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Published now for the sixth year, the European Economic Advisory Group (EEAG) Report on the European Economy consists of two parts: one dealing with short-term macroeconomic issues and the other with the choice of a long-term economic model for Europe. The senior European economists who comprise the EEAG*, say that since December 2005 the European Central Bank (ECB) has increased its main refinancing rate in six steps by 1.5 percentage points to a level of 3.5 percent at the end of last year. This, together with an appreciation of around 10 percent of the euro against the dollar, implied more restrictive monetary conditions in the euro area last year. A likely continuing appreciation of the euro, a steady decline in inflation and increasing real interest rates will make overall monetary conditions in the euro area in 2007 even less accommodative than last year. The EEAG says in the report: Not only were monetary conditions in the euro area at the end of last year as restrictive as they have ever been. Also an estimated reaction function of the ECB (a forward-looking Taylor rule) indicates that the actual interest rate is somewhat above target at the moment. Therefore, further increases in the ECB interest rate would not be in line with the bank’s past behaviour. For this reason, we have assumed that the ECB will opt for an interest-rate pause, leaving the main refinancing rate at 3.5 percent during 2007 and 2008. But, given the current pronouncements of the bank, additional interest rate rises are possible, although only higher inflation than earlier expected or stronger macroeconomic developments would justify such a policy. On the other hand, if there were to be stronger fiscal consolidation efforts, this could create room for lower interest rates. The main conclusions regarding the short-term issues are:
As to the issue of what economic model Europe should opt for, the main conclusions are:
Chapter 1: Macroeconomic outlook and policy
A mild slowdown in the world economy with growth of slightly below 5 percent both this year and next is forecasted. Growth in the EU will fall somewhat, but the recovery will continue: output is expected to grow by 2.2 percent 2007 and 2.5 percent in 2008.
The fiscal deficits in the EU states are falling. But in view of future demographic pressures, the current reductions are insufficient. Indeed, they are potentially dangerous, as they may create the illusion that fiscal problems have been overcome. Governments should also restructure their spending in favour of investment, R&D and education.
A likely continuing appreciation of the euro and falling inflation will tighten monetary conditions in the euro area. An analysis of past behaviour of the ECB suggests that its key interest rate is now above target. Therefore, it is hard to justify further interest rate hikes.
The common monetary policy in the euro area has at times fitted individual countries very badly. There is no trend towards increased business cycle synchronisation. Overall, the consideration given to the large member states by the ECB is often not commensurate with their economic weight.
Chapter 2: Macroeconomic adjustment in the euro area
The chapter analyses the macroeconomic adjustment problems in the euro area and what we can learn from them. The main focus is on Ireland and Italy.
Ireland is a typical example of an expansionary shock. This has led to a strong appreciation of the real exchange rate, which makes the country vulnerable to a global downturn. The Irish experiences point to two previously underestimated problems.
Italy has been exposed to strong contractionary shocks: increased competition from emerging economies and negative productivity growth. At the same time wages have increased faster than in other eurozone countries. As a consequence, there has been a strong real appreciation. The current attempts to improve competitiveness through a reduction in payroll taxes are insufficient. The only way out is across-the-board deregulations in markets for products and services to boost productivity growth.
Chapter 3: The new EU states
The ten countries that acceded to the EU in 2004 have experienced fast growth. Only one of them, Slovenia, has so far been accepted into the eurozone. Last year, Lithuania’s application was turned down and Estonia was advised not to apply, in both cases because of too-high inflation.
Strict application of the inflation criterion as a way to postpone entry into the monetary union is creating a potentially vulnerable situation for the countries participating in ERM II. The reason is the risk of overheating followed by capital flow reversals and financial stress. Given that these countries fulfil the other EMU criteria, they should be allowed quickly to adopt the euro, provided that inflation mainly reflects high growth (the so-called Balassa-Samuelson effect). The chapter proposes a Balassa-Samuelson rebate of up to one percentage point that should be added to the inflation criterion when applied to fast-growing, new member states.
Chapter 4: The Scandinavian model
The Scandinavian model has come to be seen as an alternative to the Anglo-Saxon model, capable of combining good macroeconomic performance with high social protection. Finland and Sweden have had high output growth, although employment developments have been less satisfactory. In Denmark, labour market developments have been very favourable, but output growth less so.
The Scandinavian countries have been more successful in generating employment – mainly due to high female labour participation – than in generating hours worked. Hours worked per person are higher than in most euro area countries, but substantially lower than in, for example, the US. Benefit dependency rates are also high.
The Scandinavian experiences are not evidence that one can do without market-liberal reforms. Instead, product market deregulations have clearly contributed to high output growth. Denmark shows how moderate reductions in benefit generosity and higher requirements on the unemployed can reduce unemployment significantly. The flexicurity explanation (generous unemployment benefits and low employment protection) of low Danish unemployment is largely a myth not borne out by economic analysis.
The policy lesson for Europe is that measured reforms in both product and labour markets can be very effective. Less successful Scandinavian experiences point to the importance of simultaneous reforms in interconnected social insurance systems (unemployment insurance, early retirement, health insurance, etc.). Otherwise, lower benefit generosity in one system only causes an overflow of benefit recipients onto other systems.
Chapter 5: Tax competition
Corporation tax rates in the EU have fallen significantly, fuelled by tax competition from the new EU states. This has been criticised as unfair, because the new member states with the lowest tax rates also receive grants from the rest of the EU. But grants and low taxes serve the same end: to attract capital and reduce income dispersion across the EU.
A continued fall in corporation taxes is to be expected. This raises equity concerns. The best solution appears to be a destination-based tax, levied on capital owners where they consume. This tax does not distort the location of productive activity. The chapter proposes the de facto introduction of such a tax by raising the VAT (which is a tax on profit and labour income) and making an offsetting reduction in labour income taxes.
Such a tax reform can be made by an individual country, since it would attract capital from other countries. If all countries used such a tax, then tax competition for capital would largely disappear.
Chapter 6: Economic nationalism
A number of EU countries have pursued selective, nationalistic economic policies in recent years, for example by blocking competition-enhancing cross-border mergers and promoting national champions. Such policies typically benefit private interest groups and lead to losses for consumers.
Sometimes economic nationalism can benefit national residents as a whole at the expense of foreign residents if national firms that receive various forms of support can earn monopoly profits abroad that are transferred to the domestic economy. But the potential benefits are usually offset by the nationalistic policies of competing countries, while the costs in terms of distortions remain. This is an argument for coordination of the lowering of entry barriers to foreign firms across the EU. Otherwise there is an incentive to delay such reforms nationally, as this can allow domestic firms to consolidate their positions and thus improve their possibilities of capturing markets in other EU countries.
Economic nationalism is often associated with public ownership, both full and partial, of corporations competing with private firms. An effective way of combating economic nationalism is therefore to restrict public ownership. A debate should be opened on the introduction of a European rule that would restrict public ownership in competitive environments. Public ownership is often a remnant of the past that has persisted for no good economic reasons.
*On the European Economic Advisory Group at CESifo (EEAG): The EEAG Group consists of eight internationally renowned economists from eight European countries. Chaired by Lars Calmfors (Stockholm University), it includes Seppo Honkapohja (Universities of Helsinki and Cambridge), Giancarlo Corsetti (European University Institute Florence), Michael P. Devereux (University of Oxford), Gilles Saint-Paul (University of Toulouse), Hans-Werner Sinn (Ifo Institute for Economic Research and University of Munich), Jan-Egbert Sturm (KOF Swiss Economic Institute, ETH Zurich), and Xavier Vives (IESE Business School, University of Navarra).
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