And what of short-term fiscal dynamics in the euro area? President Draghi recently underscored the importance of fiscal policy as a short term stabilisation tool as well as the difficulty of utilising it in the current imperfect union. Consider the following comparison between the euro area and the UK. In the euro area, the private sector continues to generate surplus savings of 3½% of GDP (Chart 7). Those must be recycled effectively to generate an expansion. The UK no longer faces that challenge. Its private sector is in balance. The euro area unemployment rate of 11½% is twice that in the UK. Gross general government debt in the euro area is roughly the same as in the UK and below the average of advanced economies. The weighted average yield on 10-year euro area sovereign debt is around 1%, compared to 1½% in the UK. And yet, the euro area’s fiscal deficit is half that in the UK. It structural deficit, according to the IMF, is less than one third as large. It is difficult to avoid the conclusion that, if the euro zone were a country, fiscal policy would be substantially more supportive. However, it is tighter than in the UK, even though Europe still lacks other effective risk sharing mechanisms and is relatively inflexible. A more constructive fiscal policy would help recycle surplus private savings and mitigate the tail risk of stagnation.
For instance, fluctuations in private consumption are considerably larger in Iceland than in other developed countries, and much greater than can be explained by fluctuations in external conditions. But there is a certain problem concerning the implementation of various types of exchange rate peg, in that studies of the structure of the Icelandic economy suggest that a flexible exchange rate is in some ways a beneficial arrangement for Iceland. It is also clear that concluding Iceland’s EU membership application will take some time and, if Iceland does choose to join the EU, adopting the euro will take even longer. As a consequence, it is very important to ask whether monetary policy, demand management in general, and the regulatory and supervisory framework of the financial sector can be reformed in such a way as to make a flexible exchange rate on the basis of the Icelandic króna an attractive option without sacrificing free movement of capital. Such a solution could benefit Iceland either in the run-up to euro area accession or for the longer term. The Central Bank report entitled Monetary policy in Iceland after capital controls contains a discussion of possible reforms aimed at addressing the shortcomings in demand management and the regulatory framework before the financial crisis. A subsequent report, Prudential rules following capital controls, outlines the regulatory framework that would reduce the financial system risk that can accompany free movement of capital. Together, the recommendations in these two reports would make domestic monetary policy more effective and would hopefully reduce excess exchange rate volatility.