Before EMU starts: economic policy stimulates recovery in Europe

The decision on EMU strongly affects the course of monetary and fiscal policies in 1997 and especially in 1998. We assume that the monetary union will start in January 1, 1999 with a sizable number of participating countries. Once the decision on the members is made in the spring of 1998, any differences between short-term interest rates in the participating countries can be eliminated. Currently, money market rates in Italy, in Spain and in Portugal are substantially higher than, for example, in Germany. These high rates will be reduced quickly. Monetary policy will thus become more expansionary not only in these countries but also in Western Europe as a whole. It is not likely that the central banks in countries with relatively low interest rates will tighten their policy because such moves would be resisted in the light of the severe unemployment in Europe. While fiscal policy is concerned with reducing budget deficits this year in order to qualify for EMU, the course will change in 1998. Governments can afford to loosen this policy stance because the actual deficits in 1998 are not decisive for the entry into the monetary union. Also, the stability pact will become effective only from 1999 onwards, so there will not be any sanctions even if budget deficits are excessive in 1998. Therefore, further substantial cuts in expenditures or increases in revenues are not likely. In a few countries, even tax cuts were announced for 1998, for example, in France and in Germany. In summary, fiscal policy will have an expansionary effect on economic activity in 1998. The upswing in Western Europe will continue in 1997 and in 1998. Export conditions are favorable since the world economy will expand at a healthy pace. The increase in internal demand will accelerate because of the impulses from economic policy. In practically all countries, capacity utilization will reach or even surpass its normal level in the course of next year. As central banks will be expansionary in the fourth consecutive year, the phase of disinflation in Europe is coming to an end. Inflation will go up somewhat in 1998 and more so in the following year. Because of the deteriorating outlook for inflation, European currencies will further devalue against the US dollar and long-term interest rates will increase considerably. All these developments are a burden for the start of EMU. The future European Central Bank will have to follow a restrictive course if it wants to demonstrate its commitment to price level stability. . The Dublin resolution for a "stability pact" is intended to limit budget deficits after EMU will have started. However, the agreement is not sufficient to reach this target for several reasons: First, the governments themselves will decide on sanctions; this raises the possibility that political factors play a major role and that opportunistic behavior will dominate. Second, the sanction mechanism has no bite because too much time goes by until sanctions are implemented. Furthermore, in order to avoid the payment of a fine it is sufficient to reduce the budget deficit to a level of 3 percent of GDP once in five years. A strict sanction mechanism is probably objected by several governments because they fear that it would prevent the automatic stabilizers from working appropriately, so that, e.g., fiscal policy would have to be restrictive in a recession. However, this fear is not warranted because the cyclical budget deficits in all EU countries have not been veiy large during the last fifteen years. In order to avoid excessive deficits in the future, it would be necessary to reduce the structural deficits considerably, in some cases even to zero. This is an ambitious target, but it is precisely what was decided upon in Dublin. So far, however, this is merely a promise because in practically no major country efforts are made to balance the budget by 1999 — a fact which reduces the credibility of the Dublin resolution even more.