The assessment: macroeconomic policy after EMU

1© 1998 OXFORD UNIVERSITY PRESS AND THE OXFORD REVIEW OF ECONOMIC POLICY LIMITED

THE ASSESSMENT:MACROECONOMIC POLICY AFTER EMU

OXFORD REVIEW OF ECONOMIC POLICY, VOL. 14, NO. 3

CHRISTOPHER ALLSOPPNew College, OxfordDAVID VINESBalliol College, Oxford

In this paper we discuss the emergence of the new European macroeconomic structure within EMU. Wefocus on three important elements: the wage-fixing authorities in each country, the fiscal authorities ineach country, and the single European Central Bank (ECB). We identify serious problems which mightarise in coordinating both the wage-setters and the fiscal authorities, and argue that these problems couldbe exacerbated if the ECB conducts monetary policy inappropriately. In the light of this we provide recom-mendations for the conduct of monetary policy by the ECB. The paper also briefly discusses financialstability issues and the interaction between the countries in EMU and the rest of the world.

I. INTRODUCTION

With 11 countries joining the European Economicand Monetary Union (EMU) at the beginning ofJanuary 1999, macroeconomic policy within Eu-rope—both for the 11 countries which are joiningand for the UK, Sweden, Denmark, and Greece,which will remain outside—will be transformed.The articles in this issue of the Oxford Review ofEconomic Policy all relate to the general theme ofhow the new Europe will function and the chal-lenges that are likely to be faced.

A vast amount has been written on the subject ofEMU, most of which has been in the context of thedebate about whether EMU is desirable or not—

that is, about whether the European Union (EU) orsome part of it is an optimal, or, more realistically, afeasible currency area. National debates, too, havefocused on the pros and cons of entry as a kind ofcost–benefit calculation. For the 11 joining coun-tries, while a good deal of the analysis remainsrelevant, the context has changed dramatically. Thequestion now is how to make the system work. Evenfor the ‘outs’, the context is transformed by thereality of EMU. The trade-offs are different, and,rightly or wrongly, the question of entry is increas-ingly seen as when, rather than whether.

This Assessment examines some of the main eco-nomic issues that seem likely to arise in the newEuropean economy, drawing, where appropriate, on

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the articles in this issue of the Review. The approachis selective. (For an overview of many of the mainissues see, especially, the Tour d’Horizon by BarryEichengreen below). The discussion is organizedinto four sections. Section II, which is the main focusof this Assessment, is concerned with the system asa whole. What will it look like? How will it function?What problems might arise and how should they beaddressed? We argue that the central challenge is toensure an appropriate monetary-policy reaction func-tion for the new European Central Bank (ECB).Without this, other parts of the new Europeansystem are in serious danger of falling apart. SectionIII discusses two other issues, monetary stabilityand the relationship between EMU and the rest ofthe world. Section IV presents some conclusions.

II. THE SYSTEM AS A WHOLE

Compared with the amount of discussion of theimplications for individual countries or regions ofgiving up sovereignty over interest-rate and ex-change-rate policy and the equally large literature inthe optimum currency area tradition, there is re-markably little about what Europe, or what the EU-11 countries will look like as an economic entity. Yetthe most important issue of all is whether, macro-economically, the new Europe will function well orbadly. Strains and difficulties between countries arelikely to appear solvable if the context is a healthygrowing Europe, but dangerous if the group as awhole performs badly.

A lot rides on success. In political terms, the EMUwhich has been agreed is a fair-weather systemwhich contains rather little risk-proofing. It is com-mon to hear the view casually expressed that Eu-rope must succeed, since it would be so disastrousif it did not. But this view has actually underpinnedsome of the serious political decisions which havebeen taken. Thus, the Pact for Stability and Growthagreed at the Amsterdam summit in the summer of1997 only makes sense within a context of recoveryand growth (see below and the article by MarcoButi, Daniele Franco, and Hedwig Ongena). Simi-larly, the conventional wisdom is that labour-marketreform is a necessary condition for success (e.g.

IMF (1997) and Michael Artis’s article in this issue)and that it will happen independently of whetherEuropean demand for labour grows rapidly—simplybecause it is necessary. And the new Europeanlender-of-last-resort cum financial-stability-manage-ment structure is not yet in place—even though thismight be needed if Europe experiences recession orsome kind of financial crisis. The creation of EMUhas raised the stakes for macroeconomic policy-makers.

It is true that a good deal of the architecture formacroeconomic policy is now in place. The institu-tional structure of the ECB is clear. The 11 joiningcountries met the Maastricht convergence criteria,and the ‘Stability Pact’ is in place to ensure continu-ing fiscal virtue. But there is much that remains to bedetermined. Above all, we argue that there areserious, yet-to-be-resolved issues about how mon-etary, fiscal, and supply-side policies will be coordi-nated across ‘Euroland’. The system has not beentested, and certainly not in adversity. How the policyframework would work and adapt in response to amajor shock or other difficulties seems hardly tohave been discussed in the context where the mainpolitical problem was to ‘get the show on the road’.

(i) Background

The political vision behind the creation of EMU isthat the elimination of currency risk could underpinthe drive towards the creation of a genuinely inte-grated single European market: in effect, a new‘United States of Europe’.

In one important way this new Europe will be verylike the United States of America. Whether onetakes the Euro-11 or the whole of the EuropeanUnion, the EU-15, Europe, treated as an entity, is alarge, relatively closed economy—comparable withthe USA. The EU’s share of world GDP in 1996, at20.4 per cent, was almost the same as that of theUSA (20.7 per cent). Similarly, for exports, exclud-ing intra-trade, the EU’s share of world exports was14.7 per cent compared with the US share of 15.2per cent. And external trade as a proportion of GDPwas about 8 per cent for both the EU and the USA.1

A clear implication is that overall macroeconomic

1 For comparison, Japan’s share of world output was 8 per cent; the figure for exports as a share of GDP is similar to that ofthe USA and Europe at about 7½ per cent.

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C. J. Allsopp and D. Vines

policy, and especially monetary policy, is likely to bemuch more oriented towards the domestic economyand less towards the exchange rate and the externalsector than has been the case in individual Europeancountries. In this respect, the USA analogy is likelyto be instructive.

But the analogy with the USA should not be over-drawn. There are also important differences.

First, as discussed in several of the articles in thisReview, European labour markets are relativelyinflexible. Mobility within and between countries islow and wages and prices appear relatively rigid. Inthe traditional literature, wage flexibility is a substi-tute for exchange-rate changes in aiding ‘regional’adjustment, and inflexibility is a definite negative—weighing against the adoption of a common currency.2

Second, the fiscal system in Europe bears littleresemblance to that of the USA, where federalstabilizers are important. Although tax shares areconsiderably larger in Europe, the central, EU,budget and inter-country transfers are, in compara-tive terms, of negligible importance. Fiscal policy isdecentralized, which will raise important questionsof coordination in the new Europe. (It is worthnoting, however, that, in principle, fiscal policy couldbe much more flexibly used in Europe than in theUSA, where tax and expenditure changes are noto-riously difficult.)

A third significant difference, much less frequentlydiscussed, is that the macroeconomic structure offinancial flows is very different from that of theUSA. Europe is a high-saving area: here the analogywould be with Japan, not the USA. Related to this,Europe was in approximate external balance (asmeasured by the current account of the balance of

payments) in the 1980s, contrasting with the typicaldeficit position of the USA and the apparentlystructural surplus of Japan. In the 1990s, Europewas buoyed up by exports and a rising trade andcurrent account surplus—which, by 1997 was, at$126 billion, considerably greater than that of Japan($94.5 billion) (OECD, 1998).

Partly because of these historically determinedfeatures, the macroeconomic situation that has de-veloped in the run-up to EMU was very differentfrom that in the USA. Europe in the late 1980s and1990s has appeared to face two crises—one ofunemployment and the other of an exploding trendof public debt. In 1998, unemployment on averagefor the EU was nearly 11 per cent, worse, in termsof the overall figure if not in terms of social effects,than in the inter-war depression. And governmentdebt, which, at the beginning of the 1980s, was about40 per cent of GDP, rose more or less inexorablythrough the 1980s (apart from a pause in the trendrise during the boom years of the late 1980s), androse further in the 1990s—from about 60 per cent ofGDP in 1990 to 78 per cent in 1996. (There wasa slight fall of 1 percentage point to the referenceyear of 1997.) These twin crises are related: bothcan be seen as a consequence of slow growth. In aslow-growing environment, both tax revenues andemployment are stagnant.3 Slow growth meansalso that private investment tends to fall relative toprivate savings, making it hard to balance theeconomy without larger budget deficits.4

The quest for solutions to these twin Europeanproblems of debt-and-deficits and unemploymentbecame, in the 1990s, entangled with the birth ofEMU. The problems would, of course, have re-quired policy action with or without the creation ofEMU. But what actually happened was that ‘fiscal

2 The paradigm case where nominal exchange-rate changes help regional adjustment is in the Keynesian world of inflexible nominalwages and prices and flexible real wages. However, with inflexible real wages, devaluation would just lead to inflation. Thus, realwage inflexibility is not a reason for not giving up the devaluation option—see Eichengreen, in this issue.

3 And the converse is true. In the USA the rapid growth which has occurred in the past five years has (i) enabled unemploymentto be safely brought far below any previous estimates of its natural rate, and (ii) removed the budget deficit faster than generallythought possible.

4 With a constant capital to output ratio, v, the investment to output ratio is related to growth by the usual formula I/GDP =vg, where g is the growth rate. With the capital–output ratio at (say) 3, a reduction in growth of 1 per cent point per annum implies,in the long run, a fall in the investment–output ratio of 3 percentage points. There is no guarantee that there would be a matchingfall in private savings. In the neoclassical growth model, for example, adjustment would be borne by the capital–output ratio, whichwould rise and thus absorb the excess savings—an adjustment brought about by a fall in real interest rates. In reality, if neitherthe savings rate nor the investment rate of the private sector were to adjust, then, by identity, the fall in private investment relativeto private saving would have to be balanced by a rise in the government deficit or an increase in the external current account surplus.

