He has written extensively on international relations, globalization and more recently on European affairs. He has recently published The Great Disruption (Polity, 2007), Norms over Force . The Enigma of European Power (Palgrave) , 2008. He has edited a forthcoming volume on EU Foreign Policy in a globalized world. Normative power and social preferences (Routledge) . He was a special adviser to Pascal Lamy the former commissioner for trade. He is currently member of the Commission on the French white Paper on foreign policy and European affairs. A complete bio is available on his personal website : www.laidi.com (contact : zaki.laidi@sciencespo.fr) On October 25th 2007 the Wall Street Journal published a blistering attack on Europe entitled "Regulatory Imperialism". The editorial took issue with Europe's intent to force its norms on the rest of the world by taking advantage of the dynamism of its internal market both affluent and attractive and in addition highly organized.

Examples cited included the Microsoft Affair, the ban on the importation of chlorinerinsed poultry, the Reach legislation on chemical products, as well as the plan to tax airline companies as part of the battle against climate change.

While extreme, the text pointed up three important facts: the first is that Europe, which Europeans often look on as a weak actor with few means, is in reality perceived as an influential player on the world scene, less on account of its military power than on account of the force of its norms. The second is that Europe, seen from the inside as a region in the process of overall deregulation so as allow market forces full leeway, is often -in the rest of the world -seen as a hyper-regulatory actor intent on exporting its norms. Finally, the piece had the merit of emphasizing that when one weighs Europe's political influence, it is not enough to refer to its military weakness leaving aside the influence derived from its single market. We must take another approach and explore whether Europe is not above all a "normative Empire".

A Empire, in that its claim to enforce its norms beyond its own frontiers, whereas up to now norm application has been essentially endogenous . An Empire also in that the spread of these standards is increasingly based on a balance of power rather than genuinely mutual consent, even if Europe does attempt to avoid the traditional trap into which many hegemons fell: assuring stability while avoiding that stability turn into domination over the rest of the world (James). And finally a normative hegemon in that by means of regulations that are both fixed and coercive Europe, in 3 an increasing number of domains, has demonstrated its strength in an epoch of globalization. This strength is however exerted rather than claimed. *Why does Europe favour norms as its mode of influence? *Why has its normative influence become global? *What are the main areas for externalizing European norms?

These are three questions that this paper will attempt to answer.

But first let us clarify the concept of norm. It refers to a freely accepted process of harmonization of actors' preferences in order to advance common interests by strictly adhering to a certain number of rules. A normative power is therefore-at least in theory-a power of which the identity and strategy is grounded on a preference for overarching rules of behavior applicable -largely but not exclusively -to states and which has three essential characteristics: to have been negotiated and not imposed;

to have been legitimated equally by international bodies; and to be enforceable on all actors of the international system notwithstanding their rank within it. Normative power thus seeks the integration of a world order based on the legitimacy of rules, the predictability of behavior and the enforceability of accepted principles.On the European level, the Monetary Stability Pact is a good example of a normative approach and on the global level, the Kyoto Protocol. On the other hand, the doctrine of preemptive war developed by the Bush administration to justify the invasion of Iraq cannot be considered a norm in our sense of the term since it has not been recognized internationally, and would appear by its very nature as very unlikely ever to be so.

The "normative world" is limitless. On the global level we can begin by the forty agreements that form the basis of world governance, from human rights to the environment, including labour norms, the campaign against criminality, terrorism, and ocean rights. But these are not the only accords. Accounting norms, banking guidelines, and marketing standards figure prominently in globalization regulation.

One should also distinguish between hard norms, which are embodied in texts having force of law and soft norm, which refer to court rulings or operating procedures.

Why does Europe have a marked preference for norms?

Basically the explication stems from the very nature of the European undertaking since 1957. Europe attempted to go beyond traditional conflicts between nations by recourse to the principle of a shared sovereignty, without however entirely abandoning national sovereignties. The sole means of permanently linking the fortunes of states that were determined to remain sovereign while simultaneously abdicating part of their sovereignty was to have them adhere to common norms, all the more restrictive in that they were to be negotiated. These normative provisions were first applied to the EU's hard core, that is to say the domains entirely within European jurisdiction: the internal market, commerce, and monetary policy. But they did not stop there; far from it. A domain such as the environment, where responsibility is shared, is one in which the Union's normative activism has been the most forceful or at least the most influential on the world level.

In addition it is via the decisions of European courts that the norms have been spread, providing a framework for the European area as indicated by the decision of the Court of First Instance of the European Communities concerning Microsoft. This preference for norms does obviously raise numerous difficulties within Europe itself, particularly because of the increasing differences between national options in certain domains subjected to community control such as commercial policy. A case in point is the variety of approaches adopted by member states when it came to commercial sanctions against China.

Norms also encounter obstacles in that they always appear less legitimate than national political decisions. A norm is always more fragile than a sovereign act.

With the end of the Cold War the European Union thought it would be living in a world in which traditional conflicts between states were on the wane, giving way to a logic of interdependence that would call for governance by norms (Laïdi and Lamy).

On the basis of its own experience, the EU anticipated that added rules would provide added stability, that increasing interdependence would entail an increasing demand for global norms. Hence the EU's acceptance of the rhetoric of "world governance" that is not, as one might think, a step toward world government, but a regulatory system operating on several levels so as to preserve global public goods (environment, criminal justice, sustainable development).

The call for governance by norms resembles a call to go beyond -as was the case in Europe -traditional cooperation between states. Global governance seen from Europe appears as a practical halfway platform between traditional intergovernmentalism and world federalism. Europe, which is not a state, has a vested interest in seeing that international relations are governed by norms.

Preference for norms expresses a repugnance for realpolitik, even if Europe increasingly attempts to combine the two approaches to further its interests (Laïdi).

For Europe knows that it is only by norms and not by force that it can make its voice heard. It knows as well that the fact that it is not a nation is a political handicap in particular when up against other leading countries for which the determining power is exercised by the state. Which explains the EU's increasingly common habit of saying to its partners in the course of strategic alliances or bilateral agreements: "Do take us seriously even we are not a nation." The EU's preference for norms does not mean it is the only actor to defend them. It means rather that the EU, given the lack of alternative, has the greatest interest in defending them. Which does not hold true for the major powers who favour norms when it suits them or when they have proposed them, but who let the matter drop when the norms run counter to their interests. Europe does not have such a option, unless it grant its member states a free hand. Given the context, one can well understand British interest in a Europe which, because it would not be a state, could only exercise power by fixing standards for the rest of the world on the basis of its domestic market. It is this theory that was defended in November of 2007 in Bruges by Britain's current Foreign Secretary (David Miliband). In his eyes, Europe should be a model and not a superpower. This conception has the advantage for the British of leaving intact the traditional sovereign attributes of states such as diplomacy and defence. Admittedly, most European states, who see no better alternative, also endorse this approach. The odds are that it will constitute the organizing principle for years, even decades, to come given the reluctance of the immense majority of European states to establish a common instrument for their diplomatic strategy.

Yet the nature and the scope of Europe's normative strength should not be underestimated. Even if, as well shall see, many of these European norms intended to be global are transposed from the single market, they should not be considered as simply market norms. In a world in which the influence of the market is considerable, market norms tangibly affect the lives of European citizens. It is the existence of the market that has given rise to norms for the protection of the environment and the consumer. Perhaps we should abandon too marked a distinction between "market norms" and "political norms" since the interpenetration of the two is increasingly the case; it is in this "in-between" that we should situate European strength, leaving aside the perpetual distinction between hard power and soft power. Europe's normative strength is largely derived from the power of its market (Drezner), but its impact goes well beyond the market itself.

Why do European norms now affect the rest of the world?

There are three reasons:

a)
In an increasingly open global market, national or regional preferences, such as Europe's, interact to an increasing degree with the preferences of others. It is then up to each party to justify its own preferences so as to deter challenges by others.

Over a long period the protectionist nature of the EU's Common Agricultural Policy was not an issue. But once the liberalization of agricultural exchange was on the agenda, the CAP had to conform to the relevant decisions of the World Trade Organization. And this is not the only example. All European public policies were concerned by this new reality. In a globalized world, each party has an interest in seeing that the norms that are recognized on the international scale are as close as possible to its own interests and perspectives, for it is becoming difficult to ensure protection by traditional means. Hence the crucial importance of norms in regulating world affairs.

b) In a globalized world the frontiers between the European market and the world market have of necessity become increasingly blurred (European Commission, 2007) for a variety of reasons. The first stems from the fact that the European market -since it is unified, sizable and attractive -is inevitably in a position to fix the rules for those intending to gain access to it.

The other factor that favours the externalisation of European market rules is the significant tightening of standards concerning environment and consumer protection.

Once European norms turned out to be the strictest in the world (as is the case for the Reach legislation on chemical products) all the economic actors were obliged to tighten their standards and comply with European standards if they wanted to enter the market. This is a relatively new development. For environmental issues and for food and health protection it dates back to the late 1980s. Up to then, it was the United States that set the norms since theirs were the strictest. Since then the roles have been reversed.

