TAX REDUCTIONS FOR THE LOW PAID

Competitive general equilibrium with heterogeneous labour

Why would unemployment be higher among the low-skilled workers? As Phelps (1972) pointed out, when low-skill jobs become less desirable, workers' propensity to quit increases. Furthermore, reservation wages for these employment opportunities may be relatively higher, reflecting workers' aversion to jobs that are perceived as demeaning in view of their low social status.

Other reasons for unemployment can be found in some form of real wage inflexibility. In particular, a minimum wage legislation may cause workers whose marginal product is valued less than the minimum wage, to be permanently unemployed. Under these circumstances a trade-off can arise between wages and employment when the demand for unskilled workers falls.

INTRODUCTION

Since [START_REF] Pigou | The Economics of welfare[END_REF] advocated them, 1 there seems to have been a broad agreement among economists, even of diverging doctrinal inspirations, about the usefulness of employment subsidies to increase employment and/or to lift up the wage of the low paid. The case has more recently been forcefully argued by Edmund Phelps in his monograph (1998) adding new arguments to demonstrate how such a scheme may increase social adhesion to the capitalist system. One then may wonder why, if economists are confident in what they write and say, such a remedy has not yet been implemented on a large scale in all countries suffering from unemployment and/or a too high level of incidence of low pay. A growing number of papers are devoted each year to the subject. It is true that in a number of countries, schemes which amount to employment subsidies are implemented but most of them are, to the best of my knowledge, too narrowly targeted.

The rationale behind such a broad consensus is straightforward: in decreasing for the employer the cost of hiring low-skilled workers, employment subsidies "enhance the employment opportunities for groups at the margin of the labour market -those with little work experience and/or low skills -while at the same time, maintaining socially acceptable wage rates and income distributions", as Ignazio Visco and Tom Alexander put it in the letter of invitation to the workshop. The reason why I am quoting this letter is to show, from the outset, that the purpose of this measure is not only to enhance efficiency but also, and perhaps mainly, to control the degree of income inequalities through redistribution, i.e. at least maintain equity at some socially acceptable level by increasing in-work benefits for the low paid. The employment subsidies policy is thus of a broader reach than purely economic measures to combat unemployment. It may lead to a new implicit "social contract", compatible with market economies, while reducing the degree of inequality in either income distribution or in employment opportunities. This leads to a first issue: is it desirable to reduce the degree of wageinequalities? Finis Welch, in his recent Richard T. Ely Lecture [START_REF] Welch | In Defence of Inequality[END_REF], makes the interesting observation that he believes that: "inequality is an economic 'good' that has received too much bad press". The main reason behind this assertion is that wages respond to investments in effort and in foregoing current income for enhanced future prospects. An increased educational wage premium, because it creates new opportunities, may deliver the good: a general increase in the © OECD 2000 educational level of the population. But even if we believe in the merit of an increased wage-inequality as an incentive to invest in education, we may miss an important point: for some groups of people the wage corresponding to their productivity may be too low to allow any meaningful personal effort -a fact known and emphasised by all classical and neo-classical economists but most particularly by Mill and Marshall -or any kind of investment in education.

A natural way of implementing an employment subsidies scheme, in countries characterised by a high level of payroll taxes, is through the introduction of a certain degree of progressivity in the tax system. It may be useful to encapsulate the payroll tax system in the formula: T = T* + t(w).W where T* is a non-positive parameter and t(.), a non-decreasing function of the wage rate.

Two types of subsidies have been generally advocated: -In the first, T* is strictly negative and t is a constant rate. Hence a given amount of every wage is exempted from social contribution. It is as if a fixed payment is made to firms for each employee, independent of the wage paid.

Hence the payroll tax system becomes a progressive one. -In the second, T* is equal to zero, and t(.) is an increasing function of the wage over some interval, for example between the minimum wage and twice the minimum wage. Both schemes were considered in Dreze et al. (1993). More recently, Malinvaud (1999) proposed a scheme of the second type on the basis of cost effectiveness considerations.

The paper is organised as follows: the first part will review some of the recent theoretical literature on the subject, trying to assess if the favourable opinion about employment subsidies is too model dependent. A second part will compare in a sketchy way the different economic regimes in terms of the implicit social contract imbedded in them. As most of the models used are static, the third part will investigate some medium to long-term issues regarding possible adverse effects of employment subsidies. The last part will discuss, broadly, the cost effectiveness issue.

THEORETICAL NOTES

The case for employment subsidies has been investigated in the framework of (at least) three kinds of theoretical models, which I will review briefly. The models have been either of a general equilibrium type or of a partial equilibrium variety. But I will not distinguish between them on this basis. Rather the nature of competition and the heterogeneity of the labour force will serve as criteria. This trade-off seems to be well grounded in General Equilibrium Theory. However, in such a framework -absent heroic assumptions on endowmentsredistributive schemes have to be devised to obtain equilibrium wages above the (social) subsistence level. Minimum wage cum unemployment benefits and/or minimum income is an example of such a scheme. Dehez and Fitoussi (1996a, b) present a general equilibrium model with different categories of labour, each characterised by an inelastic supply and a specific level of productivity; they study the effect on employment and wages of introducing a minimum real income, while prices and nominal wages are otherwise perfectly flexible. Compensations are paid to unemployed workers and financed by an income tax. Together with the minimum real income, this induces a minimum real wage. The fact that individuals differ in terms of their skill is an important feature of the model. The distribution of skills is relatively rigid in the short term because the acquisition of new skills takes time. However there is always a certain degree of flexibility because workers are often qualified for a variety of jobs. Skill and qualification are thus distinguished: the skill structure is rather rigid while the qualification structure offers some flexibility. This flexibility is allowed for by assuming that the structure of qualifications is pyramidal in the sense that workers with a given skill are qualified for jobs corresponding to lower skill levels.

A simple characterisation of an equilibrium with unemployment is given in real terms. The emerging wage scale is such that wages in two successive categories are equal whenever unemployment prevails in the most qualified type. 2 The equilibrium distribution of employment may be characterised by under-employment because some workers may have to accept jobs corresponding to lower qualifications. It is then shown that the existence of a (short-run) equilibrium depends on the capacity of the economy to finance the unemployment compensations from income taxes, without the creation of money. Alternative institutional arrangements, like employment subsidies, perform better in such a framework. Firms receive a subsidy such that workers in category j cost their marginal productivity, © OECD 2000 even if they receive a net real wage equal to the minimum income. In this setting, there is full employment and the authors show that it is actually possible to cover the subsidies from taxes. The employment subsidies regime is thus compatible with full employment and a balanced budget under minimal assumptions.

Full employment can be obtained through a wage subsidy scheme if, and only if, the minimum net income of the wage earner is strictly less than the weighted average of marginal productivities. Such a solution may be spontaneously achieved if the wage structure is such that the degree of inequality in the wage distribution is smaller than the degree of inequality of marginal productivities. Social norms may impose such implicit systems of subsidies. However, it may also be explicitly imposed through taxation if the high skilled workers do not reduce their supply of labour -as assumed in that model -because of the increased taxation.

To sum up, the introduction of a wage subsidy scheme will have two effects: in a country characterised by a relatively high level of the minimum wage (say France), it will "force" full employment, because the "high" minimum wage perceived by the worker is greater than the cost of labour paid by firms. In a country where the minimum wage is not binding but the problem arises from a too high level of the reservation wage -which amounts to saying that the wage effectively paid to the less skilled is too low -it will lead to an increase in the net real wage perceived by the workers and thus reduce the propensity to quit of these workers. In both situations, it will lead to an increase in in-work benefits.

Employment subsidies under monopolistic competition

Marc Fleurbaey (1998) investigates the impact of employment subsidies in a basic general equilibrium model with imperfect competition. Fleurbaey's is a very interesting and policy-relevant exercise conducted within the confines of an abstract equilibrium model with several realistic features. The author is careful to point out the many weaknesses from a policy or applied point of view of the novel results, so that the reader is given timely pointers on realism. Market power generated by imperfect competition and resulting in deviations from the Walrasian configuration of full employment, when subject to appropriate levels of employment subsidies, can be made consistent with Walrasian values. This is one of the main results for a variety of special cases. The model assumes homogenous labour and thus is not suitable to fully investigate the consequences of a minimum wage. Rather it casts light on the way employment subsidies will perform their aim in an economy characterised by two kinds of externalities, namely, the prisoner's dilemma induced by market power (all firms and households would benefit from increased activity, but it is in the interest of no firm to initiate it), and the tax burden of supporting unemployed people.

© OECD 2000

The author is thus able to show, considering different types of wage rigidity, how the same formula for the computation of the subsidy enables the government to drive the economy to the Walrasian equilibrium. The principle of the formula is simple: the subsidy is made of two parts, one compensating for the difference between the actual wage and its Walrasian value and the other compensating for the slowdown effect of market power (taking into consideration imperfect competition). Hence a Walrasian benchmark has to be computed first. Such a subsidy in effect makes every firm behave as if it were a price taker.

