Shigehara (ed ) the limits of surveillance and financial market failure; lessons from the euro area crisis (2014)

frame-In addition to limits to effective surveillance, the repeated financialcrises in developed OECD countries have shed light on deficiencies inthe current prudential and monetary poli

and Financial Market

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The limits of surveillance and financial market failure : lessons from the Euro-area crisis / [edited by] Kumiharu Shigehara.

Rutsu Shigehara

List of Tables and Figures ix

Part I

1 The Limits of Surveillance and Financial Market Failure:

Some Fundamental Issues Arising from the Euro-Area

6 How Should Microprudential Control Be Strengthened

to Prevent Local and Global Financial Market Failure? 88

Jeffrey R Shafer

7 Financial Market Failures and Their Remedies 93

Carol Sirou

vii

Part IV

8 On the Connection between Monetary Policy and the

Regulation of Banking and Financial Markets 99

Stephen H Axilrod

9 Macroprudential Policy, Capital Controls and Bank

Adrian Blundell-Wignall and Caroline Roulet

Charles A.E Goodhart

Part V

11 Can Europe Get Its Political Act Together? Alternative

Robert W.R Price and Nicholas J Vanston

9.1 Determinants of bank distance to default:

9.2 Correlations of model-identified variables and

14.1 Derivatives as a percentage of asset portfolios 190

Figures

9.1 India, Korea and China: interest differential,

forward/spot and covered interest parity 122

14.4 Risk-weighted assets as a share of total assets 18914.5 Net international investment positions 203

ix

The euro-area crisis, which erupted only a few years after the break of the global financial and economic crisis originating from the

out-US housing market debacle, revealed weaknesses in regional as well

as global frameworks for financial and economic crisis prevention

In fact, neither regional surveillance within the European work nor global surveillance by international institutions such asthe International Monetary Fund and the Organisation for EconomicCo-operation and Development (OECD) was effective in preventingsuch large-scale crises in developed countries Can more effectivesurveillance be put in place to prevent their recurrence?

frame-In addition to limits to effective surveillance, the repeated financialcrises in developed OECD countries have shed light on deficiencies inthe current prudential and monetary policy frameworks which weredesigned to secure financial market stability and minimize economy-wide disturbances arising from financial market imbalances whilemaintaining general price stability How should prudential regula-tions be strengthened? How should the “herd instinct” of financialinstitutions leading to financial market instability and the problems

of moral hazard and regulatory and supervisory “capture” by largefinancial institutions be dealt with?

What are the implications of these problems for better agement of the euro area? How can member countries meet thechallenges of adapting their macroeconomic, financial and struc-tural policy frameworks required to run a single-currency area prop-erly? How can they overcome political economy issues involved inrunning such an area?

man-This book deals with this range of difficult policy issues of our time.After the stage setting for discussion of these in Part I, Part II offerstwo contrasting views of the direction of and scope for future surveil-lance One view is that surveillance should be comprehensive andcover all macroeconomic and financial aspects An alternative view

is that even strengthened surveillance would not have preventedthe crisis in the euro area Therefore we need to accept that theeffectiveness of surveillance is limited by governments which impose

x

restraints on surveillance by international institutions in their holding” capacity, as well as by self-restraint by the institutions.Elected governments are often reluctant to face up to the implications

“share-of warnings and alerts by international institutions if these could bepolitically unattractive

Part III goes beyond surveillance and builds on the view thatmicroprudential control needs to be strengthened to prevent finan-cial market failure, both globally and in the European context Sincesupervisors are subject to many of the same forces that limit the effec-tiveness of surveillance, contributors to this part focus on the need

to strengthen regulatory frameworks and to make market processeswork better Key issues include capital adequacy, the desirability

of separating many investment banking activities (notably thoseinvolving large derivative portfolios) from commercial banking, liq-uidity, governance to limit moral hazard and ways to ensure greatercomparability and transparency of information disseminated to themarkets

Part IV discusses the combined use of macroprudential and etary policies to secure financial market stability and minimizeeconomy-wide disturbances It addresses the issue of achieving

mon-an operational integration of monetary mon-and regulatory policies inEurope where institutions are decentralized, noting that even within

an individual country the monetary policy authorities and the ing and security regulators often have different policy orientations

bank-A specific issue discussed in this context relates to banks’ attempts tooffset changes in macroprudential policy by changing the riskiness oftheir portfolios in other ways Given the need to ease the task of bet-ter coordination of supervisory policies, a scheme is proposed to putless pressure on the regulations and to apply more pressure on mea-sures to influence the incentives facing bank managers with respect

man-of the euro-area crisis is revealed as the balance man-of payments quilibria associated with the build-up of unsustainable debts, bothpublic and private, in several member countries where excessive

dise-credit expansion was caused by the lack of monetary policy pendence in the single currency area It examines various efforts toreduce balance of payments imbalances and the respective roles ofdebtor and creditor countries in the area, and it points to the impor-tance of flexible nominal wages and prices, and movements of labour

inde-in order to return to a sustainde-inable equilibrium

Part VI provides both an executive summary and a fuller reportabout oral discussions concerning these topical issues that took placeamong paper authors, preassigned discussants and other participants

in the international conference entitled “The Limits of Surveillanceand Financial Market Failure: Lessons from the Euro-Area Crisis”,which was held in Paris on 23 September 2013 The event gatheredfirst-class economists with rich experience in domestic and inter-national economic and financial policy-making, as well as policyadvisory work, in Europe, the USA and Japan, and aimed at in-depthdiscussion of these fundamental issues of our time with a view tofinding ways for better management of the euro area and the globaleconomy more generally The programme of the conference and thelist of contributors to it are given in the annexes

The conference was initiated as a non-bipartisan, non-political untary activity by me as president of the International EconomicPolicy Studies Association Special thanks are due to Robert Raymond,advisor to the association and treasurer of La Maison de l’Europe deParis, whose assistance enabled me to hold the conference at a mag-nificent hall in the premises of La Maison de l’Europe de Paris in theheart of the French capital

vol-For the publication of this book, I received invaluable assistancefrom Paul Atkinson, executive director of the association I amalso indebted to Aimee Dibbens, Commissioning Editor, PalgraveMacmillan, and Kate Boothby, Copy Editor, for their extensive help

Kumiharu ShigeharaTokyo, 31 May 2014

Paul E Atkinson Executive Director and Senior Fellow of the

Inter-national Economic Policy Studies Association Former Deputy tor of the Directorate for Science, Technology and Industry at the

Direc-OECD Former editor of OECD Economic Outlook.