The strength of the European market and the substantial tightening of its norms constitute in fact the major source of Europe's normative power. And it seems that Europe is ready to assume this political purpose. The stringent norms reflect Europeans' marked dislike for risk, whether it be the environment or food protection.

On the Eurobarometer risk scale, these issues rate well above criminality or terrorism. One senses moreover that the legitimacy of the single market is increasingly based on the market's non-commercial aspects. And it is evident that the European Commission encourages this development so as to establish its own legitimacy and its own control over member states.

The increasing permeability between the internal market and the world market should not lead to the conclusion that the question is settled and that non-European nations will adhere to European norms, considered as the strictest. Rigorous norms are an obstacle for those eager to penetrate the European market, but also for Europeans seeking non-EU markets. For if we sell China expensive products conforming to tough environmental standards and if our competitors, the Brazilians for example, are not held to these standards, we are at a comparative disadvantage.

Hence the necessity of persuading the Chinese and the Brazilians to also tighten their norms and thus contribute to the creation of a competitive arena that does not penalize high-standard countries. Even within Europe the issue is not settled. The fear of exporting pollution and importing unemployment has led to certain industries being exempted from costly participation in the next European Trading System (Financial Times, 28 November 2007).

c) The intermediary areas between the internal market and the world market have now greatly increased in number. Up to now, there was on one hand the European internal market and on the other the world market. At most there existed between these two entities a decompression chamber constituted by the countries seeking admission to the Union. Today the scene is far more complex. Europe is surrounded by a wide area that is both problematic and unstable. Before choosing which countries from this area will be admitted to the Union, Europe has -prior to integration -to stabilize them. That is the gist of Europe's proximity policy and of the ambiguous message that underlies it's "sharing everything with the Union except for its institutions". In return for the easing of access to the European market, those on the periphery are in reality asked to assimilate the acquis communautaire which are supposed to be an advantage for them, but which also profit European economic agents that are thereby less disoriented (Gstöhl).

A policy based on norms that are accepted since they have been negotiated

here comes up against its limits.

On one hand because, contrary to what might suppose, Europe hardly ever negotiates the contents of its norms with its partners. Basically, it's a case of "take it or leave it". And on the other hand because the extent of acceptance of European norms obviously depends more on the balance of power than on free choice.

Moreover it is not certain that Europe's partners have much to gain from a policy that can appear generous ("everything except for the institutions"), but which in reality amounts to accepting European norms without taking part in their elaboration.

The linking of norms to the political balance of power should keep us from a starry-eyed vision in which normative strength is "an idealistic power", gentle, peaceful, and placid. But it should also lead us to take norms seriously and not reduce them to the interplay of inconsequential rules, without importance since they only concern market regulation

What are Europe's normative boundaries?

There are today three domains in which Europe's normative influence seeks permanent status so as to satisfy both the demands of its citizens and the interests of its economic agents as well as those of its member nations.

a) Environment: It is in this domain that Europe's political influence is by far the strongest and has the greatest effect on the organization of international relations.

This influence can be explained by a decided preference for environmental issues that stems both from the high density of the European population and from the environmental externalities that are always present when a region, cramped for space, is heavily industrialized and thus polluted. (European greenhouse gases

[GHG] account for 15% of the world's emissions, whereas the European population is under 8% of world population.) A preference that stems as well from the food and hygiene crises that Europe confronted in the late 1980s. This commitment was facilitated by the shared character of environmental benefits and by compatibility between the interests of member states and those of the Commission, not to mention the interest of leading nations in supporting these demands whenever, for a variety of reasons, it did not cost them much.

The Kyoto Protocol proved to be, in this perspective, a perfect vehicle for normative influence, precisely because meeting the specific targets set by community consultation has become the basis of Europe's engagement. In the beginning the political ends to which Kyoto would be put by Europe were not anticipated. On one hand, because the subject of climate change had not yet become popular. On the other, because Europe was but one actor among many. The United States was fully committed to the process and it can even be said that the Kyoto Protocol relied to a great extent on the United States, in particular concerning emission trading. But once the Americans began to withdraw and to campaign politically against the Protocol to prevent its application, Europe, fully supported by public opinion, began identifying with the Protocol that appeared as a symbol of their distinct political identity. For it was Europe that succeeded in convincing Russia to sign the Kyoto Protocol, making way for its official implementation in 2005. In return Europe supported Russia's entry into the WTO.

Since then Europe has tried to exploit its advantage by issuing proposals for an After-Kyoto in which GHG emissions would be further reduced and emerging countries persuaded to accept the provisions from which they have so far been exempted in Of the three, Reach is the most important since it requires registering 30,000 chemical substances which industrialists are obliged to prove do not present any environmental or health risk. Moreover these provisions, applied not only to

European companies but to all those intending to enter the European market, are quite costly (Selm and de Veer). Which explains the strong resistance put up by the Americans (Ackerman, Stanton, Massey). Even in the domain of GMOs where Europe, in the WTO, backed down when faced by the Americans, U.S. farmers are more than reluctant to plant the new strains of GMO until they are certain that the European market will not be closed to them.

b) Regulating global competition

Strictly speaking competition policy refers to the rules that are designed to prevent market players from forming cartels. In a broader sense it in fact refers, for a given market, to provisions intended to distinguish between economic agents by means of innumerable regulatory obstacles. Respect for competitive rules is thus an issue in Europe's internal market as well as for its trade policy.

The stakes are high since Europe is not only the largest solvent market in the world and the leading economic power, but the first in world investments.

increasingly important. As long as Europe remained an introverted economic area, the rules of competition concerned only countries with strict norms. Conforming to rules governing intellectual property, for instance, had never been a major issue for Europe as long as it traded within its borders or with the United States and Japan.

Today the situation is entirely different since trade has been expanding with emerging countries whose norms are looser. Europe thus has an impressive roster of normative cases to settle, closely linked to its commercial policy (Maur).

In fact, until the mid-2000s Europe tried to put through its normative agenda via a multilateral channel known as the "Singapore issues" (investment protection, competition, transparency, and trade facilitation). But after the 2004 failure in Cancun and the deadlock in the WTO multilateral negotiations, Europe -without admitting as much -decided to explore bilateral ways to advance its normative agenda (Woolcock). And it's obvious why. When 80% of imitations intercepted in Europe are of Chinese origin, it would appear legitimate to address China directly, rather than waiting for a multilateral solution. All the more so in that the issue in this case was less the drawing up of new rules than their effective application. Europe willingly admits that, when it comes to issues other than tariffs, it has more success in bilateral than in multilateral negotiations. Moreover Europe is in the process of tightening provisions concerning intellectual property in its bilateral agreements, coming closer to the United States that has always considered that, in such matters, bilateralism was more effective than multilateralism (Pugatch).

Since 2006 Europe's trade policy has taken a bilateral turn so as to take root in emerging countries, particularly China that is its leading commercial partner.

Faced with public scepticism as to the advantages of globalization, Europe knows that it can prove its effectiveness and its legitimacy only by demonstrating that the opening of new markets will result in the creation of jobs -and not only the loss (European Commission, 2006a).

Today it is countries with a high-growth potential that Europe is most interested in. To meet its objective Europe intends to deploy its battery of norms in the key areas of respect for intellectual property, access to government markets, and discrimination against foreign investors, not to speak of the fundamental social norms concerning environment, energy efficiency and human rights. There is, of course, the risk that its commercial policy then be overburdened with, conditionalities when the balance of power is in Europe's favour (Fantini and Modini). The issue should be squarely faced, all the more so in that it is clear that Europe has no intention through these agreements of relaxing its control over sensitive aspects of agricultural production and even less so over the movement of people.

c) World governance

We opened this paper with the assertion that a preference for world governance was the core of European political ideology. And that this ideology was further affirmed as American unilateralism became stronger.

The call for global governance has been implemented by Europeans in several ways:

In the WTO Europe has spoken out for a "broad agenda" intended to ensure that the opening of new markets and the regulation of these markets progress simultaneously by including, as we have seen, social and food protection norms. In the UN Europe has been the sole voice to appeal for the creation of a Global Environmental Agency.

Scenarios

What political scenarios for the future can be drawn from this analysis? The first consists of seeing in the current situation the start of a process leading to fullfledged European power. I will call this scenario Power in Progress. The second would not be a transformation of European power but a transformation by Europe of the issues at stake in power: a scenario of Transformative Power. Lastly, the third would be the perpetuation of the present situation which we will call Derived Power.

Scenario 1: Power in Progress

This scenario has a number of arguments going for it. A growing power, progressively becoming aware of its common interests, develops common implements for its commitments. For shared interests, a shared -even uniquecommand; a scenario akin to America's. But of the three, this is the most improbable scenario. For unlike the United States, Europe's point of departure is a set of nation states determined to share, but not dissolve, their sovereignty. So the comparison with the U.S. doesn't really hold (Laïdi,a). In addition, the transition from a shared recognition of interests to a shared policy runs into numerous obstacles. The second obstacle is that acknowledgement of common interests will never dissuade certain states from resorting to free-riding, even if it means claiming to act in the common interest while being the first to go it alone. The French project for a Mediterranean Union is an excellent example.