Despite the fact that employment subsidies are financed at least partly by a tax on profit and other incomes, they lead to a decrease in unemployment but also to an increase in all real incomes (real wages and real profits) and to an improvement in the government budget. The reason is the same as in the preceding model: full employment because it leads to a higher GDP increases the redistributive capacity of the economy. The paper considers two other thought experiments, subject to the same qualifications as above, which are also illuminating didactic sources. One of them shows the superiority, in all sorts of Pareto sanctioned ways, of employment subsidies over demand management under conditions of downward wage rigidities; the other shows the superiority of employment subsidies, when financed from profits, over Weitzman's profit sharing scheme. Again, although in a rather different framework, the same conclusions emerge: employment subsidies will not only reduce the unemployment level, but they will boost real wages thus increasing in-work benefits.

Partial equilibrium models

I turn now to another interesting exercise, but this time in a partial equilibrium framework, exploring similar policy issues: the effect of employment tax cuts on the level of (un)employment and wages. [START_REF] Pissarides | The impact of employment tax cuts on unemployment and wages; the role of unemployment benefits and tax structure[END_REF], in an exceptionally clear paper, explores the quantitative "impacts of the structure and level of employment taxes on equilibrium unemployment".

Pissarides considers four partial equilibrium models: the competitive case, a bargaining example, a search model and an efficiency wage model. Their unifying geometric theme makes it easy to compare and contrast policy effects in a lucid way and gives added strength to the quantitative exercise: "… employment and wages are determined at the intersection of a conventional labour demand curve and a wage setting function" (p. 157). This almost disarmingly modest claim hides some serious analytic meat in the paper but also shows the author's finesse in tackling some deep questions and coming up with illuminating insights on the basis of building blocks of a textbook variety. This simple Marshallian attitude and approach places the burden of the exercise, or rather, its description, on the fragile shoulders of the slope of the wage setting function. He is able to frame his models in such a way that the slope of the wage setting function contains within it "the © OECD 2000 relation between taxes and unemployment benefits and the structure of taxation" (p. 157). That is a great deal of burden for such a slender creature but it does its job well, at least in the seasoned hands of this expert.

If the ratio of unemployment benefits to the post tax wage is not changed at the moment the employment tax cut is introduced, the four models considered have little hope for an employment effect of the tax cut. Most of it will show up in an increased wage. The reason is that when unemployment benefits are indexed to wages, real wages are flexible, and the wage setting function steeper. The structure of taxation matters only when wages are determined by a bargain as they are in the union and the search models. The reason is that an increase in the marginal rate of taxation allows firms and unions to save more when they renounce a given increase in wage. A shift towards progressive taxation will have a beneficial effect on employment in these two models even if the average rate of tax is unchanged. The merit of the paper by Pissarides is to show that the success of an employment subsidies scheme depends both on some critical parameters and on the way we portray the labour market of the economy where the scheme is to be introduced. But even in the pessimistic case, when the unemployment tax cut would have no employment effect, it will lead to an increase in real wages. It will thus serve a purpose in countries were the most serious problem is social integration through work, rather than unemployment. So, where is the catch? It is in the fact that all of this is predicated upon models that rely on representative agent specifications. This makes it somewhat less than useful as a framework inside which specific questions about employment subsidies for the low paid or the unskilled and semi-skilled can be discussed. Is there a way out by some simple modification of the specifications? We think not. No representative agent model can be of use in the context of the questions we have on the agenda. Indeed, the agenda for discussion requires heterogeneous agent dynamic models in transition from one equilibrium to another -in disequilibrium. The challenge, then, is to construct them without compromising on the rationality underpinnings at the micro-level and the ethical framework by which the macroeconomy is circumscribed. Pissarides is not unaware of this (cf. p. 158 to his perceptive reference to the constraints imposed by a "political equilibrium"). The same remark applies, in fact, to all the categories of models considered so far.

The three types of models considered so far, even if the last one is the most cautious one about the effect of a reduction in the payroll tax, all point to some beneficial effects -i.e. an increase in employment and/or an increase in wages -of a employment subsidies scheme, except under special circumstances. We may consider that this is sufficient to go in that direction even if all models do not have the same purpose, and that in this respect are all partials. The first one considers a heterogeneous labour system in a perfect competition framework, both in the labour and the product markets. The two others have a homogenous labour supply © OECD 2000 with imperfect competition either in the goods or the labour market. A more convincing proof of the usefulness of employment subsidies would require a theory able to combine a heterogeneous labour system with imperfect competition in all markets and some institutional features, such as a minimum wage and/or minimum income. Besides, none of the stories I have discussed consider investment and accumulation behaviour; they are, essentially, static models. So, in a sense, what the subsidies scheme is achieving in this kind of model is to modify the budgetary constraints of the agents in such a way that the change in their spending behaviour regarding employment and consumption leads to full employment. In this interpretation they are more accounting models than theoretical ones. Of course the outcome of the scheme is assumption dependent, especially regarding the diverse elasticities considered. But over a broad range of values for these elasticities, and provided the supply and demand functions are not pathological, the outcome will be positive. Maybe the accounting nature of the exercise increases the robustness of the conclusion rather than weakening it. Besides, when one considers the model with heterogeneous labour supply and institutions, the obvious point it is making is that it is welfare enhancing to let the price system perform its allocative function while dealing with redistributive issues through the tax system.

It is fair to conclude this sketchy survey of theoretical analysis, by noticing the fact that there exists enough theoretical indices in favour of employment subsidies to adopt such a scheme in countries where unemployment and/or a too high incidence of the low paid are problems. At least it appears that the case against employment subsidies and payroll tax reduction have not yet been made.

SOCIAL ACCOUNTING: IMPLICIT SOCIAL CONTRACTS AND ECONOMIC REGIMES

In the Dehez-Fitoussi model, imperfect as it is, it is possible to sketch a one for one correspondence between economic regimes and implicit "social contracts". The pure "Walrasian contract" is one where any equilibrium price vector is considered as acceptable, even if it leads to the (involuntary) decrease of the population, because even in this case it does not lose its welfare properties. The "unemployment compensation cum minimum wage contract" which is almost universal in industrial countries may be unsustainable as the occurrence of unemployment reduces the redistributive capacity of the economy. The spirit of this kind of social arrangement is to provide everyone with a minimum subsistence level even if some remain unemployed. Hence the idea of a third kind of social contract which could provide, theoretically, everyone with a decent level of (net of taxes) wages and a job. Intuitively, this regime is one where the basic payroll system is supplemented by a set of transfers going top down, from the highest paid jobs to the lowest, thus reducing their spread. Such a system might appear quite reasonable, especially © OECD 2000 because wage distribution within a firm or industry always includes an element of arbitrariness. 3 It is well known that individual productivities are difficult to measure leading managers to focus on the global outcome of team (or firm) effort. While it is possible to rank jobs in terms of productivity, it is never easy to assign to each agent a precise cardinal measure of productivity. Again, this suggests that every system for assigning shares of aggregate income to individual jobs is to a certain extent a matter of social convention. And indeed even today the actual systems that we do observe differ quite substantially from country to country. That leaves to economic policy a possibility of controlling for the degree of inequality in income distribution.

But such a result can be achieved through different means leading to different consequences in terms of unemployment. It is convenient to reason as if a common factor were at the root of increased wage inequalities in the US and increased inequalities in employment opportunities in Europe, namely a skill biased technical change. On both sides of the Atlantic the same phenomena have led to an increase in earnings inequality, but in Europe this has been compensated for by a direct intervention on the price of labour, through the management of the minimum wage and tax and transfer policy changes, in such a way that the distribution of disposable income has remained roughly stable. A paradigmatic case is that of France where, as shown by [START_REF] Picketty | Les créations d'emploi en France et aux États-Unis: 'service de proximité' contre 'petits boulots'?[END_REF], the distribution of disposable income has been remarkably stable from 1970 to 1996, 4 a period during which the rate of unemployment has grown from less than 3 per cent to more than 12 per cent. But such stability could have been achieved at a much lower cost if instead of an "income maintenance" strategy, the French government had chosen a "job subsidy strategy".

Are the models promising too much -full employment with an acceptable degree of inequality -or are the political obstacles to the implementation of such a scheme too important? There is in effect a transition period where some agents, say the more qualified workers would have to pay for both the old system (i.e. unemployment compensation) and for the subsidies. And as Picketty rightly points out, this could be enough to prevent the implementation of the scheme, even if eventually all agents would be better off under the new scheme. The theoretical models above are not designed to say something about transition periods; they are all, by construction (as pointed out above), static models even if their authors forget it, sometimes.

Since I have argued that a case can be made to show that the implicit contract embedded in the "employment subsidies" regime dominates that embedded in the minimum wage regime, I will restrict our attention to comparing "employment subsidies" (ES) to "free market type" (FM) solutions. My claim is that there are strong reasons to believe that the employment subsidies regime is preferable and for reasons which have not been spelled out in the theoretical model.