Stephen H Axilrod Consultant on policy and markets Former Staff

Director for monetary and financial policy at the board of nors of the Federal Reserve System and Staff Director and Secretary

gover-of the Federal Open Market Committee Also, former Vice-Chairman

of Nikko Securities Co International, headquartered in New York

Author of Inside the Fed: Monetary Policy and Its Management: Martin

through Greenspan to Bernanke, revised edition (2011) and The Federal Reserve: What Everyone Needs to Know (2013).

Gunter D Baer Former Secretary General of the Bank for

Interna-tional Settlements (BIS) Former Secretary General of the Committee

of Governors of the EEC central banks Rapporteur, together with thelate Tommaso Padoa-Schioppa, of the Delors Committee

Adrian Blundell-Wignall Special Advisor to the Secretary-General

on Financial Markets and Director of the Directorate for Financialand Enterprise Affairs at the OECD

Charles A.E Goodhart Professor Emeritus and member of the

Finan-cial Market Group at the London School of Economics Former ber of the Bank of England’s Monetary Policy Committee Developer

mem-of Goodhart law, an economic law named after him

André Icard Member of the Enforcement Committee of the French

Prudential Supervision and Resolution Authority Former DeputyGeneral Manager of the BIS Former Directeur Général des Etudes atthe Banque de France Co-editor, together with Jack Boormann, ofthe final report on the reform of the international monetary system

xiii

prepared by the Palais Royal group initiated by Michel Camdessus,Alexandre Lamfalussy and the late Tommaso Padoa-Schioppa.

Val Koromzay Former Director of the Country Studies Branch of the

Economic Department of the OECD

Leif Pagrotsky Former member of the cabinet of the Swedish

gov-ernment, former Minister of Industry and Trade and former Minister

of Education, Research and Culture Former Vice Chairman of theGeneral Council of the Riksbank

Robert W.R Price Senior Fellow of the International Policy Studies

Association Former Head of the Monetary and Fiscal Policy Division;General Economic Analysis Division; and Country Studies Division

II in the OECD Economics Department Former editor of OECD

Economic Outlook.

Caroline Roulet Economist, Directorate for Financial and Enterprise

Affairs at the OECD

Jeffrey R Shafer Consultant Former Vice Chairman of Citigroup

Global Markets Former Undersecretary of the US Treasury for national Affairs Former staff official of the OECD and the FederalReserve (board of governors and NewYork Bank)

Inter-Kumiharu Shigehara President of the International Economic Policy

Studies Association Former Chief Economist and Deputy General of the OECD Former Chief Economist and Director-General

Secretary-of the Institute for Monetary and Economic Studies Secretary-of the Bank Secretary-ofJapan

Carol Sirou President of Standard & Poor’s Credit Market Services,

France

Nicholas J Vanston Senior Fellow of the International Policy

Stud-ies Association Former Head of the Country StudStud-ies II Division;Structural Policy Analysis Division; and Foreign Trade and PaymentsDivision in the OECD Economics Department

William R White Chair, the Economic and Development Review

Committee of the OECD Former Economic Adviser and Head ofthe Monetary and Economic Department of the BIS Former DeputyGovernor of the Bank of Canada

The Limits of Surveillance and Financial Market Failure: Some Fundamental Issues Arising from the Euro-Area Crisis

Kumiharu Shigehara

Just a few years after the outbreak of the global financial and nomic crisis which originated from the US housing market debacle,another financial crisis erupted in the OECD area, this time in theeuro area It was triggered by a sudden loss of market confidence

eco-in the sustaeco-inability of Greek government debt feco-inance The crisissoon spread to Ireland and Portugal,1 and, by the middle of 2011,Spain and Italy were affected by mounting market concern abouttheir sovereign debt Unlike Greece, several of the latter countrieshad over the years maintained general government net financialbalances in a better form than other member countries, such asGermany and France, which have not suffered from acute financialmarket stress But in many of them, private-sector saving short-ages relative to domestic investment were covered over years bycapital inflows from abroad to match persistent current accountdeficits

A principal underlying cause of the external deficits was nominalwage increases far above labour productivity growth and the result-ing inflation of unit labour costs leading to a significant erosion ofcompetitiveness against trading partners and, in particular, Germany

In some of these countries, notably Ireland and Spain, the lation of the household/corporate sector debt was associated withhousing market bubbles After the burst of these bubbles, the real aswell as the perceived need for an injection of public funds to reinforce

accumu-3

the capital base of unsound banks, as well as to protect bank itors, started to erode the soundness of public finance, and strainsuddenly developed in their government debt financing In fact,financial market participants started to discriminate across euro-areasovereign bonds only from around the second half of 2008, follow-ing the financial market turmoil that erupted in the USA aroundmid-2007.

depos-Why was the crisis in the euro area not anticipated in time toprevent it?

While the detailed records of regional surveillance conductedbefore the outbreak of the euro-area crisis within the frameworks

of the European Community and euro-area based institutions arenot accessible to outside observers, the European Central Bank (ECB)publicly acknowledged that, in addition to the lack of rigorousimplementation of the Stability and Growth Pact, “the economicgovernance framework was also unable to prevent the emergence

of excessive macroeconomic imbalances in the euro area” under theheading “The Lack of Macroeconomic Surveillance” in the sectionentitled “Economic Governance in the Euro Area – Why a QuantumLeap Is Required” in the article “The Reform of Economic Gover-

nance in the Euro Area – Essential Elements” (Monthly Bulletin March

2011).2

Besides regional institutions engaged in surveillance of the euroarea, the International Monetary Fund (IMF) as a principal globalinstitution has been in charge of the surveillance of individual mem-ber countries and the euro area as a whole so as to ensure globalfinancial stability and the promotion of economic growth.3

My review of the back numbers of the IMF flagship publication

World Economic Outlook (WEO) conveys the impression that the IMF’s

early warning function in the run-up to the euro-area crisis was notsatisfactory (see Appendix 1) A far more systematic post mortem was

conducted by Pisani-Ferry et al and the result was reported in The

2011 TSR Study – An Evaluation of IMF Surveillance of the Euro Area, in

which they noted:

In general IMF surveillance failed to take fully into account theimplications of being in a currency union both for national poli-cies and for the governance of the euro area, whose weaknesseswere not fundamentally criticized.4

Another international institution which has been engaged in thesurveillance of individual member countries and the euro area is theOECD Unlike at the IMF, a systematic exercise by outside experts

to review the OECD’s (published and unpublished) documents forsurveillance on euro-area member countries and the area as a wholehave not been carried out at the OECD However, my review of the

back numbers of its flagship publication, Economic Outlook (EO), since

2000 suggests that the OECD issued warnings about some emergingfundamental problems in several euro-area member countries at afairly early stage (see Appendix 1) For example, in the December

