CHAPTER IV European Economic and Monetary Union

International Monetary Fund
Published Date:
September 1998
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During 1997/98, the Executive Board held a series of discussions on issues related to EMU. Early in the year, Directors assessed the implications of EMU for financial markets (see Chapter III); preparations for EMU and EMU in the context of the World Economic Outlook were taken up in May and August 1997 and in March 1998.

At their meeting in May 1997, Directors noted that completion of EMU would represent a milestone in the economic integration of Europe and was of major importance for the international monetary system. They underlined the desirability of completing the project in a timely way, noting that a great deal had been accomplished already in preparing EU economies for EMU and in establishing the policy framework within which economic policies would be conducted once monetary union commenced. The EU authorities needed to follow through on their policy commitments and work closely together to secure the foundations for monetary union to ensure a smooth transition to EMU, Directors noted.

While noting that most EU countries had already achieved a high degree of convergence in the areas required by the Maastricht Treaty—most remarkably with regard to inflation—Directors observed that further progress was needed in the fiscal area in 1997. They underlined that, for most countries, additional fiscal measures would also be needed in 1998 to reduce deficits further in line with the medium-term requirements reflected in the Stability and Growth Pact.

The continuing high structural unemployment in Europe concerned Directors, and they emphasized that urgent action was needed to reduce labor market rigidities in most EU countries. In the context of a common monetary and exchange rate policy, inadequate flexibility in labor markets would impair the ability of individual countries to adjust to asymmetric shocks. Some Directors were concerned that failure to address labor market rigidities would result in persistently high unemployment that could erode public support over time for macroeconomic policies directed at low inflation. Directors also stressed the importance of factor and product market liberalization to ensure sustainable growth and job creation in the EU.

In establishing a macroeconomic policy framework for the monetary union, it was important to balance policymakers’ need for flexibility with the desire to establish rules that would help underpin the credibility of policies in the new environment. Directors thought that the Stability and Growth Pact had struck a reasonable balance between those two considerations. They believed that surveillance by the EU’s Council—oriented to giving an early warning of the emergence of excessive deficits—together with the threat of financial penalties, should provide a strong bulwark against fiscal indiscipline.

Directors generally agreed that the euro would, over time, constitute an attractive reserve currency that might rival the dollar. The roles of the euro and the dollar would depend importantly on developments in financial markets in Europe, including the regulatory environment and the variety of instruments available, as well as fundamental economic developments.

When the Executive Board discussed EMU in August 1997 at its review of the World Economic Outlook, Directors again remarked on the impressive degree of economic convergence achieved in Europe, including strengthened public finances, lower inflation and interest rates, and relatively stable exchange rates. Some Directors were of the view that the advances in economic convergence and the strong commitment to begin EMU as envisaged had served to lessen considerably the risks and uncertainties in the run-up to EMU.

A number of Directors stressed that the best way to minimize any remaining uncertainties about the start of EMU, and to ensure that a sustainable and strong EMU began on time, would be for countries to take fiscal action in the remainder of 1997 and in 1998 that continued to demonstrate their commitment to the requirements of the Maastricht Treaty and of the Stability and Growth Pact. Several Directors noted the risk that a number of candidates for membership might slightly exceed the fiscal deficit target. They agreed with the staff, however, that—particularly in view of the reductions achieved in cyclically adjusted deficits and the longer-term framework established with the Stability and Growth Pact on fiscal discipline—small excesses of actual deficits over the reference value should not be viewed as an impediment to EMU proceeding on schedule. In contrast, a few other Directors noted that a strict application of the Maastricht fiscal deficit criterion would be important so as not to impair the credibility of EMU.

Directors noted other challenges to sustain a successful monetary union that still had to be faced during the transition to the single currency. They broadly agreed that, in addition to sound financial policies, improving Europe’s labor market performance was critical for the success of EMU. Directors emphasized that comprehensive labor market reforms to reduce structural unemployment would not only help boost medium-term growth and improve fiscal performance, but would also help Europe adjust faster to adverse economic disturbances when monetary union was in place and increase public support for the project. Directors generally agreed that the independence of the European System of Central Banks, and its mandate and capacity to achieve price stability, should be well safeguarded by the provisions that had been put in place relating to its functioning. They generally felt that the exchange rate would not be a suitable nominal anchor for monetary policy in the euro area. Directors felt that the introduction of the euro would be accompanied by a significant restructuring of financial markets and possible instability in money demand relationships. Directors considered that the European Central Bank (ECB) would likely use a wide range of indicators in conducting monetary policy, especially in the early stages of EMU. It was noted that transparency of monetary policy would be important in securing and maintaining the credibility of the ECB.

A number of Directors observed that despite the considerable progress in fiscal consolidation, budgetary positions in many EU members might worsen in the medium to long term as a result of demographic developments; these problems would have to be addressed, irrespective of EMU.

At their March 1998 discussion of the World Economic Outlook, Directors considered that the objective of establishing a monetary union among a large number of EU member countries was within reach, in accordance with the agreed timetable. Progress in fiscal adjustment and the convergence of inflation and interest rates had been impressive. But further fiscal consolidation was desirable in the near term to strengthen medium-term growth potential and to provide for greater policy flexibility within the Stability and Growth Pact. Directors expressed particular concern, however, that structural reforms in labor and product markets were lagging.

In its April 1998 meeting, the Interim Committee requested the Executive Board to examine further the implications of EMU for IMF operations and for the conduct of IMF surveillance and to report its findings in time for the Committee’s next meeting in October 1998.

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