European Affairs

Spring 2002

 

Special Report: Managing Europe's New Money
Europe Is Doing Well, But Needs Further Reforms
Klaus P. Regling

 

In 2001 the world economy went through a synchronized slowdown as four simultaneous global developments reinforced each other. First, the economic downturn was initiated by a common oil price shock in 2000, followed in the euro area by a rise in food prices. Second, monetary policy was tightened, quite appropriately in view of rising inflation. Third, the bubble in the information, communications and technology sector burst. Fourth, world trade did not grow in 2001 for the first time in 20 years.

These four common shocks hit the euro area like all other major economic regions of the world. But, the euro area was affected more than it would have been 10 or 20 years ago as, in addition to the traditional trade links, the effects of the shocks were amplified by intensified cross-border corporate linkages, increased financial interdependence and heightened correlation in business and confidence indicators. As a consequence, growth in the euro area fell from 3.4 percent in 2000 to 1.6 percent in 2001, and was still contracting in the fourth quarter of last year.

In the spring of 2002 there is growing evidence of a global, simultaneous upturn. In the United States, the upturn started as early as the fourth quarter of last year, with consumption surprisingly strong, and growth continued at a very high rate in the first quarter of this year. Our forecasts show a deceleration from these high rates in subsequent quarters, as the inventory effect disappears, but for the 2002 annual average we see a healthy growth rate of 2.7 percent.

The rest of the world, particularly emerging markets, will benefit from developments in the United States, and from the revival of world trade. Japan is the exception, but even there real Gross Domestic Product may stop declining.

In the euro area, most business confidence indicators bottomed out in November 2001 and industrial production is now also moving into an upward trend. Consumer confidence did not fall below its long-term average, but household demand has remained sluggish so far.

Initially, therefore, the recovery is moderate and based on the unwinding of the shocks which caused the slowdown, on a rebuilding of inventories, a return of confidence and a pick-up of international trade.

As the past interest rate reductions and the working of the automatic stabilizers take effect against the background of an improved international environment, the euro area economy will gain momentum leading to an annual growth rate of 2.6 percent in the fourth quarter of this year. However, the contraction of GDP in the last quarter of 2001 weighs heavily on the annual average growth rate in the current year, which is likely to remain limited to 1.4 percent.

In 2003, the euro area is projected to achieve above potential growth as it remains free from major internal and external imbalances. It will benefit from limited over-capacity, healthy saving rates of households and a sustainable current account balance. All member states should benefit from the pick-up, but not to the same extent.

Private consumption, helped by the downward trend in inflation and brighter employment prospects, holds the key to faster growth. Investment in equipment will still contract on average in the current year, but a turnaround is in the offing as spare capacities are absorbed and demand prospects brighten.

Compared to the United States, euro area growth may appear to be lagging behind, in the 1990s as well as during the forecast period. But if one makes a correction for population growth, this is much less evident.

The reason is that the U.S. population grows by about one percent per year, against a population gain in the euro area of less than 0.25 percent. Consequently, even if productivity gains in Europe accelerate to U.S. levels, the goal the European Union set itself in Lisbon two years ago, headline GDP growth would still lag behind the United States.

The slowdown took its toll on the labor market, but the damage is likely to be smaller than in previous cyclical downturns, thanks to past structural reforms. After the strong employment creation of previous years (note that nine million jobs were created between 1997 and 2001 in the euro area, one million more than in the United States), employment creation will be very subdued, at 0.3 percent in the current year, before rebounding to 1.1 percent in 2003. In four countries, Germany, Austria, Finland and Sweden, overall employment is expected to decline in 2002.

Unemployment will be on a rising path until the third quarter of this year, before resuming its downward trend so that the average unemployment rate in 2002 will not rise above 8.5 percent. Next year, at 8.1 percent, it could be even marginally lower than the average unemployment rate in 2001.

The decline in inflation since June 2001 was interrupted at the start of 2002 by changes in indirect taxes, a surge in food prices and a marginal increase stemming from the introduction of euro bills and coins. The downward trend of inflation should resume as the direct impact of these shocks fades, but the indirect effect is still being felt, which explains why inflation is slow to fall. The inflation rate is forecast at 2.2 percent this year and two percent in 2003, compared to 2.5 percent in 2001.

In this context and in the light of the low increase in labor productivity last year (for cyclical reasons), it is important to maintain wage moderation. Wages are expected to increase at about three percent per year in the euro area in 2002 and 2003, somewhat faster than in previous years. However, as productivity gains will accelerate, in line with the recovery, unit labor costs should increase less than last year.

The actual general government deficit in the euro area last year worsened to 1.3 percent of GDP from 0.8 percent in 2000 (excluding UMTS licenses1). The underlying structural deficit widened to 1.5 percent of GDP from 1.3 percent, but the ongoing process of tax reduction and reform to strengthen the supply side of the economy is partly responsible for that. As member states intend to resume fiscal consolidation, the deterioration in the actual government deficit in the euro area to 1.5 percent of GDP in 2002 is marginal and of a cyclical nature.

