European Affairs

Spring 2002

 

Special Report: Managing Europe's New Money
The EU Is Beginning to Embrace Economic Change
Rodrigo de Rato

 

The worst of the recent economic slowdown is now generally thought to be over in both Europe and the United States. In Europe, the downturn was more severe than expected. At the beginning of last year, it was commonly believed that the United States would bear the brunt of the slowdown.

As the year progressed, however, although Europe as a whole maintained growth at a little below two percent, the big European economies were worse hit. Some of them, like Germany, followed the U.S. cycle rather closely.

In the last quarter of 2001, the period immediately following the terrorist attacks of September 11, the four largest European economies - Germany, Britain, France and Italy - all performed less well than the United States.

On the other hand, Europe has maintained macro-economic fundamentals that are probably more solid than in the United States, especially in the relationship between savings and investment. European consumption and residential construction has remained relatively strong.

Medium to small European economies, such as Spain, the Netherlands and Ireland, have been doing much better in recent years than the larger economies. Spain, for instance, has outperformed the European median growth rate for the past five years and brought its budget into balance in 2001.

An important conclusion to be drawn from the events of last year, however, is that Europe has greater difficulty in absorbing economic shocks than the United States, largely because of the flexibility of the U.S. economy.

But if prospects for the world economy look fairly good for this year and even better in 2003, a number of risks remain. One is that increases in oil prices could damage the U.S. and European recoveries by increasing inflationary pressures and by reducing the spending capacity of households and businesses.

My opinion, and that of most European authorities, is that recent oil price levels of $23 to $27 a barrel will not be enough to undermine Europe's recovery, and that the European economy will be growing at a rate of as much as 2.5 percent by the end of the year.

The second risk to the world economy is the possibility that the United States could face difficulties in financing its current account deficit, now running at about four percent of Gross Domestic Product. That could lead to a sharp fall in the value of the dollar, which could disturb the world economy.

The third risk is a collapse in financial markets, which have been volatile in recent months. But as the recovery grows stronger, the outlook for corporate profits will probably improve, keeping stocks at around their current levels.

We cannot ignore the risk of protectionism. Trade relations between the United States and Europe have become highly sensitive as a result of numerous disputes, for example over U.S. steel tariffs and privileges granted to American companies under the Foreign Sales Corporation tax regime. We must try to settle these problems through negotiations without either side retreating to entrenched positions.

We should not, however, underrate the risk that these disputes will lead to increased protectionism. That would be particularly dangerous at a time when we shall need a favorable global trade climate if we are to solve the problems we are seeing in developing economies, not least in Argentina.

Intervention by international institutions will not be enough to solve these problems. The countries concerned will need to get back to real economic growth, which can only come through trade.

It would be a tremendous mistake on the part of the United States and Europe to halt the drive to freer world trade as a result of their bilateral disputes. Although our disputes are certainly significant, we should be able to resolve them in a positive way.

In Europe, 2002 will certainly find its place in the history books for many reasons, one of which will undoubtedly be the success of the euro. We are all very much aware that there were doubts about the euro in some European countries and in the United States.

I believe, however, that those doubts were dissipated by the smooth introduction of euro bills and coins at the beginning of this year. The changeover was extremely quick, and it was well received by public opinion in all 12 countries of the euro area.

The existence of the euro is now a fact, and, in my opinion, a positive fact, not only for Europe, but also for the world economy. The euro certainly made it easier for Europe to react to the events of September 11, and to their impact on the international economic and financial system, in a synchronized and coordinated manner.

Another European claim to fame in 2002 has been the achievement of a significant degree of macro-economic stability. But despite what are probably stronger economic fundamentals than the United States, Europe has still been growing more slowly than the United States for the past ten years.

That is a remarkable development that shows where the weaknesses of the European economies lie. The weaknesses are to be found, in my opinion, in the relatively weak growth potential of the European economy, which has not increased even with the arrival of the information society.

