The Euro Area

Summary The German elections of September 18, 2005, ended in deadlock.33 The two largest parties, the CDU and the SPD were unable to form a government. The solution is a grand coalition with little hope that there will be a mandate in Germany for meaningful reforms. The economy of the euro area as a whole has structural deficiencies that originate mostly in a “social model” that is not fiscally sustainable. The major countries-Germany, France and Italy-have similar problems. In a recent euro area Article IV consultation, the International Monetary Fund (2005Jul7) expressed uncommon frustration and questioned “whether policies will muster the decisiveness needed to address the area’s still formidable problems.” Europe has declined steadily over many years and did not benefit from the technological revolution of the turn of the century. McKinsey documented in the mid-1990s that France and Germany were significantly below world class in most of the key industrial segments. Germany had lost its historical talent and courage for innovation. A study of the Bureau of Labor and Statistics (BLS) of the United States shows that productivity increases in the euro area occurred mostly before 1973 and that the United States continued on a trend of growth in productivity while Europe fell behind. The European Commission has revived the Lisbon strategy in an attempt to develop Europe as an attractive place where to work and invest. As in all continental efforts, directives at the center may find a diversity of implementation at the national level. The success of a new Lisbon Agenda requires deep reforms in product and labor markets. The elections in Germany and Italy suggest that such reforms may be politically infeasible. The three major economies of Europe-Germany, France and Italy-tightened their public finance to enter into the EMU with deficits of less than 3 percent of GDP and debts of less than 60 percent. Of course, the debt ratio of Italy has been above 100 percent. The EMU only has monetary policy while fiscal coordination proceeded through the Stability and Growth Pact (SGP). In practice, the SGP has not worked as all three major economies quickly breached their deficit ceilings of 3 percent after 2000. In March, the ECOFIN Council reformed the SGP in such a way that Professor Feldstein (2005, 11) argues that: The danger in looking forward is that each country will find ways to rationalize growing fiscal deficits, comfortable in the knowledge that there will be no formal pressure from other EMU countries and that the interest rate effects will be the same for all EMU countries. The failure to obtain popular support for Agenda 2010 in Germany suggests that politicians may not engage in further reforms of entitlements. The economies of the euro area require upfront fiscal consolidation to prepare for the approaching effects of population ageing in the 2010s. There is an important lesson of Europe for other countries that social models end in rigid markets, low growth and unemployment. The United States should focus its fiscal and monetary policies on their merits to increase interest rates to neutral levels while adjusting the fiscal deficit during a cyclical upswing and not on complex proposals to avoid a run on the dollar based on simulation models.