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EUROPEAN COMMISSION
GROUP OF POLICY ADVISERS
ML, D/65, 28 February 2005
Group of Economic Policy Analysis (GEPA)
Summary of the first meeting, 4 February 2005, Berlaymont
Session 1. The euro-dollar exchange rate
In recent years, the euro has strengthened against other major currencies, thereby correcting a
previous undervaluation of the single currency. At the same time, currency markets have seen
a weakening of the US dollar linked to concerns about the sustainability of the US current
account deficit. The US external deficit, which is approaching 6 per cent of US GDP, is the
counterpart of a historically low household saving rate coupled with a sharp deterioration in
the public sector balance in recent years. In view of these developments, several
commentators have argued that the US external imbalance is not sustainable, and that
potentially large exchange rate movements will be required to reduce it to a more sustainable
level. However, exchange rate movements by themselves are unlikely to be sufficient, and
most of the required adjustment in global imbalances will have to come from saving and
productivity developments. Negative consequences for the euro area of a strengthening of the
euro are likely to be concentrated in sectors which are highly exposed to competition from the
dollar zone. In order to minimize these effects, the euro area needs to engage with its
international partners in order to promote policies that will contribute to an orderly adjustment
of imbalances. In terms of domestic policies, the euro-area needs to pursue the agenda of
structural reform in order to better weather the global adjustment process.
The second presentation assessed the economic performance of the euro-area economy in
light of the floating exchange rate regime. A floating exchange rate regime is an important
element of a stability-oriented approach to the conduct of policy. The importance of exchange
rate policy for the euro area is clearly recognised in the Treaty, which clarifies that exchange
rate policy must serve the same primary objective as monetary policy, i.e. price stability.
However, the exchange rate is neither an intermediate target for monetary policy nor a goal,
as this would risk a conflict with price stability. This does not mean that the exchange rate is
neglected as an economic variable. The exchange rate is an endogenous variable that reflects
the actions of all market participants in an open economy. It reflects their beliefs and
expectations about the future course of relevant variables. Thus, understanding exchange rate
movements is an important element when analysing the underlying forces and shocks driving
the economy. Policy should not react mechanistically to exchange rate movements. Instead, it
should react to the underlying dynamics and shocks. Evidence shows the creation of the euro
area has been associated with (i) increased volatility of the effective real exchange rate, (ii)
well-anchored inflation expectations, (iii) reduced inflation volatility, (iv) reduced long-term
interest rates volatility and (v) low (and unchanged) GDP growth volatility.
Following these presentations, the discussions centred on the following themes:
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• Euro-dollar exchange rate: Since February 2002, the euro has appreciated by more than
50% against the dollar. Even so, the present strength of the euro needs to be put in
perspective. Looking at a long time series, the euro-dollar exchange rate is well within the
range defined during the last decades.
• US adjustment. The weakness of the dollar may be linked to the US current account
deficit, which is approaching 6% of GDP. However, some external members argued that
even the US must respect its inter-temporal budget restraint. In terms of future
corrections, exchange rate movements can certainly help to quell US excess demand.
However, while exchange rate movements are necessary, they are not sufficient. In
addition, it was argued that the current account deficit needs to be reduced. However, this
takes a long time to materialise and is not easy to achieve. For that to happen, the US has
to increase its net exports and cut domestic demand. However, an adjustment only through
quantities instead of prices is unlikely, as it would imply a US recession.
• Putting US deficits into context. Some participants argued that it is necessary to put
current imbalances in a wider context. A focus on yearly current account and budget
deficits do not yield much information. Accordingly, they argued that the worry for
Europe of current US spending is not the deficit, but rather the risk of a higher interest rate
environment created by increasing US borrowing needs. In spite of the US Net Foreign
Assets position being negative, the US remains (in net terms) a recipient of capital income
from the rest of the world. As long as this situation remains there will be no pressure on
the US to change.
• Asian central bank reserve holding policies. It was argued that changes to the dollar
today depend on Asian central banks’ reserve holding policies. In case of a sudden change
in such policies there would be a risk of overshooting. As regards the attractiveness of the
euro as a reserve currency, it was argued that euro debt and money markets are broadly
regarded as just as efficient as US markets. This is a key factor determining a currency’s
international role. Therefore, the euro’s role as a reserve currency is likely to increase in
the coming years.
• Impact of euro-dollar exchange rate on economic developments in the euro area. The
exchange rate is an endogenous variable that reflects the actions and expectations of all
market participants in the open economy. Empirical evidence suggests that the most
important source of real exchange rate fluctuations comes from risk premium shocks to
the uncovered interest rate parity relation. Simulations performed with the Commission’s
own QUEST model find that, in such circumstances, the impact from exchange rate
fluctuations on economic activity is small. Models suggest that the impact on economic
activity from the euro’s appreciation is slightly negative in the short run (1-2 years), but
turns positive over the medium term (three or more years). Accordingly, the impact of the
euro’s appreciation vis-à-vis the dollar on euro-area growth is so far low. The impact on
growth may differ between member states depending on e.g. market flexibility and
economic structure (e.g. importance of services). Overall, the model results are in line
with the experience of the last six years, where a significant increase in the volatility of
the real exchange rate has proved compatible with reduced volatility of GDP growth and
inflation, relative to the pre-EMU period.
• Lisbon reforms: It was argued that the reforms envisaged by the Lisbon Agenda would
put Europe in a better position to deal with any protracted imbalances. It is particularly
important to have clear policy targets regarding the services sector, a key to achieving
higher growth in the EU.