2001 EO, the erosion of Italy’s competitive position was discussed as a

matter of the OECD’s particular concern in the country note on Italy

(p.67) In the subsequent issues of EO, the evolution of Italy’s

com-petitiveness and related policy issues regularly featured the countrynotes, with particular attention paid to divergent developments inrelative unit labour costs

However, such warnings were ignored by national policy-makers

As a matter of fact, the correction of imbalances in the euro areawas set in motion essentially under financial market pressures whichforced deficit countries to adopt fiscal consolidation5 as well asthrough the market-induced financial deleveraging of the privatesector in these countries, pointing to the importance of financialmarket discipline which unfortunately started to play its role with

a long delay and too abruptly The resultant contraction of tic demand in the deficit countries has been a main cause of theirwage and price deflation and current account improvements Euro-area surplus countries’ contribution6has so far basically been limited

domes-to financial assistance through existing and new European ties7 together with IMF loans.8 Faster domestic demand expansion

facili-in surplus countries should facilitate facili-intra-euro-area current accountadjustment processes and the narrowing of differentials in cost andprice competitiveness in the euro area, but it has not been takingplace under single monetary policy geared to the objective of main-taining area-wide inflation “below but close to 2 percent” There is

a view that the ECB should raise its inflation objective to a higherrate,9 but it is not clear that such a policy will be helpful The IMFview on this point is not very clear.10 Its recommendation regard-ing the role of structural policies in Germany appears to be moreconvincing,11 but its effects may require time before they start to

visibly attenuate the economic and social costs of adjustment indeficit countries.12

Immediately after the start of European monetary union (EMU),issues arising from divergent cyclical positions in individual euro-area member countries out of line with its common monetary policywere discussed in some detail in a special section about the European

Union (EU) of the EO June 2001 issue.13The OECD argued there:

If fiscal policy does not play a stabilizing role, the unwinding

of excess demand is by default left to market forces Ireland,the Netherland and Spain are already experiencing much fastergrowth in unit labour costs in the total economy than othermembers of the monetary union, and this loss in competitivenessvis-à-vis their euro partners is likely to persist in the coming years.The eventual gradual weakening of net external balance will act

to reduce the extent of the overheating, though this might take arelatively long time While this “gold standard” type adjustmentmechanism will ultimately prove effective, it will inevitably result

in important structural changes in the economies affected, notablythe allocation of resources away from their traded goods sectors.This will require the institutional structure in the smaller countries

to be efficient in reallocating resources from declining to ing sectors Reliance on market forces to deal with overheatingthus call for reforms in product and labour markets to increase thecapacity of the economy to adjust smoothly to changed circum-stances Furthermore, there is a possibility that real interest ratesshaped by area-wide nominal rates and high domestic inflationwill result in excessive credit expansion, leading to unsustainableincreases in property values and in investment and capital stocks.This points to a risk of balance sheet problems in the wake of over-heating Supervisory policies need to ensure that financial systemsmaintain diversified portfolios and strong capital bases so as to beresilient as overheating ends.14

grow-However, the records of national and international bank supervisors

since the publication of the EO of June 2001 show that they were

behind the curve Are there reasons for believing that they will do agood job next time?

Moreover, one cannot be optimistic about the effectiveness ofsurveillance at the global level by the IMF and the OECD15 as well

as at the regional level (within the frameworks of the euro areaand the European Community in the case of the current crisis inEurope)16 given political reality in individual nations.17 In the end

it may continue to be financial market forces which oblige nationalpolicy-makers to adopt adjustment policy measures which are nec-essary but disliked by electorates This raises the question of how

to make financial markets more forward-looking to prevent abruptchanges in market conditions and the disruption of real economicactivities

With this issue in mind, efforts have been strengthened over theyears to facilitate the diffusion of surveillance documents by interna-tional institutions, at a remarkable pace at the IMF, though muchless so at the OECD However, published versions of their warn-ings are “sanitized” and as such are sometimes not considered to

be fully reliable and credible by the financial markets.18 On theother hand, any strong messages from public institutions, particu-larly from those that are directly engaged in policy-making (such

as the ECB),19 involve the risk of upsetting the financial marketsand adding to their volatility The balancing act here is extremelydifficult

A lesson learnt from a series of crises in Latin America since theearly1980s and the Asian crisis in the late 1990s was that effortsshould be strengthened to improve statistical information aboutdebtor countries in the non-OECD area and its dissemination tofinancial market participants and the outside world more generally.However, the global financial crisis of 2007–2009 originated in theUSA, where data on household debt and other data are fully available

to financial market participants Statistics not just on fiscal deficitsbut on external imbalances and such underlying determinants ofimbalances as cost and inflation divergences among euro-area mem-ber countries have also been readily obtainable by financial marketparticipants

Why were these data regarding underlying imbalances acrosseuro-area member countries developing over so many years afterthe start of the euro not properly reflected in market prices oftheir euro-denominated government debt instruments? Were there

reasons for financial market participants to believe that ing problem countries in the euro area would be bailed out inone way or another without losses on their part? What wasthe significance of the “no bail-out” clause of the MaastrichtTreaty?20

emerg-It is true that banks are allowed to attach a zero-risk weight

to sovereign debt under the standardized approach of Basel II,which was carried over into Basel III Moreover, while the inter-nal ratings-based approach within the Basel II framework did try

to encourage large and sophisticated banks to be more inating in their sovereign exposures, the EU’s Capital Require-ments Directives introduced a generalized zero-risk weight for all

discrim-EU central government debt denominated and funded in domesticcurrency.21

That said, market prices should have been differentiated if kets had perceived that countries with unsustainable fiscal positionswould not be bailed out and private investors would be forced toincur losses.22

mar-Another issue relates to differentials for nominal interest rates onprivate-sector debt which is not subjected to the zero-risk weightingunder the standardized approach of Basel arrangements nor cov-ered by the EU’s Capital Requirements Directives Why did theyremain narrow among euro-area countries despite inflation differ-entials among them, thus distorting financial resource allocationwithin the euro area for an extended period? The two financialcrises originating in the OECD area suggest that sufficient statisticalinformation flows will not guarantee the good functioning of OECDfinancial markets if they are left to function with their inherentdynamics.23

There is a saying in Japan that “There is no risk in crossing a road

if you are walking in a group.” Will the use of public funds in ing out troubled banks and protecting depositors and institutionalinvestors that has taken place, and is likely to continue, to deal withthe current euro-area crisis induce new episodes of herd behaviour onthe part of financial market participants?24

bail-Do these observations made and the questions raised here implythat financial crises are bound to happen again in the OECD area

as well as in the rest of the world in the future? Should we remainresigned?

