Thursday, December 05, 2002

UK Treasury Having Second Thoughts on Euro?

The UK Treasury's growing reservations about the wisdom of fixing exchange rates have been revealed in a little-noticed supporting document published with this week's pre-Budget report. Treasury officials have said that the paper has been prepared for the New Delhi meeting of the Group of 20 rich and poor countries a week ago, and was written with developing countries in mind. Nevertheless it probably provides a good test of the temperature of the water being written in what might be called "Treasury-speak" (stealing yet another Roachian expression).

Officially the assessment of the five economic tests for the decision on the euro, due by next June, has not begun, you would however have to be blind not to see some of what is going on in Brussels and Frankfurt, and not, in good British style to raise the proverbial eyebrow. The language in the paper, 'Macroeconomic Frameworks in the New Global Economy, is the strongest yet heard from the Treasury about the potential risks of joining a monetary union. It warns, for example, that if a country wants to establish "a rigidly fixed regime, for example through monetary union", then "the conditions which must be met to minimise the risk of destabilising shocks are specific and demanding". Among those conditions are that "the economy must be very open, with a high share of trade with the country to which it is pegged, the economy and financial system must already extensively rely on its partner's currency, and the shocks it faces must be similar".Much of the evidence continues to raise doubts over whether Britain would or could meet those "demanding" conditions.

The paper also offers an interesting review of thinking behind current UK monetary and fiscal policy. Interestingly enough Britain has become, it seems, the land of the middle way. Contrasting the Schylla and Charybdis of complete discretion (read Greenspan and the US Fed) with fixed rules (read Duisenberg and the ECB) Britain's system is, we are informed, one of constrained discretion (this means that while you may be able to get your hand into the till, you can only take so much out at a time). The first real hint that not everyone is happy with the way things are going in Euroland comes with the following reservations expressed about the problem with fixed rule regimes:

the relationships on which such rules are based tend to break down in the face of financial deregulation, changing technology and widening consumer choice;

rigid rules do not allow any flexibility to respond to economic shocks, leading to substantial costs of adjustment and, at the extreme, irresistible pressure on the rule itself. If a fixed rule becomes too costly to maintain, it will tend to undermine credibility, rather than support it. For example, a rigid fiscal policy rule which requires offsetting adjustments irrespective of an economy’s cyclical position could exacerbate the cycle and undermine public support for the policy.

Obviously someone is thinking about the problems with the stability pact. These problems are not, however, insuperable in principle. This weeks proposals from Pedro Solbes - which would in fact give the UK (but not France, Germany, Italy and Spain) considerable leeway with defecit management - can be seen as going some way towards calming British anxiety here. In another little aside they also indicate that they are not as blind as Frankfurt seems to be to the real problems of the moment:

Shifting the policy focus towards sustainable long-term goals requires governments to set realistic and appropriate objectives for macroeconomic policy which are clearly defined, and against which performance can be judged. For example, the UK has introduced a clear, single, symmetric inflation target. The symmetry of the target means it is clear that inflationary and deflationary pressures will be resisted equally, and there is no dual targeting of inflation and the short-term exchange rate.

In treasury-speak this means that the deflation watch is on. On the subject of monetary union and other forms of fixed-peg system the document contains the following:

The exchange rate can provide an alternative nominal anchor for monetary policy. Countries have put in place a variety of different exchange rate regimes, ranging from a rigidly fixed regime (e.g. through monetary union or a currency board), to regimes that peg the exchange rate to a greater or lesser degree. At the other extreme, a freely floating rate requires domestic monetary policy to provide the nominal anchor.

A fixed exchange rate does not allow any scope for ‘constrained discretion’ in response to shocks. Since it sets a rigid rule, shocks have to be absorbed elsewhere in the
economy, if stability is to be maintained.

If a country wants to establish a fixed exchange rate as part of a longer term policy framework, the conditions which must be met to minimise the risk of destabilising shocks are specific and demanding: the economy must be very open, with a high share of trade with the country to which it is pegged, the economy and financial system must already extensively rely on its partner’s currency, and the shocks it faces must be similar. It must also be willing to give up monetary independence for its partner’s monetary credibility; this means that its fiscal policy must be flexible and sustainable, and it must have flexible labour and product markets to cope with shocks when the exchange rate can’t adjust. The real credibility of any peg thus does not come from the peg itself, but from putting in place the wider institutional arrangements that support the regime and which facilitate adjustment. Experience suggests that a peg in itself cannot be relied upon to be the driver for the essential, wider-ranging reforms.

Some have argued that in a world of international capital mobility, it is not credible for countries which are open to capital flows to run intermediate forms of exchange rate regime in the long-term. This is because they do not have the institutional backing provided by more rigid regimes, such as currency boards, so lack sufficient credibility and strength to withstand speculative attacks. Thus only the extreme ends of the spectrum, (of freely floating or very rigid regimes such as monetary union or a currency board) are feasible. But even with a very rigid fixed exchange rate regime, such as a currency board, the same conditions apply, i.e. monetary and fiscal policy have to operate in a way consistent with it. A fixed exchange rate regime cannot be expected to solve a country’s economic problems if the appropriate macroeconomic framework is not in place. Argentina’s recent experience demonstrates the difficulties of sustaining a fixed exchange rate regime, even where a currency board is used.

