Policy Challenges for the Euro Area

• Author: Klaas Knot, Donogh McDonald, and Karen Swiderski
• Position: Economist in the European Union Unit of the IMF's European I Department/Advisor in the European Union Unit of the IMF's European I Department/Senior Economist in the European Union Unit of the IMF's European I Department

Improved economic performance and a sound policy framework in the euro area provide a solid basis for EMU. But important challenges remain: making an eclectic approach to monetary policy transparent, strengthening public finances further, addressing the structural causes of high unemployment, and ensuring an appropriate mix of economic policies.

In preparing for European Economic and Monetary Union (EMU), the euro area countries have considerably improved their macroeconomic policy environment from what it was in the early and mid-1990s (Chart 1). Inflation has fallen to very low levels, fluctuating around an annual rate of 1 1/2 percent during 1997-98, and there is little sign of inflationary pressure for the period ahead. Public finances are in far better shape than earlier in the decade. Despite lackluster economic growth in the region, the average ratio of government deficit to GDP was reduced by more than 3 percentage points between 1993 and 1997.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

To ensure that EMU runs smoothly-and, especially, to achieve and sustain the higher growth rates that will be necessary to reduce high unemployment rates-euro area countries will need to consolidate and capitalize on these achievements. This will require continued prudent macroeconomic policies combined with reforms aimed at making labor and product markets more flexible. Effective policy coordination will also be needed, because fiscal and structural policies will continue to be designed and implemented at the national level.

Monetary policy

The design and implementation of monetary policy in the euro area will be the preserve of the European System of Central Banks (ESCB), comprising the European Central Bank (ECB), which will make monetary policy decisions, and the national central banks, which will be primarily responsible for implementing those decisions.

The ESCB's mandate clearly gives priority to price stability, which has been defined by the ECB as inflation of less than 2 percent in the euro area as a whole. The emphasis on price stability is reinforced by the high degree of independence given to the ESCB and other provisions that insulate decision makers from political pressures. In pursuing low inflation, the ESCB will be continuing policies already firmly established by the national central banks. Nonetheless, EMU represents a change in the monetary policy regime in two key respects. First, the scope for national monetary and exchange rate policies-already constrained by the European Monetary System's exchange rate mechanism (ERM)-will disappear. Second, the geographic orientation of monetary policy will broaden to take account of conditions throughout the euro area. Until now, because of the anchor role the deutsche mark has played in the ERM, the Deutsche Bundesbank's policies have been the predominant influence on the monetary stance of euro area countries.

This change in regime will produce important challenges for the ESCB. Some of these-such as putting in place the pertinent information and operational systems, or compiling area-wide monetary statistics-are fairly straightforward, if time consuming. Others are more complex. In particular, the ECB will initially be faced with many uncertainties concerning the demand for financial assets and the mechanisms through which monetary policy influences the economy. Of course, even long-established central banks such as the Bank of England, the Bundesbank, and the U.S. Federal Reserve System often have to deal with these problems. However, the difficulties of assessing the impact of policies are likely to be even greater for the ECB-at least initially-because of both the restructuring of financial markets that will accompany the introduction of the euro and the...