1 In May 2010, Greece became the first euro-area country to receive cial assistance from the EU and the IMF in exchange for implementing an economic programme designed by the Troika of the European Commis- sion, the ECB and the IMF By the end of 2010, Ireland, and somewhat later – in May 2011 – Portugal, were forced to rely on the same rescue mechanism.

finan-2 ECB, Monthly Bulletin March 2011, pp.104–106, http://www.ecb.int/pub/

pdf/other/art1_mb201103en_pp99-119en.pdf See also endnote 19 below with some comments on the ECB’s annual reports On the European Commission’s Macroeconomic Imbalance Procedure (MIP), see endnote

16 below.

3 See Shigehara and Atkinson, “Surveillance by International tions: Lessons from the Global Financial Crisis”, OECD Working Paper No.860, May 2011, http://www.oecd-ilibrary.org/economics/surveillance- by-international-institutions_5kgchzchkvd2-en See also IMF, “IEO Eval- uation of IMF Performance in the Run-Up to the Financial and Eco- nomic Crisis”, http://www.ieo-imf.org/ieo/files/completedevaluations/ Crisis-%20Main%20Report%20(without%20Moises%20Signature).pdf and

Institu-“IMF Management and Staff Respond to the Report by the Independent Evaluation Office on IMF Performance in the Run-Up to the Financial and Economic Crisis”, February 2011, http://www.imf.org/external/np/ sec/pr/2011/pr1134.htm.

4 See p.2 in Pisani-Ferry et al “The 2011 TSR Study – An Evaluation of IMF Surveillance of the Euro Area”, 2012, http://www.imf.org/external/ np/pp/eng/2011/071911.pdf.

5 On recent debates about fiscal consolidation and multipliers, see, among others, Blanchard and Leigh, “Growth Forecast Errors and Fis- cal Multipliers”, IMF Working Paper WP/13/1, January 2013, http: //www.imf.org/external/pubs/ft/wp/2013/wp1301.pdf and “Fiscal Con- solidation: At what Speed?”, May 2013, http://www.voxeu.org/article/ fiscal-consolidation-what-speed.

6 On the role of surplus or creditor countries, see Philip Turner, “Caveat Creditor”, BIS Working Papers No 419, July 2013, http://www.bis.org/ publ/work419.htm.

7 See ECB, “The European Stability Mechanism”, Monthly Bulletin, July

2011, http://www.ecb.int/pub/pdf/other/art2_mb201107en_pp71-84en pdf.

8 See Pisani-Ferry, Sapir and Wolff, “EU-IMF Assistance to Euro-Area Assistance: An Early Assessment”, May 2013, http://www.bruegel.org/ publications/publication-detail/publication/779-eu-imf-assistance-to-euro- area-countries-an-early-assessment/.

9 Schmitt-Grohé and Uribe, “The Case for Temporary Inflation in the Eurozone”, August 2012, http://www.columbia.edu/ ∼mu2166/jep.pdf Their model predicts that full employment in peripheral Europe could

be restored by raising the euro-area annual rate of inflation to about 4%

for the next five years See also Ball, “The Case for 4% Inflation”, May

2013, http://www.voxeu.org/article/case-4-inflation.

10 The IMF states:

By way of example, inflation in Germany and the Netherlands, the other major surplus economy in the euro area, would have to be about

3 to 4 percent to keep euro area inflation close to the ECB’s target of

‘below but close to 2 percent,’ if inflation in Greece, Ireland, Italy, Portugal, and Spain were kept around zero to 1 percent and infla- tion elsewhere remained in line with the ECB target This underscores the importance of wage and spending adjustments in the surplus economies for the proper functioning of the EMU.

of inflation in their more recent IMF paper, “Rethinking Macro Policy II: Getting Granular”, April 2013 (pp.8–9), http://www.imf.org/external/ pubs/ft/sdn/2013/sdn1303.pdf.

11 The IMF argues:

In Germany, structural reforms will be needed to boost the relatively low level of investment and, more generally, increase potential growth from domestic sources In the near term, the underlying strength in the labour market should foster a pickup in wages, inflation, and asset prices, and this should be seen as part of a natural rebalancing process within a currency union.

(WEO of October 2012, p.28)

12 Political economy aspects of difficulties in dealing with the euro-area sis are discussed by Underhill in “The Political Economy of (Eventual) Banking Union”, VOX, 16 October 2012, http://www.voxeu.org/article/ political-economy-eventual-banking-union.

cri-13 See also ECB, “Monetary Policy and Inflation Differentials in a

Heteroge-neous Currency Area”, Monthly Bulletin May 2005, pp.61–77, http://www.

“One Money, One Cycle? Making Monetary Union a Smoother Ride”, OECD Economics Department Working Paper No 401, 2004, http://www oecd-ilibrary.org/economics/one-money-one-cycle-making-monetary- union-a-smoother-ride_321284370330).

15 The frequency of the OECD’s surveillance of individual countries has been reduced to once every two years, given the need to cover a growing number of non-member as well as new member countries within existing staff resources After the accession of New Zealand in 1973, it was con- ducted once each year for 24 member countries only until the mid-1990s, when the OECD membership started to be enlarged more widely The reduced frequency has been limiting the scope of its timely surveillance.

A reappraisal of the modality of surveillance by the OECD is urgently required to make it more relevant to changed global economic circum- stances See Shigehara, “The Way Forward: Streamlining Policy Discus-

sions for More Effective Multilateral Surveillance” in The OECD at 50,

the 50th anniversary book of the OECD, May 2011 (pp.152–153), http:// office.shigehara.online.fr More to the point related to the euro-area crisis,

as intra-euro-area divergences in competitiveness – a fundamental cause

of the crisis in Shigehara’s view – resulted from differences in unit labour cost and price performance across euro-area member countries that in turn largely reflected intricate interactions between macroeconomic and social, labour, industrial and other structural polices over a prolonged period, a holistic approach to adjustment policies is required to reverse such divergences Shigehara therefore argues that the joint participation

of very senior policy-makers in macroeconomic and structural policy areas from examining countries as well as from countries to be exam- ined should be encouraged to strengthen the effectiveness of OECD for both bilateral and multilateral surveillance of the euro area.

16 See ECB, “The Reform of Economic Governance in the Euro Area –

Essen-tial Elements”, Monthly Bulletin March 2011, pp.113–116, 117–119, http:

//www.ecb.int/pub/pdf/other/art1_mb201103en_pp99-119en.pdf One of the conclusions in the article is that

the quality and independence of fiscal and economic analysis needs

to be guaranteed This requires the establishment of an independent advisory body at EU level comprising persons of recognized compe- tence This body would provide an external ex post assessment of the conduct of budgetary and macroeconomic surveillance by the European Council and the European Commission (p.118)

On MIP, which allows the European Commission and the European Council to adopt preventive recommendations under article 121.2 of the treaty at an early stage before the imbalances become large, see European Commission, “Macroeconomic Imbalance Procedure (MIP)” http://ec europa.eu/economy_finance/economic_governance/macroeconomic_ imbalance_procedure/mip_framework/index_en.htm See also the Euro- pean Commission’s first Alert Mechanism Report, “Tackling Macro- economic Imbalances in the EU”, http://europa.eu/rapid/press-release_ IP-12-132_en.htm.