© OECD 2000

Most of the advantages accruing to the ES solution can be related to the externalities that it generates in terms of human capital. The first and most obvious externality arises from the benefits associated with providing everybody with a job. While no "free" human capital accumulation can take place for agents that are unemployed, economic activity goes along with skill acquiring, training, and knowledge building, at a rate at least comparable to the free market solution and perhaps even larger, since it goes along with a better standard of life.

Moreover, employment subsidies, by reducing the risk of becoming unemployed, favours the development of long term job relations. Agents are more willing to invest larger resources in collective action and in return, firms are ready to provide them with long-run contracts. This has several effects. First, it leads firms to devote larger resources to workers' training and education, because they know that they will be able to derive benefits from their employees' improved abilities. Again, it is obvious that human capital accumulation is favoured.

A second effect relates to the fact that the cross-sectional transfers associated with employment subsidies have dynamic effects as well. The existence of long-run relations provides a way to introduce built-in incentives to work efficiently, precisely because income increases along with the stock of achievements. Hence, in the ES solution, both firms and employees can derive all sorts of externalities that cannot be achieved as efficiently through the Walrasian solution.

Of course, the trend that has developed in the past 20 years has pushed towards quite a different direction. Rising unemployment, along with high real interest rates have led to the unravelling of long-run economic relations. Faced with an increased risk of being laid off and with a more discounted future, agents have asked for higher pay whenever possible, and have been drawn away from intertemporal contracts. This has tended to increase competition for the low pay jobs. In turn, the situation of older and now "overpaid" workers has been contaminated.

THE MEDIUM RUN

To discuss the notion of social acceptability, within a formal economic model, whether of the micro-or macro-variety, one needs to bring in ethical considerations and these, even now, are uneasy bedfellows in a subject dominated by neoclassical orthodoxies. On the other hand, to incorporate (personal) income distributions in such a way that a macro-model, with suitable micro-underpinnings, can be made to speak with, and to, the stylised facts involves explicit dynamic considerations. In other words we need to work with a model of growth, which is intrinsically dynamic, that has dynamic microfoundations. The kind of dynamics that will enable the researcher to look at the growth and decay of firms, rather than technologies in the aggregate; the kind of dynamics that propels the distribution of personal incomes to show the dynamics that the stylised facts capture; and the kind of © OECD 2000 dynamics that encapsulate the varying degrees of returns to scale at the firm level, even though the aggregate data are consistent with constant returns to scale. The first two points are obvious, as the models presented are of a static nature. But it does not need more than a modicum of historical sensitivity to remember that thirty years -or so -ago, in the wake of the publication of A Theory of Justice by John Rawls, economic theorists began to mull over the theoretical conundrums posed by the conflict between equity and efficiency in formal growth contexts. Growth theory had, of course, come of age whilst development theory had branched off; the former becoming normative and the latter essentially descriptive and institutional. This normative underpinning to growth theory made it eminently suitable to discuss and frame Rawlsian issues -as Phelps, Sheshinski and others did with great finesse. Optimum taxation, mediated by fairness considerations, was a topic that dominated the decade. Social Choice Theory had also come of age and thus there seemed, in the horizon, a possibility for a normative growth theory to be embedded in a political equilibrium where efficiency was mediated by equity considerations -the latter referring predominantly to the distribution of personal incomes. Now, thirty years on from John Rawls, the conundrums facing the policy activists today, paralysed by crude positivism instead of normative foundations, seem to be a lack of consensus on the ethical norms driving social forces. This is, perhaps, part of what [START_REF] Phelps | Low-Wage Employment Subsidies versus the Welfare State[END_REF][START_REF] Phelps | Rewarding Work[END_REF] is groping for and we feel it is a legitimate search, in the context of the stylised facts confronting us at this time.

On the third point, we may venture some preliminary thoughts, of almost an impressionistic nature to indicate another channel through which employment subsidies may work. This is more an avenue for future research, than a report on facts and/or theories. The question has to do with the size distribution of firms and its evolution over time. Stephen J. Davis and Magnus Henrekson (1995) have convincingly argued that such a distribution can easily be adversely affected by the fiscal cum social contribution system. In almost all countries, and this is particularly true in the Swedish case, the fiscal treatment of amortisation tends to favour large firms which have a history of being large, over small firms and new firms. This tendency is exacerbated by high payroll taxes, high marginal rates of income tax and labour protection, as the latter is much more deterrent to the entry of new firms in view of the higher level of uncertainty to which they are exposed. The bias towards being "big" has several adverse effects on employment and growth: it disfavours direct business ownership, smaller organisational forms and less capitalintensive production techniques. "For example, the successful development of markets for certain new products may require a form of flexibility that is best provided by smaller, newer companies" (Davis and Henrekson,p. 22). This is all the more important since growth in at least the last two decades has been motored by the development of the service sector which is, on reasonable assumptions, made © OECD 2000 of smaller firms. We may add to that, referring to the theory of endogenous growth (Aghion and Howitt, 1998, particularly Chapters 4 and 9), that the process of innovation and creative destruction which account for Schumpeterian growth, depends heavily on the flow of new entries as "older" firms seem to have lesser incentives to innovate. Now two points are in order: the first is (relatively) well known; the second is of the order of a conjecture.

First, as empirically demonstrated by [START_REF] Picketty | Les créations d'emploi en France et aux États-Unis: 'service de proximité' contre 'petits boulots'?[END_REF], in a comparison between the structure of employment between the US and France, an industry which accounts for almost all the difference in overall employment between the two countries is that section of the service sector which contains Restaurants, Hotels and other Personal and Household Services. In the US this sector relies heavily on low skill labour and pays relatively low wages. The same holds true for Sweden (see Davis and Henrekson, op. cit.). Subsidies on low wages will undoubtedly increase the flow of entry of new firms in this sector. Hence the structural relation between the size and growth of firms must be coupled to the evolution of personal income (wage or earnings) distribution in some coherent way so that the macro-stories make sense.

Second, even if the aggregate data were consistent with constant returns to scale, there is a strong presumption that at the firm level, there exists varying degrees of returns to scale. Where is the cut-off point between increasing returns and constant or decreasing ones? On this question too there is a strong presumption that small firms, and especially new ones, are faced with fixed, lumpy, set-up costs at entry, in brief to a form of indivisibility which leads to increasing returns to scale. There is thus, for these firms, a clear-cut case for subsidies. Whether the subsidies should be targeted at investment and/or labour in these firms depends on the nature of their activity. Perhaps subsidies should apply to both, but even if they apply only to the latter, they will undoubtedly lead to a decrease of set-up costs. The important question remains whether new firms are likely to employ a comparatively larger proportion of low skilled labour. It is likely, for the types of services referred to above, that this is the case. But we have also to notice that the development of the service sector concerns some activities which are intensive in high skilled labour as well. But the point I wanted to make is that, considered in a broader context of a growth model with microfoundations, employment subsidies may be required even if there is no cost of labour problem, and if there is one they may perform other beneficial functions.

BACK TO EARTH: THE COST EFFECTIVENESS ISSUE

I will rely heavily in this section on a recent report by Edmond Malinvaud (1998). Vis-à-vis the literature cited until now, the paper by Malinvaud is an © OECD 2000 exception: it is in effect extremely careful about the transition period following the modification of the payroll system, trying to evaluate the effects of the modification through time. This is achieved by using an approach which, albeit partial, is cast in terms of dynamic equations to evaluate the progressive effects of the measure on employment, wages and prices.

The case studied is that of payroll tax reductions for low-paid workers in France. From the outset, Malinvaud stresses the fact that the full effect of such a reform will show itself in 10 to 20 years, at a moment when we have reason to think that unemployment would be only of a structural nature, i.e. when the output gap will have disappeared. Hence the partial equilibrium nature of the exercise is justified by the fact that firms with this horizon will be on their demand for labour function. Besides the various problems posed by an ageing population, and which are shared by almost all OECD countries, the main impediment to full employment is that the price of unskilled labour is administered through minimum wage legislation, independently of market conditions.

The initial conditions are the ones prevailing in France: the rate of social contribution being 57 per cent of the cost of labour for all wages higher than 1.3 times the minimum wage. It starts at 41 per cent for the minimum wage and increase linearly to reach 57 per cent at 1.3 times this amount. The lower rate of social contributions at low wages has been the consequence of reforms implemented in 1994 and above all in 1995. It has been followed by huge debates about its efficiency. Two arguments were made: the first, empirical, was about the low wage-cost elasticity of the demand for labour. Empirical studies give widely diverging figures, from 0 to -0.8, although it is generally recognised that the elasticity is the higher, the lower the level of workers qualifications (cf. e.g. Dormont, 1997). The second was about the effect of the payroll tax cut on profit. If unemployment were of a non-classical nature, decreasing the rate of employer social contribution was considered by many politicians and a few economists as a gift to firms. The second argument is of a very short-term nature, but the first is still a question of debate between econometricians. But with almost five years of distance it appears that a strong consensus has emerged in favour of payroll tax reductions in the lower segment of the wage distribution. It also appears that the employment content of growth in the light of the present recovery seems to have significantly increased, in consequence at least partially of the reform.

