Macroeconomics Macroeconomic Stabilization Policies in the European Economic and Monetary Union (EMU) and the case of Portugal Pedro Pereira Nunes (937) Pedro Silva (959)

April 19, 2006 1

Agenda

1.

EMU - Introduction

2.

Stabilization Policies in the Euro zone

3.

Stabilization Policies in EMU States

4.

Portugal as an EMU Member

5.

Presentation Discussion

2

1. EMU – Introduction Scope and Purpose

Objectives: • Understand the Macroeconomic impact EMU have had in domestic economies like Portugal; • Convey to the audience the basic issues regarding EMU: • What has been the impact on our country / economy of the EMU? • In what way are EMU Members constrained? • What are the major risks of belonging to the EMU? • How to evaluate the performance of Portugal during the EMU transition? • What are the challenges Portugal face in the near future? 3

1. EMU – Introduction The 3 stages of monetary cooperation in EU

•The idea of a EMU was first presented in the summit meeting of Hague in 1969, by the German Chancellor Willy Brandt. • In 1979 EMS was established, where most nations of the EEC linked their currencies to prevent large fluctuations relative to one another (ECU). In 1989, the Delors Report defined the three stages to introduce EMU: Stage I (1990-1993)

Exchange controls were abolished, and capital movements were completely liberalized in EEC.

Stage II (1994-1998)

The European Monetary Institute is established as the forerunner of ECB (which was formed in 1998).

Stage III (1999- )

From the start of 1999, the Euro is now a real currency, and a single monetary policy is introduced under the authority of the ECB.

• In 1/Jan/2002 the EMU the national banknotes and coins were replaced by Euros. 4

1. EMU – Introduction Maastricht Treaty and Stability and Growth Pact

Maastricht Treaty (MT; formally, the Treaty on European Union) •Signed on 7/02/1992 in Maastricht, and entered into force on 1/11/1993; •Imposed several rules to Members, from which the most important are the budget and the public deficit limits (3% and 60% of GDP, respectively). •ECOFIN - responsible for analysing those and deciding on subsequent procedures. Stability and Growth Pact (SGP) •Implemented in 1/01/1999 with the purpose of reinforcing the MT and imposing more strict rules regarding excessive deficits; •Multi-annual plan, annually revised and closely followed by the EU; •Faster pace of the excessive deficits procedure, along with a new set of sanctions (“nuclear bomb”). 5

1. EMU – Introduction Benefits vs. Costs of belonging to EMU

Benefits

• Elimination of the conversion costs between two different currencies; • Elimination of the foreign exchange rate uncertainty costs; • Decrease in Central Banks’ money reserves; • Financial stability; • Strong reputation of EMU; • Increased competition (banking, services and goods);

Costs

• Monetary policy autonomy lost; • Fiscal policy is strongly constrained (by SGP and MT) • Costs of substitution of domestic currency by the Euro (temporary effect); • Effects of some EMU potential benefits will only be experienced by the population in the long-run, when the majority of the negative impacts can be felt in the short-run (since 1999);

• EMU – large internal market. 6

1. EMU – Introduction Benefits vs. Costs of belonging to EU but not to EMU (1)

•The EU Non-participant Countries in the EMU, maintain their currency, keep monetary policy under their authority and do not transfer its currency reserves to the ECB. •In 1999, a new exchange rates mechanism went into force, ERMII, which establish a link between the euro and the currencies of the countries that are on the process of adherence to EMU (e.g.: Denmark). •This link limits the autonomy of the countries in that situation, and so they have to conduct a monetary policy very much aligned with the Euro zone. They will continue to support the costs of uncertainty regarding the exchange rates of their currencies, and they will probably pay higher interest rates than EMU Members. 7

1. EMU – Introduction Benefits vs. Costs of belonging to EU but not to EMU (2)

•Despite those costs, EU Members non-participating in the EMU, collect some benefits from the union single currency. They benefit from the information cost reduction and transactions with EMU countries, and also enjoy some additional political and bargaining power in foreign affairs (outside the EU sphere). •The EU Members that do not want (yet) to enter into the EMU, don’t have the monetary constraints that ERMII impose. Though, they have to deal with the great influence of the euro and so their monetary policy is also partially affected by the euro. •Finally, countries outside the EMU, are actually affected by the same constraints ruled by the SGP, except for the sanctions (e.g.: budget and public deficit limits). 8

2. Stabilization Policies in the Euro zone Broad objectives

Macroeconomic stabilization makes use of a combination of budgetary and monetary policies to positively influence internal equilibrium: • Induce real GDP convergence towards potential GDP (sustained economic growth); • Approach the unemployment rate to the natural rate of unemployment;

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2. Stabilization Policies in the Euro zone Economic shocks: the need for Macroeconomic stabilization

Macroeconomic stabilization is needed to respond to economic shocks that push the economy away from potential GDP. These shocks may be of two types: • Symmetric: all the Euro area is affected in the same way (synchronous with the business cycle); • Asymmetric: only specific parts of the Euro area are affected (asynchronous with the business cycle).