More general political economy issues of European monetary integration are discussed in Spolaore, “What is European Integration

about? A Political Guide for Economists”, June 2013, http://sites.tufts edu/enricospolaore/files/2012/08/Euro-June-2013.pdf.

17 See Shigehara, “Multilateral Surveillance: The IMF, the OECD and G-20”,

la Ligue Européenne de Coopération Economique, Paris, 1 February 2011, with the text at http://office.shigehara.online.fr and the video picture at http://www.dailymotion.com/video/xh5xan_kumiharu-shigehara_news.

18 One of many recommendations by the IMF Independent Evaluation Office (IEO) emanating from its evaluation of the IMF’s performance

in the run-up to the financial and economic crisis was its executive board consideration of the possibility of issuing staff reports without the need for board endorsement in order to promote more effective bilateral surveillance The IEO’s view is that this could be followed by a peer-review process structured to give surveillance greater traction However, this pro- posal did not receive any support from the board See http://www.imf org/external/np/pp/eng/2012/021412.pdf.

19 For example, in the annual report for 2007 where the ECB commented

on the rise in the ratio of household debt to GDP in the euro area during 2000–2007, it stopped short of issuing specific warnings, simply stating:

“It should be noted that the ratio represents an average level and the level of indebtedness may vary across different households in the var- ious countries of the euro area” (p.50), http://www.ecb.europa.eu/pub/ pdf/annrep/ar2007en.pdf More generally, while the ECB’s annual reports published before the outbreak of the euro-area crisis regularly provided statistical information on the fiscal positions of individual euro mem- ber countries and at times added some comments about household debt and house price developments in some of them, it gave no warning or information about intra-euro-area current account imbalances and their determining factors, such as divergences in inflation and unit labour costs across euro-area member countries See also Erixon, “Money Mischief in the Eurozone: Reforming the European Monetary Union”, ECIPE Occa- sional Paper No 01/2013, http://www.ecipe.org/media/publication_pdfs/ OCC12013.pdf.

20 Article 103, Treaty on European Community, http://eurlex.europa.eu/ LexUriServ/site/en/oj/2006/ce321/ce32120061229en00010331.pdf.

21 See Turner, “Benign Neglect of the Long-Term Interest Rate”, BIS ing Papers No 403 (footnote 26, p.17), February 2013, http://www bis.org/publ/work403.pdf Hannoun points out that the EU’s Capital Requirements Directive is not in line with Basel II See his presenta- tion “Sovereign Risk in Bank Regulation and Supervision: Where do

Work-We Stand?” at the Financial Stability Institute High-Level Meeting, Abu Dhabi, 26 October 2011, www.bis.org/speeches/sp111026.htm?ql=1.

22 See Appendix 2 for a summary of empirical findings on nants of sovereign bond spreads in the euro area Among them

determi-is Attinasi, Checherita and Nickel, “What Explains the Surge in Euro Area Sovereign Spreads during the Financial Crisis of 2007– 2009?”, ECB Working paper series No 1131, 2009, http://www.

ecb.int/pub/pdf/scpwps/ecbwp1131.pdf, Haugh, Ollivaud and Turner,

“What Drives Sovereign Risk Premiums? An Analysis of Recent dence from the Euro Area”, OECD Economics Department Working Papers No 718, 2009, http://www.oecd-ilibrary.org/economics/what- drives-sovereign-risk-premiums_222675756166, and Barbosa and Costa,

Evi-“Determinants of Sovereign Bond Yield Spreads in the Euro Area

in the Context of the Economic and Financial Crisis”, Banco de Portugal Working Paper 22, October 2010, http://www.bportugal.pt/ en-US/BdP%20Publications%20Research/wp201022.pdf basically tried to explain the emergence of large sovereign bond spreads in the euro area from around the second quarter of 2008 They did not explain why the spreads remained so small for such a long time before then despite grow- ing underlying imbalances, such as widening differentials in inflation and

intra-euro-area competitiveness (see Box 1.5, p.45, May 2010 EO) On the

effects of the ECB’s outright monetary transactions (OMTs) on the yield curves of Spanish and Italian government bonds and the risk of reduc- ing incentives for structural reforms, see Benink and Huizinga, “How to

Limit the ECB’s OMT?”, Vox, 12 July 2013, http://www.voxeu.org/article/

how-limit-ecb-s-omt.

23 On the conflicts of interest inherent in the credit-rating business and their implications for prudential regulations, see Efing and Hau, “Cor- rupted Credit Ratings: Standard & Poor’s Lawsuit and the Evidence”,

Vox, 18 June 2013

http://www.voxeu.org/article/corrupted-credit-ratings-standard-poor-s-lawsuit-and-evidence On new European regulations

of credit agencies, see Institut Montaigne, “Nouvelle tion europeìenne des agences de notation: quels beìneìfices en atten- dre?”, March 2013, http://www.institutmontaigne.org/fr/publications/ nouvelle-reglement ation-europeenne-des-agences-de-notation-quels- benefices-en-attendre For an assessment of the performance of a European credit rating agency, see Bartels and Weder di Mauro, “A Rating

reìglementa-Agency for Europe – A Good Idea?”, Vox, 4 July 2013, http://www.voxeu.

org/article/rating-agency-europe-good-idea.

24 See Boone and Johnson, “Will the Politics of Global Moral ard Sink Us Again?” http://harr123et.files.wordpress.com/2010/07/ futureoffinance-chapter101.pdf A less pessimistic view is expressed by Brunnermeier, Crockett, Goodhart, Persaud and Shin, who argue: “While

Haz-we cannot hope to prevent crises completely, Haz-we can perhaps make them fewer and milder by adopting and implementing better regulation”, Last

word, Executive Summary in The Fundamental Principles of Financial lation, Geneva Reports on the World Economy 11, http://www.princeton.

Regu-edu/∼markus/research/papers/Geneva11.pdf.