Obviously the force of these comments is directed towards the problems of more fragile economies of the newly developing countries type. It should not however escape our notice that the UK economy has a very different form of 'openness' to that of the main Euro economies, an openness to international finance, and rapid capital movements (remember 1992 and the EMU exit). The UK economy may experience shock whichs differ fundamentally from those to which the other Euro economies are susceptible. It should also be noted that while the weaknesses of the fixed rate regime type are identified (and even Argentina is mentioned) the document is strangely silent on the problems of a free-floating regime (which, of course, are enormous for a developing economy, but seem not to be extreme in the context of the UK's current needs).
Sweden To Hold Euro Referendum

In what is going to be the first real popular test for the Euro, Sweden has announced plans to hold a referendum on whether to adopt the single European currency on September 14, 2003, Swedish Prime Minister Goeran Persson said on Friday following a meeting of political party leaders. Of course, there's a lot of water to go under the bridge between now and September 2003.

"We have agreed to hold a referendum on the second Sunday in September," Persson said, urging the country's political parties to cooperate across party lines to ensure a "yes" vote. Sweden is a member of the European Union but has joined Denmark and Britain in opting -- so far -- to stay out of the euro zone. Persson said he was optimistic about securing a "yes" vote but acknowledged that the Swedish public was deeply split over the issue. "I believe it will be a yes, but it is far from certain," he said. "We are all a little divided on this issue. That is why we are holding a referendum." Most opinion polls over the past year have indicated Swedes would back swapping their currency, the krona, for the euro, although recent surveys point to more resistance. A Gallup poll published Friday showed 40 percent of Swedes would say "yes" if a referendum were held today, 34 percent would say "no" and 25 percent were undecided. The poll showed however that the "yes" camp's lead had shrunk from 20 percentage points in July to just six points in November.
Source: EU Business

Solbes Presents the Commission Pact Reform Proposals

Pedro Solbes, EU commissioner for economic and monetary affairs, on Wednesday set out the Commission's proposals to reform the operations on the EU's stability and growth pact, which commits member states to limit their budget deficits. As I indicated earlier in the week, it is hard to see how these proposals, which are likely to benefit mainly non-Euro zone members can be well received by the hard-pressed debit-ridden countries (Greece, Italy and Germany in particular). A careful reading of the text could see it as an unambiguous tightening of the pact, especially the part which refers to the requirement for " a careful examination to be made by the Commission of outstanding public debt, contingent liabilities (such as implicit pension obligations) and other costs associated with ageing populations." It remains to be seen how EU finance ministers will interpret and react to the text. The Communication presents five proposals to improve the interpretation of the Pact in order to ensure a more rigorous adherence to the goal of sound and sustainable public finances:

Due account should be taken of the economic cycle when establishing budgetary objectives at EU level and when carrying out the surveillance of Member States budgetary positions. The 'close to balance or in surplus' requirement of the SGP would be defined in underlying terms. This isolates out the impact of the economic cycle on budgetary positions. As such, it provides a better picture of the true state of public finances in a country, and enables the Commission to carry out a better assessment of compliance with budgetary commitments given in the Stability and Convergence programmes.

Clear transitional arrangements should be established for countries with underlying deficits exceeding the "close to balance or in surplus' requirement. They would be required to achieve an annual improvement in the underlying budget position of 0.5% of GDP each year until the 'close-to-balance or surplus' requirement of the SGP has been reached. This rate of improvement in the underlying budget position should be higher in countries with high deficits or debt. Also, a more ambitious annual improvement in underlying budget positions should be envisaged if growth conditions are favourable. This proposal recognises that account must be taken of economic conditions when setting the pace of budgetary consolidation, but that the deadline for reaching the goal of the Pact cannot be postponed indefinitely.

A pro-cyclical loosening of the budget in good times should be viewed as a violation of budgetary requirements at EU level, and should lead to an appropriate and timely response through the use of instruments provided in the Treaty. Countries must avoid a pro-cyclical loosening of budget policies in good times as the automatic stabilisers provide enough cushion over the economic cycle.

Budgetary policies should contribute to growth and employment. The 'close to balance or in surplus' requirement should be combined with the right incentives to help ensure the implementation of the Lisbon strategy. A small temporary deterioration in the underlying budget position of a member state could be envisaged, if it derives from the introduction of a large structural reform, like for example a tax reform or a long term public investment programme whether in physical infrastructure or in human capital. However, this should only be envisaged if the Member State concerned fulfils strict starting budgetary conditions: substantial progress towards the 'close to balance or in surplus' requirement and general government debt below the 60% of GDP reference value. Moreover, the Commission must verify that there is a clear and realistic deadline for returning to a position of "close to balance or in surplus", and that an adequate safety margin is provided at all times to prevent nominal deficits from breaching the 3% of GDP reference value. To reflect differences in the sustainability of public finances across Member States, a small deviation from the 'close to balance or in surplus' requirement of a longer-term nature could be envisaged for Member States where debt levels are well below the 60% of GDP reference value, and when public finances are on a sustainable footing. This will require a careful examination to be made by the Commission of outstanding public debt, contingent liabilities (such as implicit pension obligations) and other costs associated with ageing populations.