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2. Stabilization Policies in the Euro zone Responsibilities and main concerns – ECB

The European Central Bank (ECB) is an independent Institution responsible for defining and executing the monetary policy for the Euro zone. ECB main concerns are: 1. Maintaining price stability; 2. Supporting the general policies of the European Union: production and employment stabilization may be pursued but not at the cost of the first objective;

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2.

Stabilization Policies in the Euro zone ECB monetary policy strategy and targets

ECB monetary policy strategy consists of three main elements: •

A quantitative definition of price stability;

•

A prominent role for money in the assessment of risks to price stability;

•

A broadly based assessment of the outlook for price developments.

ECB’s price stability objective targets to maintain the inflation rate close but below 2% over the medium term. 12

2.

Stabilization Policies in the Euro zone Price stability assessment

Price stability is assessed by the year-on-year increase of the Harmonized Index of Consumer Prices (HICP) for the Euro area. Euro area HICP is calculated as an average of the national HICPs for the 12 Euro Area countries, weighted by their relative household consumption expenditure shares. These are illustrated in the following table (for 2005 Euro area HICP):

Different Euro area countries have different relative importance regarding the way they affect ECB’s price stability objectives. Because of this, ECB has an incentive to pay more attention to the ones that have bigger Euro area shares 13

2.

Stabilization Policies in the Euro zone ECB monetary policy when compared to the US Fed

ECB has a clear and more important objective: price stability; Like ECB, the Fed takes price stability into account but also considers other goals, namely: maximum employment and moderate long-term interest rates. There are two main reasons for differing reactions between the U.S. Fed and the ECB: •

Institutional reasons because of different target setting;

•

ECB is seen to consider high growth as a more serious danger to price stability than the Fed does.

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2. Stabilization Policies in the Euro zone Responsibilities and main concerns – European Union Macroeconomic stabilization tools: • Monetary policy: ECB may use it to stabilize the Euro zone economy but not at the cost of price stability; • Budgetary policy: European Union Budget is neither suited

nor intended to drive

macroeconomic

stabilization (limited to 1,24% of the Union's gross national income);

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2. Stabilization Policies in the Euro zone The Stabilization tools and roles

Macroeconomic stabilization tools: • Monetary policy: driven by the ECB and mainly directed to price stability; • Budgetary policy: established by the member’s National Budgets that together define the Union’s global budgetary policy;

The member’s national Budgets combined with the ECB monetary policy define a set of policies that influence interest and exchange rates and therefore production and employment. 16

2. Stabilization Policies in the Euro zone The need for coordination Coordination is needed: • Between Members: the set of national budgets and economic policies should be aligned between members to avoid destabilization at global level. This is handled by (ECOFIN);

the Economic and Financial Affairs Council

• Between ECB and Members: the President of ECOFIN participates in the meetings of the ECB Council although does not benefit from explicit direct influence on the decisions (detains no voting rights).

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2. Stabilization Policies in the Euro zone ECB and ECOFIN interaction

Budgetary Forecasts, wage rate expectations

Budgetary Policy Guidance

ECOFIN

ECB

Monetary Policy Decisions

Economic and monetary policy expectations 18

2. Stabilization Policies in the Euro zone Symmetric Shocks – example

Portugal

Germany

PP

PG ASG

ASP

AD’P

Potential GDP

ADG

ADP

YP

AD’G

Potential GDP

YG

• Adverse shock decreases Euro zone aggregate demand; • A Common Central Bank can deal with these shocks (e.g. through an Euro zone monetary expansion); 19

3. Stabilization Policies in EMU States Do EMU Member States still have fiscal policy autonomy?

•After losing the monetary policy to ECB, EMU Members still have fiscal policy to manage asymmetric shocks and to promote macroeconomic stability along the business cycle (but strongly restricted by MT and SGP). •The main restriction is the 3% of GDP budget deficit limit. This might be a constraint in a recession, where tax revenues automatically decrease and unemployment benefits start to rise.