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convergence criteria’ (the 3 per cent of GDP deficitlimit and the less stringently applied 60 per cent debt-to-GDP ratio) were embedded in the MaastrichtTreaty as preconditions for entry into EMU, andthat, subsequently, further fiscal restrictiveness waswritten into the ‘Excessive Deficit Procedure’ andthe ‘Stability and Growth Pact’ as rules for theoperation of EMU. In the run-up to the 1997 dead-line, the desire to jump the hurdles thus erected hada major influence on economic policy decisionswithin individual countries.

During the 1990s, Europe was affected not just bythe Maastricht fiscal consolidation process, but alsoby the world slow-down at the end of the 1980s, andby the major shock of German reunification. Thecombination of the last two shocks was sufficient tobreak the exchange-rate mechanism (ERM) in1992–3. The fiscal tightening (or, in the jargon,‘consolidation’) was one of the reasons for thestuttering recovery and the continuation of poorgrowth and high unemployment through to the mid-dle of the decade. This contributed to continuingnervousness about the EMU project. However,over time, the mix of policy changed, with fallingnominal interest rates and, for core Europe, a sub-stantial fall in the exchange rate relative to the dollar.By 1998, recovery seemed assured: with employ-ment growing and tax revenues rising this suggestedthat there would be a relatively easy and benignglide-path into EMU for the 11 countries joining in1999. As the start of EMU approached, however,there was a mounting threat to this basically optimis-tic scenario—from the financial and exchange mar-ket turmoil that developed in 1998 and from theconsequences of the likely world slow-down (if notrecession).

(ii) The Short-run Macroeconomic Framework

It is helpful to clarify discussion of macroeconomicpolicy in the new Europe by thinking of the Europeaneconomies in terms of a simple, generic, text-book-style model. (Note that we are presenting this modelnot as a characterization of reality, but, so to speak,‘backwards’, as a standard of reference againstwhich complexities can be highlighted.) The modelin each country is of a natural rate (or NAIRU—non-accelerating inflation rate of unemployment)type with an equilibrium rate of unemployment andout of equilibrium behaviour of the ‘expectations

augmented Phillips curve’ type. Prices and wagesare sticky in the short run. Inflation, given expecta-tions, responds to output or unemployment gaps.Nominal expenditure responds to interest rates (witha lag) and also depends on fiscal policy and theexchange rate. The countries are joined togetherand with the rest of the world by trade linkages.Given international capital mobility, the exchangerate of each country depends on interest rates—e.g.in terms of some Dornbusch-type overshootingmodel. The system is completed by reaction func-tions for the monetary and fiscal authorities. Thereaction function of the monetary authorities isgeared to some nominal target—which might be themoney supply, or, more likely these days, someexplicit or implicit target for inflation.

This system is the kind of model that many Europeanpolicy-makers actually appear to have in mind. Themodel can be thought of as applying to individualcountries but, with modifications, to the whole EMUbloc once EMU comes into being.

For the countries joining EMU the most majorchange will be the obvious one of adopting a com-mon currency, and of ceding control of monetarypolicy to a constitutionally independent central bankthe ECB, committed to the overriding objective ofprice stability. In terms of the above model thecountries in EMU no longer have variable exchangerates vis-à-vis each other and there will be only oneEurope-wide interest rate. Clearly, one of the mostimportant parts of the new macroeconomic frame-work is the interest-rate reaction function of thecentral bank: how the ECB changes interest rates inpursuit of its objective(s) as conditions change andas shocks occur. The reaction function of thecentral bank is unknown—the target is unlikely to bepublished, and it is suggested that there will be a‘monetary reference point’ with only an implicittarget for inflation.

The new framework, however, also involves sub-stantial changes in the fiscal policy regime. For-mally, the 11 countries have agreed to the Stabilityand Growth Pact. Within that constraint, however,fiscal decisions will remain essentially decentral-ized. For Euroland, fiscal policy will continue todepend on the fiscal actions of 11 independentnational authorities. In terms of the above model itis not at all clear how one is to write down the fiscal

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reaction functions. There are intricate questionsabout how, or rather, whether, fiscal policy will becoordinated (formally the forum charged with this isEcofin (the Council of Economic and Finance Min-isters) but there is also a sub-group (Euro-11) offinance ministers of the 11 joining members, agrouping promoted, especially, by the French). Andthere is a further question of the extent to whichfiscal policy will or will not be coordinated with theactions of the monetary authorities. (There are alsoambiguities. The Council of Economic and FinanceMinisters, in this case effectively the Euro-11, notthe ECB, is responsible for the exchange-rate re-gime which clearly could, under some circum-stances, be inconsistent with the ECB’s freedomand responsibility for interest rates.)

Turning from changes in the policy regime to the‘transmission mechanisms’ from policy to outcomeswithin the new Europe, there are equally importantuncertainties about what will change. Here, wemention just two. First, a key aspect concerns thetransmission mechanism of monetary policy throughto expenditure. It is clear that national experiencesare little guide, not least because, for relatively openeconomies, much of the transmission occurs via theexchange rate—a channel which will be greatlyattenuated when it works only for Europe as awhole. Other transmission mechanisms—see espe-cially the important article by Duncan Maclennan,John Muellbauer, and Mark Stephens in this Re-view—vary greatly between countries. The diverseresponse is a serious problem in its own right, butalso means that rather little is known about how thesystem as a whole will react to interest-rate changes.(Moreover, indicators, such as the various moneyaggregates, will change their meaning.) Second, thebearing of policy changes on to output, employment,and, ultimately, on to inflation, will depend on thedegree of wage and price flexibility and ultimatelyon characteristics of the wage-bargaining and price-formation process (as well as on expectationsmechanisms). These are unlikely to remain un-changed. (Many of the articles in this Review stressthe possible changes and uncertainties in this sup-ply-side area—see Eichengreen, Soskice andIversen, Calmfors, Artis, and, in a longer-termcontext, Barrell and Pain).

The startling thing which emerges from this briefreview is the degree of uncertainty over what the

macroeconomic structure of the new Europe willlook like. Fiscal responses are largely unknown andsubject to gaming and coordination difficulties. Thereaction function of the central bank is unknown.The transmission mechanism to expenditure is onlyknown approximately. The degree of wage priceflexibility is unknown and might change. The posi-tion of the NAIRU is extremely uncertain andprobably subject to persistence or hysteresis. Moreo-ver, the main actors—the central bank, the (11)fiscal authorities, and wage bargainers, will interactstrategically. The change in regime may change notonly the way in which expectations of inflation areformed but also the equilibrium rate of unemploy-ment.

Because the ‘model’ in the mind of policy-makers isitself an important part of the macroeconomic frame-work, such a degree of uncertainty is of itself nottrivial. Moreover, there are substantive disagree-ments. Views on fiscal policy appear to differgreatly between, say, the German Bundesbank andAustria or Sweden (and, with the new governmentelected in the autumn of 1998, with the GermanFinance Ministry). And opinions differ on whetherEurope’s very high unemployment should be diag-nosed as ‘structural’ or whether it could be reducedby faster growth in demand. Differences of viewabout how the system works are probably the mostpotent source of non-cooperation in economic policy.Moreover, there is a danger of ‘coordination on thewrong model’.

Below, we look more closely at some of the issuesthat arise. We start with the ‘supply side’ beforemoving on to fiscal and then monetary policy.

(iii) Unemployment and the Supply Side

The key question, in the short term, about Europeanunemployment is whether it is ‘structural’ or whetherit might be reduced, without igniting inflationarypressure, by policies to promote faster growth.There are other important questions, however, aboutwhether labour markets and the all-important nexusbetween unemployment, wage bargaining, and in-flationary pressure will change because of EMU.

UnemploymentAs discussed by Artis in his article in this Review,there is no doubt that the conventional wisdom on

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European unemployment, which at the start ofEMU stands at the scandalous level of about 10½per cent for the EU as a whole, is that it is mainlystructural. Such a diagnosis has large implicationsfor economic policy within EMU.

The implications are most clear within a natural-rateframework. Then, a reduction of structural unem-ployment, brought about by labour-market reform(or coordinated restraint), leads through automati-cally (though with a lag) to reduced unemploymentand higher output. Labour-market reform, if it suc-ceeds in lowering the natural (or equilibrium) rate ofunemployment, is sufficient to produce the benignresult of lower unemployment and, during transition,higher growth. Equally important is the negative—other policies, such as demand-management policy,are not important as far as unemployment is con-cerned. (So the monetary authorities can get on withtheir task of controlling inflation.)

Such a position is well represented by the influentialscenarios published by the IMF (1997) and referredto by Artis in his article (see his Table 3). In the‘reform scenario’, labour-market reform (startingnotionally in the year 2000) lowers the natural rate(by 2 percentage points) and leads to faster growthand (hence) the opportunity for further fiscal con-solidation. By contrast, in the ‘reform fatigue’ sce-nario, there is no initial fall in the natural rate, noincrease in growth, and the fiscal situation, inevita-bly, gets worse. What is more, the authors suggestthat in the ‘fatigue scenario’ that the natural raterises towards the actual rate—poor performancegets locked in: i.e. hysteresis occurs. (For a fullerdiscussion, see Allsopp and Vines, 1997.)

Such exercises, which are highly model dependent,need to be treated with extreme care. From a policypoint of view, it is useful to distinguish three posi-tions. One, exemplified by the IMF’s optimisticscenario, is, as noted, that labour-market reform byitself is sufficient to produce the improvement.5 Asecond position accepts the diagnosis of unemploy-ment as mainly structural, and still sees reforms asnecessary to avoid inflation if growth is to pick up.

In this case, however, policy also needs to focus onensuring that growth does occur: the stimulation ofdemand and labour-market reforms need to be‘sequenced’ together to avoid either unemployment(if demand grows too slowly) or inflation (if reformsare inadequate). In the third case, the diagnosisof unemployment as structural is itself ques-tioned, as is the necessity of labour-market re-form, and the emphasis is firmly on policies topromote expansion.

The consensus in favour of labour-market ‘reform’and ‘flexibility’ is not hard to understand from apolitical economy point of view. It is one of the fewthings on which agreement can be reached. In termsof the above three positions, even those who sub-scribe to the third—that reform is not necessary—could hardly be against the position that reformwould be helpful.