And finally, the idea of common interests still leaves room for differing priorities.

Europeans have every reason to develop a common energy policy in view of their collective vulnerableness to energy volatility. But this does not prevent them from envisaging the pooling of interests in very different ways.

Scenario 2. Transformative Power

Here Europe's activities are seen as influencing the collective perception of world issues and their priorities. Climate change is a good illustration of this scenario. Through its efforts Europe has succeeded in putting the issue at the top of the world agenda despite strong opposition from the United States. In addition, Europe has managed to make of it the first to be shared by all members of the international community. A considerable achievement because climate change is beginning to have political consequences in a variety of domains, such that in a few years we will no doubt see political or military conflicts closely linked to environmental issues. Hence we can consider Europe's transformative power as a plausible outcome, but we should neither exaggerate nor misestimate it. It is characteristic of the international system to generate new issues, but this does not mean that traditional questions of security, where Europe is far weaker, will be set aside. In addition, the fact of bringing certain issues to the fore does not mean that Europe will remain the king player. In other words, if tomorrow the question of climate change were to become a strategic issue of a more classic kind, Europe would not necessarily be the best prepared to confront it. We can only hypothesize that Europe's soft power will see to it that the political issues stemming from the existence of world public goods will not systematically degenerate into violent conflicts involving armed force.

Scenario 3: Power by default

In this scenario Europe's power would consist of fragments that Europe made no attempt to consolidate. It would be more of a derived power rather than a constructed power: one which gave no indication of a will to collective authority.

Europe would remain a fragmented power, one that did not try to acquire power's traditional attributes. It would exercise this power by default, with no conscious purpose, which does not mean however that it would be powerless. Of the three scenarios, the first appears the least probable. We should thus count, for the next twenty years, on the other two; it is the combination of scenarios two and three that holds the key to understanding Europe's place in the world

  the name of differential treatment, a principle which Europeans champion, even if it is but a means to have their own policies appear more credible. Kyoto targets, the European Union effectively fixed the norm that was to be central in the international negotiations held in Bali in December of 2007. But Europe must meet two challenges. The first is to be exemplary in environmental matters, not simply in rhetoric but in practice. Yet on this score the results are not yet in. In 2004 the GHG emission levels for Europe's 25 were at their highest since the adoption of the Kyoto Protocol in1997. The black spot for Europe remains road and air traffic. In addition, the proportion of European exports with high carbon intensity is superior to that of the United States or China, which renders attempts to tax importations of polluting countries hardly credible(Delgado).For Europe to set an example is a crucial issue, but the outcome remains uncertain. A political strategy is needed capable of inciting the emerging countries to share this approach, not to speak of the fact that the United States might be reluctant to see these countries absolved from taking meaningful steps before 2020 as proposed in the latest UN development report. It will be most difficult. Yet it is only by such criteria that European nations can continue priding themselves on being "a green power". The other major environmental chapter over which Europe has

	Europe thus committed itself in April of 2007 to reduce by 20% its emissions of
	greenhouse gases by 2020 (and even by 30% if a reduction of the kind was accepted by the other states), then a 50% reduction before 2050 keeping 1990 as the reference year. In the Kyoto agreement the reduction of GHG for Europe was fixed at 8% between 2008 and 2012. By being the first geopolitical region to commit itself technical: the Reach directives (Regulation, Evaluation and Authorization of Chemicals), the WEE (Waste Electric and Electronic Equipment) and the ROHS to After-considerable influence on the world level concerns three questions that can appear (Restrictions of Hazardous Substances).

In 2010, according to the EU Commission's own estimates, GHG emissions in Europe of the 15 will only have been reduced by 0.6% below the 1990 level, whereas Kyoto stipulated an 8% reduction by 2012

(European Commission, 2006b)

. For Europe of the 25, the outlook is more encouraging, but not necessarily significant; the former Eastern bloc states are closing out the polluting factories left over from the Soviet era.

  Even in private-sector regulation, European influence is no longer minimal.Taking accounting norms, for instance, the new norms adopted in Europe since 2005 were in the beginning closer to American norms than to the former European norms. In a field in which there was only one de facto world standard (the American) alongside a myriad of local standards, there are now two dominant norms, even if the are many similarities between them.Yet global governance is far from having lived up to its promise and Europe is a long way from matching acts to principles.As we have seen the WTO has not really succeeded in furthering a "broad commercial agenda" of the kind Europe had called for. Since the Doha Conference Europe has failed in its attempts to link trade to respect for environmental regulations, as it has failed to link commercial agreements with fundamental social norms and have its partners respect the famous "Singapore issues". In fact Europe is talking of global governance less frequently than before. The Barroso Commission has above all tried to demonstrate that globalization will prove to be an advantage for Europe.Moreover Europeans' interest in further global governance is lukewarm above all when it comes to creating new institutions. But that's only half of it. Europe, that talks of a more open world, tends by its national divisions to block a fairer representation of emerging countries in the Security Council as well as in the G-7 and the IMF. In the latter case the voting rights of China, India and Brazil, taken together, are 20% below those of Italy, Belgium and the Netherlands. How can one purport to defend a pluralist vision of the world and insist on emerging countries taking up their responsibilities in world economic governance when one denies them representation proportional to their population? On the energy issue, which is for it of prime importance, Europe is at the parting of the ways. In trying to convince the Russians of the merits of an Energy Charter, Europe is defending the idea that market institutions guaranteed by norms are preferable to bilateral geopolitical agreements (Helm). But Europe here encounters resistance not only from Russia, but from the majority of member states for whom energy remains a sovereign prerogative(Finon and Locatelli).Norms are not possible without justice, unless one considers that norms are in the final analysis but a means to power in the hands of those who lack the strength to exercise it otherwise.

	But little by little the International Financial Reporting Standards (IFRS) have become
	a "European" global accounting norm in competition with the American accounting
	standards, the US-GAP (Generally Accepted Accounting Principles in the United
	States).

  There are often in Europe discrepancies between what are perceived to be interests and their reality. Objectively, Great Britain has major interests in Europe. But this in no way reduces British opinion's hostility to sustained support for commitment to Europe. It explains why, moreover, the theory that Britain is in fact intent on dominating Europe has never been confirmed; rather than influencing Europe, Britain's goal is to prevent Europe from interfering with British interests.

A genuine risk of cartelization does exist because most global investing is done through mergers and acquisitions, thereby automatically increasing the likelihood of market concentration. Faced with this risk, Europe has considerable means at its disposal; their import was evident on two different occasions involving two different issues: when in 2001 a European court, on the basis of extraterritorial powers, effectively prohibited the merger of two American companies (General Motors and Honeywell Bull); and in 2007 when this same court condemned Microsoft for having eliminated its competitors from the operating systems market by denying them access to technical information on Windows. What stands out in this affair is both the fact that Microsoft was condemned in Europe whereas it had not been in the United States. And also that it was an American company that brought charges against Microsoft in Europe as if it considered it would be easier to do so in Europe than in the United States (Vannini).

The condemnation of Microsoft is evidence of a European conception of competition that is today different from that of the U.S.. In Europe's eyes, competition must not only provide an advantage for the consumer but ensure as well the continued existence of market competitors. In other words, there can be no genuine competition in the absence of genuine competitors; whereas for Americans the competitive structure of the market itself is of less importance than the advantages to be derived by the consumer (Bertrand and Ivaldi). Microsoft's quasimonopoly would, in the latter perspective, have been acceptable if the consumer were to benefit from a steady price reduction.

The other aspect of competition has to do with the rules guaranteeing fair competition between economic actors. For Europe this aspect -at a moment when its trading patterns have been changing radically and rapidly -has become


Executive Jean-Paul Fitoussi

ECONOMIC AND MONETARY AFFAIRS

The reversal in the trend of productivity growth between the US and the UK on one side, and the main countries of continental Europe on the other, appears with great evidence from the data. The current debate focuses on differences in labour market performance, which should account for the growth and productivity divergence. While some measures aimed at increasing the participation and employment rates in the EU are certainly desirable, excessive precariousness of the labour market would have deep social implications, and should be subject to democratic approval. Furthermore, one striking aspect of the debate on productivity growth is the moderate emphasis given to investment and capital accumulation. By looking back to the late 1960s, one can observe a striking positive correlation between productivity growth and both private and public investment. If we consider the inherently long term features of investment, the data also show a positive correlation between investment and trend growth (the OECD measure for potential growth). The correlation between investment, productivity, and potential growth, should be better understood and investigated than what is done in the current debate. By doing that, we should also reassess policy in terms of its capacity to provide a favourable environment for capital accumulation. In this respect, the self complacency of policy makers in the EU may appear excessive. The Stability and Growth Pact has seriously affected the capacity of large European countries to invest (the comparison with the golden rule of the UK is in this respect telling), and when assessed with respect to the growth performance of the Euro zone, the monetary policy of the ECB seems less accommodating than usually believed. Excessive interest rates may contribute to explain investment stagnation in the past decade, especially when seen in comparison with the US

Introduction

In the past decade, the growth rate of productivity and of GDP in the Euro zone have lagged behind the ones of the US. This is a recent phenomenon, though, because most of the post-war period has been characterized by a catching up of productivity and income by the European countries. Figure 1 shows a general measure of productivity -Real GDP over employment-, for the US and for the largest countries of the European Union1 . We can observe that the productivity of the US was substantially larger than all European countries in 1965. Figure 2 shows the yearly percentage increases in the two sub periods 1965-1990 and 1992-2005, emphasizing the change that happened in the last decade.