Together, these effects may leave Governments with a very narrow margin to implement the necessary budgetary adjustments to cope with a fall in AD. 20

3. Stabilization Policies in EMU States Discretionary fiscal policies

A Discretionary fiscal policy is deliberate manipulation of government purchases, taxation and transfers, in order to promote macroeconomic goals. Expansionary fiscal policy Price Level

AD0 + ΔE AD0

Contractionary fiscal policy

AD1

AS

B

A

Potential GDP

Real GDP

Price Level

AD0 AD0 - ΔE AD1 B

AS A

Potential GDP

Real GDP

A – Increase in Gov. purchases/tax cut

A – Decrease in Gov. purchases/tax increase

B – Multiplier effect

B – Multiplier effect

These policies are hampered by 3 time lags: recognition, law-making and impact. 21

3. Stabilization Policies in EMU States Automatic Stabilizers

Automatic stabilizers are structural features of governmental spending and taxation that smooth fluctuations in disposable income and consequently on consumption over the business cycle. This type of fiscal action is triggered by the state of the economy, without explicit action by the government: • Revenues side of the budget – induced taxes • Expenditure side of the budget – needs-tested spending Both types of stabilizers are aimed at decreasing the multiplier effects of changes in autonomous expenditure (investments, government purchases and exports). In case an adverse economic shock occurs, automatic stabilizers are typically not sufficient to restore production and full employment. The use of other policy instruments (such as the discretionary fiscal policy) is usually also needed. 22

3. Stabilization Policies in EMU States Budget deficit limit - consequences

Accounting manipulations, measures exclusively directed at temporary effects, – “creative accounting”.

Rigidity of the limit

According to the EMI, in 1997, 25-50% of the deficit reduction (in 8/11 countries eligible to enter in EMU) was due to these “special” measures.

Most EMU Members have been struggling to keep their deficits below the 3% mark

They have been implementing procyclical policies (expenditure cuts and tax increases during recessions)

Which have been hampering the EMU economic growth, the unemployment reduction and social recovery. 23

3. Stabilization Policies in EMU States Why 3% of GDP as the limit for budget deficit?

•The limit imposed to budget deficits can be seen as a political pressure to lead EMU Members to adopt healthy policies. 9Private savings rate

Problem of a single cut-off rate

Different economies have specific:

9Public investment needs 9Current account deficit 9Automatic stabilizers

Depending on the country at stake, a temporary deficit in a recessionary period that goes beyond the 3% ceiling might not be a threat to its financial sustainability (as the 1989 Delors’ Report emphasized, though it was not considered in the MT). N.B.: According with Buti et al. (1997), the average increase in the budget deficit exclusively due to the automatic stabilizers, during the recessions occurred in EU in the period 1961-96, was 3,1% of GDP. 24

3. Stabilization Policies in EMU States Is there an optimal approach for an EMU Member State?

In order to be able to promote an anti-cyclical stabilization policy, considering the actual constraints, a EMU Member should: 1. Maintain a budget surplus during expansion periods, periods to allow automatic stabilizers to act in case a recession occur and still preserve some margin to make discretionary adjustments in revenues and Government spending. 2. Rely on a set of structural reforms with medium to long-term impact on budget. Examples: Social Security and Health Care systems reform. The flexibility of the markets should also be addressed in order to ease the wages and prices adjustments in case an asymmetric shock occurs (in order to prevent further fall in production and rise in unemployment). 25

3. Stabilization Policies in EMU States Asymmetric Shocks – example (1)

Portugal

PP

Germany

PG

ASP

ASG

AD’G

ADP AD’P Potential GDP

ADG

DP YP

Potential GDP

YG

A Common Central Bank cannot deal with Asymmetric changes in aggregate demand for Portugal and Germany. 26

3. Stabilization Policies in EMU States Asymmetric Shocks – example (2)

How can Portugal and Germany deal with this shock if they form a monetary union? • Definition of monetary union: • Common currency; • Common central bank setting one interest rate; • Thus Portugal cannot stimulate demand using monetary policy; nor can Germany restrict aggregate demand using monetary policy; What alternative adjustment mechanisms are there then?