But is reform actually necessary? According to the‘natural rate’ framework it clearly is. The consen-sus position is to maintain that framework as a basisfor policy and to accept the implication that thenatural rate has risen in Europe. But another view isthat European experience of unemployment showsthat the natural rate framework itself is simplyinadequate. In fact, as is well known, the natural ratemodel does not fare at all well in the Europeancontext and European unemployment remains aconsiderable ‘puzzle’ (Blanchard and Katz, 1997).The issues are discussed by Artis. Here we want tostress one point. This is that much of the data onEuropean unemployment is suggestive of strongpersistence effects, or hysteresis. Most obviously,empirical estimates of structural unemployment fol-low closely on actual unemployment developments.And we have already noted that the IMF itselfsuggests that poor performance would get ‘lockedin’ with a rise in the natural rate towards the actualrate experienced. This has paradoxical conse-quences. Poor aggregate demand policy (whichcauses unemployment to rise) could raise the meas-ured natural rate. This—according to the consensusposition— would make labour-market reform all themore necessary.

5 This is a simplification. The model contains an assumed reaction function for interest rates, and the way in which a reductionin the equilibrium rate of unemployment actually generates higher output is that the resulting lower wages cause lower interestrates: these cause higher demand which leads to higher output and thus higher employment. However, the important thing aboutthis process is that, in the IMF scenario, it is essentially automatic: a conclusion of higher employment follows ‘mechanically’from an assumption of labour-market reform.

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We argue below that this has important implicationsfor the way in which monetary policy should beconducted.

Will European labour markets change?Lars Calmfors, in his article, is highly sceptical of theconventional view that giving up monetary and fiscalfreedom will increase efforts at labour-market re-form—‘because there is no alternative’. As far aslabour-market flexibility is concerned, there couldbe, he argues, a (probably small) effect. But, as faras equilibrium unemployment is concerned, since itshould not be affected by monetary or exchange-rate policy anyway, it is hard to see why giving upinstruments that do not work should stimulate re-forms that do. In his careful analysis, he points alsoto arguments that work the other way. Here we noteone in particular which has a long pedigree (seereferences in Calmfors, below). This is that, sincelabour-market reform is less costly and easier tointroduce if monetary policy supports demand andtakes up the slack while it is being introduced, thenreform in an individual country is more likely outsideEMU in a situation where its labour-market reformsand monetary policy can be coordinated. This isbecause an individual country within EMU introduc-ing reform could not rely on a monetary response.As a result, the likelihood of reform is reduced bybecoming a member of EMU.

A similar argument could clearly apply to Europe asa whole. It appears much more likely that neededlabour-market reforms will actually be introduced ifgrowth in Europe revives than if Europe sinks backinto slow growth and further rises in unemployment.Thus, changes in the equilibrium rate of unemploy-ment—if they depend on reforms—are unlikely tobe independent of macroeconomic policy—and,especially, the monetary policy pursued by thecentral bank.

The standard argument, however, that the incentivefor reform would be attenuated, still applies. This isbecause an individual country within EMU introduc-ing reform could not rely on a monetary response.The response, if it came, would depend on what washappening in the EMU area as a whole. From thispoint of view the adoption at the 1997 Amsterdam

summit of a coordinated strategy for labour-mar-ket reform throughout Europe seems entirely right.6

Coordinated reform, however, does only part of thework. The other necessary condition is that thereaction function of the central bank would in factrecognize this, and that it can actually be anticipatedthat coordinated reforms would pay dividends interms of monetary relaxations. (It is clear, too, that,in practice, the sequencing of labour-market re-forms and monetary actions is likely to be extremelyimportant: a central-bank attitude that refused tomove interest rates until reforms were seen to leadthrough to lower inflation could easily lead to stand-off.)

The article by David Soskice and Torben Iversenraises a second extremely important issue. Howmight the German and European wage-bargainingsystems (as distinct from reform efforts) change asa result of the replacement of the Bundesbank withthe ECB? (See also, Dornbusch et al., 1998). Thereare, as the authors note, several possibilities. But thebasic message comes across loud and clear. Thereis a danger that the removal of the Bundesbank and,therefore, the attenuation of the threat position onthe monetary authorities’ vis-à-vis the Germanunions could lead either to a rise in equilibriumunemployment in Germany, or to a systemic infla-tionary shock throughout the EMU area. Such aresult is not certain—it depends sensitively on wage-bargainers’ objectives and on how they perceivelikely reactions elsewhere (including their conjec-tures about the response of the ECB), which arelarge unknowns. (One way the potential problemcould be removed, for example, is if the ECB were,in effect, to target German inflation.)

The kinds of argument behind the expectation thatthe German inflation/unemployment trade-off couldworsen are familiar. Thus, within Germany, unem-ployment (above ‘full employment’) could arisebecause uncoordinated unions, each wanting toraise real wages at the expense of some reductionin employment, would seek to achieve this result byraising nominal wages. The extent to which theywant to do this depends on the (ex ante) perceivedtrade-off between wages and (un)employment. Eventhough, ex post, there may be no improvement in

6 It is recognized that the content of reform strategies will vary markedly between countries, depending on national circumstancesand institutions.

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real wages (so the unions actually lose in theprocess) equilibrium unemployment has to rise tothe point where there is no ex-ante tendency forwages to rise. Effectively, the unions are caught ina prisoner’s dilemma. (Very similar models are usedto explain unemployment as a consequence of theneed to stop leap-frogging wage bids by imperfectlycompetitive firms.)

The key aspect of the Soskice–Iversen story is theargument that the Bundesbank’s position—seen tobe non-accommodating with respect to Germanwage developments—alters the ex-ante trade-offsand lowers equilibrium unemployment in Germany.(They regard the model as relevant to the Germansituation before reunification.) The way this worksis that a rise in the wage would be expected to loweraggregate demand, so that the (un)employment costwould be greater, and the amount of unemploymentnecessary to choke off the tendency for wages toleapfrog is thus reduced. Thus, the Bundesbank, ineffect, acts to increase the relevant demandelasticities, taking the situation nearer to that of acompetitive labour market. Thus, removal of theBundesbank’s reaction function raises equilibriumunemployment in Germany. The authors conjecturethat the high wage demands from IG Metall (themetalworkers’ union) in the autumn of 1998 with‘the Bundesbank on its deathbed’ were a worryingpractical manifestation of the theoretical tendency.

At a less formal level, the authors report a tendencyfor wage bargaining within Europe to treat Germanyas a leader in wage developments. The primeexample is probably The Netherlands. In thesecircumstances an inflationary shock emanating fromGermany (e.g. because of the removal of theBundesbank threat) could become generalized—effectively a ‘common’ or systemic ‘supply shock’throughout Europe.7

A well-known problem with the type of simplegaming models sketched above is that the results areextremely sensitive to the assumptions made and to

the precise specification. It is often said that thislimits their policy relevance. Here, we would argue,on the contrary, that the theoretical fragility ismatched by genuine uncertainty about how Euro-pean labour markets will in fact change and adaptfollowing EMU. The supply-side interactions—es-pecially the crucial links between different Euro-pean labour markets, could evolve in various ways,some good, some bad. But we want to stressanother implication. Policy is likely to be very impor-tant in shaping responses. And policy does not justmean labour-market policy. How the supply side ofthe new European economy develops is likely todepend equally on monetary and fiscal actions andthe perceived overall framework of macroeco-nomic policy. Soskice and Iversen present a modelin which the reaction function of the monetaryauthorities affects equilibrium unemployment. Thegeneral lesson should not be ignored.

(iv) Fiscal Policy

Much of the debate about fiscal policy within EMUhas been dominated by discussion of the virtues orotherwise of the Maastricht fiscal convergencecriteria—especially the budget deficit criterion of 3per cent of GDP which had to be reached in 1997 toqualify for entry—and the Stability and GrowthPact, agreed at Amsterdam as a constraint on fiscalpolicy within EMU. There is a wider set of issues,however, about how the macroeconomic policy-making system is likely to operate when fiscal policyis decentralized but monetary policy is not.

The rationale for the Stability and Growth PactThe Stability and Growth Pact is described andanalysed by Buti et al. in their article on fiscal policyin this Review. (See also, Buti and Sapir, 1998).Here, we are concerned with the likely broad impacton the fiscal system that is emerging in Europerather than with the important detail of, for example,how, and indeed whether, fines or other sanctionswill be applied if countries do run ‘excessive deficits’(see also the discussion in Eichengreen’s article).

7 A generalized nominal wage rise across Europe arises if the nominal wage shock in Germany is matched elsewhere, but theresponse of the ECB to the common shock is discounted by the German unions. In fact, as Soskice and Iversen point out, Dutchunions actually seem to follow a different strategy from that of slavishly following German wages, instead adopting the strategy—whose outcome seems to be remarkably successful—of pricing their labour below the price ruling in Germany. If enough regionstried to undercut each other in this way, the overall situation would increasingly approximate to a competitive outcome, eliminatingunion-structural unemployment. (If the German ‘model’ appears to be ‘Cournot–Nash’, the undercutting scenario is a version of‘Bertrand’ competition.)

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The first point to make is that the Pact tells ussomething about the kind of framework of fiscalpolicy that European policy-makers appear to be-lieve in. (Perhaps one should say, since the Euro-pean political map is changing, ‘used to believe in’).Beyond the generally agreed need to avoid poten-tially explosive paths for government debt, the Pactcommits governments to aim, individually, for budgetpositions, in the medium term (i.e. over the cycle) of‘zero or surplus’.

It is sometimes not fully appreciated how stringentthis new version of a ‘balanced budget rule’ actuallyis. It is far more stringent, for example, than theoriginal Maastricht convergence criterion of 3 percent was intended to be.8 It implies, moreover, anagreed aim of considerable further ‘fiscal consoli-dation’ (that is, expenditure cuts or tax rises) fornearly all countries in EMU. (The question of howdifficult it might be to deliver on the Pact is consid-ered below, but even on optimistic assumptions, theconsolidation process of the 1990s has only goneabout half way.) Moreover, if achieved, it wouldimply quite rapidly falling average levels of the debt-to-GDP ratio in Europe.9 It is also more stringentthan the so-called ‘golden rule’, which allows bor-rowing (over the cycle) only for public investment,as adopted by the Labour government in the UK.

