to
provide structurally improved incentives, e.g. for
investment or for larger families.
Chapter 4 addresses questions about the effect of
the introduction of the euro on price differentials
across the Union and also on the cost of capital in
its member countries which may account for capi-
tal flows from the slow growing centre to the more
buoyant peripheral states.
Although price differentials have narrowed, and
should be expected to remain narrow as productiv-
ity and labour costs converge throughout the Euro
area, they should not be expected to disappear
completely.According to some evidence, ten years
ago price dispersion in Europe was about three
times that in the United States – it had already
been halved at the end of the 1990s.
Nominal interest rates on government securities
have converged virtually completely with the
announcement and introduction of the euro indi-
cating that risk premia resulting from uncertain
exchange rates and other causes have disappeared.
As these premia are generally believed to have
been higher in the peripheral states, these should
now be benefiting from a reallocation of capital in
their favour. As a result, labour productivity and
prices of goods that are not traded internationally
can be expected to rise faster than would have
been the case without the euro.A sizeable inflation
differential among the Euro countries is a natural
aspect of the real convergence process that has
been brought about by European integration in
general and by the euro in particular.
Differences in cyclical development within the
Euro area in the last few years have raised an issue
in the desirability of national inflation differentials
as a mechanism reducing the risk of overheating in
the countries or regions with the fastest growth
rates. By raising the relative price of domestic
products,in fact,national inflation differentials dis-
courage external demand.
The problem with this idea is that only a few cycli-
cal shocks require a permanent appreciation of the
real exchange rate. So, while high inflation at time
of booms in domestic demand may be a useful way
to contain domestic imbalances, prices and wages
then need to come down after the boom is over.
Downward nominal rigidities preventing a fast
adjustment can create quite a bit of unemploy-
ment.
Provided that they are not excessive, inflation dif-
ferentials need not be reversed in the presence of
persistent differences in productivity growth in the
CESifo Forum Special 4
SummaryCESifo Forum Special 5
Summary
tradable sector of the economy, or in the presence
of international taste shocks (an upsurge of
demand for Italian pasta or French wine …). Even
in these cases, however, overshooting of equilibri-
um inflation is a real risk. Inflation differentials
need to be reversed in other cases, including
domestic demand booms due, for instance, to
export dynamics fuelled by a weak euro.The adop-
tion of policies promoting wage and price flexibili-
ty is a key step in the future of the Euro area.
Chapter 5 compares growth in Europe and the
United States in recent decades. Although Europe
was, as one would expect, catching up in the 1950s
and 1960s,this virtually ceased in the 1970s,and the
United States has pulled further ahead in the 1980s
and 1990s – and at a particularly remarkable rate
in the second half of the last decade. The chapter
examines the effects of general factor endowments
and their accumulation with special emphasis on
the role of information technology. Here the
Scandinavian countries share a number of charac-
teristics with the United States rather than the core
European countries. The analysis highlights the
effects of both industrial and labour market regu-
lations in Europe as well as shortcomings in educa-
tion and access to the Internet in much of the
Continent. This last effect is attributed to inade-
quate openness of the sector to effective compe-
tition.
Chapter 6 argues that traditional social pro-
grammes of the modern welfare state have concen-
trated on replacing the earnings which are not
enjoyed by those without jobs.This offers an incen-
tive to those capable of earning only very low
wages to qualify for (higher) benefits by declining
jobs which, as a result, are also not offered. An
alternative is developed, already implemented in
varying degrees in a number of countries, in which
tax credits are used to supplement the wages avail-
able to low productivity workers – whose benefits
when not in work may also be reduced after a peri-
od of joblessness. Traditional social insurance
schemes used also to offer higher benefits for lim-
ited periods and this feature, too, should be re-
emphasised.
A fairly detailed proposal is put forward on a basis
which should allow the living standards of both the
working and most of the non-working poor to rise
at no net cost to governments while raising
employment output and growth. In essence, it
implies requiring government work in exchange
for existing welfare benefits, cutting welfare bene-
fits for those who do not work although they are
classified as being able to, and paying a wage sub-
sidy to those who take low-paid jobs in the private
sector.
Finally, Chapter 7 re-examines the case for reform-
ing the Common Agricultural Policy. The health
and environmental aspects of modern agriculture
have been highlighted by British experience with
BSE and FMD. Historically, agricultural support
has been rationalised by reference to security of
supply, income maintenance, or, increasingly, envi-
ronmental concerns. It is argued that production
price supports, the scale of which is set out, act as
incentives to intensification which is environmen-
tally damaging and poses threats to animal welfare
and human health. Hormone beef and GMOs are
no more threatening to the health of Europeans
than of Americans and therefore should not be an
issue in transatlantic trade although regulation of
their use in production may be in order.Trade with
developing countries is also affected by the CAP to
their disadvantage on average – a problem that
might be aggravated by EU enlargement to include
countries such as Poland and Hungary with large
agricultural sectors.
The EU allows member states to enforce standards
of animal welfare in excess of Union-wide minima.
It is argued that doing this merely diverts produc-
tion to less demanding regimes.It would be better to
define different standards and to acquire appropri-
ate labelling (as also of hormone use, GMOs etc).
Farm support should be switched much faster from
price support (with the environmentally damaging
side effects) to explicitly environmentally friendly
programmes (possibly rationally administered
within an EU framework) compatible with a more
liberal trading regime.

Introduction; Executive Summary

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Introduction; Executive Summary

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