he founding fathers of European Monetary Union wanted to enhance European political stability and economic welfare by fostering further political, economic, and financial integration among European countries. Considerable progress towards these objectives has been made during the first five years of EMU, but further efforts are needed to secure the achievements and master the challenges still lying ahead. Most importantly, euro area governments must give higher priority to policies aimed at raising the medium-term economic growth prospects of the currency area.
Although earlier intentions to complement monetary union eventually with political union have proved too ambitious, the creation of EMU has undoubtedly led to greater political integration of member states. This is most visible in the area of fiscal policy, where coordination among member states and between member states and the ECB has been institutionalised. In the run-up to EMU, some argued that fiscal policy coordination would be superfluous since financial markets would act as disciplinarians, punishing countries with irresponsible fiscal policies by forcing up their bond yield spreads over benchmark yields.
In reality, however, fiscal policy divergence has not been fully reflected in a corresponding widening of yield spreads, despite the explicit denial of bailouts by the European Central Bank to governments in financial difficulties 1. To make up for this deficiency and prohibit irresponsible national fiscal policies affecting the community of EMU members, the Stability and Growth Pact was established and the Euro Group within the Council of Finance Ministers founded. The former provides the platform and the latter the de-facto institutional framework for fiscal policy coordination among EMU members.
Unfortunately, however, economic policy coordination has not been an entirely smooth process. Some EMU member states have shown more respect for the agreed macro fiscal policy rules than others, and there have been differences about the need for harmonisation—and scope for competition—in the area of tax policy and tax regulations. Clearly, without fiscal policy discipline and/or a healthy degree of fiscal and regulatory competition, EMU is unlikely to bring the expected economic benefits. Hence, there is a need to reassess the degree of political integration of member states needed to ensure the successful functioning of EMU. At a minimum, there needs to be a stronger commitment by all EMU participants to respect established rules, even when this seems inopportune for domestic political reasons.
The launch of EMU has triggered economic integration among member states just as the creation of a customs union and the Single European market did before it. Recent studies have shown that trade among EMU countries has risen significantly since 1999, supporting the hypothesis that the currency union has fostered trade relations.
Moreover, the empirical evidence available suggests that EMU is encouraging cross-border direct investment. At the same time, however, prices of similar goods and services still differ more than they do in the US—a mature currency union—suggesting that the process of economic integration is still far from complete 2. To realise the benefits of economic integration made possible by EMU, remaining obstacles in the regulations of product and services markets need to be removed.
Financial market integration
Perhaps the most tangible achievement of EMU so far has been the integration of financial markets. As an ECB study recently found, financial market integration has progressed most in market segments where products have been defined clearly, market rules have been harmonised across the euro area, and where a common infrastructure has been created 3.
Thus, the degree of integration is most advanced in money markets and has progressed considerably (though it is still imperfect) in government bond markets. But the degree of integration has remained moderate in the equity, high-yield debt securities, and asset-backed securities markets. Bank loans have remained the predominant source of funds for the non-bank sector, with the corporate bond market gaining importance only slowly.
The average risk free rate of interest fell and market risk premia decreased in the run-up to EMU as national inflation rates converged to the levels historically experienced by the low-inflation countries. This—and the favourable economic environment in 1999-2000—stimulated borrowing by private households and corporations, with outstanding liabilities of the latter rising to 59% of GDP in the first quarter of 2003 from 48% of GDP in the same quarter of 1998.
However, bank loans have remained the predominant source of funds for the non-bank sector, with the corporate bond market gaining importance only slowly. The value of debt securities issued by non-financial corporations increased to 7.9% of GDP in the first quarter of 2003 from 5.6% in the first quarter of 1998.
According to the ECB, this is in part the consequence of a lack of harmonisation in product specifications, which reflects, among other things, continuing differences in national bankruptcy laws 4.
The biggest disappointment during the first five years of EMU has been the lacklustre performance of the Euroland economy. While GDP growth averaged 2.7% in the US in 1999-2003, it averaged only 1.9% in Euroland, not much above the 1.2% recorded in Japan over the same period. A number of observers have blamed the lack of more expansionary monetary and fiscal policies in the wake of the 2001 world economic downturn. More likely, however, growth has suffered because of insufficient flexibility in the major EMU economies, which has prevented a quick adjustment to the changing economic environment. In addition, there are signs that (total factor) productivity growth in Euroland has declined in recent years, while it has increased in the US.
Euro Land: Corporate Debt
Source: OECD, DB Global markets Research
Hence, the biggest challenge for euro area policy makers is to improve economic flexibility and raise the trend of productivity growth in Euroland. At their summit in Lisbon in 2000 they adopted a strategy aimed at achieving these objectives. Unfortunately, they have failed to make progress in implementing it. However, continued rigidity of the Euroland economy and declining trend growth would erode European social and fiscal policies and in the event pose a serious threat to the long-term political viability of EMU.
Author: Thomas Mayer,
CFA Managing Director, Chief European Economist
Tel.: +44 20 7547 2884
1However, recent analysis by the ECB suggests that bond
market investors reward those euro area countries that have
followed more prudent fiscal policies. See ECB, Monthly Bulletin,