In this context, see also Allen et al., “Cross-Border Banking in Europe: Implications for Financial Stability and Macroeconomic Poli- cies”, Centre for Economic Policy Research 2011, http://www.voxeu.org/ sites/default/files/file/cross-border_banking.pdf; Goodhart, “How should

We Regulate Bank Capital and Financial Products? What Role for ‘Living

Wills’? ”, chapter51.pdf and Large, “What Framework is Best for Systemic (Macroprudential) Policy?” http://harr123et.files.wordpress.com/2010/ 07/futureoffinance-chapter73.pdf, both in The Future of Finance, ditto; and Kowalik, “Counter-cyclical Capital Regulation: Should Bank Regula- tors Use Rules or Discretion?” The Federal Reserve Bank of Kansas City Economic Review, Second Quarter 2011, http://www.kc.frb.org/publicat/ econrev/pdf/11q2Kowalik.pdf.

http://harr123et.files.wordpress.com/2010/07/futureoffinance-For more recent discussion about micro- and macroprudential icy issues, see Haldane, “Constraining Discretion in Bank Regula- tions”, a paper given at the Federal Reserve Bank of Atlanta con- ference entitled Maintaining Financial Stability: Holding a Tiger by the Tail(s)”, 9 April 2013 http://www.bis.org/review/r130606e.pdf, Constâncio, “How can Macro-prudential Regulation be Effective?”, March 2012, http://www.ecb.int/press/key/date/2012/html/sp120328.en pdf?eaa76 bcd1e135ce893e0171fca7f4439 and Committee on the Global Financial System, “Operationalising the Selection and Application

pol-of Macroprudential Instruments”, December 2012, http://www.bis.org/ publ/cgfs48.pdf and Section IV “Macroprudential Instruments” in an IMF staff position note by Blanchard, Dell’Ariccia and Mauro, “Rethink- ing Macro Policy II: Getting Granular”, April 2013, http://www.imf org/external/pubs/ft/sdn/2013/sdn1303.pdf See also Box 1.5 “Macro-

prudential Regulations”, OECD Economic Outlook May 2013, preliminary

version (pp.52–54).

On the relationship between monetary and macroprudential policies, see Angelini, Neri and Panetta, “Monetary and Macroprudential Policies”, ECB Working Paper Series No.1449, July 2012, http://www.ecb.int/pub/ pdf/scpwps/ecbwp1449.pdf and IMF, “The Interaction of Monetary and Macroprudential Policies”, December 2012, http://www.imf.org/external/ pp/longres.aspx?id=4732.

For recent theoretical contributions on the interactions of various types of financial regulation, see Goodhart, Kashyap, Tsomocos and Vardoulakis in “An Integrated Framework for Multiple Financial Regu- lations”, 2012, http://www.federalreserve.gov/Events/conferences/2012/ cbc/confpaper3/confpaper3.pdf and “Financial Regulation in General Equilibrium”, National Bureau of Economic Research Working Paper Number 17909, 2012, http://www.nber.org/papers/w17909.

Appendix 1

Tensions in the Euro Area: A Summary of Observations by Key International Institutions

This appendix provides a summary of observations about tensions in

the euro area found in the IMF’s WEO and the OECD’s EO in their

half-yearly issues between 2000 and 2012 It is followed by a briefsummary of observations made by the BIS in its annual report

A Observations on the building-up of tensions until late 2008

Observations made by the IMF and the OECD during this period aregrouped under the following headings: (1) fiscal balance, (2) hous-ing market imbalances, (3) external imbalances and (4) inflationdifferential and competitiveness

1 Fiscal balance

The fiscal positions of euro-area countries were discussed not onlywith reference to ceilings under the Stability and Growth Pact(SGP) but often from a perspective of controlling aggregate demandpressure

In the IMF’s WEO, a general remark about the need to use fiscal

policy to deal with divergences in economic developments and tion pressures in individual member countries of the euro area wasmade in the May and October 2000 issues (p.19 and p.13, respec-tively) In the latter issue, the IMF noted that “substantial differences

infla-in underlyinfla-ing cyclical positions were likely to persist for a period”(p.13)

In the October 2001 issue of WEO, the IMF noted that some

coun-tries – including France, Germany and Italy – would have difficultyreaching the fiscal targets for 2001 set by their respective nationalstability programmes It then argued that “from a short-term cyclicalperspective, a tightening of fiscal policy would generally be inappro-priate at the present stage” and that greater focus should be placed

on structural rather than actual fiscal balances (p.28)

In the September 2005 issue of WEO, the IMF warned that five

euro-area countries (France, Germany, Greece, Italy and Portugal) wereexpected to exceed the 3% limit of the SGP in 2005, in some cases

by significant margins It argued that

with fiscal pressures from aging set to accelerate very shortly, mostcountries should ideally achieve a broadly balanced fiscal position

by the end of the decade – requiring an average improvement instructural balances of about 1/2 percentage point of GDP annu-ally – accompanied by further progress in pension and healthreforms The IMF staff’s assessment of present budgetary policies,particularly in the largest countries, suggests they fall far short

of meeting this requirement, with most showing little ment or a deterioration in 2005–06; this would pose a key test

improve-of the revised SGP procedures, and that the additional flexibilitythey allow should not used as an excuse to postpone adjustmentaltogether (p.13)

While the IMF’s WEO did not make country-specific comments

about developments in fiscal positions of small euro-area members

on a regular basis, the OECD’s EO provided them for all member

countries, small as well as large

Greece

In the June 2000 issue of EO the OECD advised Greece to offset

the expected easing of monetary conditions in the run-up to ing the euro area by stepping up the pace of fiscal consolidationthrough restraints on government spending To support this argu-ment it included a figure which showed that the differential betweenthe 12-month Greek treasury bill rate and the Exchange Rate Mech-anism central rate had narrowed sharply from late 1999 (p.100)

join-A similar recommendation on the acceleration of fiscal tion to restrain domestic demand in the face of monetary easingimmediately before Greek entry into the euro area and afterwards

consolida-was repeatedly made in the subsequent issues of EO (December 2000,

p.83; June 2001, p.94; December 2001, p.90) Later, in the December

2006 issue of EO (p.85), noting that “For the first time in many years

the authorities may durably bring the deficit below 3% of GDP”, theOECD argued that “fiscal objectives should now become more ambi-tious by aiming for a substantial primary surplus, given the high level

of debt and favourable outlook for demand Moreover, sive reforms of the pension and health care systems are needed toensure long-run fiscal sustainability” The need for continued fiscal

comprehen-consolidation was repeated in the EO issue of December 2008 (p.141),

despite weaker economic conditions

The OECD argued in the June 2000 issue that

with fiscal and structural policies the only instruments nowavailable, the focus should be on strengthening the supply side

of the economy and ensuring effective implementation of thenew national wage agreement The budget surplus needs to bemaintained at the current high level in order to contribute tonational savings and to finance future liabilities

This argument was supported by a figure titled “Inflation has erated” (p.107) Further specific fiscal policy recommendations were

accel-offered in the December 2000 issue of EO:

The key policy issue is to ensure that price and wage increases,which have been stimulated by the weak exchange rate and oilprice hikes, do not get out of control The structural budget surplus

is set to rise, tightening the fiscal stance Further tax cuts should beoriented to raising labour supply rather than increasing real wagesand cuts in indirect taxes to reduce headline inflation should beresisted (p.89)

Comments in the same vein were repeated in the June and December

2001 issues (p.100 and p.96, respectively)

In the June 2002 issue of EO the OECD warned that “For an

economy experiencing a temporary downturn, the shift in fiscalstance from sizable structural surplus to small deficit has beeninappropriately large and suggests weakness in the budget sys-tem” (p.82)

EO issues afterwards did not include specific comments about

fis-cal policy for several years until the December 2006 issue, in whichthe OECD argued that “Fiscal and regulatory policy should focus onkeeping inflation in check The budget should prioritise spendingitems that alleviate bottlenecks in the economy, such as investment

in human and physical capital, and refrain from fuelling

consump-tion” (p.91) In the June 2007 issue of EO, noting that “the relatively

high level of inflation leaves the economy vulnerable to a loss ofcompetitiveness”, the OECD recommended that “Fiscal policy shouldavoid excessive increases in spending that would further add todemand or reduce the scope to respond to a downturn in revenues”

(p.129) Later, in the December 2008 issue, as the economic andfinancial situation deteriorated, the OECD argued that “Fiscal policyshould be allowed to support demand in the near term but once therecovery is underway substantial measures will be needed to restoremedium-term sustainability” (p.150).

Italy

Italy’s fiscal deficit was kept below 3% of gross domestic product

(GDP) until 2004, but in the December 2004 issue of EO the OECD

predicted a deficit of just over 3% in 2005 (p.58) Half a year later, inthe June 2005 issue, it suggested a 2005 deficit of 4.4% and warnedthat this deficit would rise further in 2006 in the absence of new ini-tiatives (p.64) In the December 2005 issue it gave a new warningthat the deficit could rise to 4.75% in 2007 (p.62) In the June 2007issue the OECD noted that “An impressive fiscal adjustment is beingachieved in 2006 and 2007, albeit at the cost of 2 percentage pointjump in the tax-to-GDP ratio which, if sustained, could have harmfulconsequences for growth in the medium term” (p.86) After a sub-stantial budget deficit reduction in 2007, the fiscal stance became

somewhat expansionary in 2008 In the December 2008 issue of EO

the OECD argued that the automatic stabilizers should be allowed towork as the economy weakened (p.108)

Portugal

Portugal is another small member country, together with Ireland,

which was advised as early as the June 2000 issue of EO to rely on

fis-cal consolidation to contain inflation Specififis-cally, the OECD arguedthat “Preventing the intensification of price and wage pressures callsfor more ambitious targets for fiscal consolidation” (p.127) In theDecember 2000 issue the OECD called for fiscal consolidation “giventhe state of the cycle, the external deficit and the recent intensifi-cation of price and wage pressure” (p.109) In the June 2001 issuethe OECD stated that “a tight fiscal policy” was required to “raisenational saving” and to achieve “a smooth re-absorption of the verylarge current account deficit” (p.121) In the December 2001 issuethe OECD called for decisive measures to contain slippage from thefiscal targets for 2002 and 2003 caused by the cyclical downturn.Essentially the same policy recommendations were repeated in the

subsequent EO issues.

In the June 2005 issue of EO the OECD referred to SGP ceilings:

“If the new government stands by its decision not to rely on off measures to curb the fiscal deficits, the 3% of GDP deficit limitwould be overshot by a large margin in 2005 and 2006.” In the June

one-2008 issue, reference was again made to SGP ceilings for Portugal:

“The budget deficit shrank further in 2007, falling below 3% of GDP.Additional fiscal consolidation and structural reforms are called fordespite the weaker external environment” (p.174)

Spain

In the December 2000 issue of EO, the OECD called for fiscal

tighten-ing for domestic demand management: “In the face of ristighten-ing coreinflation and still relaxed monetary conditions, the fiscal stanceshould be tightened to damp demand pressures” (p.115) In theJune 2004 issue, the OECD made a similar argument: “With mon-etary conditions likely to remain relaxed and output gap closing,the authorities should avoid any fiscal stimulus This would imply

a widening budget surplus over the projection period because of itive cyclical effects” (p.111) The OECD recommendation on fiscal

pos-tightening for anti-cyclical purposes was repeated in the EO issues

of June and December 2005, 2006 and 2007, until Spain started toexperience an economic slowdown In the December 2008 issue theOECD noted that “Discretionary fiscal policy easing of around 1½per cent of GDP has been supporting growth in 2008 The automaticstablisers should also be allowed to operate in 2009 and 2010 Stepswill then need to be taken to curb spending pressures in the longerterm” (p.179)

2 Housing market imbalances

The IMF expressed concern about the risk of a turnaround in assetprices after sharp increases, particularly for property, in the smaller

euro-area countries on several occasions (May 2000 WEO, p.18; September 2004 WEO, p.27; April 2006 WEO, pp.22–23).

To moderate a housing boom in Ireland, the OECD argued that

“Tax incentives that boost the demand for housing in an alreadyoverheated residential market should be cut” in the December 2003

issue of EO (p.89) where the OECD included a figure regarding

devel-opments in house prices In the December 2007 issue the OECDshowed a figure entitled “House prices and building are falling” and

warned that “tax revenues partly depend on the property marketand will grow more slowly in coming years” (p.133) The June 2008issue also included a figure entitled “House prices and building aredeclining” (p.150).

As for Spain, the OECD included a figure entitled “Housing ment and price increases remain high” for the first time in the

invest-December 2006 issue of EO (p.111) In the June 2007 issue the OECD

noted increases in the household debt burden and warned that themain risk surrounding the OECD’s economic projection for Spain lay

in a more pronounced adjustment in the housing market, given alarge share of residential construction in GDP (p.156) A slump inthe housing sector was also shown clearly in a figure included in theDecember 2008 issue (p.179)

Besides brief remarks about housing market imbalances in thesetwo countries, the impacts of a common monetary policy of the ECB

on housing market conditions in euro-area countries were examined

in the June 2008 issue of EO (p.59) It noted that

incomplete business cycle convergence within the euro arearesulted in a situation where, for some member countries includ-ing Ireland and Spain in particular, monetary policy rates were per-sistently and significantly below what traditional rule-of-thumbwould have suggested Over the 2001–2006 period, the cross-country correlation between various indicators of housing marketbuoyancy and the deviation between actual euro area interest ratesand country-specific rule-of-thumb rates is striking.1