The cost of the exemption between the minimum wage and 1.3 its value is currently evaluated ex ante at FF 48 billion (roughly, 0.6 per cent of GDP). Macroeconometric simulations have shown that in the long run this exemption will contribute to the creation of about 350 000 jobs, and its net cost would be FF 27 billion. The problem with such a scheme is that it leads to very high marginal rate of payroll taxes at the low level of the wage distribution leading to stagnant carriers and/or poverty traps. To avoid such an outcome -according to the formula © OECD 2000 in the introduction -two strategies are possible: a uniform exemption on the part of all wages inferior to the minimum wage; or a less steep progressivity in the payroll tax. The first has much to recommend to it, as it amounts to a uniform subsidy per job, but it is too costly ex ante, about FF 220 billion, or almost 3 per cent of the GDP. Two instances of the second are considered by Malinvaud. The exemption will decrease linearly between one and two minimum wage units, with an ex ante cost of a bit more than FF 100 billion and a supplementary impact on employment creation of about 250 000. But all the methods considered by the author to finance the scheme -an increase in the VAT; an increase in the generalised social contribution (CSG) or an increase in the profit tax -will reduce significantly the effectiveness of the reform. Besides we are very uncertain of some of their effects. For example an increase in the taxation of corporate profit being also an increase on the tax on pure profit would decrease the return to entrepreneurship and may hinder growth. It is why the preferred measure proposed by Malinvaud is to finance the exemption by an increase in the rate of social contributions paid on higher wages. The scheme then proposed is to increase linearly the rate of social contribution, starting at the present rate of 41 per cent, until a wage corresponding to 1.8 times the minimum wage, reaching at that wage a payroll tax of 58.7 per cent of the cost of labour, an increase of 1.7 per cent of the tax paid on the wage higher than 1.8 times the minimum wage. This will create some unemployment among the higher skilled workers (15 000), which will be transitory because it will eventually lead to a decrease in their net wages. In toto, the supplementary job creation would be of the order of 150 000. (Malinvaud assumes an employment elasticity of 1.1 for the low wages and 0.7 for the higher ones.) Another recent evaluation has been performed by Sterdyniak (1998) and Villa and although it was based on somewhat different assumptions, it leads to results entirely consistent with Malinvaud's results and estimates.

With the work of Malinvaud, we are back on earth: a decrease in payroll tax will not be the miracle solution which will solve at once our employment and distribution problems, but it will have, in the long run, some merit: an employment creation of almost half a million in ten years, i.e. 2 per cent of the actual volume of employment. It is good to record these figures at a time where we economists seem to have a tendency to oversell the measures we propose.

© OECD 2000

NOTES

1. There seems to be a tendency to assign pririties to [START_REF] Pigou | The Economics of welfare[END_REF] for having considered employment subsidies, followed by Kaldor (1936) andFrisch (1949). However, this business of apportioning credit to pioneers is always tricky and almost never wholly satisfactory, especially when it is about issues of policy. For example it may be remarked that the genesis of the famous Frisch memorandum of 1949, to the UN, was based on the work done by Lindahl, Myrdal and Ohlin for various Swedish government commissions of the early 1930s. In particular, the framework adopted by Frisch, later codified by Tinbergen and Bent Hansen as the classical theory of economic policy of the targetinstrument variety, descends directly, literally, from two of Lindahl's macropolicy monographs of the late 1920s and Myrdal's report to the Unemployment Commission of the Swedish government, in 1934, entitled: The Economic Theory of Fiscal Policy (cf. Bent Hansen, 1958, Chapter 1, for references and some discussion on priorities and origins). Moreover, the specific proposals contained in Ohlin's monograph of the same year (1934), "Monetary Policy, Public Works, Subsidies and Tariffs as Means against Unemployment", (italics added), is also relevant for our present discussion (in this, the year of the Ohlin Centennial!). Finally, there was also the Beveridge Report of 1944 where Appendix C was contributed by Kaldor and the question of wage subsidies was discussed, in the context of reaching full employment, albeit briefly. 2. See Fitoussi (1994) for a comparative study on wage distributions in the United States, United Kingdom and France. 3. On this issue, cf. Fitoussi (1992). 4. For example, the interdecile ratio P90/P10 of the household distribution of disposable income per consumption unit has gone has gone up from 4.9 in 1979 to 5.9 in 1986 in the US while it has been stable, around 3.5, in France (Atkinson et al., 1995).


COMMITTEE FOR ECONOMIC AND MONETARY AFFAIRS

Briefing paper n° 1-2002

After the cash changeover Jean-Paul Fitoussi

Economic outlook

Current forecasts for Europe are currently grounded on a compromise between two alternative hypothesis, which I will describe in a stylised way.

According to the first which may be called the big economy assumption, the European economy not being poisoned by structural desequilibria -the huge private sector deficit (about 5% of GDP) which characterises the American economy as a consequence of past overinvestment -should soon rebound in such a way that the prospect for 2002, and in a greater extent for 2003, will be rather bright. After all, one of the benefit rightly expected from the creation of the euro is that it transforms a collection of small and medium sized economies into one big economy arithmetically less open to trade and enjoying thus a greater degree of autonomy.

According to the second that I propose to term the fluctuat, nec mergitur assumption, the European economy will recover only as a consequence of the recovery of the US economy (and thus of other parts of the world). Look at the growth rate in America, you will then be able to deduce the one in Europe. For reasons which will be explained latter, Euroland is supposed to have no growth autonomy and its economic activity follows suit that of the rest of the world. To understand why this second assumption is a bit artificial, assume that the world is composed of two big economies and ask the question: how one of this economy may recover if the other has not already recovered?

The answer is that it exists only one possibility, simultaneous recovery. The rationale for this second assumption is that Europe follows a "passive" economic policy which means a combination of a "soft" monetary policy -more ex post than ex ante decreases in interest rates -and of a fiscal policy where only automatic stabilisers are allowed for. For example the real rates of interest are clearly positive in the Euro area (between 1.5 and 2%) and negative in the US. The fiscal impulse in the US represents so far 2% of GDP, and another one per cent is discussed currently by the congress. The expected balance of the federal budget will pass from a surplus of .7% of GDP to a deficit of about 2.5%, when in Europe we are still discussing of the need to put some limit to the play of automatic stabilisers.

If we combine the two hypothesis we are led to the conclusion that in Europe both the slowdown of growth and the recovery will be mild as compared to the US. In effect the up and down of the "autonomous economy" will propagate to Europe but in an attenuated way, because Euroland is a big economy with a low degree of openness. Hence the current forecasts for growth are of the following profile: 1.5% in 2001 and2002;3% in 2003, for the Euro area economy;1% in 2001, 0.6% in 2002and 3.9% in 2003 for the US economy.

As a recovery will show up soon, at the latest at the end of the present semester, but more probably already in the second term of this year -so the consensus view goesmarket participants are not expecting a strong move from the ECB, at maximum a decrease of 25 basis points in February or March.

Most forecasters acknowledge that we should have only faint confidence in these forecasts, because of the exceptional circumstances which characterises the world economy since September 2001. Is the cash changeover in Euroland going to strongly influence these prospects? To answer this question, we will try to disentangle for expository purposes the macroeconomic from the microeconomic effects of the cash changeover.

The effect of the cash changeover: macroeconomics

It is quite uncertain to assess the effect of the cash changeover on inflation and/or on demand. Leaving apart the question of the spending of mattress money, on which we know little because it depends on fiscal laws in each country and on the impact of the changeover on the hoarding behaviour of people, there is no macroeconomic theory which convincingly argues that a change in the unit of account affects economic behaviours. Assuming even that mattress money will be in great part spent before the end of the period of double circulation, it may well be reconstituted latter, so that say, by the end of the year 2002, mattresses in euro will replace mattresses in former European currencies. In effect, there is no a priori reason to believe that the preference system of hoarders depends on the specific currency in which they hold their money, unless we make the assumption of a lower degree of confidence vis à vis the new currency, which will be counterfactual.

Of course if the hoarding of money was in part "involuntary" and if fiscal measures decided to cope with the introduction of the euro allow to launder some of these funds, the proportion of mattress money in the total assets of the economy will permanently decrease, increasing thus the demand for goods and/or for other assets. A clear indication that a phenomena of this type is under way is that the demand for cash in the euro area has fallen by 22% (seasonally adjusted and six month annualised rate of change) in October 2001. There are also indications that holding of currency have been shifted into overnight deposits (ECB Monthly Bulletin, December 2001), so that it appears that the net effect on M3 will be very limited and not only because currency represents a very small proportion of M3. So the assumption that people are just substituting cash by saving deposits can't be ruled out, but it implies that for unclear reasons people discover suddenly that there exist more productive forms of saving, or that new fiscal measures have been very amicable to the laundering of money. In what extent this portfolio reallocation will impact on short term interest rates?