04/02/2005 GEPA 2
Session 2. The Lisbon Agenda: Economic Reforms of Product and
Factor Markets
There has been a disconnect between the rhetoric of the intergovernmental meetings on
Lisbon and the public debate in individual countries, according to the first presentation.
Accordingly, the Strategy needed to be revised. First, the number of Lisbon targets should be
reduced. Targets should only be defined which are under the control of governments. Second,
EU wide targets should correspond to areas where there is a clear case for supranational
intervention. Third, national targets could be defined in areas in which there are national
policy failures. The progress made towards these targets should be reviewed within one
national Lisbon plan encompassing all the various dimensions of economic policy. So far,
there have been several parallel plans ranging from stability and convergence to competition,
from poverty to employment. In this national plan, governments would set country-specific
targets in areas where political resistance to reforms is stronger with the Commission
monitoring whether progress is made towards their attainment. The plans should be endorsed
by national parliaments. Before voting, the parliaments should receive the Commission’s
comments. This would put supra-national authorities in a condition to talk directly to
European citizens, highlighting the advantages of competition and other public goods
provided at the European level.
The second presentation examined the link between product market reforms, competition
policy and economic performance. It argued that achieving the product market reforms
envisaged by Lisbon is of great economic importance. Theoretically, the positive effects of
such reforms are well-known (e.g. better resource allocation, productivity increases…). This
has positive effects on growth and employment, as supported by ample empirical evidence.
These benefits are not achieved automatically though, but require policies to ensure effective
competition. As markets change, these policies have to evolve. An important aspect of
competition policy today should be to contribute towards an environment where new firms
and new markets can flourish. In achieving this goal, there is a division of labour between the
European institutions and member states. There is a case for a European role where there are
externalities across member states or where member states find it difficult to commit and
hence are unable to follow sustainable policies. Competition policy plays an important role in
reaching the objectives set by the revised Lisbon Agenda. For example, Brussels has a crucial
role to play in making the Single market work (particularly for services).
The ensuing discussion focused on the following issues:
• Reasons for Lisbon lack of delivery. Some external members thought that the process is
the reason why Lisbon is not working. There is a disconnect between the Spring Council
and national debates. The national arena cannot be bypassed, however. Therefore, many
members welcomed the National Action Plans envisaged by the Mid-term Review,
arguing that national plans are more likely to be effective, as they represent a bottom-up
approach.
• Refocusing Lisbon. The Mid-term Review is a step in the right direction, as it refocuses
the objectives and the instruments of the Lisbon Agenda. However, some members argued
that the Mid-term Review does not go far enough in streamlining. For example, while the
Communication outlines three areas of action and ten priority themes, the accompanying
documents still contain well over a hundred progress indicators. To streamline and deal
with all these indicators will require an enormous amount of work from the Commission.
Therefore, further refocusing would be welcome.
04/02/2005 GEPA 3
• Extend constituency beyond governments. It was argued that the EU should connect with
those benefiting from Lisbon’s reforms, i.e. consumers and new entrants. In order to break
the pervasive influence of special interest groups, new entrants and consumers should be
encouraged to make their voice heard. Furthermore, some argued that the EU can be
useful by changing the attitude of people. The EU could change the expectation level of
citizens and alter the conditions for public discussions. This would change the strategy of
national political parties, who currently have little electoral incentives to carry out
reforms.
• Further integration or reform. In light of the political problems of reaching agreement on
reforms or European legislation further opening up markets, it was argued that the EU
most probably has to choose where to invest its scarce political capital. Either it can push
for more domestic reform of e.g. labour and product markets. Or it can try to achieve
further integration in e.g. services. It is unlikely to achieve both though.
• The Single Market is a key instrument. In seeking to achieve the Lisbon objectives, the
EU should focus on areas where it has competence. Overall, the Single Market is the key
instrument to achieve the Lisbon Agenda’s objectives. In particular, it is essential to create
a dynamic Single Market that favours new entrants. To achieve this, some external
members argued that the Commission must play a much more active role.
• Higher education and research a core area: One area of particular importance for
achieving Lisbon is higher education and research. These sectors remain segmented along
national lines. To correct this, it was argued that universities should be subject to more
competition and the EU research budget should be put to much better use. According to
some external members, the EU’s research budget is too top down and has the effect of
protecting established local champions.
• Integration of services: There is overwhelming evidence that services is a sector where
the EU is less flexible than the US. This sector matters for EU economic growth, as it
accounts for roughly 70% of EU GDP. Therefore, it was argued that further EU action to
forge together an internal market for services is needed.
• Budgets supporting Lisbon. Budgets both at national and EU level are other important
instruments to achieve the Lisbon objectives. It was argued that budgets need to be
redirected towards better supporting growth. Some external members argued that the SGP
can help to some extent, as its stringency may oblige a refocusing of national budgets. At
Community level, some external members argued that the budget should be refocused on
(i) research and innovation, and (ii) addressing the social consequences of restructuring at
firm, regional and member state level.
• Accept being a scapegoat. Member States often blame the EU for imposing painful
decisions. Some external members argued that the EU should stand ready to act as a
scapegoat. This role can be constructive, if it enables national governments to pass
otherwise unpopular reforms. However, the EU should carefully choose areas where it is
ready to take on such a role.
04/02/2005 GEPA 4
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