We can notice that while the US is the only country that experienced an increase in the growth rate of productivity (almost doubled), all the European countries experienced a reduction, particularly sharp for the countries like Spain and Italy, that because of their initial backwardness, had progressed most in the preceding decades. It is also worth mentioning that while decreasing, the growth rate of productivity in the UK remained slightly larger than in the US. In fact, relative to the early 1990s, the UK has the most productive economy of our sample.

The Causes of the Anglo-Saxon Predominance

The current debate on growth and productivity only focuses on the latest period, and it revolves around the question of how the European countries can get out of their 'soft growth trap'. The ECB (e.g., the October 2006 Bulletin) summarizes the debate by identifying a number of factors that can explain why the US and the UK grow faster than the larger continental economies, and experience higher productivity growth. The elements that are evoked are well known in the literature:2 a)

A substantially larger (almost 10 percentage points) employment rate in the US b) Longer hours worked in the US. This has triggered a debate, not settled yet, on whether the difference in labour supply depends on a different preference for leisure, or on different revenue incentives (i.e., excessive tax burden in the European countries).

c)

The US experienced a larger (around twice as much) investment in ICT than Europe. ICT is widely recognized as a major determinant of recent productivity growth.

The third element, in particular, may help to explain why the increase of employment has not triggered a slowdown of productivity growth in the US.

This diagnosis is robustly supported by data, and largely shareable. What is less convincing is the recommended therapy, which focuses exclusively on the effort to make product and (mainly) labour markets more flexible.

Some of the currently debated measures are certainly necessary and useful, and their implementation only depends on the overall impact on public finances. It is for example the case of a reduction in the tax wedge. Other measures, nevertheless, -like the incentives for part time or the reduction of labour protection -need to be carefully weighed. For these measures, the increased flexibility of the labour market may come at the price of an increased precariousness of labour, a result that would change the organization of our society, and as such needs to be the explicit outcome of a democratic and political process rather than a technocratic choice. Furthermore, the future costs for social security would need to be carefully evaluated, as precariousness would most probably be associated with lower capacity to provide social contributions.

To sum up, the effort to make the labour markets more flexible has to be encouraged, but carefully drafted in order to avoid a deep modification of our societies, that would be unwarranted unless explicitly subject to a democratic choice.

Investment and Productivity

Two things in the debate about productivity appear puzzling; the first is the already mentioned exclusive focus on the recent comparison between the US and European countries. The second is the secondary importance attributed to the role of investment, which is often mentioned but never really studied, especially in what concern the positive implications of economic policy. The minor role attributed to investment is particularly at odd with the emphasis that economic theory (even at the textbook level) puts on the link between capital accumulation, productivity and potential growth.

These two odd features of the debate are deeply intertwined, because by extending the comparison to the decades preceding 1990, the explanatory power of institutional labour market differences fades away. The US was already relatively more flexible, but its productivity performance at the time was lower than the European's. It is then necessary to go back to the role of investment, to make sense of the differences in growth and productivity. Figures 3 and4 show the yearly average increase in capital stock, for the private and public sector respectively, divided once again in the two sub samples 1965-1990 and 1992-2005 3 .

The first one shows that European countries experienced much larger private investment than the US in the previous sub period. In the second period, nevertheless, in the framework of a generalized drop of investment rates, the US and the UK limited the reduction; in the past 15 years, their average private net investment rate was larger than the one of Germany and Italy. Figure 4 shows the average rate of Government Gross Fixed Capital Formation. The similarity with figure 2 is in fact quite striking, as the only countries that experienced an increase in public investment, since 2002 (the US and the UK), are also the ones that increased most their productivity. It is worth mentioning that steep decrease in public investment for European countries coincides with the run up to the Euro, which in many countries implied a tightening of monetary and fiscal policy. As was to be expected, this tightening hit harder expenditure items like investment, which were less "visible", without significantly affecting politically sensitive items like current spending. With this in mind, the dramatic increase of public investment in the United Kingdom becomes an indirect proof of the appropriateness of the golden rule of public finances, which regulates public expenditure net of investment. In the UK the soundness of public finances was assured without harming investment, and hence guaranteeing the continuing increase of productivity and potential output. By contrast, the countries subject to the strict constraints of the Maastricht Treaty, and then of the Stability and Growth Pact, seem to have relied on drastic reductions in the rate of increase of public investment, that may help to explain the stagnation in productivity growth.

The relationship between investment and productivity can be summarized as in figure 5, where the increase in productivity is mapped against investment (each country has two points per series, corresponding to the two sub-periods). It can be seen that the relationship is positive for both private and public investment.

Investment and Potential Output.

Investment is a both a short and long run phenomenon. The short run effect on aggregate demand is well known. But an equally important role of investment is that it builds the future capital stock of the economy. It is through this channel, if any, that it has effects on the long run potential of the economy. But these effects are by definition delayed, as investment takes time to become productive capital. To emphasize the long run features of investment I first took five years averages , and so on).

Then I plotted them against potential output growth (as calculated by the OECD), in the following period, in order to capture the delayed effect of capacity construction building. I added Japan to the six other countries, because of its long stagnation. Figures 7 and8 plot the correlation, for the total of the countries, and for each of them separately. We can observe a robust positive correlation between investment and delayed potential output growth, that furthermore is replicated for almost all countries taken individually (the only exception is Spain, for which nevertheless we only have 5 points).

These correlations are of course only suggestive, but they underline the need to better investigate the role of investment in the determination of productivity, and not to focus as is too often the case, only on labour market rigidities.

Policy Implications

What precedes confirms the initial educated guess, that there is more than labour market rigidities to explain the differences in potential growth that we observed in the past 15 years. Investment, both public and private, seems to play a very important role. But if we shift the emphasis to investment, then we need to look at the determinants of it, among which policy plays a crucial role. I already pointed out above the striking difference in terms of actual and potential growth between the UK, which followed a fiscal rule that preserves public investment, and the large continental countries that were bound by the Stability Pact.

But also monetary policy is an important determinant of investment. The emphasis on price stabilization in this respect is usually justified by two main arguments. The first is that a stable macroeconomic environment keeps the risk down and hence is favourable to investment. The second argument is that at any rate, the main determinant of investment behaviour is the flexibility of labour and goods markets; as a consequence, the key to increased competitiveness is the implementation of structural reforms.

Nevertheless, comparing the recent history of the US and the EU, we can tell a rather different story, in which monetary policy, investment and its long term effects on productivity play a central role. In the first half of the 1990s real interest rates were much higher in Europe than in the US4 , and that was a major determinant in the difference of private investment rates 5 in the two zones, that continued all along the 1990s. The high investment rates (among other things in R&D) had the effect of increasing the stock of both physical and human capital in the US. As a consequence of the different stock of capital, the period of relatively high growth that Europe experienced between 1997 and 2000 was particularly rich in employment, but productivity did not increase substantially.

It was a "prductivityless" recovery! On the other hand, in the US, the productivity component of growth was relatively more important than job creation. In fact, it was only the exceptional growth rate that allowed the US to create jobs in a period of exploding labour productivity.

The early 2000s, give us further indications of the link between growth, investment and productivity. Investment dropped significantly in the US, after the boom of the late 1990s; the recovery after the short recession of 2000-2001 was mainly due to resilient consumer spending. Nevertheless, productivity continued to increase, and as a consequence, the US is experiencing a period of "jobless growth". This allows concluding that the long term effect of investment on productivity is crucial, as the current productivity increase clearly build on past investment.

This perspective on the recent macroeconomic developments in the US and in Europe highlights -in disagreement with the ECB -the role that the budgetary and monetary tightening experienced in the EU since the early 1990s have played to depress investment, and hence productivity growth.

Increasing productivity and potential growth necessarily requires strong investment, both public and private, in order to build the necessary human and physical capital stock.