The adoption of the Pact thus suggests that fiscalrestraint and consolidation is seen by policy-makersas a good in itself. (The alternative, cynical, view isthat no one expects it to be seriously enforced.) Butwhy should countries have agreed to cooperate inthis way?

As is well known, one important reason for theadoption of the Maastricht fiscal criteria was wor-ries, especially in Germany, about ‘fiscal irresponsi-bility’ and possible spillover effects within EMU.Likewise, the rationale for the Stability and GrowthPact has frequently been seen in terms of the needto impose discipline on countries, which, it is alleged,would—given half a chance—play fast and loose

with deficit finance. The usual sub-text is that aresponsible core which sees the virtues of fiscalrestraint needs to impose its preferences and viewof the world on an irresponsible few.

In our view, this fiscal irresponsibility/fiscal disci-pline type of argument fails to account for the mostblatant political economy fact about the conver-gence process—namely the apparent enthusiasmwith which policy-makers attempted to meet theMaastricht convergence criteria and beyond that,their (essentially uncoerced) adoption of the Stabil-ity Pact. It is easier to explain what went on if policy-makers are thought of as subscribing to the view thatfiscal consolidation is, in fact, desirable and in their(country’s) own best interest.

One argument we have used before (Allsopp andVines, 1996) is that, in those countries starting froma difficult fiscal position, the political élites wel-comed the external discipline (and threat of exclu-sion) as helpful in controlling their own constituen-cies, thus allowing better policies. The growingconsensus in the 1990s in favour of fiscal ‘consoli-dation’ is also indicated by increased pressure frominternational bodies, such as the IMF and the OECD(see, especially, IMF, 1996), and, most obviously ofall, by the adoption of similar fiscal objectives bycountries not constrained by the EMU convergenceprocess. The UK, an ‘out’, has adopted a set ofmedium-term fiscal objectives similar to those of theEMU countries.10

But there is a second, more important, argument(see Allsopp et al., 1998a, b). With an objective ofhigh output (and employment) and low inflation aswell as fiscal consolidation, EMU makes a differ-ence to what can be attained. Outside EMU, acountry wishing to lower fiscal deficits can tightenfiscal policy and, at the same time, balance this withinterest-rate cuts and, as a result, a fall in theexchange rate. This change in the policy mix can, inprinciple, stimulate just enough of an increase indomestic expenditures and net exports to ensure

8 At the time of the Maastricht Treaty, 3 per cent was about average for EU countries.9 One of the few things that could be said in favour of the original 3 per cent deficit and 60 per cent debt ratio criteria is that

they appeared roughly consistent with each other in that, at 5 per cent nominal growth—say, 2½ per cent real growth and 2½ percent inflation—the 3 per cent deficit would imply a constant debt ratio of 60 per cent.

10 The Labour government in the UK has adopted a version of the ‘golden rule’—a somewhat less stringent, and arguably better,budget aim than that of the Stability Pact. There is also a sustainability criterion which effectively codifies an objective of a stableor falling debt-to-GDP ratio.

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that there is little or no effect on output or employ-ment.11 Within EMU, however, this option is notavailable. Fiscal restraint by an individual countrywill not be offset by interest-rate and/or nominalexchange-rate changes unless all others consoli-date at the same time. Thus, the output and employ-ment costs of unilateral consolidation are likely to bemuch larger within EMU than outside it.12 As aresult, generalizing for the group of countries withinEMU, there would then be too little fiscal restraint.Even though all want to tighten fiscal policy, all arecaught in a prisoner’s dilemma.

Part of the solution is clearly a binding pact that allmembers of EMU should carry out restraint to-gether. This cooperative policy has a much betterchance of being followed by system-wide interest-rate cuts, offsetting for each country the costs offiscal consolidation. The Stability and Growth Pactcan thus be seen as imposing the cooperative solu-tion as far as fiscal policy is concerned.

To make sense, however, coordinated fiscal re-straint must actually lead through to the monetaryrelaxation that validates it. Market forces may welldo some of the work, with an expectation of interest-rate cuts bringing down long-term interest rates. Butthe monetary effects also depend on the reactionfunction of the central bank. That is, the coordinatedfiscal strategy requires also to be coordinated withmonetary policy.13

However, this further required kind of coordinationseems deeply problematic. Consider what happensif the needed monetary reaction does not eventuate.As an extreme case, suppose that interest rates donot fall at all. Then, coordinated fiscal restraintunder the Stability Pact is worse for each individualcountry than is non-coordination. Fiscal restraintelsewhere magnifies (via net trade) the output andemployment costs of domestic fiscal restraint. Farfrom wanting restraint elsewhere, each individualcountry policy-maker would now want others toreflate. This game now suggests that non-coordi-nated fiscal policy would be ‘too tight’ and that therewould be benefits (at least in the short term) from

cooperative fiscal reflation (precisely the sort ofpolicy proposal that was put forward, it seems, bythe new German Finance Minister in late 1998, forreasons which appear alarmingly like those de-scribed here). And this is not all. To anticipate ourdiscussion below, it might then seem entirely pru-dent for the central bank not to cut interest rates. (Inlate 1998, noises from the nascent ECB, in responseto suggestions of fiscal reflation, sounded like astatement of exactly this position.) But the adoptionof such a position by the central bank would thenvalidate the decision of the fiscal authorities to favourcooperative expansion. The central bank can appar-ently be sucked into the prisoner’s dilemma whichthreatens to engulf the conduct of fiscal policy.

What conclusions can be drawn? One conclusion,similar to the conclusion of the last section, is that agreat deal depends on the objectives of nationalgovernments and on perceptions of reactions else-where—especially the reactions of the central bank.But one can go further than that. The Stability Pactbolts down national objectives for fiscal policy in away that will be hard to change. Internationalagreements are not lightly thrown away or ig-nored—though they may be interpreted more or lessstringently. More importantly, it really does appearthat EU governments are concerned to limit deficitsand debt in the medium term. Given this, there isreally only one strategy that makes sense: continu-ation with something like the Stability Pact (modi-fied, it is to be hoped, to remove some of its faults andto make it considerably more flexible) together withthe pursuit of an appropriate monetary policy. Thealternative of cooperative fiscal reflation looks notonly unlikely (even given that the position of the newGerman government is substantially different fromthat of the old one) but wholly undesirable. Thestrategy of relatively tight monetary policy with anoffsetting expansionary fiscal policy threatens areturn to the problems of the 1980s of high debt, lowinvestment and growth, and high unemployment.

Shocks and stabilizationIt is commonly agreed that, under EMU with ex-change rates locked and no scope for national

11 There is the second-order point that a lower exchange rate means that the level of output and employment consistent withmaintaining inflation unchanged may fall marginally. But this point is second order. See the simulations reported in Allsopp et al.(1998a, b).

12 The simulations reported in Allsopp et al. (1998a, b) suggest that the falls in output are four times as large.13 See the discussion in Allsopp et al. (1998a, b).

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variations in monetary policy, fiscal policy will needto play a greater part in stabilization. A principalfear is that the 3 per cent deficit limits of the Pactcould interfere with this stabilization role.

Buti et al., in their article, turn this worry on its head.They argue that with high deficits and debt in thepast, fiscal stabilization was already effectivelyimmobilized. The medium-term objective of budgetbalance, instead of being seen as restrictive, is putforward as enabling. Only if countries achievesomething like medium-term structural balance willthe automatic stabilizers (which are large in Euro-pean countries) be allowed to operate as theyshould. Medium-term restraint is needed to promoteshort-term stabilization.

Generally, the context in which fiscal stabilizationwithin EMU is discussed is that of asymmetricshocks or asymmetric effects (the latter arising,especially, from the differential operation of a com-mon interest-rate policy). Here we are concernedwith a different (though, of course, related) issue:how would fiscal policy operate against commonshocks. Common shocks might arise from a collapseor surge in world demand for EU exports, or, internally,from common (or correlated) demand shocks. It ispossible to envisage, for example, an EU-wide swingin savings behaviour analogous to (but, it is to behoped, smaller than) the savings swings that sodestabilized the UK and Scandinavia in the late1980s.14

The usual position taken is that the stabilizers shouldbe allowed to operate, Europe- or EMU-wide.These would deliver a high degree of ‘automatic’stabilization. In Europe a change of 1 percentagepoint in the output gap leads to a change in thegovernment deficit of about half that. Such a degreeof stabilization is considerably larger than that deliv-ered by the federal system in the USA, basicallybecause Europe is more highly taxed. There is nopresumption that such a degree of stabilization isoptimal: discretionary policy could magnify or dimin-ish the operation of the stabilizers.

For the EU-15 countries as a whole in the period1981–97, the maximum change in the EU deficit

was 4 per cent of GDP (in fact, this was thereduction from 1993 to 1997; the rise from 1989—the top of the 1980s boom—to 1993 was about thesame at 3.9 per cent of GDP). So, one could argue,if the average deficit were zero, similar fluctuationswould take the deficit between plus and minus 2 percent of GDP, figures well within the Stability Pactmaximum of 3 per cent of GDP. (The difficulty ofgetting to an average position of zero—discussed inmore detail below—is dramatically indicated by thefact that the only 2 years since 1981 when theStability Pact limit would not have been breachedare 1989 and 1997.) Thus, it can be argued, if trenddeficits are reduced to zero, the Stability Pact limitis unlikely to bind in aggregate—though it might forindividual countries.

But, with a decentralized system of fiscal authori-ties, it cannot just be assumed that the automaticstabilizers will be allowed to operate. As we haveargued elsewhere (Allsopp et al., 1995; Allsopp andVines, 1996), if governments dislike running deficits,there will be a temptation in a decentralized fiscalsystem to free-ride on the stabilization provided byothers. This prisoner’s dilemma leads to a sub-optimal degree of fiscal stabilization.

With the additional incentive not to run deficitsowing to the Stability Pact, we would argue thatthere is a real danger that an uncoordinated anddecentralized fiscal system will lead to too littlefiscal stabilization in aggregate —even to the pointwhere the automatic stabilizers will tend to be over-ridden. This tendency is not independent of the size(or number) of decentralized fiscal units: with alarge number of small fiscal units each having largeimport leakages, standard arguments suggest thatthe tendency towards the units free-riding on thestabilization elsewhere would be much increased(Allsopp et al., 1995).

