The European economy: 2006 review - strengthening the euro area

In this Communication, the Commission reports on the European economy in 2006, describing the challenges it faces, such as pressure on competitiveness at a time of globalisation, and setting out ways in which the euro area can be strengthened through effective policies. It then outlines the experience gained from the early years of the euro area.

ACT

Communication from the Commission: the EU economy: 2006 review. Strengthening the euro area: key policy priorities [COM(2006) 714 - Not published in the Official Journal].

SUMMARY

The Communication sets out the priorities for ensuring the smooth running of the euro area and strengthening its role in the global economy. The European Commission wishes to increase policy coordination and improve governance, notably through the growth and employment strategy in Member States belonging to the euro area.

Working towards a stronger euro area

The future will bring new challenges to the eurozone, particularly in the form of major changes in global markets, such as competitive pressures or the slowing of export markets. The European Commission feels it essential to ensure that the euro area economy as a whole can respond to potential shocks with adaptability and resilience. It must therefore prove itself capable of strong and sustained growth on the international stage at a time when the other drivers of global activity may be slowing down. This would help keep international markets open and growing strongly.

In order to strengthen the euro area, the European Commission wishes to:

accelerate structural reform and foster integration. Structural reform can improve the potential for growth and boost the efficiency with which member economies respond to shocks. Reform is also needed to help address the long-term challenges of population ageing and global economic change at international level. Fuller and less uneven integration of financial markets could bring significant welfare gains and a smoother adjustment process;
strengthen budgetary positions and improve the quality of national budgets. Budgetary policy can contribute to efficient adjustment and sustained growth. The Commission feels that policymakers should make better use of periods of favourable economic conditions and ensure medium-term adjustment in line with the Stability and Growth Pact;
reinforce coordination within the EU and the euro area. The euro has brought much greater interdependence between Member States belonging to the euro area, including through the speed and scale of financial flows. Instruments for coordinating economic policy at national and EU level are therefore essential to foster the efficient functioning of the euro area. The Commission believes that budgetary coordination under the Stability and Growth Pact needs to be enhanced;
promote the enlargement of the euro area. Adoption of the euro in non-Eurozone countries can help stimulate growth and employment and can also protect these economies from turbulence in international markets;
persuade citizens. A skilful steering of Economic and Monetary Union (EMU) by policymakers is not sufficient, however, if the message does not reach citizens. Citizens have benefited in many ways from EMU, through price stability and ever deeper economic integration, according to the Commission. However, while opinion polls show that citizens are aware of the euro's practical value, they are less clear on the wider benefits. The Commission would like to show citizens that adoption of the euro is a path to strong and sustained increases in living standards as well as to economic and financial stability.

The experience from the early years of the euro area

Before the advent of Economic and Monetary Union (EMU) in 1999, the preparation of monetary union was dominated by a debate on the benefits and costs of the euro and on prerequisites for ensuring its success. During this time, many predicted that EMU would not work and would be short-lived. Experience has shown these pessimistic forecasts were wrong. The Commission asserts that:

the euro has quickly established itself as a strong and stable currency;
Eurozone economies have responded well to shocks such as the doubling of oil prices and international financial turbulence;
Inflation has remained remarkably low and stable by historical standards.

However, even though the eurozone as a whole has responded well to shocks, individual economies have not always adjusted to country-specific shocks as smoothly as one would have liked. In the Commission's view, generally, the euro area has not yet been able to achieve high growth and employment over a sustained period. The following factors can explain the prolonged divergences in growth, inflation and current-account imbalances within the euro area:

developments in the period preceding monetary union, such as a strong decline in interest rates in the run-up to the adoption of the euro, a relaxation of credit constraints on households, and reunification of Germany (which had a sizable impact on relative competitiveness within the euro area);
interaction between developments in individual euro area economies, such as strong and sustained investment in real estate, fed by the compound effect of fewer credit constraints, migration and tourism;
influence from national policies and the market combined, which occasionally inhibited smooth adjustment. For example, in the Netherlands, pro-cyclical effects emerged in the labour and financial markets as well as in budgetary policy. This contributed to a "boom-bust" cycle;
the fact that prices and wages adjusted slowly to changes in national cyclical conditions, reflected by prolonged adjustment in some cases, especially at times of slowing economic activity;
the spill-over effects between euro area economies have the potential to be significant. Economies in the monetary union are therefore affected by demand and competitiveness;
the global economy can also impinge on euro area members in ways that pose adjustment challenges within the monetary union;
experience of nominal and real convergence has varied considerably, partly reflecting national policy approaches.

Ensuring the smooth running of the euro area through effective policy

The European Commission presents five specific policy considerations, which have the potential to improve the running of monetary union:

macroeconomic policy must be run prudently; this requires a detailed analysis of budgetary positions;
markets of goods and services must become more flexible;
financial market integration needs to be accelerated;
wage setting must take into account the implications of monetary union;
the global dimension must be considered when assessing policy stances at Eurozone and national level.

See also