In any case, it is difficult to know both the size of "involuntary hoarding", and the extent to which new fiscal measures are permissive of laundering funds. A common presumption is that the phenomena would have very weak effects, if any, on global demand. It seems thus that the best prediction about the consequence of the changeover is that it may affect the time profile of both the inflation rate and consumption spending, but not their average level. One may object that a change in the time profile of a variable could have lasting real consequences. An exogenous increase in consumption in a given quarter may boost the economy, if entrepreneurs believe that at least part of it is permanent. It follows that expectations on the transitory or permanent nature of the consumption shock will matter. Only if entrepreneurs have static expectations will the transitory increase in consumption demand have lasting effects.

The effect of the changeover: microeconomics

When we come to the behaviour of firms, we have to consider the fact that the cash changeover is not only a change in the unit of account, but also an exogenous real shock because it implies a change in the list of prices in markets characterised by imperfect competition. The type of imperfect competition which dominates the economy will then determine the overall effect on prices of the cash changeover.

In an imperfect competition environment prices are not frequently changed because for most firms, changing the list of prices constitutes a transaction cost. This phenomena accounts for a certain degree of "rational" price rigidity (See e.g. Stiglitz). There is thus a presumption that when the price list has to be changed at an exogenously imposed specific date and for all participants in the market at once, the change will include now price increases that firms were planning to implement at a latter date. (There is also the real cost of changing currency for the retailers: cash machines, time spent with the customers etc.., but this cost seems to be of a second order of importance). In passing, that means that monetary authorities should not give too much importance to the instantaneous rate of inflation. During some times, say a year, headline inflation rates will not mainly reflect past inflation pressures, but rather pricing behaviour in an imperfect competition setting where all firms are constrained to change their prices at the same date.

If the market structure matters, it is because firms may take advantage of the imposed change for testing the elasticity of their demand, i.e. the robustness of their market shares. If firms act on the presumption that others firms will take advantage of the situation to increase their mark-up, each of them will follow suit on the assumption that the elasticity of the demand for their own product is lower than the elasticity of overall demand. It will be so, especially in customer markets where there exist a lasting relationship between firms and their customers. In such markets, firms know that an increase in the price of the good they sell will not lead to a significant decrease in their market share, at least for a while. One could object that in such markets, each firm will be eager to show to its customers that it is not going to take advantage of the changeover -but not knowing the elasticity of their demand, nor the behaviour of other firms, trying also to have a price list which will be readable in the new currency (psychological prices) and last understanding that changing the price list now will delay the moment where they can change it again, constitute strong incentives to increase their mark-up. If the most frequent market structure is the customer market one, there is some presumption that for a period, mark-up will increase.

But if the market is rather of the type "oligopoly à la Cournot", the simultaneity of price changes may well lead to a price war. In those markets the incentive may work exactly the opposite, firms being tempted to increase their market shares by lowering prices. Those markets are in effect characterised by a few big firms selling a rather "homogenous" product, so that firm demand elasticity is supposed to be high. The market for distribution may be taken as emblematic of this structure. People are not going in hyper surface because they are in a relation of confidence with the seller, but for price reasons. On the other hand, the marketing behaviour of firms operating in those markets is typically aimed at building some "loyalty" links between firms and their customers. Each of the big firms are, through advertisement efforts and in giving some advantages to regular customers, trying to "fidelise" goodwill. There is thus an element of customer market in the market for distribution. This element, which implies product differentiation, actually lower the price-elasticity of the demand addressed to each firm. May be the best assumption for this type of markets is that the cash changeover will not affect prices.

We have little empirical knowledge on the structure of markets in our economies, and thus about the overall effect of price setting behaviours in different types of markets. More empirical research is needed. But as the cash changeover is hopefully a non recurring event, the pressure for implementing such a research program is weak. It was in effect a unique laboratory experiment.

Of course, some have argued that whatever the effect of the cash changeover, it will be of a second order of importance vis à vis the effect of increased competition brought about by the easiness of price comparisons throughout Europe allowed for by the expression of prices in the same currency. But the increase in the degree of competition depends itself of several factors of which the expression of prices in the same unit of account is not probably the most important. And its full effect will probably show up in the long term.

Concluding remarks

There are several factors which are at play to determine the future rate of inflation of which the more important seems to be the followings: the degree of slack in European economies, the evolution of food prices, the evolution of the price of oil and others primary products, and the effect of the cash changeover. The first three factors are clearly acting towards a sizeable decrease of inflationary pressures. As far as the cash changeover is concerned, its net effect on the instantaneous inflation rate is likely to be positive but reversed as time go on, so on balance, its influence on the inflation rate will be small. It could have been more important if the changeover happened in a period of buoyant growth.

In a sense the introduction of the euro in a period of a growth slowdown, has decreased the likelihood of a strong effect on prices. Hence the equation facing the ECB is not modified in any meaningful way by the effective introduction of the euro, provided one understands that the "information content" of the instantaneous inflation rate -as far as future inflation is concerned -will be, for a time, very weak.


Br iefing paper

Economic and monetar y conditions in the eur o ar ea: cr ossing the Atlantic Ocean Jean-Paul Fitoussi (5 March 2001) Outlook With respects to my last briefing paper (november 2000), the economic outlook for the euro zone has evolved, but in a direction and in extent which remain uncertain. The fashionable world is " resilient" .

Most forecasting institutes expect the euro area to be relatively resilient, with growth slowing only slightly this year to stay well above 3%. Hence basically they are forecasting the continuation for 2001 of the present growth cycle. But the term " resilient" is supposed to captures the uncertainty surrounding the forecast : " despite the slowing down of world growth, the euro area will not be much affected" .

Why this rather obscure, or even negative way, of designing the prospects? There is a deep reason for that. Economic thinking continues to be dominated by a crude version of the (keynesian) locomotive theory according to which the essential international transmission mechanism is the trade effect.

Because the economic slowdown in the United States seems more significant than previously expected, and because the recovery in Japan is still delayed, external demand addressed to the euro area is likely to weaken.

But growth in the euro area is not so much driven by external demand. If it where how can one explains the long periods of slow growth which have characterised Europe between 1991Europe between and 1997Europe between , or between 1982Europe between and 1986? Both periods correspond to strong growth in the United States. Apparently in crossing the Atlantic Ocean, the beneficial trade effect had vanished or even reversed. Hence others transmission mechanism which may overcome the trade effect are at work (cf. Fitoussi and Phelps:

The slump in Europe: reconstructing open macroeconomic theory, Basil Blackwell, 1988). Without entering the details of the theoretical reasoning, it is worthwhile to try to understand these effects.

The present situation in the euro area is one of a relatively strong internal demand, rather massive job creation, and an historically high level of consumer confidence. The slight decrease in the european rate of growth during the second half of the year 2000 was obviously not due to the weakening of the american economy but to the surge of the price of oil magnified by the depreciation of the euro. What then would be the effect on such an economic situation of a slowing down of growth in other parts of the world? For sure european exports should slow down, but in an extent which will be all the more moderate that the euro area is a rather closed economy. Hence the trade effect should not be that strong. But three other effects are at work, the exchange rate effect, the (long term) interest rate effect and the primary good effect. In a nutshell, the expected appreciation of the euro, the weakening of the pressure on the allocation of world saving and thus the likely decrease of long term interest rates, and last the decrease with respect to trend of the price of primary goods, will have both beneficial supply and demand effects well above the weak negative trade effect. The combination of these three effects is analogous to a positive supply shock, as it entails a decrease in costs, but also because the reduced long term interest rate has a significant effect on asset valuation, and thus on mark-up. The decreasing rate of inflation has besides a positive effect on purchasing power and thus on demand.

All that lead to expect a re-acceleration of growth in the first semester of 2001.

M onetar y conditions in the eur o ar ea

Against this background, how to evaluate the course of monetary policy? First, it is not that astonishing that the Governing Council of the ECB did not decrease interest rates in its last three meetings. If the preceding reasoning contains some true, the case to follow the decisions of the Fed is not so well established. That the ECB is the only major central bank not to have cut rates this year is just reflecting the fact that the economic situation in Europe is different from what it is in the US or elsewhere. In the last quarter of the year 2000, many observers were forecasting that the rate of interest would be increased by a quarter of a point at the beginning of the year 2001. This did not happen. The phase of tightening of monetary policy has come to an end before expected.

Taking a broader view of the course of monetary policy during the year 2000, one may even assess that monetary policy has been and still is rather accommodative. An index of monetary conditions which combines changes in exchange rates and interest rates show a rather continuing easing in monetary conditions since january 1999. And it appears that such an index is broadly linked with GDP growth. Recent appreciation of the euro, and the expected continuation of this appreciation --most institutes are forecasting that the euro will come at least to parity with the dollar in the year 2001together with the likely decrease of the inflation rate, seem to indicate that monetary conditions will become tighter throughout this year, without reaching the point of being restrictive. The substantive fiscal easing in the euro area may thus lead to a progressive inversion of the policy mix. It is why many observers are expecting stable official interest rates throughout the year as the most likely outcome. But one factor remains difficult to assess, namely the effect of increased competition in the euro area; the degree of competition will increase for two reasons : the coming into being of the euro (but this should not be overstated), but more surely the increased competitiveness of foreign (to the euro area) firms, due to the appreciation of the euro. Such an appreciation leads not only to a mechanical decrease of the price of imported goods, but also to a decrease in the mark-up of " national" firms to cope with increased competition from abroad. Hence the desinflation of the year 2001 may be more pronounced than expected.