If fiscal stabilization is inadequate, one obviousconsequence would be that too much of thestabilization role against common shocks wouldhave to be taken up by the central bank. Interestrates would have to fluctuate to, perhaps, a damag-ing extent—and so would the euro exchange rate.The issues are familiar enough. In the UK, for

14 Calmfors, in his article, presents simulations of the Swedish savings shock—taken, for illustrative purposes, to be 10 per centof GDP.

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example, since the granting of instrument independ-ence to the Bank of England in 1997, there havebeen frequent calls for more fiscal action to slowdemand so as to reduce the need for interest ratesto rise and hence to lower the exchange rate whichbears particularly on the traded goods sector.

In the longer term, if the national/regional stabilizerswere not allowed to operate, there would be pres-sure to provide such stabilization centrally. Therecould, indeed, be pressure for fiscal federalism, notbecause it was regarded as desirable per se, butbecause of the perceived need for EMU-wide fiscalstabilization combined with the tendency for lower-tier (national) governments to eschew this role(Allsopp et al., 1995; Eichengreen, this Review).

Meeting the objectives of the Stability and GrowthPactWe have argued elsewhere that the medium-termobjectives of the Stability Pact, which we interpretas roughly zero budget balance over the economiccycle, require a major change in the private sectorsof European countries (Allsopp and Vines, 1996). Inparticular, achievement of zero structural balancewill be hard unless there is a sustained revival ofprivate investment and growth in Europe.

A first question is how much improvement in thepublic-sector position has been achieved during theMaastricht fiscal consolidation process, and how faris there still to go? Buti et al., in their article, describethe achievements that have been made. They aresubstantial. All but one of the 15 EU countries metthe 3 per cent of GDP deficit criterion (the exceptionis Greece). Nevertheless, the average deficit for theEU-15 remained at 2.4 per cent in 1997, suggestingthat there was considerably further to go to meet thezero or surplus criterion for the medium term. Infact, according to OECD figures (OECD, 1998), theimprovement from 1990, when the deficit was 3.8per cent of GDP, to 1997 was about 1½ percentagepoints—good but not exactly startling, given theefforts involved.

An impression of much better performance is givenby looking at structural deficits which correct forvariations in the (estimated) output gap and theoperation of the automatic stabilizers. Again usingOECD figures, the structural deficit in 1990 was 5.1

per cent, and this was reduced to 1.7 per cent in1997—an improvement of 3.4 per cent of GDP.Commission figures for the structural deficit in 1997put it at 1.9 per cent of GDP (the same figure for theEU-15 or the EU-11). The IMF estimates thestructural deficit for the EU-15 to be 0.9 per cent ofGDP. Both the big correction and the small 1997numbers make it seem that much has been achieved.However, the figures need careful interpretation.

What the structurally adjusted figures actually showis that there have been major changes in tax sched-ules and expenditure programmes to take EU gov-ernments towards the position where, if GDP wereon trend, deficits would be contained. In 1990, theadjustment needed was, according to the OECD,very large—over 5 per cent of GDP. By 1997, it wasmuch smaller and, since in 1997 output was belowtrend, the adjustment still needed is smaller thanindicated by the uncorrected deficit. The mainreason for the above-noted differences between theestimated structural deficits in 1997 is differences inthe estimated or assumed output gap in that year.The IMF, in particular, estimates a considerablylarger output gap for 1997 than the Commission.(Since output and unemployment gaps are related,this also means that the Commission regards moreof Europe’s high unemployment as ‘structural’.)

What the figures show, therefore, is that there havebeen major changes in tax schedules and expendi-ture programmes of a restrictive kind. These changesare necessary if the objectives of the Stability Pactare to be met. The figures suggest there is still someway to go—but estimates of the extent of further‘consolidation’ needed are highly sensitive to as-sumption about where GDP is in relation to trend.On an optimistic view about growth and reductionsin structural unemployment—as illustrated in theIMF’s ‘reform scenario’ referred to above—taxescan even be cut. The point is ultimately obvious:given the fiscal ‘consolidation’ that has alreadyoccurred, if Europe were to recover and grow fast,the problem of deficits would soon disappear.

But while the fiscal consolidation is necessary it isnot sufficient: the key to meeting the objectives ofthe Stability Pact is to get the growth. One worryingaspect of the situation is that such growth as therewas in Europe over the 1990s was supported by net

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trade and a rising balance of payments surplus.15

Public-sector restriction was offset by buoyantexports. That process cannot be relied upon for thefuture, and in 1998, there appeared to be a major riskthat the payments surplus would prove unsustain-able. The clear implication is that the emphasis inmeeting the objectives of the Stability Pact in themedium term has to be on a revival of domesticdemand, and especially, a revival of private invest-ment on a sustained basis.

The need for a strong revival of investment andgrowth over the medium term has extremely impor-tant implications for the needed reaction functionof the monetary authorities. Take, for the moment,the needed rise in investment and growth as given.Then the requirement is that the monetary authori-ties manage interest rates down to the extent nec-essary to ensure that the desired growth and invest-ment response occurs—and, of course, to be pre-pared to raise interest rates if the boom appears tobe likely to get out of hand. Effectively this is the kindof reaction function that (given low inflation) hasbeen apparent under Greenspan in the United States.

One can go further. An accent by the monetaryauthorities on promoting growth and investmentcould lead to policy moves by the fiscal authoritiestowards further budgetary restraint, taking the sys-tem further towards meeting the medium-term ob-jectives of the Stability and Growth Pact. With anaccent on growth, stability, it might be said, follows.Such a strategy, leading the way with interest-ratedeclines, was, in broad terms, successfully followedin the UK after it was ejected from the ERM in1992.16

There is a potential difficulty. It might be arguedthat, even if monetary policy were to becomeproactive and lead the expansion process in ad-vance of budgetary improvements, the relevantresponse elasticities might be too small. We have

pointed to the need for a relatively large change inthe domestic private-sector savings/investment bal-ance and, although this actually occurred in theUSA, monetary easing might not be enough in theEuropean context. The example of Japan, with asomewhat similar structure of financial flows to thatof Europe, is not encouraging. Investment, it may beargued, depends more on confidence and growthexpectations than on interest rates per se.

Such arguments, in our view, miss out an importantpoint. A perceived commitment by the monetaryauthorities to go for growth and full employmentwould have a powerful effect on growth expecta-tions and, hence, for ordinary accelerator-type rea-sons, on investment. For the same reason it shouldalso affect consumption. Thus, the commitment tothe growth part of the Stability and Growth Pactwould appear to be a crucial part of the overallstrategy.17

The story so far suggests a disturbing conclusion.The medium-term objective of fiscal restraint em-bodied in the Stability and Growth Pact requires achange in the mix of policy and a revival of invest-ment and growth. The strategy only looks coherent,however, with a growth-oriented reaction functionfor the ECB. Without the appropriate monetarypolicy and appropriate perceptions about whatmonetary policy is trying to do, the strategy looks farfrom robust and could be destabilizing.

(v) Monetary Policy and the European CentralBank

We have already argued that monetary policyhas important interactions both with the supplyside, and with the way in which fiscal policy islikely to work in the new Europe. Here weconsolidate the arguments, discussing their impli-cations for how European monetary policy willneed to be conducted.

15 The current account surplus in 1997 was 1½ per cent of GDP and the swing since 1990 was 2 per cent of GDP. Moreover,the private sector’s balance—the surplus of private savings over private investment—has hardly changed. By identity, the surplusof the private sector is the sum of the public deficit and the current account surplus, so that, in 1997, with a public deficit of 2.4per cent and an external surplus of 1.5 per cent, the private surplus was 4 per cent of GDP—hardly different from its average overthe 1980s. Meeting the objectives of the Stability Pact over the medium term would require a major change in private savings inrelation to investment (a fall in savings or a rise in investment—and, it is to be hoped, the latter).

16 An additional feature of the UK strategy was the announcement of future tax increases.17 In the simulations reported in Allsopp et al. (1998a,b), such ‘optimistic’ forward-looking effects in consumption and

investment are a crucial reason why fiscal consolidation for Europe as a whole leads to so little extra unemployment for such ashort time.

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We discuss the set-up of the ECB, the ‘reactionfunction’ which it will operate, and the risk that agood monetary policy will not be forthcoming. Weconclude the section with a recommendation as tohow monetary policy ought to be conducted. Mon-etary policy is considered in detail in the article byCharles Bean in this Review.

The European system of Central BanksThe Treaty establishes the European System ofCentral Banks (ESCB) and, at its centre, the Euro-pean Central Bank. The system is described byBean in his article. In terms of the way it has beenset up, the ECB is probably the most independentcentral bank in the world (Buti and Sapir, 1998). Theprimary mandate of the ESCB is ‘price stability’,with, then, lexicographically (‘without prejudice’ toprice stability), a duty to support the general eco-nomic policies in the Community. Under this man-date, the ECB is, in the jargon, both ‘instrumentindependent’ and ‘goal independent’. That is, it isfree to choose its monetary instruments and itsoperating procedures as well as setting its ownobjectives—which may or may not be publiclyannounced. As Bean notes, this is in stark contrastto new role of the Bank of England. In the UK,interest-rate policy is delegated to an independentmonetary authority (the Monetary Policy Commit-tee of the Bank of England) which is instrumentindependent, but not goal independent: the target isset by the government (currently the target is for 2½per cent inflation). The Monetary Policy Committeehas a clear mandate and relatively little discretionexcept over the speed at which inflation, followinga shock, should be brought back to the 2½ per centtarget. To allow for lags, the normal operating ruleis to seek to bring inflation back to target within 2years. The target is symmetrical: that is, the Bank isexpected to raise or lower interest rates dependingon whether it looks as if inflation will exceed or fallshort of the target. Whereas the UK system isarguably the most transparent and accountable inthe world, the ECB is unlikely to be ‘transparent’,and it is not clear to whom it will, in practice, beaccountable. Once the UK system has beddeddown, the reaction function should become predict-able and monetary policy moves should contain littleinformation and, therefore, should not move mar-

kets much. (For a discussion of inflation targeting inthe UK, see King, 1997.)