Crucial to this increase in investment is a friendly environment, in which policy necessarily plays a role, as the experience of the US clearly shows. 1965-1990 1992-2005 Source:

Figure

  Figure 1 -Productivity Index

Figure 3 -Yearly Average Increase in Private Capital Stock

			Figure 5 -Investment and Productivity
	8%	6%
	7%	1965-1990 1992-2005 Government
	1% 2% 3% 4% 5% 6% Average Productivity Growth	1% 2% 3% 4% 5%	Private
	0%	0%
		US -4%	-2%	IT 0%	2%	UK	4%	FR 6%	8%	BD 10%	ES 12%	14%
		Source: OECD	Average Investment Growth		Source: OECD
		Figure 4 -Yearly Average Government Gross Fixed Capital
						Formation
	13%
		1965-1990 1992-2005
	11%
	9%
	7%
	5%
	3%
	1%
	-1%	UK	FR		ES		GE		US	IT
	-3%
		Source: OECD

Figure 6 -Investment, Productivity and Potential Output

			Figure 7 -Investment and Potential Output Growth
		1.6
	Potential Output Growth (t to t+1)	0.4 0.6 0.8 1 1.2 1.4 0.2						Source: OECD My calculations
		0
		0%	2%	4%	6%	8%	10%	12%	14%
				Average Net Investment (t-1 to t)
			Figure 8 -
	17%		Potential Output
	15%		Productivity
	13%
	11%
	9%
	7%
	5%
	3%
	1%							Source: OECD
	-1%
		0%	2%	4%	6%	8%		10%	12%
					Private Investment

Investment and Potential Output Growth

		1.6				JP UK FR ES GE US IT
	Potential Output Growth (t to t+1)	0.4 0.6 0.8 1 1.2 1.4 0.2						Source: OECD My manipulations
		0
		0	0.02	0.04	0.06	0.08	0.1	0.12	0.14
				Average Net Investment (t-1 to t)

I normalized at 1992=100 for essentially two reasons. First, to mark the structural break that appears in the early 1990s (in particular with the Maastricht Treaty). Second, to partially neutralize the discontinuity in the data introduced by the German reunification. A more careful assessment of the German data also justify my choice below to eliminate the year 1991 from my subsamples.

See e.g. How to Elevate the potential growth rate of Europe, speech by Jean-Claude Trichet, President of the ECB, Berlin 16 October 2006.

Because of data availability, we were able to obtain net investment for the private sector, but gross investment for the public sector (for which the OECD does not provide data on the capital stock).

From 1990 to 1996 the short term nominal rate in the US was below

5%, while it was at around 8% in the European countries, while inflation was more or less the same.5 As I mentioned already, the insufficient private investment was accompanied by a decrease of public investment due to the budgetary restrictions implied by the run up to the Euro.


European Parliament

COMMITTEE FOR ECONOMIC AND MONETARY AFFAIRS Briefing paper n° 1 -October 2006 Diverging Tendencies of Competitiveness

Jean-Paul Fitoussi

In 2003 Chancellor Schroeder launched an ambitious structural reform package (Agenda 2010), that simultaneously reformed the pension system and the labour market (following the proposition of the Hartz commission report, of August 2002). This program reinforced a trend already visible since the year 2000, aimed at increasing competitiveness of the German economy by reducing production costs. This effort was rather successful, as figure 1 shows. The competitive situation dramatically improved with respect to Italy, which was unsuccessful in controlling wage increases. But relative labour costs significantly dropped also with respect to France, which was in a similar situation at the end of the last decade. Germany became more competitive with respect to the UK and Spain as well.

This impressive performance in increasing cost competitiveness has been greeted as the proof that the sick man of Europe was finally getting healthier, and ready to take its place as the locomotive for growth. The concern then shifted to those countries, like France and specially Italy, which did not engage in a process of structural reforms, thus putting at risk growth and stability for the EU as a whole. The comparative way of evaluating national economic policies may sometimes be misleading. A country may have good reasons to embark in a strategy of cost reduction which others have not. That is especially the case of Germany: as it is well documented, German unification led to a significant loss of competitiveness which should have led to a real depreciation of the mark in the second half of the 90s. In other words Germany joined the euro with an overvaluated currency. Should the other countries have embarked in the same strategy this would have nullified the German efforts without any significant benefit for the euro area. The search for competitiveness in a monetary union amounts to a non-cooperative game.

Because in fact, competitiveness is not an objective per se. Rather, it is instrumental to increase growth and welfare, the final objectives of policy action. By taking these variables as an indicator of performance, as seems more reasonable, we can remark that the German disease may not be over after all. Figure 2 shows some selected macroeconomic variables for Germany. The growth performance since 2000 has been all but satisfying, and the modest recovery that we can observe since the beginning of 2005 is not expected to last well into 2007, when among other things the announced increase in VAT could depress internal demand. Furthermore, the already modest recovery is turning out to be a jobless growth, in spite of the increased flexibility of the labour market. Since 2000, unemployment has increased more than 2 percentage points. Finally, consumption on average has been increasing below the growth rate of the economy, and this is hardly surprising given the stagnation in real wages (real wages increased only by 2.8% in Germany since 2000) and the persisting unemployment.

The only visible effect of the increased cost competitiveness of the German economy is the strong improvement of the current account balance that over the period has yielded a surplus of 125 billions euros. We remark on the other hand that the Euro zone commercial balance increased of 30 billion euros over the same period, which means that the increased competitiveness of Germany has mainly caused a reallocation of market shares within the area. Germany's surplus is mainly absorbed by a corresponding deficit of its neighbours (France's position worsened of 46 billions, Spain's of 44, Italy's of 14). The improved situation of Germany was obtained at the expense of a deterioration of the position for other countries in the Euro zone. Furthermore, like competitiveness, the ex-post national external balance in a monetary union is not per se an objective (as it could have been for the union as a whole), but an instrument, and as such it is not an indicator of good performance. It could even be said that the benefit of globalization being an optimal allocation of saving, it is not even an objective for a country characterized by its own currency. Otherwise, we should conclude paradoxically that the United States, which experienced important external deficits at least since the early 198Os, is the worst performer of OECD countries.

The growth performance is particularly disappointing if we compare it with the other countries, whose competitiveness position worsened with respect to Germany (figure 3). France Italy Germany Source: OECD OECD Without even mentioning the average OECD performance, that since 2002 was considerably better, we can observe that France on average grew faster than Germany, and that the situation of Italy is not dramatically worse.

In conclusion, at least so far the bold effort in cost competitiveness, that we can define as a non-cooperative "competitive disinflation", did not bring the results its advocates hoped. The limited increase in growth can be attributed to the external balance, while internal demand and employment stagnated.

One could on the other hand argue that structural reforms, as all phenomena that involve deep modifications of the economy, can entail transitions in which the disruption hurt the economy before the benefits appear to compensate. Furthermore, the deeper is the transformation, the longer is the transition. According to this view, then, the best is yet to come, and we can expect the German economy to experience stronger growth as the system absorbs the structural changes.

In fact, simply by looking at standard economic analysis, it becomes hard to subscribe to this optimistic view. The natural consequence of a strong reduction in real wages (the main channel for boosting cost competitiveness) is a compression of domestic aggregate demand (consumption and investment). This has of course direct short term effects, in terms of sluggish growth. But, prolonged periods of slow growth also have long term effects that are often overlooked. If investment is consistently below normal, long term productive capacity, and hence the potential for future growth are also affected. Thus, a competitive disinflation strategy to be successful needs an increase in external demand (by means of increased market shares) capable to match and more than compensate the decrease in domestic demand. Furthermore, this effect needs to appear in a sufficiently short time horizon, to avoid the long term adverse effects of low investment on potential growth.

But if the balance between external and internal demand components is the crucial factor determining the success of competitive disinflation, then country size becomes the main analytical element of the analysis. Smaller, more open economies face a very strong price elasticity of external demand. This means that everything else equal, a reduction in the price of their exports will increase the total demand for their goods of a larger amount. Thus, competitive disinflation may prove a winning strategy for a small country, especially when the exchange rate with its large neighbours is fixed (e.g. Ireland, or the Netherlands). A cost reduction will increase the exports of an amount that is significant for the country itself, more than compensating the decrease of domestic demand. The large trading partner, on the other hand will not necessarily feel the competitive pressure, and hence will not retaliate. Ireland is a good example of an export led growth, obtained through aggressive wage and price policies, which triggered a virtuous cumulative process feeding back through expectations and household wealth into domestic consumption and investment.

A large country on the other hand, has a larger share of domestic demand in GDP, and consequently a lower price elasticity of exports. Furthermore, its actions are more likely to affect its trading partners.

As we saw above, the important reduction in Germany's wages and labour costs has depressed internal demand, and the effect on exports has not been sufficient to compensate it. Furthermore, as its trading partners (France, Italy, and Spain) were negatively affected by the loss of market shares, their income could decrease, together with their demand for German goods. Last, but not least Germany's trading partners will most likely engage in the same strategies, reducing the competitive edge that Germany has temporarily obtained. The theory then predicts a race to the bottom, in which successive waves of reduction in costs will leave the competitive situations more or less unchanged, and further depress internal demand at each round. Such non-cooperative game will in the end leave every country worse off.

The constraints on macroeconomic policy set by the European institutions (the Stability and Growth Pact, and the statute of the European Central Bank) further complicate the picture, as the governments are prevented to sustain domestic demand by means of active policies.

The conclusions that we can draw from this analysis are not encouraging. The modest effect of the German competitive disinflation is likely to be structural, i.e. linked to its size with respect to the trading partners. Thus it does not seem plausible to expect substantial benefits from this strategy once the transition is over. Furthermore, if Germany's trading partners retaliate adopting the same strategy, Europe as a whole could be facing hard times. The generalization of noncooperative behaviour may well lead to a malaise in the European Union. The Euro zone will then be threatened if France and Italy follow Germany, not if they don't.