Should then the ECB reverse the course of monetary policy? What are the pro and cons as we find them in the last monthly bulletin of the ECB?

Looking at monetary aggregate -the first pillar -is not really informative for reasons which were spelled out in preceding papers. There is some deceleration in M3, but argues the ECB, its rate of increase is still higher than the target. " Overall, while some caution still needs to be exercised, following the recent slowdown in monetary growth, the risks to price stability from the monetary side have become increasingly balanced." (ECB, Monthly Bulletin, february 2001).

Price developments show a decrease of headline inflation from 2.9 in November to 2.6 in December.

This deceleration is expected to continue throughout the year 2001, for reasons emphasized above.

The December figure incorporates a sizable increase of the prices of unprocessed food, partly explained by " the current health concerns associated with beef consumption" . Admittedly, we cant infer from such a volatile component of the HICP index lessons for the future. But there is more to the point. Because this increase is linked to health concerns, and to the need to ameliorate the security of consumption, there is obviously a measurement problem. If prices increase pari passu with quality improvement, there is no inflation, and the growth of the index is overstated. In view of the fact that the " mad cow" problem is a serious one, and taken seriously by european governments, there is no doubt that decisions which have been already taken and decisions which will be taken in the future will lead to a much needed quality improvement. The price index in the future should be revised accordingly to avoid an overestimation of the inflation rate.

But what about core inflation? The annual rate of increase in the HICP excluding unprocessed food and energy was unchanged in december as compared to november at 1.5%. But the ECB is fearing that second round effects associated with past increases of headline inflation may still show up. For the moment, looking at labour costs, there is no clear sign of the presence of a catch up effect. (The ECB rightly recognizes that the growth of hourly labour costs is overestimated because of measurements problems, mainly related to the reduction working days in some economies.) And For the future, there are some indications of a deceleration of producer prices and manufacturing input prices.

All that means that risks to price stability if they existed are progressively, if not rapidly, vanishing.

But it is uncomfortable to assess medium term inflation prospects from the informations contained in the monthly bulletin, not only because it does not include a model or a framework allowing to forecast inflation, given monetary policy, but also because it does not include even estimation of most recent developments: in a bulletin published the 28 th of february, it is odd not to find an estimation of the rate of growth of the forth quarter 2000, nor an estimate of the rate of inflation for january 2001.

To sum up, it seems to me that 1) there is nothing wrong in the recent (non) decisions of the ECB, 2) that the case can be done for a decrease of the official interest rate in a not too distant future, and that 3) the course of monetary policy in the euro area will be better understood if the reasoning behind it is made more explicit.


Jean-Paul Fitoussi

monetar y conditions in the Eur o ar ea : The ECB, the FED and the eur o

secretary Paul O' Neill it will be illusory to believe that Europe will avoid to be hit by business conditions in the other side of the Atlantic. In my last briefing paper I tried to sketch the broad reasons explaining why the transmission of the US slowdown to Europe will not be as mechanical as some would like us to believe, provided that monetary conditions in Europe do not become more restrictive. True growth forecast for Europe have been generally revised downward -the IMF revision being the more severe (from 3.4 to 2.4) -but most institutes are agreeing on a figure slightly under 3%, the consensus forecast being 2.7%. At least for the moment a strong impact is not in sight. But there is also the question of Europe' s responsibility towards the global economy. World growth which has been buoyant in 2000, at a rate around 5% is expected to be a little above 3% in 2001. It is thus no wonder that bitter comments are coming from IMF officials about the excess of prudence of the ECB: according to Michael Mussa the IMF' s chief economist " It is time for the ECB to become part of the solution, not part of the problem of slowing growth…on purely domestic ground the balance was at least neutral, and from a global perspective the case for easing was unambiguous" . These are strong words especially if one considers what would be appreciated as a good move by the ECB, a moderate cut of, say a quarter of a point. To say the least, the absence of such a move by the ECB -an actual interest rate of 4.75% instead of 4.5% --would be, in the worst case, considered as a very small mistake. (And, incidentally was the FED right in not having cut its rate between may 2000 and january 2001?) " On purely domestic ground" , the case against the ECB is not so obvious: headline inflation can well in May revisit its peak of november ( 2.9%). This is due to a serie of price shocks that have Briefing paper n°2 for the Committee for Economic and Monetary Affairs of the European Parliament 22/05/01/2 hit the euro-area in the past two years: oil, euro depreciation, food prices etc.. Core inflation may also hit the 2% level. This succession of unfavourable events should not have lasting effects, but may well refrain the ECB from cutting the interest rates. Especially in view of the potential second round effect that the rate of inflation could have on wage pressure. If the ECB were using a Taylor rule, the interest rate would not be so different from what it is now.

Expectations and the eur o-dollar exchange r ate

But monetary policy should have a forward looking character. What matters is growth say in six to nine months ahead and inflation in eighteen months. There is little doubt that in 2002 inflation will recede in the euro area to a figure slightly under 2%. For most observers, this expectation embodies the assumptions of a quarter of a point cut in interest rate towards the end of the first semester 2001, and a rebound of growth in the second semester. Thus at constant monetary policy, the rate of inflation would be lower. It seems also that the expectation for inflation is more firmly asserted than the expectation for growth. That means that with respect to last year the balance of risk has shifted: the probability of a further slowdown of growth seems higher that the probability of a further increase in the inflation rate or even of the probability of inflation staying at the current level. Hence a move for " insurance" purpose could be justified even if the present exchange rate of the euro implies that monetary conditions remains accommodative. But there is no need to rush and such a move may still await a few more weeks.

There are plenty of alternative explanations for the present " weakness" of the euro (see my briefing paper of june 2000 ). One of them is worth considering because it may lead to some indeterminacy as to the effects of European monetary policy. According to this explanation, the euro-dollar exchange rate is governed by growth differential, and despite the present slowdown of growth in the US, most institutes and observers (and the markets) expect the growth differential to become again favourable to the US by the second semester 2001. The V shape recovery scenario for the US economy is thus favoured and this is why the European currency did not recover. Hence the argument goes, a decrease in european interest rate, because it enhances growth, is also likely to lead to an appreciation of the euro. But that leads to an indeterminacy with respect to the net effect of monetary policy. If a cut in interest rate leads to an appreciating currency, monetary conditions in Europe may not change. The boost to internal demand would be partly compensated by a decrease in net exports. Intriguingly, the standard effect of crowding out of net export which was associated with expansionary fiscal policy is Briefing paper n°2 for the Committee for Economic and Monetary Affairs of the European Parliament 22/05/01/3 now associated with monetary policy. Presumably, however, the first effect will dominate the second, the euro area being a big country less open to trade. On top of that, this " new" theory implies that an expansionary monetary policy will have a mitigated effect on the inflation rate, the rise of the exchange rate of the currency leading to some imported desinflation. Is there a rationale for this new view of seeing the consequences of monetary policy?

The only rational explanation we can think of is the following : present conditions are such that the current rate of growth has a lasting effect on potential growth because it enhances investment in new technologies. It thus leads to a permanent increase in factors productivity and in the rate of return of capital. This effect has already shown up in the US but not yet in Europe.

There is thus a strong incentive for capital to flow in Europe, provided the ECB gives unambiguous signs that it cares for growth. This total factor productivity effect, together with the term of trade effect, adds to the desinflationary consequence of a decrease in short term interest rates. If there is some true in this reasoning, there is a lot to gain for the ECB in cutting its main lending rate and very little to loose. Indeed, favouring growth may be part and parcel of monetary policy stricto sensu, a kind of intermediate goal to achieve price stability, at least during the few years to come.

Asymmetr ical effect of monetar y policy

We know that in view of the heterogeneity of business conditions within the euro area, monetary policy might have asymmetrical effects. As underlined by the ECB annual report (May 2001) the dispersion of inflation rates has widened. A decrease in interest rates may thus add to inflationary pressures in countries where the inflation rate is already comparatively high, and have only delayed effects on output in other countries. An appreciation of the euro will also have asymmetrical effects due to the different exposures of european countries to extraeuropean trade. For example, will Germany benefit more from a decrease of interest rate or from a " weak" currency? We will have to wait for more careful studies on these questions before giving an informed answer to them.