The economic slowdown in 2001 represented the first real "stress test" for macro-economic policy making in the European economic and monetary union. This policy line consists of letting the automatic stabilizers work but not embarking on active demand management.

All countries are committed to maintaining or reaching budgetary positions that are close to balance or in surplus by 2003-2004, and this prudent fiscal stance was confirmed in the latest round ofstability programs and by the European Council in Barcelona in March.

Budgetary projections of the Commission indicate that Germany, France, Italy and Portugal have to step up their efforts to bring government accounts close to balance or into surplus. For all countries, as the recovery gains strength, the next test of the Stability and Growth Pact will be not to waste the "growth dividend" by relaxing fiscal policy, as too often happened in the past.

So, the short-run prospects are rather bright for Europe and the world economy. Output growth has resumed and is expected to reach and exceed potential in the second half of this year and into next year.

Sound fundamentals and macro-economic stability have placed the EU economy in a good starting position for a decent economic performance in the medium run. Since the second half of the 1990s, this environment has contributed to strong employment growth and allowed for a modest increase in the potential growth rate of about 0.25 percent.

Despite the progress made, however, potential growth is still rather low in the European Union. This limits the scope for a stronger economic performance in the medium run. Capacity constraints will eventually limit the extent of the economic expansion and result in upward price pressures.

Moreover, in the long run, when labor supply dries up as the effects of aging populations are fully felt, the potential growth rate is expected to be pushed down, in the absence of productivity accelerating measures.

Consequently, the European Union's structural policies are focusing on three objectives: 1) raising labor force participation and employment; 2) strengthening conditions for high productivity growth; 3) promoting sustainable development.

The EU unemployment rate has fallen by more than three percentage points since the mid 1990s. Despite this impressive performance, human resources are still under-used in the European Union. Unemployment, and in particular long-term unemployment, is still high in a number of member states. This points to structural problems.

Moreover, labor force participation rates are unsatisfactory, especially for older workers and women, and significant efforts are needed to raise them to the targets set in Lisbon and to take account of the impact of aging.

Measures aiming to "make work pay" (such as modernizing tax and benefit systems), supplemented by participation enhancing facilities (such as increasing child care facilities) need to be intensified to raise the labor supply and the participation rate.

Making full use of human capital also implies that employment policies are not limited to increasing the quantity of labor supply. The importance of knowledge and skills is ever increasing. Ensuring the quality of human capital requires a sound foundation in basic education, a better school-to-work transition, and closer links between higher education and the labor market.

In the light of developments in the past few years, it should not be impossible to achieve the Lisbon targets, if policy efforts to improve labor market performance continue unabated.

In the long run, the development of standards of living is broadly determined by the rate of productivity growth. Disappointingly, the strong employment growth that started in the second half of the 1990s has not been accompanied by a strong labor productivity performance.

In fact, productivity growth actually slowed by half a percentage point on average between the first and second halves of the 1990s. Comparing the EU member states to the United States, the leeway to increase productivity and employment performance in Europe is considerable.

Member states therefore need to promote an environment favorable to investment and innovation. Measures are needed to liberalize, open up, integrate and build competition in European goods and services markets. More efficient and integrated product markets contribute to lower prices by increasing pressures on firms to price competitively and keep down labor and capital costs through increased competition.

A more flexible productive system will shift resources where they can be most profitably employed. Economic reforms thus improve productivity and enhance employment opportunities.

Although significant progress has been made, there is still a lot of potential for improving market competition and the entrepreneurial environment. The completion of the Single Market continues to be a priority. Efficiency in product markets will be further enhanced by reducing the overall level of state aids, breaking down artificial (regulatory and technical) barriers that continue to segment many markets and hamper market entry, and by reinforcing competition in network industries (energy, rail, air transport and postal services).

Achievement of a single market for capital is a necessary counterpart of the Single Market for goods and services and will enhance the efficiency of channeling savings to investment.

The ultimate objective of economic policies is, of course, to increase the well-being of citizens, now and in the future. From this perspective, two main policy challenges stand out: safeguarding environmental sustainability and preparing for the aging of the population.

First, economic policies can make an important contribution to enhancing environmental sustainability. Member states should make more use of economic instruments like taxation and insurance liability schemes, which permit a cost-effective and consistent introduction of the polluter-pays principle.

Second, the impact of aging populations will not be limited to the budget. Aging will also pose important economic and social challenges. To address these, the Commission recommends that member states pursue a comprehensive strategy, including reform of pension and health care systems, in order to place them on a sound financial footing, and efforts to increase employment. Such measures would also contribute to the necessary safeguarding of sustainable public finances.

As a result of population aging, the risk cannot be ruled out that large budgetary imbalances - in breach of the requirements of the Stability and Growth Pact - may emerge in the future in several countries. In this context, delays in budgetary consolidation could have long-term consequences as there is only a limited window of opportunity to prepare before the impact of demographic changes begins to be felt.