Finally, even if we were to assume that cost competition may work with respect to the European and North American trading partners, it is hard to believe that it would be the appropriate response to the challenge coming from emerging economies. How much will we have to lower wages before we can compete with China's labour costs? How much of our welfare state will we have to give up, to give firms the necessary flexibility? What will be left of the European social model, if we engage in price competition with East Asian countries? If cost competition does not seem a viable path to walk, another strategy must be put in place to face the increasing pressure that comes from emerging countries and to counter the tendency to non cooperative behaviour that threatens the European project.

In fact, an increase in a country's competitiveness may come from a reduction of labour costs, with all the problems detailed above, or from an increase in productivity. Better quality goods can compete even with the low cost production coming from emerging markets. Figure 4 shows the evolution of a rough measure of productivity, real GDP over employment. It is immediately apparent that these figures are more coherent than labour costs with the growth figures reported above (figure 3): the OECD average is well above the three largest eurozone countries, and within this group France fares better than Germany and Italy.

The key to increasing productivity is strong private investment, so that policies aimed at increasing competitiveness need to create a business-friendly environment. Measures to cut costs must be complemented and preceded by development of financial markets, implementation of industrial policies, funding of basic research, and academic excellence. Furthermore active policies, by smoothing the cycle, may act as an insurance and lower uncertainty. This sustains investment, and hence both the quantity and the quality of productive capacity.

Research and Development, industrial policy, and even demand management (because of the demand linkages between European economies), are all characterized by increasing returns. This naturally calls for cooperation among European governments that allows exploiting economies of scale. Instead of fighting with each other with the illusion of gaining cost competitiveness, European governments should cooperate to build a business friendly environment, to develop private investment and competitiveness.

Figure

  Figure 1-Cost Competitiveness: Relative Labour Cost

Figure

  Figure 2 -Germany: Selected Macroeconomic Variables

Figure 3 -

 3 Figure 3 -Real Growth Rates (Y/Y,%)

Figure

  Figure 4 -Productivity (Real GDP / Employment)


Jean-Paul Fitoussi

"Shifting the tax burden: from direct to indirect tax"

A consumption tax amounts to exempt savings from taxation. As such, it would have important distributional effects, first of all from the poor to the rich, but also towards capital intensive industries; and intergenerational, away from the very young (students) and the old. For what concerns long term effects, most studies show that a consumption tax would be moderately more efficient and much simpler than the income tax. Nevertheless with such a tax, the progressivity of the current system could not be replicated. Attempts to mitigate the regressive features of the consumption tax would unavoidably lower the efficiency gains, and significantly increase complexity. I conclude that the passage to a consumption tax has to be done on the basis of a judgement of value (how progressive should our tax system be?), and not based on technical arguments. Shifting to a consumption tax would also imply an extremely complex transition that could be characterised by unemployment and inflation. For monetary policy, monitoring the economy during this transition would be extremely complex. Given the mixed picture that emerges from the analysis, I conclude asking why the consumption tax has taken such an echo in the current debate. May be because it is supposed to serve objectives that are not explicitly stated: either the objective of increasing competitiveness (but then, other tools like the exchange rate seem more straightforward and efficient), or the objective of reducing public spending.

Introduction

The recent debate on a substantial reform of the European tax system comes after the same matter has been discusses for almost a decade in the United States. On both sides of the Ocean, proponents of a radical reform argue that it would be possible to obtain a more "pro growth" and efficient system, and often see the switch to a consumption tax away from direct taxation as a mean to obtain such a goal. The literature on public finance pins down four main characteristics against which to evaluate a tax system: The first is its efficiency, i.e. its capacity to minimize the impact on private agent's decisions (on saving, investing, working, etc.). The less it distorts these decisions, the more efficient the system is. The second characteristic is fairness, i.e. the equality of treatment; then, a tax system must be simple, in order to be transparent to citizens, and not costly to manage for the administration. Finally, the tax system has to ensure adequate revenue to cover public expenditures. In what follow I will try to assess the merits of a consumption tax compared to a system of direct taxation on the basis of these characteristics. Then, I will consider what would happen during the transition between the two systems, and analyse the consequences for the conduct of monetary policy. Before doing that, in the next section I will briefly describe how a consumption tax would work.

The Consumption Tax

The consumption tax is a tax on expenditure that can take many different but analytically equivalent forms (VAT, flat rate, retail sales tax). The difference with respect to the income tax is that by taxing expenditure it leaves out of the tax base savings. Thus, the choice of whether to tax consumption or income amounts to the choice of whether to tax savings or not. Both in the US and in Europe tax revenues substantially come from income taxation, but while in European countries an important consumption tax exists (in the form of a VAT tax), in the US consumption taxes are negligible1 . The income tax is progressive, so that the average tax rate is larger for the rich than for the poor. On the other hand, given that rich people typically save a larger percent of their income than poor people, a simple (proportional) tax on consumption would be regressive, in the sense that it will lead to a decrease of the average tax rate for the rich and an increase for the poor. The regressive features of the simpler version of the consumption tax may be attenuated in various ways, e.g. by granting tax deduction to poor people, or imposing different tax rates on different categories of goods (as already happens with the VAT in Europe) 2 . Nevertheless, given the typical consumption structure of households in advanced economies, it would be impossible to replicate the progressivity of the current income tax system simply by modulating VAT rates or deductions. Thus, the passage from a progressive income tax to a neutral (at best) consumption tax would unequivocally reduce the overall progressivity of the system.

The change in income distribution is not the only important allocative effect of a consumption tax. Eliminating taxation on savings provides a powerful incentive to savings and investment, and is thus likely to boost output in firms and industries that make extensive use of capital, while depressing the labour intensive sectors. Furthermore, by suppressing all tax deductions, exclusions and credits, a consumption tax would eliminate all distortions that were introduced for other policy objectives, and that presumably create an obstacle to the efficient allocation of capital among sectors. On the other hand, if the tax rates on different goods where to be differentiated in order to reduce the regressive effects of a consumption tax, then other relative price distortions would appear. Other important distributional effects, like the double taxation of existing wealth, would appear during the transition between the two systems. I will come back on this later, also for a discussion of policy implications.

Assessing Benefits and Costs of a Switch to a Consumption Tax

As I argued in the introduction, assessing a tax system involves four main dimensions: efficiency, fairness, simplicity, and adequate revenues. To obtain a meaningful comparison of tax laws, we need to reason in "revenue neutral" terms, as most studies do. A first important remark is that it exists a tradeoff between fairness and simplicity. The proportional consumption tax would be remarkably simpler than the income tax, but as we saw from the simple example before, it would be strongly regressive. To reduce this effect it is necessary to introduce deductions based on income, or complex systems of differentiated tax rates. Thus, a first conclusion is that the simplicity advocated by the proponents of consumption taxes does not come for free, but has to be paid giving up at least some of the fairness.

Efficiency considerations are at the core of arguments in favour of switching to a consumption tax. The economy would become more efficient, in the sense of producing more output per person, if reforming the tax code eliminated tax-related distortions in decisions to work, save, and invest. In fact, agents consider after tax revenues (wage or capital returns) when deciding how much to work and how much to save and invest. The income tax reduces the after-tax compensation for these activities. While the gain in efficiency is straightforward in theory, an estimation of its actual amount proves to be a difficult exercise. In 2002 Jane Gravelle 3 surveyed several studies for the US; the long run change in real output obtained switching to a consumption tax ranged from 1.7 percent to 7.5 percent, depending on the assumption of the chosen model. Among those attempts, the paper by Altig et al 4 proves particularly interesting because it also examines variants aimed at mitigating the strong regressive effects of a pure proportional consumption tax. Their model of the US economy has coherent theoretical foundations and a realistic representation of the existing federal tax system. The long-run percentage differences from a baseline path, which describes how the economy might perform under the current tax system, is remarkable for the pure consumption tax, almost a 10 per cent increase in the long run level of real output. The increase in real output reflects greater saving and investment as well as an increase in the labour supply. Nevertheless, these gains are strongly reduced when introducing corrections to the regressivity as the deduction would reduce the tax base (the increase of output would only be 4.5 per cent), or giving tax relief to owners of existing capital to avoid double taxation (more on this in the next section). In this case the benefits in terms of real output would become almost negligible, not even 2 per cent.

The simulations of Altig et al illustrate another tradeoff that emerges when comparing tax systems. Measures designed to improve the fairness of a consumption tax system may erode the long-term gains in economic efficiency. Adding special transition rules or deductions also may increase the complexity of the tax code. We can thus conclude that a consumption tax is simpler and/or more efficient only if we are ready to sacrifice the redistributive role of the tax system. A choice that may be legitimate, but that first has to be clearly stated, for agents to know what they are accepting; and second, linked to that, has to be the object of a conscious political choice. It is not a technical matter.

