Gently Turning
The political economy of EMU
David Soskice
Wissenschaftszentrum Berlin, Duke University
Bob Hancké
London School of Economics and Political Science
with the co-operation of
David Brown
Clara Crespo
Alexandra Hennessy
Carol St Louis
Report for project
2000-203-1
'Institutionen, Wirtschaftswachstum und Beschäftigung in der EWU'
financed by the Hans-Böckler-Stiftung
First version: please do not cite without permission
Comments welcome
May 2002
Acknowledgements
Our thanks go to many of our colleagues for their help in preparing this report: Richard Bronk, Wendy Carlin, Damian Chalmers, Stefan Collignon, Tom Cusack, Sebastian Dullien, Donatella Gatti, Frank Gerlach, Simon Hix, Dermot Hodson, Ilona Köhler, Hannelore Minzlaff, Waltraud Schelkle, Daniela Schwarzer, the members of our project advisory board, as well as seminar participants at the ETUI, IG Metall district Stuttgart, LSE, Duke University, the ANU, and the WZB.
Table of contents
1. Introduction: The political economy of EMU 4
2. The political economy of wage-setting in EMU 12
3. The political economy of fiscal policy in EMU 32
4. Conclusion: Implications for economic growth 47
Literature
Chapter 1
Introduction
The political economy of EMU
1. Introduction
The economic spectre currently haunting Europe is a very different one from that encountered only a generation ago. In the mid-1970s European economies faced stagflation, a simultaneous occurrence of stalling economic growth, rising unemployment and sharply increasing inflation. Even the active pursuit of Keynesian policies --Nixon's statement that 'we are all Keynesians now' could not have come at a less propitious moment-- proved unable to tame the beast and put the European economies back on the growth track.
Today, inflation is conquered, after almost two decades of sustained disinflation policies in the current EMU member states. Unemployment, however, remains high in the euro area (albeit with marked differences between large and small economies, with the latter consistently performing on a par with the Anglo-Saxon economies despite well-developed and generous welfare states). Even several years of above-trend growth in the late 1990s made only a small dent in the EMU-wide aggregate unemployment rate. To a large extent, this deplorable record on unemployment is related to the restrictive regime heralded by the Maastricht criteria, and the start of EMU --consisting of a non-accommodating central bank, a restrictive fiscal policy framework, and a collection of highly diverse and unco-ordinated wage bargaining systems-- led to profound fears among many that Europe was now entering the worst of all worlds.
Although EMU has only been formally in existence for only two years, much of macroeconomic and structural policy-making in Europe in the last decade has been conducted under its potential shadow. Many commentators have seen EMU and its precursor ERM regime as static: a conservative monetary system which has relatively successfully kept inflation at a low level, ruling out discretionary fiscal policy and imposing a steady pressure towards flexible product and labour markets. There is considerable merit in this view. It encompasses moreover two opposed normative positions: By many economists it is seen as providing the preconditions for growth and low unemployment in Western Europe, while others criticise it as the cause of low growth and high unemployment.
We take a different view in this report. We argue that there has been movement in macro-economic policy from the quite restrictive stance that the Bundesbank imposed on what is now the EMU area, to a more flexible approach in relation to fiscal policy in which Ecofin is beginning to play a more important role. And while the basic monetary stance has certainly remained conservative, the ECB has focussed on inflation while remaining pragmatic on fiscal developments. Secondly, we argue that the ominous 'linear' view of increasing labour market flexibility and concomitant union decline as a consequence of EMU is far from the whole picture. Certainly, there is no significant development of a pan-European labour relations system, let alone centralised or co-ordinated bargaining at the EMU level. The balance of power, moreover, has perceptibly changed towards employers over the past decade. In addition, labour markets have become, along a range of dimensions, more flexible than they were. None the less, labour markets still look quite different in most EMU member states from those in the UK and the US. This is true most evidently in three areas: collective bargaining, vocational training and employee representation.
This report seeks to answer two questions. The first is how to understand the current policy set-up in EMU. We hypothesised above that fiscal and to some extent monetary policy currently operate in a more pragmatic and flexible way than was originally envisaged. How does monetary and fiscal policy currently operate in EMU, and what role does collective bargaining play in relation to monetary and fiscal policy? Why did policy develop in this way over the past decade? The second question takes off from that analysis. Given the answers to the first question, what type of feasible developments in monetary and fiscal policy and in the related area of collective bargaining can be envisaged in the future in EMU to aid growth and reduce unemployment?
This introductory chapter will give a summary of our most important findings and arguments developed in more detail in later chapters. We will start with a short review of the origins of the current policy framework and of how we see it operating. We will outline the interaction between wage-setting, fiscal and monetary policies that will be the subject of chapters 2 and 3. The chapter ends with the policy recommendations treated in more detail in chapter 4.
2. Monetary policy, fiscal policy, and collective bargaining in EMU
Macroeconomic policy in EMU has not reached a steady state. There is considerable disagreement about monetary policy, including within the ECB, and certainly among member governments. There is no clear statement about the goals of fiscal policy, what is permissible, and what the respective roles are of Ecofin and of national governments. The relatively clear rules that apply in the UK and the US do not hold with anything like the same force in EMU. Despite this lack of clarity, however, some shapes are emerging.