The sustainability of public finances should become a core policy objective at EU level with greater weight being attached to government debt ratios in the budgetary surveillance process. Countries with high debt levels well above the 60% of GDP reference value would be required to set down ambitious long-term debt reduction strategies in their stability and convergence programmes. Failure to achieve a "satisfactory pace" of debt reduction towards the 60% of GDP reference value should result in the activation of the debt criterion of the excessive deficit procedure.
Source: European Commission for Economic and Financial Affairs

Calmfors and Corsetti Join the Hunt

Hot on the trail of EU commissioner Pedro Solbes, two more European economists argue the case for a loosening of the stability pact in today's Financial Times. A loosening which would allow not cyclical but structural deficit fluctuation. This is to encourage the 'good boys' and punish the 'bad' ones. Only one problem, most of the beneficiaries are non-Euro countries, and it's hard to see how the non-beneficiaries are going to arrive at a clean bill of health.

Their proposal is to allow countries with a debt-to-GDP ratio below a given percentage, for example 55 per cent, to run larger deficits than 3 per cent of GDP in recessions. The deficit limit could then be raised in steps as the debt ratio was lowered. Such a "ladder" of deficit ceilings could enhance the incentives for fiscal discipline, as governments would be seen to enjoy the benefit of moving up a rung after reducing their debt. They stress that for reasons of credibility it is important that any changes in the maximum deficit do not accommodate the current budgetary problems of Germany, France and Portugal etc. Their proposed 55 per cent limit would not do this, as these three countries will all have debt ratios close to 60 per cent - and rising - next year.

They also stress that it would be a mistake to change the long-term rules to solve a short-term problem, that there is no "quick fix", as the present situation was caused by insufficient fiscal retrenchment in the earlier boom. The problem is that it was probably presicesly these countries - those with debt to GDP ratios over 55% and rising, and who are now facing recession - that Prodi had in mind when he called the stability pact 'stupid'. I fear it is precisely the 'quick fix' that the politicians are looking for.

The European Union's stability pact has been much derided. To restore some credibility, the European Commission will tomorrow present its reform proposals. Yet preserving the spirit of the pact will require more fundamental changes than a new interpretation.

The basic problem is how to combine long-run fiscal discipline with short-run flexibility. The stability pact is mainly geared towards the first aim: to create a counterweight to the risk of fiscal profligacy. There has always been a fear that the incentives for fiscal responsibility would weaken once monetary union was created. Recent developments confirm these fears. At the same time, there is a case for refining the stability pact to facilitate counter-cyclical stabilisation.

Any modification of the EU fiscal policy framework involves a trade-off. On one hand, reforms must not be seen as giving in to claims from member states with current difficulties, since this would ruin the future credibility of any rules. On the other hand, if the current framework is viewed as too rigid it will lose its legitimacy.

What should be avoided is a relaxation of the budget target over the cycle, given the future strain on government budgets of ageing populations. Reductions in government debt, and thus in interest payments, are one way of mitigating this problem. So this is not the time to loosen budgetary requirements by introducing a "golden rule", according to which governments can borrow for investment.
Source: Financial Times

Pedro Solbes Wants to Give Flexibility to the Pact

In a new draft paper containing proposals to reform the stability pact, Pedro Solbes wants to reward those countries with sound finances and low debt, by giving them more flexibility to combat economic downturns. Only problem, the good countries are mostly non-Euro ones. To quote the FT: "Those benefiting most from this new flexibility would be Britain, Ireland, the Netherlands, the Nordic countries and most of the EU's 10 candidate countries - mainly from the communist bloc - which have low debts and small pensions liabilities".

Pedro Solbes, EU monetary affairs commissioner, wants to focus more attention on high debt, arguing Europe is failing to prepare for an impending pensions crisis. He hopes his paper on budgetary co-ordination will restore much-needed credibility to the stability pact, which was designed to underpin the euro by imposing fiscal discipline.Mr Solbes will try to answer the charge that the stability pact lacks flexibility by proposing that countries with "high-quality public finances" - including low deficits and low debt - should be able to borrow to fund investment.

The question of what qualifies as "good" investment, boosting growth and justifying short-term deficits, will be controversial. For instance, the Commission welcomes Britain's expenditure on hospitals and schools, while France says it should be able to spend more on research and development. In Germany labour reform is a priority. The Commission will give its view on each state's budget proposals each year, but the final verdict will lie with EU finance ministers.

Those benefiting most from this new flexibility would be Britain, Ireland, the Netherlands, the Nordic countries and most of the EU's 10 candidate countries - mainly from the communist bloc - which have low debts and small pensions liabilities......Belgium and Greece both have debts of over 100 per cent of GDP - far above the 60 per cent limit set at Maastricht - but Italy is by far the biggest problem: its debt is 110 per cent and rising.
Source: Financial Times