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3. Stabilization Policies in EMU States Asymmetric Shocks – example (3) Portugal

Germany

PP

AS’G

PG

ASP

ASG AS’P AD’G

ADP

ADG

AD’P Potential GDP

YP

Potential GDP

YG

An automatic stabilization occurs but if wages and prices are not flexible enough this will take long as well as a high cost. Low labor mobility in the Euro zone also adds to this problem. 28

3. Stabilization Policies in EMU States Likelihood of asymmetric Shocks – is this really a problem?

How likely are asymmetrical shocks within the monetary union? This is a controversial matter amongst Economists: • There are the ones who say that the possibility of asymmetric shocks will decrease with time as a consequence of the increasing economic and financial integration and the progressive convergence of EU economic policies; • There are the ones who advocate that asymmetries will aggravate with time e.g.: Krugman (1993) defends that the integration process favors regional specialization of economic activities as a consequence of economies of scale and externalities increasing vulnerability to regional asymmetric shocks) 29

4. Portugal as an EMU Member Budget deficit limit – beneficial consequences?

Despite the negative effects the budget deficit limit has been imposing to EMU domestic economies, it had beneficial effects to the Portuguese economy: • Historically low inflation (in 1997, EMU globally reached the lowest value in 40 years); • Low budget deficit; • Low long-term interest rates. rates

It has been indeed a remarkable progress for Portugal.

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4. Portugal as an EMU Member Evolution of Consumer Price Indexes Growth of Consumer Price Indices 18,0 16,0 14,0

Annual % Change

12,0 10,0 8,0 6,0 4,0 2,0 0,0 -2,0 198191 Average 1992

1993

1994

1995

1996 Japan

1997

1998 Portugal

1999

2000

2001

United States4

2002

2003

2004

2005

2006

2007

Euro area

31

4. Portugal as an EMU Member Evolution of Budget Surplus / Deficit Budget Surplus (+) / Deficit (-) 3,0 2,0 1,0

% of Nominal GDP

0,0 -1,0 -2,0 -3,0 -4,0 -5,0 -6,0 -7,0 -8,0 -9,0 1988

1989

1990

1991

1992

1993

1994

1995

Japan

1996

1997

Portugal

1998

1999

United States

2000

2001

2002

2003

2004

2005

2006

2007

Euro area

32

4. Portugal as an EMU Member Evolution of Long-Term Interest Rates Long-Term Interest Rates 14,0

12,0

% per annum

10,0

8,0

6,0

4,0

2,0

0,0 1993

1994

1995

1996

1997

1998 Japan

1999 Portugal

2000

2001

United States

2002

2003

2004

2005

2006

2007

Euro area

33

4. Portugal as an EMU Member Evolution of the Gross Public Debt Gross Public Debt 80,0

70,0

% of Nominal GDP

60,0

50,0

40,0

30,0

20,0

10,0

0,0 1995

1996

1997

1998

1999

2000

2001

Portugal

2002

2003

2004

2005

2006

2007

Euro area

34

4. Portugal as an EMU Member Evolution of GDP Growth Real GDP Growth 6,0 5,0 4,0

% of Real GDP

3,0 2,0 1,0 0,0 -1,0 -2,0 -3,0 198191 Average 1992

1993

1994

1995

1996

1997

Japan

1998 Portugal

1999

2000

2001

United States

2002

2003

2004

2005

2006

2007

Euro area

35

4. Portugal as an EMU Member Facts and Challenges

• Portuguese economy started to recover in the first half of 2005, driven by exports and private consumption; • GDP growth is expected to increase in 2006 and 2007, but still lagging behind average growth of the Euro area. Moreover, domestic economy will continue to operate below its potential for that period; • Fiscal consolidation remains the key policy challenge. In 2005 the country felt a major slippage due to strong social expenditure and the cancellation of all oneoff measures; • The deficit is expected to narrow over the projection period as a result of: • Higher tax rates; • Spending freezes; and • More in-depth reforms on the expenditure side. 36

5. Presentation Discussion

Q&A 37

References

•Cavaco Silva, A. (1999), “União Monetária Europeia – Funcionamento e Implicações”, Verbo; •European Central Bank (2004), “The Monetary Policy of the ECB”; •Federal Reserve Board (2005), “The Federal Reserve System Purposes and Functions”, Ninth Edition; •OECD (2005), “Economic Outlook No. 78”, December; •Parkin, M. (2005), “Economics”, seventh international edition; •Ypersele, Kouene (1984), “O Sistema Monetário Europeu – Origens, funcionamento e perspectivas”, Serviços das Publicações Oficiais das Comunidades Europeias. 38