The Problems of Transition

The preceding section made it clear that switching to a consumption tax would not have significant positive effects in terms of simplicity and efficiency, unless we were ready to accept a strong reduction of the progressive features of the current system. Thus, we concluded that no system is unequivocally better than the other. In addition to that switching to a consumption tax would also imply formidable problems linked to the transition between the two systems. The first that we have already touched upon is the problem of existing wealth. All capital and wealth that exist at the moment of the transition originated from income taxed under the old system. When this wealth will finally be spent, under the new system, it will be taxed again. Thus, the passage to the new system has a very strong bias against the owner of that wealth (the old and the rich). This should be taken care by transitional provisions, that would as we saw greatly reduce the efficiency gains, and furthermore add to the complexity of the new tax code. Exonerating savings from the tax base would also have another serious shortcoming in terms of intergenerational distribution. Over the life cycle, consumption exceeds revenues in the young age and in the old age. Thus, those in these classes would be the losers from the new system. While for the old this problem seems only linked to the transition (those who will be old in the future will have saved more), the problem of the young seems more structural, and potentially serious; in fact, by penalizing them, such a system may well penalize the accumulation of human capital, with negative effects on the long run growth potential of the economy.

Problems may also appear in the labour market. First of all, the shift of resources to capital intensive sectors is likely to cause important layoffs in the more traditional industries, at least in the short-to-medium run. Problems for employment may also originate in the necessary adjustment of wages and prices following the introduction of a consumption tax. Such a tax requires the price of consumer goods to rise relative to wages. Consumers would pay a substantially higher price for goods that embed a much larger sales taxes. In the long run, and assuming that revenues for the government remain constant, the decline of income taxes would exactly offset the rise in consumption taxes, leaving households with the same purchasing power. Nevertheless, during the transition such compensation would not be complete, and would depend on how the increase in consumer prices relative to wages occurs. If all the adjustment fell on prices, holding wages constant, there would exist serious risks of sustained inflationary pressures, as it would become unclear to consumers what the "correct" price level in the new system should be5 . If part of the adjustment were instead be accomplished by nominal wage changes, then the predictable resistance of workers would most probably cause stickiness, and hence a prolonged period of disequilibrium relative prices, and unemployment. Given the importance of the required adjustment, unemployment could be large, and the transition long.

Monetary Policy Behaviour

The long run effect of a consumption tax on interest rate is far from clear, depending on many contradictory effects. In fact, both supply and demand of loanable funds would change, and in addition the optimal debt/equity ratio for investment financing would be significantly different. Thus, the final long run effect on the equilibrium interest rates, and thus the necessary course of action for the central bank, is very hard to forecast. Furthermore, the transition would entail a formidable challenge for monetary policy. We can assume that the central bank would not contrast the jump in prices necessary to achieve the new correct price-wage ratio. But what if instead the relative price change did not happen smoothly and unemployment appeared? And how to deal with private agents expectations? For example, consumers might anticipate their purchase of durable goods anticipating the future regime change. On the other hand, firms may postpone purchases of capital goods, because under the consumption tax investment would be cheaper. Furthermore, these effects would most probably change in intensity in different sectors and countries. Thus understanding whether the interaction of these behaviours would be expansionary or contractionary, and adjusting the path of monetary policy accordingly, may become an extremely difficult task. If in addition the tax rate was not properly set from the outset at the level necessary to replicate the overall tax burden of the income tax, then the central bank would have to deal with the involuntary contractionary/expansionary fiscal stance, and with the expectations of successive adjustments that it would entail.

Conclusion

The preceding paragraphs have shown that the adoption of a consumption tax would not unequivocally improve upon the existing system based on an income tax, and that the choice to give up fairness in exchange for efficiency and simplicity needs to be political. I also argued that the problems posed by the transition are likely to be large and difficult to solve. Less radical changes of the current system, based on the income tax, may be designed to improve transparency and efficiency, without altering the basic characteristics of progressivity. 6 We can therefore ask why such a vast debate developed in the past months about the proposal of switching to a consumption tax. The same "fundamental tax reform" has long been debated in the United States, where nevertheless the discussion appears to have more sense. The US current system is more biased towards income taxation, is less progressive than most European tax systems; furthermore, their economy has a chronic problem of low savings that may in the long run hamper its performance. For all these reasons, a consumption tax may be worth analysis and consideration. But in Europe none of these conditions is met. Savings are high, the current tax system is already a mixture of income and consumption tax (VAT), and the welfare state is still large. So why to discuss of a consumption tax for Europe? The only explanation is that proponents have in mind other consequences, not directly linked to the characteristics of the tax system. A possible hidden scope for a consumption tax could be the attempt to boost competitiveness. In fact, taxing consumption means among other things taxing imports and detaxing exports. The modality chosen to implement such a tax in the EU would then become crucial. If the passage to a consumption tax was decentralized, i.e. if each European country was left free to set its own rates and to change them at will, then we would most likely assist to a wave of fiscal competition, a non cooperative "race to the bottom" in which each country would try to alter relative prices (the real exchange rate), making impossible a revenue neutral transition and seriously damaging public finances. If instead such a process was managed at the European level, with the objective of improving competitiveness towards the rest of the world, other problems would arise. The first is that national tax rates would have to be set with the double objective of being revenue neutral with respect to national income taxes, and to be neutral in what concern intra European competitiveness. This seems an excessively ambitious objective for Europe, especially given the current decisional procedures. Furthermore, even assuming that such a centralized process was successful, it seems more straightforward and efficient to intervene on the nominal exchange rate than on relative prices, in order to improve competitiveness.

Another possible hidden explanation of the emphasis on the consumption tax is the attempt to reduce the size and the redistributive role of the government. A revenue neutral consumption tax would involve such large changes in prices, and transition problems, that it is plausible to expect, when implementing the tax, an outcome somewhere in the middle. Thus, we would observe a reduction in tax revenues, and at that point, the soundness of public finances would call for a reduction of government spending. Such an agenda would be perfectly legitimate, if it were the outcome of a transparent democratic process. The problem is that, like for other reforms (namely the labour market), we are left with the feeling that they are introduced with the stated objective of solving specific "technical" problems (unemployment, or inefficient tax codes), but with the hidden objective of changing the social system of Europe without looking for democratic support.

The only exception are state retail sales and tax exempt savings accounts. C. Alan Garner shows by means of examples that VAT taxes, retail taxes, or even a flat rate tax are all equivalent ways of taxing consumption ( "Consumption Taxes: Macroeconomic Effects and Policy Issues", Economic Review of the Federal Reserve Bank of Kansas City, second quarter

2005).

Gravelle, Jane G. 2002. "Behavioral Responses to a Consumption Tax," in George R. Zodrow and Peter Mieszkowski, eds., United States Tax Reform in the 21st Century. Cambridge, UK: Cambridge University Press.

Altig, David, Alan J. Auerbach, Laurence J. Kotlikoff, Kent A. Smetters, and Jan Walliser. 2001. "Simulating Fundamental Tax Reform in the United States," American Economic Review, June.

The experience of the introduction of the Euro has precisely showed how the temporary ignorance of households was exploited by a non perfectly competitive distribution system, with permanent effects on prices.

For a proposal regarding mainly but not only France, see the forthcoming report of the Conseil d'Analyse Economique, by Christian Saint-Etienne and Jacques Le Cacheux.

Empirical results on the regressivity of consumption taxes give mixed results. François Bourguignon and Dominique Bureau show that the VAT for France is not regressive even with the current architecture of only two rates. (L'architecture des prélèvements en France, Rapport du Conseil d'analyse économique, n. 17, Paris, 1999). The retail tax levied in most of the US states, with its single rate, is on the other hand regressive as expected (Feenberg, Daniel R., Andrew W. Mitrusi and James M. Poterba. 1997. "Distributional Effects of Adopting a National Retail Sales Tax." In James M. Poterba, ed., Tax Policy and the Economy, Cambridge, Ma, MIT Press.).


European Parliament COMMITTEE FOR ECONOMIC AND MONETARY AFFAIRS

Briefing paper n° 2 -May 2005

Fiscal Indiscipline: Why no reaction yet by the markets?

Jean-Paul Fitoussi

Executive Summary

Two stylized facts emerge as we observe the evolution of public finances in the past few years. The first is a general trend towards a deterioration of fiscal positions, mainly due to cyclical factors (the persistently deceiving growth performance of the Euro zone).

The second, a remarkable lack of reaction of financial markets (long term rates) to this deterioration. This is a puzzling set of findings, as the theory tells us that long term rates should react to larger deficits either because they indicate future tightening of monetary policy, or because they require a risk premium. A first explanation of this puzzle is straightforward: markets have perceived the system as well designed in spite of the latest development and hence did not react to the worsening of fiscal position, seen as temporary and harmless; such an interpretation nevertheless may be dismissed on the ground that if the system was perceived as good and well functioning, its very recent modification (March 2005) should have triggered a negative reaction that until now did not materialize. A more convincing explanation recognizes that markets do not focus on public finances alone, but look at more general conditions concerning Saving and Investment. With such a global perspective in mind, long term sustainability does not seem more at risk today than it were a few years ago; hence, the lack of reaction of markets is all but paradoxical, but may simply reflect the lack of credibility of the current formal fiscal framework for Europe.