But the point I would like to make here is rather different. The euro area is characterised by countries having different levels of development. The weight of the countries having a relatively low GDP per capita is for the moment significant. Things may change when the UK and Scandinavian countries will enter the area, and will change again with the enlargement. But for the time being, that means that due to the Balassa effect a sizeable dispersion of the inflation rates should be allowed for. The only way of achieving such a result is to allow for a higher average rate of inflation. The less than 2% objective of the ECB may be too low to embody this structural factor.

A supplementary argument is that, even absent the former factor, such an objective is difficult to reach in a period -the last three years -characterised by a variety of external shocks. That it has been reached in 1998 and 1999, is also the consequence of an unexpected shock, the huge decrease of the price of oil. As a result, headline inflation has been higher than the objective in 2000 and will stay also higher this year. Quite rightly the ECB has acknowledged this fact, stressing that its aim is medium run price stability. But it is also obvious that this gap between headline inflation and the objective, limits strongly its room for manoeuvre, especially when growth slows and when a case can be made for a more expansionary monetary policy. If the slowdown has an adverse effect on productivity (the so called productivity cycle), it will temporarily add to inflationary pressure due to the increase in unit costs.

But admittedly, it is not yet time for the ECB to amend its objective. May be the pragmatic way in which de facto it is handling it can be rationalised -a medium term objective under 2% is entirely consistent with short term variations up to 3% --so as to add rather than to substract to its credibility.

The FED

Because the FED has constitutionally an eye on the growth rate, its room for manoeuvre is objectively greater. First these duality of objectives has the great advantage of preventing to put explicitly a figure for inflation, with the side effect of avoiding to be accused for not reaching the objective. From 1980 to 2000, the US inflation rate has been lower than 2% only one year, namely in 1998. This sheer fact tells a lot on how a central bank can buy a strong credibility without having to be dogmatic about a figure. It is not a question of conservatism: it is widely held now that Central bankers should be more conservative than the average of society. It is a question of allowing for mistakes. Monetary policy is a human activity, an art, which implies a lot of judgement. It has to take account of the future and the uncertainty surrounding it. Nobody could be persuaded, and certainly not the Peoples of Europe, that it is a technical matter obeying mechanical laws of motion. Credibility is not the property of an institution never doing a mistake -that is out of this world -nor never taking a risk -that could be very dangerous under certain circumstances. It is, on the contrary, linked to an institution learning from its mistakes and having the capacity of repairing them.

One could argue that the FED has probably made a big mistake in not having cut its interest rate before January 2001. Some are even asserting that the slowdown of growth in the US is man made, as it obeys the traditional pattern of recessions which have generally been the consequence of monetary policy having stayed too restrictive for too long. Most institutes and Briefing paper n°2 for the Committee for Economic and Monetary Affairs of the European Parliament 22/05/01/5 many observers in the fall 2000 were expecting a slowdown of the US economy: the only uncertainty was about whether the landing would be soft or hard. As a central bank should be forward looking, the FED should have changed the course of monetary policy before the landing. Admittedly, the job of monetary policy has become much more complex nowadays, were central banks have to look both at the inflation rate and at asset prices, especially in the US were these are playing such an important role. The widely held view that asset prices had to deflate a bit more may explain the lateness of the reaction of the FED. But whatever judgement will prevail in retrospect, we have to recognise that even if there were a mistake, the FED did act energetically to repair it, having decreased in less than 4 months the interest rate by more than 200 basic points. Summar y 1) So far, there has been nothing wrong with the ECB not having cut its main lending rate. What may be expected in the weeks to come is a decrease of a quarter of a point. There is some arrogance in the pressure coming from the other side of the Atlantic and the ECB should not obey to this. The policy conducted by the FED is not exempt from mistakes.

2) An important question raised by a common view -shared by many economists and the markets --is that a move towards lower interest rates by the ECB will lead to an appreciation of the euro. A possible interpretation is that current growth affects potential growth because of higher productivity due to new technologies. If that is true there is a strong case for the ECB cutting its rate, as this would be on the whole desinflationary in the medium run.

3) When comparing the ECB and the FED actions, one should have in mind the rather different explicit objectives of both institutions. The absence of a formal inflation objective of the FED, (a consequence of the fact that the FED has also a growth objective), allows for a greater room for manoeuvre, but also for more mistakes, along with the possibility to repair them. Credibility is probably the outcome of this " trial and error" process.

A way out for the ECB, that it seems to be taking de facto is to stress that the medium run character of its objective is entirely consistent with an headline inflation rate, say, up to three per cent, and to rationalise when it will allow such a gap to develop. This will increase the legibility of European monetary policy, and will give it both more credibility and more room for action.

  Briefing paper n°2 for the Committee for Economic and Monetary Affairs of the European Parliament 22/05/01/4


1

Briefing paper N°3-2001

The fiscal stance and economic coordination in Europe

Jean-Paul Fitoussi

On the 30 th of August, Governing Council of the ECB decided to lower the key interest rates by 25 basis points. May be this decision was the only available in view of the evolution of core inflation in Europe, but for reasons made clear below, it is not going to ease the fiscal debate in Europe. In his introductory statement, President Duisenberg said "under the present circumstances, the automatic stabilisers should only be allowed to work fully in those countries whose budget positions are closed to balance or in surplus". What should one think of such a position?

The Fiscal debate

The slowdown of growth in Europe, has had as a normal consequence an increase in "headline" deficits almost everywhere. This has given a pretext to the Commission for inviting some member States, namely Germany, France, Italy and Portugal, on the basis that they have been too lax in good times, to pursue a procyclical fiscal policy: they "have missed the opportunity of the recent favourable growth environment to meet the target of the Stability and Growth pact". Then one is left with the impression that if you do it wrong once, you are almost condemned to do it wrong for ever. This evaluation of European fiscal policy is also missing an important point: you can't evaluate economic policy without taking into account the initial conditions of the economy. There is a broad agreement that both monetary and fiscal policy have been procyclical for obvious reasons in the few years preceding the launching of the euro and that this procyclical episode has left the three "big economies" designated by the Commission with a mass unemployment problem and a negative output gap, which preclude a strongly restrictive fiscal policy at the outset of a new growth period. The return to a "normal" countercyclical policy will take more time, just because the European governments had it wrong (admittedly for good reasons, the Maastricht criterias) to begin with. And, above all, past errors are not justifications for present ones; so, to say the least, Member States are right when they declare that one could let the automatic stabilisers play. The debate will certainly gain in transparency if structural deficit figures instead of current ones are used. But that will also imply more confidence in the methods used to evaluate the output gap.

Much ado about nothing?

What is the extent of the problem? First, the fiscal deficit of the euro area is low and although forecasted to increase, it will still be less than 1% in 2001 (from -1,2% in 1999, 0.3% in 2000, -0.8% in 2001.) And of course the structural deficit which was -0.5% in 2000 will be according to the IMF of about -0.6% in 2001.) There is no reason to worry about these figures: neither about the level nor about the evolution of the deficit. It has to be remembered that in the US the deficit has turned into a surplus only in 1998-1999 after 6 to 7 years of expansion, and two years after a sizeable increase in potential growth. And the Congressional Budget Office has just forecasted a federal deficit of $9bn for 2001! It is thus hard to understand the big words used in the fiscal debate in Europe. Truly these figures are higher than those forecasted by the governments in their medium term fiscal programs, but the latter were conditional on hypotheses regarding the rate of growth which, at least for 2001, proved to be too high. There is no wonder then that actual deficit are higher than planned ones. Should European governments be accused to have embarked on tax cut programs during a favourable growth context? As already emphasised, a procyclical fiscal policy in a period of quasistagnation, has meant for most European countries an increase in taxes and/or social contributions, leaving the economies when growth conditions turned to normal with an abnormally high tax burden as a ratio to GDP. This is a structural disequilibrium that governments had to address once the momentum of meeting the Maastricht criterias has been passed, and whatever the growth context. And that they did it in 2000 led by chance to the right timing, as these reforms will begin to sustain internal demand as from now, and hence may contribute to a reversal of the path of growth. So one of the arguments against the use of discretionary fiscal policy, that is the long and variable delay of implementing it, does not apply in this instance. Luck is not forbidden, as we have here an example of a structural fiscal policy which by chance has a countercyclical effect.

"Plus royaliste que le Roi"

On all these issues, the Commission seems to be more demanding than the ECB. The last monthly bulletin of the ECB (August) underlines the increased uncertainty surrounding economic growth in the euro area in the second half of 2001. But the editorial adds that fortunately (which is the way I understand the statement), "positive effects on euro area economic growth should stem from the impact of tax reductions in several euro area countries.." But the same bulletin contains also an article devoted to "Fiscal policies and economic growth". And here the position of the ECB is unambiguous.

Stressing rightly the importance of fiscal policy for long term growth, it clearly concludes that for short term purposes automatic stabilisation has to be preferred to discretionary fine tuning. It also asserts several times that fiscal policies in Europe are on the right track, e.g., p.52: "fiscal deficits have come down and sound budgetary positions have been achieved in the majority of euro area countries.