First, monetary policy takes the form of inflation targeting, with the goal of keeping inflation between zero and two percent. This being said, it is still not clear how the ECB would respond if inflation were to fall below 2%, though it seems likely that it would try and stimulate output growth in such circumstances. Nor is there an agreed economic theory, such as that of an equilibrium unemployment rate which underpins intellectual reasoning in the UK and in the US. Equally unclear is the timescale over which a return to 2% inflation should take place. While the ECB is often accused of being conservative in its use of interest rates to stimulate growth and reduce unemployment, it is far from clear that members of the executive board have any agreed identity as conservative or non-conservative. Recent econometric work suggests that the ECB responds to divergences of forecast inflation from target and to output forecasts in a broadly similar way to the Fed (de Grauwe et al); the greater activism of the Fed on this view is simply the consequence of a greater variance in output and inflation in the US than in EMU. However, it may also be that the EMU economy is less responsive to short-term interest changes than is that of the US (or the UK), so that greater interest rate flexibility is needed in EMU.
We believe that one important development has occurred: the ECB appears not to challenge Ecofin judgements on the fiscal stance of individual EMU governments. This implies that the ECB has accepted a division of tasks in which its task is the control of inflation and the task of Ecofin (and of national governments) is to deal with cyclical fluctuations through fiscal policy. Such a bold statement courts denial, in part because there are conflicting views within the ECB. Very broadly, however, an implicit understanding seems to be shaping itself along the following lines: First, the ECB is aware that interest rates are not sufficient, at least in the short run, to prevent adverse employment movements as a result of symmetric as well of course as asymmetric shocks. Second, automatic stabilisers have to be allowed to work at the national level if these employment shocks are not to be amplified. Third, the subsequent agreements made within the SGP framework to reduce public sector deficits to zero according to a specific timetable would have been feasible had high economic growth continued. Had they been achieved, automatic stabilisers could have operated successfully within this 'augmented SGP'); however, the economic slowdown in Europe made the augmented SGP programme politically unfeasible.
We believe then that the following reshaping is occurring: On the one hand the ECB is aware that insistence on carrying through the augmented SGP programme in the context of an economic slowdown – that is, responding with increased interest rates to postponement of the programme – would lead to the possibility of a major political clash. The real concern of the ECB with fiscal policy is that it might be used (or attempted to be used) as a means of circumventing the ECB’s inflation target. Here the argument can be put most clearly in terms of an equilibrium employment rate: if fiscal policy were used to push employment above this equilibrium rate, inflation would then start to rise. So long as fiscal policy is not used in this way, the ECB does not need to engage in a conflict with fiscal policy.
Ecofin's role is very different. The Council appears to be developing a position where its major concern is ensuring that member governments do not put the ECB inflation target at risk. The collective action problem for Ecofin arises because an individual member state might be tempted to use fiscal policy to reflate; this could increase the inflation rate of the member state, and hence the European inflation rate by the weight of the economy in EMU; for the individual state an acceptable trade-off might result – the possibility of a small rise in ECB interest rates against a significant increase in domestic employment (of course, it is quite possible that this would not be in the member state’s individual interest, as a result of, for example, spill-overs, expectations). The Ecofin collective action problem is then that several member states follow such an expansionary fiscal policy, thus leading to a significant rise in interest rates.
What we see developing (albeit with lack of clarity) is a switch of Ecofin concern from ensuring the augmented SGP is carried through to a concern that national fiscal policies should not put the ECB inflation target at risk. If Ecofin is successful in doing this it solves two problems. First, it allows member states the degree of freedom necessary to conduct counter-cyclical fiscal policy and in particular the operation of automatic stabilisers; this, we believe, supplements the role of the ECB in limiting employment fluctuations. Second, it ensures that national governments take some responsibility for inflation; and this in turn reduces the need for the ECB to use interest rates to control European inflation. Both Ecofin and the ECB thus gain in developing this set of understandings.
In this new division of tasks between the ECB and Ecofin, the ECB operates the monetary rule and Ecofin allows fiscal countercyclical policy so long as that does not put at risk the achievement of the ECB’s inflation target. A facilitating factor behind this development has been the way in which collective bargaining has evolved in EMU. As we will show in chapter 2 on collective bargaining, labour markets in EMU have neither moved in the direction of pan-European coordination nor towards UK-American style labour markets. All the EMU member states remain characterised by a high collective bargaining coverage and in each some capacity for wage coordination at the national level. Germany, Austria, Belgium, the Netherlands and Italy have in addition well-developed vocational training systems (in Italy only in certain regions); employee-representation at company-level through works councils gives an incentive to unions to engage in strategies to promote productivity growth, often in conjunction with training; and wage coordination across sectors is strong.
Why should such systems of collective bargaining facilitate the new understandings between ECB and Ecofin? There have been two major developments over the last decade within the collective bargaining framework of EMU member-states, both driven by the growing increase in world product market competition and the globalisation of financial markets. First, employers have exerted increasing pressure on the collective bargaining system, moved by the need to keep unit labour costs in line with developments in the markets in which they are competing. Large employers have not generally wanted to move collective bargaining on wages down to company level; markets for skilled employees are generally tight (despite high unemployment in some member states), and a move to company wage settlements is seen as potentially inflationary. At the same time, the need to maintain or increase real profitability to meet the expectations of financial markets has added to the downwards pressure on unit labour costs from employers. Thus the first point is that employers have become more engaged in co-ordinated wage bargaining, and in the current global context have exercised a moderating influence.