Should the European Central Bank (ECB) be concerned about emerging inflation differentials and current account imbalances among members of the economic and monetary union (EMU)? And should there be explicit policy coordination with the fiscal authorities of the euro area? These are some of the questions addressed in CEPR’s latest Monitoring the European Central Bank (MECB) Report, published earlier this year, and the September 2001 MECB Update.

The Report notes that there are widening inflation differentials between high-growth countries – Ireland and Spain in particular – and the core of the euro area. Should the ECB worry? The MECB team’s answer is that inflation differentials should not be demonized. In a common currency area, they are the mechanism for adjusting real exchange rates where adjustment is needed. So for a country in a currency union, above average inflation may be entirely appropriate. This suggests that having first convinced citizens that inflation is an undesirable phenomenon, governments and the ECB must now proceed to step two and explain that temporary inflation differentials can be desirable, leading to higher real income and the proper macroeconomic adjustment.

The current situation in Ireland provides a first testing ground. The country can clearly sustain a high growth rate for the foreseeable future, but not quite the current growth rate. The Irish economy is now above its sustainable level of activity and should slow down. What form should the adjustment take? Given fast growth and strong investment demand, the appropriate current account position for Ireland may well be a deficit, a reliance on world saving. This points to the adjustment occurring through a reduction in external demand, and thus through inflation and real exchange rate appreciation. In other words, the Irish economy should be slowed down by increasing the relative price of Irish goods, and thus by increasing the real income of the Irish people.

Ireland has a large budget surplus and at present, an even larger surplus may not be necessary. Indeed, there is a strong case for using part of the surplus to finance public investment to keep infrastructure in line with the rapidly growing economy. But this is not the case in Spain, another EMU member with above average inflation. The Spanish current account deficit is large and getting larger, but in contrast with Ireland, it is not matched by high investment and high productivity growth. Spain provides a clear case for slowing down the economy through the use of fiscal policy, rather than through a real appreciation and an increase in the current account deficit.

MECB Update, published in September, considers whether the current account deficits of two other countries outside the core of the euro area – Portugal and Greece – should be a source of concern. It concludes that they should not: these deficits mostly finance the increase in investment rates induced by these countries’ deeper integration into the European Union (EU). Outside financing is possible because the single currency and the single market have increased the degree of financial integration in Europe. And since external borrowing mostly finances investment, higher output in the future will pay for the interest on the foreign debt – again, no reason to worry.

Moreover, the channel that could turn an investment boom financed abroad into a balance of payments crisis – that is, a currency mismatch between foreign borrowing and domestic lending – is much weaker within EMU, at least to the extent that foreign borrowing takes place within the euro area. So for a country that is integrating more deeply into the euro area and which starts with a level of income below average, a current account deficit is typically the manifestation of the build-up of domestic capital. Stopping it would amount to closing down an important source of finance.

Finally, the MECB team considers what attitude the ECB should take vis-à-vis the fiscal authorities in EMU given its considerable degree of political autonomy, and whether or not it should volunteer to participate in policy coordination exercises. This issue has come to the fore following the EU’s Nice summit: the Treaty provides a new institutional framework that could formalize the currently informal dialogue that takes place among the twelve euro area finance ministers and between them and the ECB president in the so-called Eurogroup.

A peculiarity of the European situation, compared with, say, the United States, is that the ECB faces not 1, but 12 fiscal authorities. This raises two issues. The first is whether or not coordination among the 12 fiscal authorities is necessary. The second is that it makes these meetings more formal than, say, a weekly breakfast between the chairman of the Fed and the US Secretary of the Treasury.

So is explicit coordination of monetary and fiscal policies necessary? The Report’s answer is no. If the monetary and fiscal authorities acting on their own ‘keep their houses in order’, there is no need for explicit coordination. If the fiscal authorities deviate from prudent fiscal policies because of a variety of short-run political incentives and constraints, then explicit coordination may even be counterproductive.

Formal meetings between the monetary and fiscal authorities designed to coordinate policies are either unnecessary or harmful, the Report argues. Informal meetings may be a useful channel of information exchange. The benefits of this exchange of information must, however, be weighed against the possibility that these meetings may be turned, by the fiscal authorities, into occasions for putting pressure on the ECB. The participation of the ECB president in the Eurogroup meetings has to be viewed in this context. These meetings may be useful as an exchange of information, but, if they are sanctioned as ‘formal’, they may become more than information exchange and so become counterproductive.

What about national fiscal authorities? Should the twelve finance ministers coordinate their policies? If it was certain that fiscal policy decisions in each country were shielded from short-term political incentives, coordination would certainly make sense. Coordination could, however, lower the political cost of incorrect policy actions, thus making them more attractive.