The role of the ECB within the overall frameworkof macroeconomic policy in the EU-11 will be verydifferent from that of the Bank of England in theUK. Partly, this is because of the institutional differ-ences just described: the ECB is goal independent,and responsible for interpreting its mandate. In thisrespect, its position is more like that of theBundesbank or of the Federal Reserve in the USA.As Bean and others have noted, the British Treas-ury is, in effect, a Stackelberg leader in the policygame: the Treasury, in its policy-making, needs totake account of the ‘reaction function’ for interestrates set up at the Bank.18 By contrast, in Europe,the single central bank faces 11 different, relativelyuncoordinated, fiscal authorities, and 11 differentlabour markets. This means that the details of itsbehaviour—the details of its reaction function—andperceptions of the ECB’s likely behaviour by othereconomic actors are crucial in determining how therest of the system functions. It also means that theECB will be the single most important macro-economic policy-making body in the new Europe,and—as such—will not naturally fall into the role ofStackelberg follower. The pressure to develop aneffective counterweight to the ECB through the so-called Euro-11 subgroup of the Council is a naturalresult of this strategic ‘imbalance’.

The ECB: operating a benign ‘reaction func-tion’ for monetary policy?The natural starting point for a discussion of theECB (and the basis of much of the literature) is tosuppose that monetary policy set by the ECB willessentially take the form of an algorithmic rule forthe interest rate. One would then discuss howvarious kinds of monetary-policy reaction functionwould operate within the context of the consensusnatural-rate model sketched out above. Within sucha set-up, the choice of policy rules and operatingprocedures becomes a ‘mere’ technical matter ofchoosing the functional form and coefficients for thereaction function. (This is not to imply that thechoices are unimportant.) If the reaction functionwere to be specified in terms of the well-known‘Taylor Rule’ approach (Taylor, 1994), the discus-

18 Bean argues that, with monetary policy delegated in this way in order to improve inflation control, it would be perverse ifthe arrangement led to a seriously sub-optimal mix of monetary and fiscal policy.

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sion would centre on the size of the coefficients toattach to the deviation of inflation (or the price level)from its target. Also important would be the questionof whether, why, and how much to feed back fromthe ‘output’ gap, or, equivalently, from the gapbetween unemployment and its natural rate.19 Simi-lar ‘technical’ questions would arise if the reactionfunction were set out in terms of inflation targetingon the British or Swedish model (this time about thespeed with which interest-rate policy should attemptto steer the economy back to its target in the face ofa disturbance to predicted inflation: see King, 1997).If an indicator-type of intermediate monetary-targetregime were adopted, the discussion would thenconcern the size and speed of the appropriateresponse to deviations of the money supply from itstarget.

If the ECB were to follow a reaction function of thiskind, it is notable that most of the problems ofcoordination that we have stressed above would goaway. They would certainly diminish in importance.Assuming that the ECB’s reaction function wassymmetrical, a tightening of fiscal policy would leadto lower output, lower inflation, and lower moneygrowth, triggering interest-rate declines. And, as faras stabilization against common shocks is con-cerned, fiscal offsets would mean that monetarypolicy had to do less of the work. Similarly, on thesupply side, labour-market reforms, lowering thenatural rate of unemployment, would lead to mon-etary policy reactions that would generate growthand reduced unemployment. Even more impor-tantly, the knowledge that the system would func-tion like this, would solve the coordination problems.Fiscal authorities would know that coordinatedrestraint would lead to growth, not unemploy-ment, and could safely view adherence to theStability Pact as solving their prisoner’s dilemma.Economic agents within the labour market wouldknow that reform would lead to lower, not higher,unemployment.

A reaction function of the required type may beemerging. The mandate of the ECB means that itmust react to inflation by tightening monetary policy,which in practice means raising the short-terminterest rate. There is more doubt about whetherinterest-rate falls would result if inflation were

under control; although the secondary mandate thatthe ECB (strictly, the ESCB) should ‘support thegeneral economic policies in the Community’ sug-gests monetary relaxations should follow, and shouldbe seen to be likely to follow.

The risks of poor ECB policyNevertheless there are risks that the ECB’s policywill be inappropriate for the new Europe. Wediscuss these risks—roughly in increasing order ofimportance.

(a) UncertaintiesThe first risk to the emergence of a clear, transpar-ent, and understood reaction function for the ECB isuncertainty. At the start of EMU, there will beconsiderable uncertainty over how to measure infla-tion (see Artis and Kontolemis, 1998). The Harmo-nized Consumer Price Index, which is under con-struction, is the natural indicator to focus on. Butthere will be little track record with which to assessits reliability in indicating ‘underlying’ inflation, andit is perhaps inevitable that a number of indicatorswill have to be used. (There are even strongerreasons for doubting the significance of any mon-etary indicators at the start of EMU.)

(b) Obscurities and asymmetriesThe second risk is more worrying: there is a lot thatappears obscure, even deliberately obscure, abouthow the ECB intends to conduct itself. In late 1998,statements by Duisenberg, the President of theECB, suggested that there would be a ‘monetaryreference point’ and an implicit target for inflation of2 per cent or less. Bean (in his article) argues thatthere should be an announced inflation target evenif some monetary aggregate is used as an indicator.As a way of achieving the desirable outcomesdescribed above, explicit targets are preferable toimplicit ones as a way of affecting expectations.(They would also provide a basis for establishing theaccountability of the ECB.) There may be argu-ments that the ECB’s target (current indicationssuggest ‘2 per cent or less’) for inflation is too low.And there are certainly strong arguments againstthe asymmetry implicit in the ECB’s proposedapproach—symmetry would ensure that falls ininterest rates can be anticipated by economic agentsif inflation falls below its target just as clearly as rises

19 For an interesting discussion of this issue in the US context see the discussions by Solow, Taylor, and Friedman in Friedman(1998).

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can be anticipated if inflation rises above its target.Indeed, the ‘expansionary’ part of the reactionfunction is particularly important at low inflationsince the Phillips curve is, in practice, likely to benon-linear: Calmfors, in his article, suggests thatdownward nominal wage rigidities are particularlyimportant at low rates of inflation. (This issue hasbeen much discussed in the USA recently.) It wouldbe very damaging if the perception grew that noinflation rate was too low as far as the ECB isconcerned.

We place great stress on the harmful consequencesof a failure to deal decisively with deflationarypressure, and—just as bad—the failure to be seenas likely to do so. A reaction function that fails toreward labour-market reform—and which is seenas likely to fail to so—could mean that the reformswill not in fact be carried out. And a reactionfunction that fails to respond adequately whenbudget deficits are being tackled—and which isseen as likely to fail to do so—could mean thatbudgetary reforms are put on ice or shelved.

(c) ConservatismA still more insidious danger concerns the forecast-ing procedures which the ECB will use in what is,inevitably, an extremely uncertain environment. Thisissue comes out clearly in the context of estimatesof the natural rate of unemployment (or the degreeof structural unemployment) and associated esti-mates of unemployment gaps or output gaps. Theseunderlie the assessment of inflationary or deflation-ary pressure. But, the empirical basis for suchestimates in Europe is very weak. There is a dangerthat the adoption of ‘conservative’ estimates ofstructural unemployment could lead to an undulycautious monetary policy.

The first fear is that this caution could be self-validating. As we have argued, a lack of monetaryrelaxation could lead to continuing high unemploy-ment and—through hysteresis—to outcomes whichactually validated the conservative estimate of struc-tural unemployment. It is not encouraging that theGoverning Council announced in late 1998 that the

ECB’s estimates of the output gap will be usedinternally and not published.

Second, we have also laid great stress on theargument that these wait-and-see attitudes could beself-validating for a further reason. (The argumentmirrors that sketched at the end of the sub-sectionon asymmetries above.) A reaction function thatinsists on seeing the benefits of labour-market re-form before monetary relaxations are contemplatedcould mean that the reforms will not, in fact, becarried out. A reaction function that insists onbudget deficits actually declining before monetarypolicy reacts would be even worse: if nominalwages were rigid downwards and a recession en-sued and tax revenues fell, the policy could evenspiral out of control. Such a focus on the actualdeficit numbers would simply be bad economics.But in the light of our discussion in the section aboveon fiscal policy it cannot be ruled out entirely.

(d) Inappropriate ‘reputation building’The final, and most worrying, set of possible prob-lems we want to highlight results from the fear thatthe central bank might deliberately seek to repudiatethe algorithmic approach to monetary policy whichwe have been describing. Our fear is that it might notwant to set up a benign reaction function of the kindwhich we have been describing because it might seea need to act strategically, or to ‘threaten’ otherplayers in the European policy process. There aretwo aspects to this fear. One involves a concernabout the means which the ECB might adopt inorder to establish its anti-inflation ‘credentials’. Thesecond is a concern that the central bank might seethe need to ‘threaten’ other players in the policyprocess in the new Europe.

One of the most familiar stories is that there will bean inflation bias arising from a perceived temptationon the part of the ECB to ‘cheat’ with surpriseinflation—needing to be countered in the standardBarro–Gordon way of reputation building (Barro andGordon, 1983). Here we agree with Bean (1998) thatthis is probably a non-problem with monetary policydelegated to an independent central bank.20 Indeed,

20 Formally, the time-inconsistency problem only arises if monetary authority increases its welfare with a short-term rise inemployment above the natural rate. Although politicians, seeking re-election, might see things this way, it seems unlikely that centralbankers would do so. Thus, Bean argues, the mere act of delegation is likely to solve the problem. This simple observation seems,to us, to dispense with the whole literature which has followed Walsh’s celebrated paper on contract design for Central Bankers(Walsh, 1995). For a critical view of the relevance of ‘time inconsistency’, see, also, Forder (1998).

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we would go further. The one part of the centralbank’s reaction function that everybody seems tobelieve in is that it will react to increases in inflationwith restrictive policies. It already has an anti-inflation reputation and no one expects it to want tocheat.21

But there is a second aspect of reputation that maybe important. We have already discussed it in thecontext of the potential role of the ECB in wagebargaining. Arguably, the threat of deflationaryresponses to wage increases in Germany will bediluted by the move from the Bundesbank to theECB in the way suggested by Soskice and Iversen.One response would be to raise the punishmentmeted out. Though the aim of a punishment strategyis to condition behaviour without actually punishinganybody, threats have to be carried out from time totime in order to make the strategy credible. Onestory, then, would be that the ECB initially needs toestablish its threat position vis-à-vis wage bargain-ers across Europe. On this story, the more intransi-gent it looks, the better.

