Economic and monetary union (EMU) has promoted prosperity and encouraged economic integration. However, the euro area as a whole has experienced low growth and a lack of resilience. These issues are related. Many of the structural rigidities that restrain growth also reduce the economy’s ability to absorb shocks. In the public debate, the union’s poor performance in these two areas has often been blamed on the single currency itself. However, this criticism is misguided. The economic problems are mainly structural; the solutions therefore are largely in the hands of individual member governments. Thus, the primary policy challenge for the euro area is to improve growth and resilience by boosting economic flexibility. The second challenge is to get fiscal policy back on track. Population ageing will hold back growth in coming decades and will have large implications for fiscal policy in all euro area countries. This Survey discusses all these issues, but puts more emphasis on the macroeconomic factors. The more structural issues will be dealt with in greater depth in the 2007 Economic Survey of the European Union.

The euro area encompasses a diverse group of economies. Some are among the wealthiest in the world, others are behind in terms of living standards. Some are booming, others have been weathering a long slump. Some sectors are flexible and quick to adapt to changes in the global economy, others remain rule-bound and rigid. Managing such diversity is a challenge. Adopting the single currency has brought considerable benefits to the euro area’s members by ensuring macroeconomic stability, boosting trade and deepening economic integration. Despite stark divergences in economic performance, price levels in member countries are converging on average rather than diverging. However, these divergences mean that a common monetary policy will not suit all countries all the time. The members face different shocks and respond to them in diverse ways. The solution is to undertake structural reforms to make economies more flexible and resilient. These include making wages more responsive to local economic conditions, boosting employment flexibility and labour mobility, reducing the stickiness of inflation by enhancing competition, and creating an efficient, pan-European financial market. The more flexible and integrated product, labour and financial markets become, the smoother the ride inside the monetary union will be. These reforms will not only promote faster adjustment to shocks, they will help overcome the main problem that many euro area countries face: slow potential growth.

Inflation has been well anchored around but slightly above 2% despite large increases in energy prices. Rising energy costs are putting pressure on the prices of a wide range of goods and services but the feed-through has been muted compared with past oil shocks. The ECB has been removing monetary accommodation to address risks to price stability now that the recovery is on a surer footing. The pace of tightening has been influenced by what it sees as significant medium-term risks to price stability, although there are downside risks as well such as the possibility of a disorderly unwinding of global economic imbalances. Its risk assessment is influenced by the recent strong growth in money and credit aggregates, although there are questions about how reliable they are as guides for policy. Monetary policy is made more difficult by wage stickiness and inflation inertia. Greater labour market flexibility and more competitive financial and product markets would help speed up the transmission of monetary policy and reduce cyclical divergences across the euro area.

Fiscal policy outcomes in the euro area are mixed: several countries are characterised by large deficits and high debt, while others have managed to keep their public finances sound. This chapter assesses the fiscal performance and takes stock of the redesigned Stability and Growth Pact (SGP). It discusses how fiscal policy can be reformed to improve outcomes. It emphasizes the urgency of seizing the opportunity that the favourable cyclical situation provides to introduce changes – starting with expenditure restraint – that would restore the sustainability of public finances, especially in high-debt countries. A key requirement for better fiscal outcomes in the euro area is that member states should embrace the EU objectives of achieving budget balance and keeping debt in check as national priorities. National medium-term fiscal frameworks and EU surveillance can play helpful roles in supporting progress in this direction.