The volatility of fiscal balances is much reduced and public debt is declining. There is no reason for complacency, and countries with imbalances remain, but major progress has been achieved compared with the situation only a few years ago." Notwithstanding the reserve contained in the last sentence, this statement resembles much a congratulation to fiscal authorities which is sufficiently rare from a Central bank to be noticed.

The policy mix and discretionary fiscal policy

A new way of thinking about macroeconomic policy evaluation has emerged from events and research of the last two decades (see, e.g., [START_REF] Taylor John | Recessing discretionary fiscal policy[END_REF]. In a nutshell, using a new "neoclasical synthesis" framework, and looking at what happens to the fluctuations of real output and inflation under alternative policy rules, the research concludes that the job of stabilisation is better left to monetary policy than to discretionary fiscal policy. The reasons are well known: the implementation lags are much shorter for monetary policy than for fiscal policy, monetary policy may be quickly reversed which is not the case for fiscal policy etc.. But this conclusion deserves two qualifications.

First, automatic stabilisers should be left to play their role, creating thus an element of certainty for the private sector. One just has to imagine the increase in uncertainty for private agents if discretionary fiscal policy is aimed at compensating the effects of automatic stabilisers to understand the strength of the argument. In addition, as set by Taylor, "The overall size of the actual changes in taxes and spending due to automatic stabilisers are frequently much larger than even the proposed discretionary changes. Both types of changes in taxes and spending impact aggregate demand, but the automatic ones are more predictable and work more quickly than the discretionary ones." This statement is all the more true in Europe, where the level of taxes in proportion to GDP is higher and where the social protection system is more generous implying a greater automatic increase in social spending when unemployment increases.

Second, the conclusion is valid only if monetary policy does actively its job (see e.g. Creel and Fitoussi 2001). It is also and perhaps mainly because monetary policy was (in the US) systematically and strongly reacting to the cyclical state of the economy, that the "new normative macroeconomics" has emerged. Were monetary policy more passive or more constrained by its mandate, discretionary fiscal policy would have to come in. This is recognised by these new types of models especially in the case where the Central bank has to focus only on inflation and/or in the case of a fixed exchange rate system, not to say an unique currency. But, after all, these conclusions are well known: monetary policy should be the preferred instrument to fight common shocks, like a more or less general slowdown of growth, but fiscal policy should be activated to fight asymmetrical shocks or whenever a common shock has asymmetrical effects. It also has to be activated if monetary policy is reacting too softly to common shocks.

Hence, the assignment problem can't be solved in Europe as easily as in the United States. But notice that in all cases, at minimum, automatic stabilisers have to be left to play their role. There is no justification in the economic literature, whatever its doctrinal inspiration, for a procyclical fiscal policy which is synonymous with not letting automatic stabilisers to play.

Economic policy coordination

As just underlined, there is no escape in Europe from discretionary national fiscal policies. A common monetary policy can't fit all euro area countries and something else is needed to perform the cyclical function, that is discretionary fiscal policy. To belabour the obvious --a point which has been made in the early debate --a country enjoying a boom will also, most likely, have a lower real interest rate than average, as if monetary policy were procyclical. And conversely, a country in the midst of a slump will be penalised by too high a real interest rate. When cycles are not synchronised, this problem arises automatically. Thus, unsynchronised cycles, asymmetrical shocks etc.. imply to go beyond automatic stabilisers, and are powerful arguments not to restrain too much the room of manoeuvre of budgetary policies.

On the other hand, the plurality of national fiscal policies increases the opacity of the European policy mix, and the complexity of the job of monetary policy. So what are the pros and cons of economic policy coordination? By that I mean two things, the coordination between fiscal authorities and the coordination between the latter and the ECB. One is just left to guess how long the process of coordination will be. This length has to be added to the implementation lags of national fiscal policies to understand that stabilisation policies will have a hard time in Europe.

One can argue that in a common currency area, there is no need for coordination of national fiscal policies (Cf. J.P. [START_REF] Fitoussi Jean-Paul | Rapport sur l'état de l'union européenne[END_REF]De Grauwe end Polen, 2000). A national expansionary fiscal policy will have two effects on other European countries: a trade effect and a financial effect. It is most likely that the first will dominate the second. The trade effect will not by definition be dissipated by nominal exchange rates movements, and if the expansionary country exhibits as a consequence, a higher rate of inflation, the trade effect will be reinforced by an increase in its real exchange rate (a lost in competitivity). The financial effect refers to the possible increase in interest rates, short and long, which may follow the increase in the euro area inflation rate and public deficit. But the inflation rate increase may be insignificant and it is probable that the public deficits in the others countries will be lower as a consequence of their induced expansion. It is thus unlikely that the two effects balance. The most probable outcome is that the other European countries will benefit from the expansion without having to bear any cost. At maximum, the increased deficit in the expanding country will be reflected in its bond yields, as there is no chance of a bail out by the centre. One may even go as far as saying that the stability pact may lead to a restrictive bias in fiscal policy, as no country has interest in being the first mover, each having interest in others doing it. Another restrictive bias may arise from an increase in the dispersion of national public deficits around their European mean.

From this analysis, I conclude that in the euro area, not only will each country retrieve a full fiscal sovereignty, but this retrieved fiscal sovereignty will by no means be unfavourable to the other countries within the area, on the contrary. After all this is what the subsidarity principle is all about.

There is another argument against policy coordination. Competition between fiscal policies may favour experimentation, innovation and the selection of best policies. But this argument should not be pushed too far: fiscal and social competition may have, and in actuality often have, adverse unintended results which may be harmful in the long run. They generally lead to a sub-optimal provision of public goods in sectors which are crucial for long term growth (education, health, infrastructure etc.., not to speak of social cohesion).

The arguments for coordination are of two kinds (Cf. P. Jacquet and J. [START_REF] Jacquet Pierre Et Jean | La coordination des politiques économiques dans la zone euro : bilan et propositions[END_REF]. First, only coordination may provide the public goods which are needed at the European level. Preserving the single market is a public good which implies fiscal and social harmonisation, as well as that of regulations. In this sense, budgetary discipline would also be a public good as it allows for a clear definition of the policy mix which, seen from outside Europe, is of the collective responsibility of member states. This type of coordination is called by Peter Kinnen, regime preserving coordination, as it allows for the continuation of the present regime.

The second kind of argument refers to externalities linked with national policies of the kind we have already discussed: for example monetary policy is geared towards the control of the average rate of euro area inflation. National policies including structural ones may influence this rate leading to a change of monetary policy adverse to other countries. To cope with these externalities, strategic coordination is required. But in view of the complexities of implementing such a coordination which in general implies discretionary policies, the temptation of adding new rules to constrain the policy maker may become too strong: for example a country experimenting a boom will be constrained to pursue a restrictive fiscal policy, and a country in recession an expansionary one, both discretionary.

Notice that such a rule may conflict with the stability pact as it increases the dispersion of public deficits around their European mean.

An European level Tax?

National governments have to keep a policy instrument in their hands, otherwise what are they for?

And how can they renounce this instrument if it is not clearly established that it will be used for the good by a higher level of government. In other worlds, the "Federation of Nation States", has to become more of a federation if one wants national fiscal policies to be more severely constrained. That would imply an increase in fiscal receipts at the level of the federation, and make the case for an European-level tax. Which tax it will be and for what associated spending are difficult questions which require a lot more scrutiny to be answered. It is obviously not a technical question, but a thoroughly political one, because it implies a new division of labour between the federation and national governments. One could nevertheless argue that the tax chosen should be a tax whose setting at the european level will avoid unfair and inefficient (because of negative externalities) fiscal competition, like corporate taxes and/or capital income taxes. The associated spending could also for the same reasons be devoted to social expenditures. Redistribution of this kind would help harmonising social conditions in Europe. One can also think --as there is a strong need for a greater integration of the university system --of spending on education and research, a sector which is crucial for the future of Europe and which has to be thought of at the European level.

Concluding remarks

The fiscal debate in Europe is putting the policy maker under too straight a jacket. Voices are heard saying that the cyclical increase in budget deficits should be prevented, recommending thus a procyclical policy! It would be better to avoid such a simplistic debate by reasoning with structural deficit figures.

In the European context, automatic stabilisers may not be enough and some room should be left for national discretionary fiscal policy. This is due to the impossibility of having monetary policy fit the situation of each country. But under present circumstances of a slowdown of growth in almost all European countries (accompanied by a decrease in inflation and an appreciation of the euro), research and experiences have shown that monetary policy would be the most adapted instrument … if used. If not discretionary fiscal policy would have to enter the picture. For example, as most European countries have decided on a pluriannual program of tax cuts, they can also decide in a coordinated way to implement the programmes on a shorter time span.

Under the present "Economic Constitution of Europe", there are arguments against and for coordination of economic policies. From arguments made clear in the paper, coordination of fiscal policies is not necessary. Of course it would help understanding the policy mix of Europe if it were correctly designed and promptly achieved. But if it leads to rules constraining even more the policy maker, it would be undesirable. A much better solution is to move in the direction of a federation and to decide on a European-level tax.