Such a strategic role for a central bank is differentfrom and inconsistent with the algorithmic, reactionfunction, approach. That it is different is obvious,since it is intended to affect equilibrium unemploy-ment, rather than lead to the achievement of targetinflation at equilibrium unemployment. That it isinconsistent arises from fact that the policies neededto establish the reputation will in general be differentfrom the policies needed to establish a transparentreaction function of a sensible kind.22 In particular,threat strategies will often be asymmetric, punishingbad behaviour rather than rewarding good (thoughthere is no reason in principal why carrots should notbe used as well as sticks).

A third possible kind of strategic behaviour by thecentral bank arises from the ESCB’s pivotal positionin the overall framework of policy that is emerging

and its involvement in the ‘policy game’. Europeancentral banks have been and are heavily engaged ina bargaining process with other elements in thepolicy-making process—especially the fiscal au-thorities. An attitude by a Europe-wide central bankthat sees its role largely as enforcing discipline onrecalcitrant fiscal authorities could be extremelydamaging and, as we have seen, could preventrather than encourage, cooperative policies of me-dium-term restraint. There is an alternative: coop-erative policies to produce a sensible fiscal mon-etary mix.

The view that central banks should play a strategicrole in enforcing discipline within overall policymaking is, perhaps, more characteristic of the Con-tinental European tradition than of the Anglo-Saxon.There may be a clue here as to why there is so muchdisagreement over transparency and accountabil-ity. Putting it simply, if you see yourself as playingpoker, you do not want your cards on the table.Whether central banks should play poker is anothermatter altogether. We argue below that they shouldnot.

Towards a sensible reaction functionWhat is needed in Europe is the reasonable antici-pation that policies of fiscal restraint and labour-market and other supply-side reforms will reliablybe rewarded by monetary policies which lead togrowth, rather than leading to unemployment and toa failure to meet deficit targets. Neither fiscalrestraint nor supply-side reform necessarily leadsautomatically to growth.23 Cooperation in theseareas is necessary, not sufficient. The only institu-tion that can play the role of providing a commitmentto growth is the central bank. The commitment isimportant, for without it the needed response ofdomestic demand—especially private investment—may be problematic.24 This requires, subject to thecondition that inflation is under control, a growth-oriented reaction function at the central bank.

21 We do not deny that there remain in Europe some political-economy questions about how independent the ‘independent’ centralbankers are likely to be. See discussions in Bean and Eichengreen.

22 We note that if an ex-ante threat strategy against certain types of contingency were fully credible, then this could be combinedwith a normal reaction function most of the time. Thus, Soskice and Iversen in effect argue that the Bundesbank’s threat strategyworked in the 1980s before the shock of reunification, but there was a switch to a policy of re-establishing the threat after the shock.

23 This is not to deny the importance of market responses and expectations. These might be strong enough to produce the desiredresult ‘automatically’. (They could even be too strong.)

24 The argument for commitment is subtle. Some institution needs to be seen to be standing ready to manage the process if itwere to go wrong. With that in place, expectations play a favourable role.

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The requirements for this effectively reverse thearguments of the previous paragraphs about poten-tial difficulties. The inflation target, implicit or ex-plicit, must be reasonable, and imply symmetricresponses. There should be a significant output-gapterm in the equivalent of the Taylor rule.25 Andforecasting procedures must have some optimisticbias, (i) so that claims about structural unemploy-ment are tested (on the US Federal Reserve model)and (ii) so that policies of structural reform and fiscalconsolidation—which take time to come through—are, so to speak, given the benefit of the doubt. Ifthey do not eventuate or fail, the reaction functionshould kick in predictably with restrictive policies tocontain inflation.

There is nothing particularly contentious about sucha reaction function—it is just the US model.

But what about the possibility that the ECB will wishto play a strategic role in the European policyprocess? Here we would argue that a Europeancentral bank has no business to adopt a strategic roleof the type described above, either to ‘discipline’ thesupply side, or within the policy-making process. Onthe former, it would seem, in any case, extremelydifficult to provide a threat strategy across such adisparate area as Europe. It would be much better,if countervailing action is required, for this to beprovided on a country-specific basis, for example,by the fiscal authorities, or strengthened employersorganizations, or, of course, from measures to im-prove coordination. In the longer term, under EMU,the main ‘threat’ within a country from pushing upwages would be from international competition—and from the loss of jobs as the location of firmschanges (see Ray Barrell and Nigel Pain in thisReview).

We are also highly doubtful about a strategic role forthe central bank in ‘disciplining’ other aspects of thepolicy-making process. A cooperative approachwould be more sensible. More importantly, ques-tions of the ‘democratic deficit’, accountability, andtransparency would certainly be raised. It mayseem wrong for an essentially technical institution,charged with controlling inflation, to take a strategicrole of that kind. Arguments of the type that any

loosening of (say) the provisions of the Stability Pactwould conflict with the central bank’s remit for pricestability seem mistaken. If fiscal loosening were tooccur, to the extent that inflation rose, the normal‘reaction function’ response should contain it. Theoutcome would be higher interest rates, and/orcurrency appreciation which might, of course, beundesirable. But the ability of the ECB to pursue itsown mission of controlling inflation would not bejeopardized.

The new ECB does need to develop its reputation.The task of meeting its objective of controllinginflation for the euro-area will be by no means easy.There are great uncertainties about how the systemworks, and about the shocks that will be met withalong the way. But the kind of reputation that isneeded is one of technical competence: the kind ofreputation a new chauffeur might aspire to—that ofbeing a good driver who is likely to get to thedesignated destination, reliably, predictably, and withminimum fuss. Such a reputation for good policy ismost obviously possessed by the Chairman of theFederal Reserve in the USA. We may summarizethis in terms of developing the reputation for follow-ing a sensible-looking reaction function for thesystem as a whole, one which is consistent with thecontrol of inflation, and supportive of other aspectsof macroeconomic policy.

III. OTHER ISSUES

This section briefly considers two other importantissues—financial stability and the strategic interac-tion between the new Europe and the rest of theworld.

(i) Financial Stability

We noted, at the beginning of section II, that thereare questions about the financial stability aspects ofthe new monetary structure, especially if Europeancountries were to face a major financial shock.Worries have been expressed, for example, abouthow lender-of-last-resort facilities will work in thedecentralized system that is being set up (Prati andSchinasi, 1998). Stability issues are discussed by

25 The argument used here—that it would help to guarantee growth—is a different argument for such a term from that commonlyused—namely that current output is a future predictor of inflation.

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both Eichengreen and by Bean in their papers in thisReview.

In fact, the spirit of the Maastricht Treaty is that theECB should concentrate more or less exclusively onmonetary policy and should not be much involved insupervisory issues or crisis management. Bean, inhis article, notes the ‘rather cryptic request’ inArticle 105 that the ESCB should ‘contribute to thesmooth conduct of policies pursued by the compe-tent authorities relating to the prudential supervisionof credit institutions and the stability of the financialsystem’. Thus, in theory at least, crisis managementremains decentralized, the responsibility of nationalauthorities. An additional complication is that, his-torically, the role played by national central banks(NCBs) in supervision and crisis management hasvaried greatly between member states. (From the,in theory at least, hands-off policy of the Bundesbankto the much more explicit involvement of, for exam-ple, the Bank of France).

One way of looking at the situation is to argue thatlittle has changed, and that supervisory and stabilityissues will continue to be tackled much as before.Against this, however, there are reasons for suppos-ing that the ECB will have to take a more centralrole. The first is that the potential problems thatmight have to be dealt with may be larger andrequire more coordination. The potential financialflows between jurisdictions are bound to be en-larged—by EMU itself and, for example, by theintroduction of the TARGET settlements system(see the discussion in Eichengreen’s article). It isalso likely that with capital market developmentsand banking sector changes, the likelihood of pan-European crises, requiring a coordinated response,will increase. The second, is that the MaastrichtTreaty and the Statute of the ESCB are themselvesconstraining. Indeed, on a strict interpretation of theTreaty, one could end up with neither the ECB northe NCBs being involved in crisis management.

It is, in fact, hard to discern what way the system willevolve. One possibility is an enhanced central rolefor the ECB, for example, in providing lender-of-last-resort facilities. On the other hand, the role ofcentral banks in back-stopping the system could bereduced. The latter would work towards reducingmoral hazard (financial institutions taking on exces-

sive risk on the grounds that liquidity would beprovided in a crisis), but might, in fact, not becredible—as argued by Prati and Schinasi (1998).Situations could arise in which the risk of wide-spread insolvency effectively forced a change inpolicy.

This type of problem is not confined to lender-of-last-resort facilities. Bean rightly stresses that seri-ous rescue operations nearly always involve tax-payers’ funds, citing the experience of the USSavings and Loan crisis as an example. Even if acrisis were to involve only liquidity problems, ratherthan solvency problems (and it is very hard inpractice to distinguish the two) there is usually riskinvolved, which may well exceed the (extremelylimited) exposure that can be taken on a centralbank’s own balance sheet. So it is more or lessinevitable, as well as desirable, that the fiscal au-thorities will be involved in any large-scale crisis orrescue operation. The fiscal authorities themselvesare, however, decentralized and subject to restraintsunder the Treaty, in the form of no-bail-out clauses,and the Stability Pact.

Potentially, the coordination issues are serious inthat the ECB, NCBs, national fiscal authorities, andnational supervisory bodies would all need to beinvolved if a serious pan-European crisis were toarise. There may be arguments for some ambiguityand obscurity about the particular conditions underwhich support to the system will be given—it issometimes argued that ‘constructive ambiguity’may help deal with some moral hazard problems.But it is important that responsibilities and proce-dures be as transparent as possible so that rapidaction can be taken if needed. Ultimately, there is atension between the need for financial discipline(including fiscal discipline) in a decentralized sys-tem, and the need for centralized political authoritythat can react quickly to events.

(ii) EMU and the Rest of the World

There are important issues about the way in whichEMU will mediate Europe’s role in the world. Themove towards EMU was at least partly inspired bya French hope, that European monetary union wouldenable French policy-makers both to regain somecontrol over French interest rates and to regain

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global monetary influence (Mélitz, in Cobham, 1994).But this empowerment, and its consequences, willneed to be carefully managed, for two reasons.