Introduction. A generalized deterioration of Fiscal Positions in the EMU.

The first five years of this decade have seen a general trend towards a deterioration of public finances in the Euro zone, and notably in the largest countries (Germany and France, but also Italy).

The Puzzle of Interest Rates Inertia

Besides the direct effect on the demand of loanable funds, the evolution of public finances, deficit and debt is supposed to affect interest rates through two channels. The first is the variation in country risk that yields an increase in the rates investors demand to hold bonds in their portfolio. Country risk, even if very weak, can explain the persistence of differences in the interest rates we observe in a monetary union. The other channel is the expectation of changes in future monetary policy. Standard theory sees the long term interest rate as the average of expected future short term rates. If the fiscal position deterioration triggers the expectation of a future ECB rate increase aimed at contrasting inflationary pressures, then long rates should also show an upwards tendency. While the empirical evidence on the relationship between debt/deficit and long term rates is mixed 2 , the main theoretical channels remain those we just outlined.

If we look at the behaviour of interest rates we can observe a second somehow puzzling fact.

The past two years have witnessed increasing turbulence, with the European economies trapped in a low growth -high deficit path, with conflicts among European institutions, with an exhausting debate on the reform of the Stability Pact, and with the general perception of an increasingly lax fiscal stance; thus we have witnessed, at least apparently, a weakening (first de facto and then de iure) of the fiscal framework for Europe, that should have entailed a sizeable increase of long term rates. Yet, in spite of all these elements, interest rates spreads (that we measure here as the difference between real long term rates of selected European countries and the equivalent in the US) did not react as could be expected, as can be seen in figure II. In fact, we can observe first that since the beginning of 2003 there is no clear upward trend in the spread. (If one looks at the level of interest rates rather than at the spread, one sees that there is no tendency towards an increase in the level of European interest rates; rather the contrary). Then, we can also see that the countries that had more trouble (France and Germany on one side, and Greece on the other) do not show a tendency that contrasts with the average of the Euro zone. The two light grey areas highlight two particular episodes that can be identified as crises. The first is the clash between the Commission and the Council, in November 2003, when the latter refused to follow the recommendation of the former to 2 In fact, a great number of other factors may play a role, as the behaviour of private savings, the Ricardian behaviour of consumers, the inflationary effects of public deficit, the distance of the economy from its potential income, and so on. Thus, it is not surprising that empirical analyses are unable to robustly assess the sign of the relationship.

start an excessive deficit procedure against France and Germany. The second, in the fall 2004, when the frauds regarding Greece's national accounts became public knowledge. In both cases, the evolution of the spreads for the countries concerned was completely in line with the Euro zone average, showing a substantial indifference of the markets for the political and institutional evolution.

Alternative explanations of the puzzle

The puzzle can be tentatively explained in two different ways. The first is to consider that the SGP has substantially well functioned; in spite of the recent deterioration of public finances, and of the breaching of the 3% limit by the most important countries of the EMU, the use of fiscal policy as a countercyclical tool was negligible. The following table shows cumulated fiscal impulses (i.e. the change in cyclically adjusted budget deficit ratio) since 2000, highlighting a striking difference between the Euro zone on one side, the US and the UK on the other. Not only, the cumulated impulse is about 0.5 per cent of GDP, but it went down, between 2002 and 2003, (of 0.4 points, from 1.0 to 0.6), denoting a mildly procyclical fiscal policy in the Euro area. Thus the table shows that if the SGP was breached de iure, it was de facto very effective in constraining fiscal policy. If this is the case, and if markets perceived this adherence to the fiscal framework as credible and good, then it is no surprise that long term rates did not move during this turbulent period: the deterioration of public finances has simply to be attributed to cyclical factors, with a very "responsible" behaviour of fiscal authorities as far as the sustainability of public finances is concerned.

But this interpretation encounters a problem once we dig deeper into the events. If the interest rate inertia could be explained by a substantial adherence of governments to a rule perceived by markets as good, then, we should have observed a change of attitude of markets once the debate on the pact headed towards a reform supposed to substantially slacken the constraints.

In other words, if markets had trust in the old framework, they should have reacted negatively to its modification. This is what was hinted by the ECB governing council in the statement we cited above, but until now there is not trace of such a reaction.

We can then advance a second line of interpretation, based on the recognition that markets have a broader perspective than to simply focus on public sector debt. Then, we can observe that in the past few years the increase of deficits has been matched by an increase in private savings, due to the "quasi-stagnation" of the economy. The increase of private savings, together with the cyclical nature of public deficits, reduced the possibility of a textbook type crowding out of private expenditure. In fact, a look at the "critical gap", i.e. at the difference between the real interest rate and the real growth rate, shows that it has been substantially decreasing since the first quarter of 2003, a sign that long term sustainability is not at risk (figure III). Thus, if we take this broad perspective, we can conclude that the long term prospects of public finances are no worse today than they were only a few years ago; they are better, if anything. Then it is no surprise that long term rates did not increase following the latest developments.

This brings us to the more general question of the current European institutions and of their fitness for the scopes set forth in a monetary union.

We argued that from the markets viewpoint, credibility and sustainability of fiscal policy are associated with long term solvency; on the other hand, the framework currently in place in Europe does associate credibility with the respect of quantitative limits. The two notions of credibility coincide only when the quantitative limits are in fact designed to guarantee long term sustainability of public finances, i.e. when the fiscal rule is appropriately designed.

When it is not the case, then markets will ignore the respect of the rule, and focus, as happened in Europe, on other factors.

In fact, the SGP blends an excessively strict long term objective (the requirement of a budget "close to balance or in surplus over the cycle" yields in fact a long term tendency towards a zero level of debt), with a monitoring scheme that is based exclusively on short term indicators, as the yearly deficit. As many argue, this mix is too straight a jacket to be credible, as most of the time it would require a procyclical fiscal policy. From a long term perspective, such a policy may be so destabilizing that it may (indirectly) lead to unsustainability. Thus it is not surprising that markets did not react to a revision of the SGP, if they consider the new framework as less destabilizing.

Figure III. The Critical Gap for the Eurozone

-3 -2 -1 0 1 2 3 4 5 Q 1 9 9 Q 3 9 9 Q 1 0 0 Q 3 0 0 Q 1 0 1 Q 3 0 1 Q 1 0 2 Q 3 0 2 Q 1 0 3 Q 3 0 3 Q 1 0 4 Q 3 0 4 % Real interest rate (Repo)
Real GDP growth rate

Critical Gap

Source: Datastream

The consolidated deficit of the Euro zone has in the recent past been among the lowest of OECD countries (see table II). Furthermore, a number of important structural reforms that significantly reduce implicit government liabilities were put in place by some large European countries. These factors were most likely considered more important in ensuring, long term sustainability, than the widely publicized but substantially unimportant formal infractions to the SGP threshold. These conclusive remarks also point at a further hypothesis, not necessarily alternative to the previous one. The lack of reaction of markets to the changes in the European fiscal framework may be ascribed to the fact that the change in the rules has done nothing than internalize a change in behaviour that had already been incorporated in market values. This carries the important implication that, being impossible to foresee if and how the new framework will alter the behaviour of governments, it is also very hard to forecast the direction of market changes. In fact, were the applications of the new rules in the next months perceived as allowing more convincing countercyclical fiscal policy, we could even observe a positive reaction of markets. The missing element, in today's Europe is growth, not long term sustainability.

  Figure I shows that both debt and deficit, for France and Germany, have been above the Maastricht reference values since 2002. A number of smaller countries have seen their finances deteriorate as well, and the euro zone average is close to the limit. The main explanation of this deterioration is the prolonged slowdown of the European economy. While the US quickly recovered from the 2001 recession, Europe got trapped in a period of slow growth, characterized by inertia in the conduct of both monetary and fiscal policies.

Figure

  Figure I. Public Finances Deterioration

  1 "Statement of the Governing Council on the ECOFIN Council's report on Improving the implementation of the Stability and Growth Pact". 21 March 2005 (http://www.ecb.int/press/pr/date/2005/html/pr050321.en.html).

Figure

  Figure II. Spread on LongTerm (10 Year Government Bonds) Rates

Table I . Cumulated fiscal impulses

 I

	Japan	0.6	-1.1	0.1	0.2	-0.4
	Source: OFCE
		2000	2001	2002 2003 2004
	Euro Zone	0.5	0.9	1.0	0.6	0.6
	UK	0.2	0.8	2.9	4.5	4.6
	USA	-0.7	0.7	3.9	4.7	5.0

Table II . Budget Deficit as a % of GDP

 II

		2003	2004	2005* 2006*	Average 2003-2006
	Euro Zone	2.7	2.9	2.7	2.6	2.7
	USA	4.6	4.3	4.0	3.5	4.1
	UK	3.3	3.4	3.0	3.0	3.2
	Japan	7.7	6.5	6.6	6.4	6.8

*: Forecasts

Source: National accounts Eurostat and OFCE forecasts