The problem is not that there are no computers in European businesses, homes, and schools. It is rather that European markets are too rigid to take full advantage of gains in productivity stemming from the new information technology as the United States has done.

This demands a response not so much on the demand side but on the supply side, by which I mean structural market reforms. This was basically recognized in Lisbon two years ago, when EU leaders launched a plan to make Europe the world's most dynamic society by better exploiting the new technologies.

To do that, we were supposed to carry out a series of structural reforms. In 2001, however, at a summit meeting held during the Swedish presidency, there was a great deal of reluctance to accept timetables for reform and market-opening measures.

EU leaders did better at their third "reform summit," which was held in Barcelona this spring with Spain presiding. They agreed on an important list of structural reforms, often with timetables and measurable objectives.

Those commitments have not only changed the future direction of economic policy in important areas such as energy, transportation, financial services and labor markets; they have also clearly endorsed the view that structural reform is one way to achieve faster growth.

At the same time, when the European slowdown began last year, and the economic fall-out from September 11 began to be felt, there was a debate in both Europe and the United States over the role that expansionary budgetary policies could play in managing modern economies.

On both sides of the Atlantic there were demands for a return to Keynesian practices of deficit spending to stimulate growth. Europeans have the impression such policies were more widely embraced in the United States than in Europe.

Most EU countries accepted the theory that budgets should be maintained within their targets without additional expenditure. Only automatic stabilizers would be allowed to operate, and more so in countries where budgets were in or near balance.

The adoption of that view was especially remarkable considering that six of the 12 countries in the euro area had general elections scheduled in the following few months. Governments were, at least to a degree, able to resist pre-election spending pressures, and budgetary policy in 2001 was mainly neutral.

In Europe there is now greater acceptance by governments that they are more likely to achieve economic growth through structural reforms than by increasing public spending to boost demand. Most of the time, of course, structural reforms are easier to proclaim than to achieve.

Nevertheless, in areas like electricity and gas, financial services, trans-European energy networks and labor markets, we now have a clear doctrine and, in some cases, quantitative objectives and timetables for reform. This should allow the European economy to become more flexible and enhance its growth potential.

That is the best contribution that Europe can make to the world economy. I understand full well that the question from the U.S. point of view is whether Europe is capable of pulling its weight in generating demand from economic growth; and how it will be done.

The response from Europe is that it will be done through macro-economic stability, regional integration, the euro and its future beneficial effects, and structural reforms to enhance growth potential.

In one area, however, reform will certainly be very difficult in most countries, and that is the labor market. The Barcelona summit meeting certainly stressed that labor market reform is needed for more jobs, so we have abandoned the theory that jobs are exclusively a product of economic growth.

Of course, jobs can be created by economic growth, but they are also a function of many other factors. These include labor market conditions, the relationship between wages and productivity, the age of the work force, the participation of women in the labor market, worker mobility, and the balance between welfare payments and incentives to work.

Labor market reform will undoubtedly be interpreted in different ways in different countries, but it is clear that, as of now, all 15 EU countries are committed to moving in this direction.

We are also debating the question of good governance. The issue has been highlighted by the collapse of Enron. But we are all aware that good governance, especially of publicly listed companies, has become extremely important as more and more families use financial markets as depositories for their savings.

Good governance and transparency in financial markets are becoming something very similar to a public service that our citizens demand. This is a substantial change from a political point of view. Governments usually respond to demands for public services, and that is going to be the case with financial markets. In my opinion, it will be a good response.

This summer, the European Union will adopt its first policy position on good governance in Europe. This is going to be one of the important issues that governments and the EU institutions will have to face in the near future.

The European Union's main challenge now is to take full advantage of its strong economic fundamentals and its progress toward deeper integration. To do so, it must place structural reform at the top of its economic policy agenda. I think it has done that, and the agenda should now be taken up by national governments and parliaments in the coming months.