First, it seems likely that soon after its establishmentthe euro will become a significant internationalcurrency (see Portes and Rey, 1997). This poses thefollowing challenge for European macroeconomicmanagement. There may initially be a shortage ofeuro assets, and a strong portfolio demand for them.(For example, the Chinese have said that they willdemand them for international reserves.) This couldhave the benign effect of bidding up euro assetprices, effectively lowering market yields and inter-est rates. That in turn would stimulate investmentand assist with the process of fiscal consolidationdiscussed above. But it could also cause the euro toappreciate, which would have the opposite effect.Which of these effects dominates will be important;it will partly depend on the conduct of Europeanmonetary policy by the ECB.

Second, EMU begins not—as envisaged just 18months ago—against the backdrop of strong globalgrowth, but in the context of a likely world slow-down and a possible worldwide recession. Europewill find that, in the ECB, it has a policy player ofstrategic importance in determining how well thewhole world responds to this problem.26 The ECBseems likely to face at birth the tension—betweenthe burdens imposed by a global strategic role andthe macroeconomic needs of the domesticeconomy—about which members of the US Fed-eral Reserve have been able to learn over manyyears.27 The ECB is likely to find that increasedglobal influence (of the kind which the French havelong sought) brings uncomfortable global responsi-bilities (of the kind which Germany has long ap-peared to want to avoid).

We can be more precise about the problem than this:at the time of writing (early November 1998) theoutline of the problem appears much clearer than itwas even a few months ago. So far the slow-downresulting from the Asian crisis has affected the USAmuch more than it has affected Europe. But in late

1998 it became apparent just how large a shock theUSA has experienced: both a collapse in the de-mand for its exports and fierce competition fromimports in home markets.

In response to this shock, the US Federal Reservemoved decisively and unilaterally (in October 1998)both to cut interest rates and to make clear thatfurther reductions in interest rates would be forth-coming as necessary. It is natural to interpret theseinterest-rate reductions as an attempt by the Fed tokeep domestic demand growing in order to replacethe fall in demand resulting from lower exports andhigher imports. The abrupt collapse of the dollar bymore than 10 per cent, which followed within aweek, was a clear consequence of this move, asfinancial markets deduced that the ensuing relaxa-tion in US interest rates was likely to be larger, andto last longer, than had previously been anticipated.Such a fall in the dollar is likely to produce, of course,an additional mechanism by which interest-ratereductions will contain the slow-down: it is a naturalpart of a way by which the US Federal Reserve isable to steer the US economy in the face of such ashock.

Such a fall in the dollar will, of course, partly transferthe effects of the slow-down from the USA toEurope and elsewhere. In as much as that happens,the appropriate response in Europe will be a cut inEuropean interest rates. Indeed, the ECB needs tostand ready to cooperate with the Fed in managingthe global shock, by means of parallel interest-ratereductions.28 A Europe following a reaction func-tion of the kind which we have advocated abovewould deliver something like what is required.

But a Europe in which the Central Bank is locked ina combative game with Europe’s wage setters andEurope’s fiscal authorities would be disinclined toplay its part in stabilizing global aggregate demand inthe way required. Remarks, both from the Bundes-bank and by Duisenberg in the last months of 1998raised the spectre that the Central Bank may indeedbe disinclined. This contrasted strikingly with theFed’s decisive response, which had the result the

26 The point is not that the ECB is new, but that it will have a global weight which none of its constituent central banks, noteven the Bundesbank, previously possessed.

27 The Asian crisis will put Europe’s central bankers on a steep learning curve about issues which US policy-makers seemadmirably capable of both understanding and managing.

28 This is not a call for elaborate coordination in the setting of interest rates, or for agreement on interest-rate levels.

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Fed was not only ready to act if necessary, but wasalso seen as ready to act as necessary.

Of course, the problem may still turn out not to besevere. But at the time of writing the possibility of amajor down-turn in world aggregate demand cannotbe discounted. The risk that such interest-rate coop-eration turns out to be needed but is not forthcomingcreates another threat to the European growthprocess, alongside those discussed in section II(v).

Such an outcome would also have wider signifi-cance. If the USA were forced to go it alone withinterest-rate cuts, the risk of a ‘hard landing’ with alarge fall in the dollar, and thus a threat to pricestability in the USA, would inevitably partly tie theFed’s hands: it would cause the Fed to behave inperhaps a more cautious way than otherwise. Thus,the whole world has an interest in the ECB develop-ing a sensible monetary policy reaction function.

As in Europe, where an over-tight monetary policyseems likely to lead to calls for fiscal reflation, theabsence of an adequate global monetary responsemay give rise to calls for coordinated global fiscalexpansion. Arguably, however, global fiscal expan-sion would not solve the world’s problems whenlonger-run objectives everywhere are pointing to-wards the desirability of more—not less—publicsaving (essentially for demographic reasons). Itwould be a shame if one consequence of thecreation of the ECB were the unleashing of forcespropelling the world towards the wrong monetary/fiscal mix.

IV. CONCLUSION

The consensus macroeconomic policy frameworkin EMU is built on three pillars: supply side and,especially, labour market reform: fiscal restraintunder the Stability and Growth Pact; and a monetarypolicy to be determined by an independent centralbank, the ECB. This Assessment has argued that,for the framework to work coherently, a growth-oriented monetary policy is essential.

That recovery and growth is needed to reduceunemployment and to meet the fiscal objectives isevident enough. It is also clear that if growth wereto slow down and unemployment were to rise,

needed reforms would be hard to introduce (particu-larly if they were seen as likely to lead to moreunemployment) and fiscal targets would not bemet—as the tax take declined and as social securityspending increased. There is, moreover, a dangerthat hysteresis-type effects would soon lead to theincreased unemployment coming to be diagnosed asstructural.

Such arguments might lead to the straightforwardview that what is needed for EMU to succeed islabour-market reform, fiscal restraint, and an appro-priate monetary policy to generate recovery, growth,and reduced unemployment. True enough, that iswhat is needed. But what is left out is how such aresult might be achieved with a group of independ-ent sovereign states.

The main argument of this paper is basically sym-metrical as far as labour-market reform and fiscalrestraint is concerned. There are 11 member states.Suppose each is convinced of the benefits of labour-market reform, fiscal restraint, and an appropriateadjustment of monetary policy. Outside EMU, eachcould coordinate an appropriate adjustment of policy.Within EMU, however, monetary policy is outsidetheir direct control. They face a prisoner’s dilemmasince the costs of labour-market reform or of fiscalconsolidation look large if not compensated for bymonetary relaxation. A cooperative agreement topursue labour-market reforms together, or, throughsomething like the Stability and Growth Pact, topursue fiscal consolidation together, solves the di-lemma since it leads to the likelihood that the interestrate will be adjusted accordingly. In broad terms,this is how we interpret the ‘widespread agreement’on the need for labour-market reforms and theconsensus on the need for coordinated fiscal re-straint under the Stability and Growth Pact.

But this puts the single central bank into a pivotalrole. We suggest that the consensus would be verylikely to fall apart unless the monetary policy adjust-ments that, in effect, validate the cooperative strat-egies, actually come about, and are seen by partici-pants as likely to come about.

We argue that this has large implications for the typeof ‘monetary reaction function’ that needs to beestablished by the central bank. (The detailed argu-ments are set out at the end of section II above.) If

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Journal of Economic Perspectives, Winter, 51–72.Buti, M., and Sapir, A. (1998), Economic Policy in EMU, Oxford, Oxford University Press.Cobham, D. (ed.) (1994), European Monetary Upheavals, Manchester, Manchester University Press.Dornbusch, R., Favero, C., and Giavazzi, F. (1998), ‘Immediate Challenges for the European Central Bank’, in D. Begg,

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inflation is under control, monetary policy must beseen to ‘reward’ supply-side improvements or evento anticipate them. Fiscal restraint, too, must beexpected to feed through to appropriate monetaryrelaxation. And, given uncertainty about where thenatural rate of unemployment actually is in Europe,it is desirable that the ‘upside’ should be tested fromtime to time—as was done in the 1990s by the USFederal Reserve. Above all, symmetry is important;it is essential that deflationary shocks lead to theanticipation of interest-rate falls. In effect, what weargue for is a ‘Greenspan-type’ of reaction functionwhich can be anticipated both by market partici-pants and other policy-makers.

The task for the ECB is bound to be difficult in theinitial years of EMU. But one danger that wehighlight is that a European central bank could betempted to adopt the strategic role of developingthreat strategies against, for example, certain typesof wage pushfulness across the EMU area, or ofseeing a role for itself in ‘punishing’ deviations fromthe Stability Pact. The former would be very hard tocarry out across a disparate area such as Europe. Inany case, if threat strategies are necessary (or, for

that matter, if cooperative agreements are neces-sary), it would seem a matter for national authoritiesand labour-market institutions. A ‘disciplinary’ rolevis-à-vis other aspects of the policy-making proc-ess—such as the Stability and Growth Pact—couldwell do more harm than good and would raiseserious issues of democratic accountability. (If fis-cal policy were to be relaxed, a normal reactionfunction response should ensure that it did not leadto inflation).

But the main reason for worry about a disciplinaryrole for the central bank is that, especially in termsof reputation building, it could work against theestablishment of the right kind of reputation andhinder the development of the type of sensible-looking reaction function that is necessary for theother pillars of macroeconomic strategy within EMUto hang together.

The development of an appropriate reaction func-tion is not just important for Europe. Increasingly,the European Central Bank will be seen as playinga role within the international financial system com-parable to that of the US Federal Reserve.

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C. Wyplosz, and F. Zimmerman (eds), EMU: Prospects and Challenges for the Euro, CEPR, Oxford, Blackwell.Prati, A. and Schinasi, G. (1998), ‘The ECB and the Stability of the Financial System’, mimeo, paper presented at

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Constraints Facing Monetary Policy Makers, Boston, MA, Federal Reserve Bank of Boston.Walsh, C. E. (1995), ‘Optimal Contracts for Independent Central Bankers’, American Economic Review, 85, 150–67.

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The assessment: macroeconomic policy after EMU