3 External imbalances

The IMF often analysed “global imbalances” between the USA, Japan,

the euro area and the emerging Asia (e.g April 2005 WEO, p.10; September 2006 WEO, p.17), but it did not develop the discus-

sion about divergent external imbalances across individual euro-areamember countries and their borrowing conditions.2

Among EO notes on Greece from the June 2000 issue onwards, it

was in the December 2006 issue that the OECD included a figureabout Greek current balances in one of the two supporting figureswith the title “The current account deficit has widened” A similar

figure was included in the December 2007 issue of EO In the

Decem-ber 2008 issue the OECD noted that “the current account deficit

soared to 15½ per cent of GDP in the second quarter of 2008, due

to the deterioration in the terms of trade”

As for Ireland, no comments or figures regarding developments incurrent balances were offered over the years until the November 2011issue, where a figure entitled “Imbalances are correcting” showed thatthe current account had turned into a surplus (p.142)

As will be described below, the erosion of Italy’s competitiveness

was critically discussed in most EO issues prior to the outbreak of the

euro-area crisis, but no specific verbal comments were made aboutdevelopments in Italy’s deteriorating current balances That said, dataregarding recent developments and prospects for its external trade

and current accounts were regularly included in EO statistical tables.

Turning to Portugal, the evolution of its current balances was a

matter of serious concern in EO Thus in the June 2000 issue of EO

(p.127), the OECD showed a figure entitled “The current accountdeficit widens” in the context of its call for more ambitious fiscalconsolidation and structural reforms to prevent “the intensification

of price and wage pressures” In the December 2000 issue the OECDcited the “external deficit” as well as “the state of the cycle” and

“the recent intensification of price and wage pressures” in arguingthat “Fiscal policy targets are unambitious”, and it included a figureregarding the current deficit which was projected to widen to 12% ofGDP in 2002 (p.109) In the June 2001 issue the OECD stated that

“Achieving a smooth re-absorption of the very large current accountdeficit will require a tight fiscal policy to raise national saving” Thisremark was supported by a figure regarding the current deficit whichhad widened to 10% of GDP in 2000 The December 2001 issueincluded a figure regarding the current deficit, which had stoppedwidening but remained large – 9% of GDP in 2001 (p.112) In theJune 2002 issue a figure showed that the current deficit had fallensomewhat but remained large – 9% of GDP in 2001 (p.98) However,comments about the current account were not made in the subse-

quent EO issues, including that of June 2008, in which the current

account deficit was projected to widen to 11.6% of GDP in both 2008and 2009 (see table, p.175)

As for Spain, the June 2005 issue of EO included a figure

enti-tled “Net exports are a drag on activity”, with another, entienti-tled

“Competitiveness is eroding in manufacturing” (p.111) But in this

as well as in the subsequent issues, no strong words of concern

were expressed about its current account deficits, which continued

to increase, reaching 10% of GDP in 2007

4 Inflation differential and competitiveness

In some contrast to the September 2003 issue of WEO where the

IMF noted that above-average inflation rates of some of the smallereconomies were expected to diminish – including sizeable falls inIreland and Portugal (p.27) – concern was expressed in the April 2004

issue of WEO about “substantial and persistent inflation differentials

across euro area countries” (p.26) In this context the key role offiscal policy as dealing with inflation pressure as well as the impor-tance of structural reforms was stressed (p.26) In the September 2005

issue of WEO the IMF warned that differences in competitiveness can

take a considerable time to reverse, and, partly associated with that,inflation differentials can be very persistent (p.25)

Developments in inflation in individual euro-area countries andintra-euro-area divergences were more fully reported in the OECD’s

EO publications.

Among them, a strong warning about the divergence of inflation

in Greece from the euro-area average was a regular feature of EO since

the June 2001 issue, almost always3 supported by a figure whichvisibly showed inflation trends in Greece in comparison with theeuro-area average In the December 2006 issue the OECD placed thesame emphasis on the need to reduce inflation as on fiscal consolida-tion by noting that “A major question is whether the fiscal targetswill be achieved and whether inflation will come down to below3%” (p.86)

On the other hand, the OECD’s concern about inflation in Irelandwas expressed as a standalone warning, not in comparison with theeuro-area average or with reference to competitiveness In the June

2007 issue of EO, however, the OECD noted that “the relatively

high level of inflation leaves the economy vulnerable to a loss ofcompetitiveness” (p.129)

Far more systematic comments were made about Italy’s relativeinflation and competitiveness As early as the December 2001 issue

of EO the OECD was concerned about “inflation inertia” in Italy,

which “raises costs and affects the exposed sectors, thereby ing competitiveness vis-à-vis the euro area” In the December 2001issue it noted that “Inflation, though declining, is likely to remain

weaken-above the European Union average” (p.65) In the June 2002 issue,Italy’s competitive position was discussed as a matter of the OECD’sparticular concern for the first time, noting that “A key risk is thatcompetitiveness might deteriorate” A figure entitled “Some erosion

of competitiveness has occurred” showed trends in relative exportprices in manufacturing and nominal effective exchange rates (p.67)

In the June 2002 issue the OECD noted that “the core inflationgap is significant”, contrasting higher inflation in Italy with infla-tion records in Germany and France between 1999 and 2002, adding

at the same time that “moderate private sector wage settlementsunderpin the prospects of reduced inflation pressure over the comingyear” (p.53)

Particular emphasis was placed on developments in unit labourcosts as a key determinant of competitiveness in the December 2002

issue of EO for the first time Figures showing this particular indicator were maintained in the subsequent EO issues for several years, with

the exception of the December 2004 issue However, this practice wasdiscontinued in the December 2007 issue.4

Regarding Portugal, the June 2001 issue of EO included a figure

showing the inflation differential with the euro-area average, whichwas projected to continue to widen (p.121) Similar figures wereshown in the December 2001 and December 2003 issues In the June

2005 issue the OECD noted that nominal wages and unit labourcosts had continued to decelerate and, after widening temporarily

in mid-2004, the inflation differential with the euro area had lized at 0.1% above the area average (p.107) In the June 2006 issuethe OECD predicted an improvement in competitiveness as a result

stabi-of wage moderation (p.118) Unemployment rising to 8% in 2007contained wage pressures and, in the June 2008 issue, the OECDpredicted the inflation differential with the euro area to be reversed

in 2008

As to Spain, in the December 2000 issue of EO, reference was

made to “rising core inflation and still relaxed monetary tions” in the OECD’s argument for tightening the fiscal stance It wassupported by a figure which showed that the inflation differentialwith the euro area was projected to widen further In the Decem-ber 2006 issue the OECD argued that reducing Spain’s inflationdifferential with the euro-area average and preventing further ero-sion of competitiveness still required structural reforms that foster