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European Affairs
European Integration
The EU's Economic Reform Agenda Has Been Blown Off Course
By Stewart Fleming
On a sparkling spring day in Lisbon in 2000, at the end of a regular summit meeting, the leaders of the European Union pronounced themselves thoroughly disenchanted with their continent's woeful economic performance, especially when compared with America's "new economy."
They committed themselves not just to reform, but to transform their nations' economic fortunes. Their communiqué declared proudly, if not entirely convincingly, that they had set themselves the goal of surpassing the United States and making the European Union "the most competitive and dy---namic knowledge – based economy in the world."
They even set a date, 2010, when this economic miracle was to be accomplished. And, to add a touch of credibility to the rhetoric, established a series of targets for the implementation of key structural economic reforms.
Now fast forward to a spring day this year in Brussels, a March day also blessed, remarkably, with clear blue skies and bright sunshine. Once again the EU heads of state and government have assembled, this time to see how far they have come in their quest for global economic leadership over the past three years.
There is, however, nothing sunny about the mood inside the gaunt Justus Lipsius building in the center of the city. This is not just because of the rancorous atmosphere stirred up by divisions over the U.S. decision to go to war in Iraq.
The war has pushed the prime purpose of the summit into the background. And that perhaps is a blessing in disguise, for there can now be no illusions that, whatever progress has been made in specific areas, the European Union has been blown off the course of far-reaching economic reform that it charted in Lisbon.
Just how far off course was clear from the summit meeting's final communiqué, which urged EU members to accelerate their efforts to create a single market in financial services, to try to engineer "the right conditions" for higher levels of research and development and to "address more effectively the challenges from aging populations." Virtually the only concrete decision to emerge from the meeting, itself indicative of fears that the economic reform process is becoming bogged down, was a call for the establishment by the European Commission of a European Employment Task Force (EETF) to speed up labor market reforms.
Even the pro-European London-based Centre for European Reform (CER) has only given the European Union a depressing C+ for progress on the Lisbon agenda in the past year. The rating is contained in a study by Alasdair Murray, The Lisbon Scorecard III: The status of economic reform in the enlarging EU, which looks in detail at each of Lisbon's economic targets.
The Commission does not seem to disagree with this judgment. In a pre-summit report to the EU Council it criticized member-states for the "sluggish pace of reforms." The Commission chided its political masters saying, "The overall picture that emerges from this review is rather disappointing. The reaction to the (global) slowdown in economic growth is characterized by policy inertia and backtracking."
Since the Lisbon summit meeting, the European Union has continued to grow more slowly than the United States, at a rate of 1.9 percent per year, compared with a U.S. rate of 2.1 percent. In 2002, the EU growth rate took a worrying dip – to 0.9 percent. There are no signs yet this year of the long awaited recovery.
Germany is hovering on the brink of recession, with an unemployment rate back above the ten percent mark and the government wondering whether it can forecast 0.2 percent growth for this year without damaging business confidence. Official forecasters, including the European Central Bank (ECB), have slashed their growth projections for the euro zone to a meager one percent for 2003.
There can be no question that the appetite for reform is suppressed when the economic climate chills. But not all the blame for the halting efforts of several leading EU countries to push ahead with the Lisbon reform agenda can be attributed to the malaise in the global economy. Or blamed on American policy-makers, led by the dominating Federal Reserve Board chairman Alan Greenspan, who lost their collective heads in the late 1990s and allowed an asset price bubble to destabilize first the U.S. and then the world economy.
For even before the global economy began to slow down, signs had already appeared that the pace of reform was suddenly faltering. A deadly combination of irrational insouciance, triggered by the economic boom of the late 1990s, coupled with fast approaching general elections, notably in Italy, Germany and France, inspired political leaders to put troublesome reforms into cold storage. They judged, correctly, that voters would have no stomach for painful new initiatives.
To the dismay of smaller countries like Finland which had taken seriously the strictures of the euro zone's Growth and Stability Pact, budgetary discipline collapsed in several countries – a symptom of the reform inertia that so worries the Commission and the ECB. Budget deficits in France and Germany are breaching the three percent ceiling specified in the Pact, rather than moving toward balance as both the Pact and the Lisbon economic framework require.
The Lisbon reform agenda ranged widely. It covered not only the need to promote entrepreneurship and innovation, but also to reduce business regulation, increase competition in services, including financial services and, most importantly, to increase employment and continue cutting unemployment. In other words it called for a new drive to make the promise of the EU Single Market a reality.
The agenda attached particularly high priority to employment policy, setting a goal of raising the proportion of the adult population in jobs from 60 percent to 70 percent – close to the U.S. level – by 2010. The female participation rate was to be raised to 60 percent and that of older workers to 50 percent.
With the outstanding and much publicized exception of Germany, Europe is making more progress than it is often credited with in reducing unemployment. Even in Germany, Chancellor Gerhard Schröder has begun to step up pressure on labor union leaders to accept modest labor market reforms, including an easing of strict rules on job protection, a cut in unemployment benefits and more local wage bargaining.
Deutsche Bank, along with many others, lays the blame for Germany's dismal growth record squarely on employment policies that give German workers some of the longest holidays, shortest working hours and most generous social security benefits in the world. Between 1997 and 2001 per capita growth in the German economy averaged 1.75 percent a year, compared with 2.24 percent for France and the United States, the bank says. The increase in total German economic growth has averaged only 1.8 percent over the last five years, compared to 2.9 percent for France and 3.4 percent for the United States, according to the Organization for Economic Cooperation and Development.
Outside Germany, however, the European Union has registered significant gains in enticing specific groups of workers back to work, especially women and young people. This does not just reflect the cyclical economic upswing of the second half of the 1990s. Active pro-employment policies in many countries have played a big part.
Until last year's economic slowdown, there was a steady reduction in EU unemployment from over ten percent in 1995 to 7.3 percent in 2001. Over the same period, the Commission says, 12 million jobs were created. Many of them were for women, a response in part to moves that countries like France and Spain have made to encourage part-time working.
The Commission estimates that even though unemployment rose last year as the EU economy slowed, some 500,000 extra jobs were still created. So the European Union has seen an end to the "jobless growth" of the mid-1990s, and last year jobs were even created as growth slowed.
But even as EU officials congratulate themselves on this success, a worrying longer-term aspect of labor market pros-pects has come into sharper focus. This is the threat that aging and shrinking populations pose to the European Union's growth prospects and government finances.
In a detailed assessment last year, the Commission warned that these demographic changes could reduce Europe's underlying long-term economic growth rate from around two percent to 1.25 percent by 2050 – and even less if productivity declined as a result of the aging process.
This would be a disaster, especially when measured against the Lisbon goal of actually raising the long-term growth rate to three percent – again a barely credible target seen from today's perspective.
Another, related, worry has moved to center stage. Governments have finally recognized that the 1980s and 1990s policy of encouraging early retirement to try to reduce unemployment is now backfiring. The policy will aggravate the looming shortage of labor and put further strains on over-generous government-financed pension systems.
An indication of just how disturbing this issue has become came at last year's Barcelona summit to review progress on the Lisbon program. The leaders agreed to try to raise the actual retirement age to 65 in order to cut pension costs and increase the supply of labor.
Rising pension costs present a real threat to national government finances in countries such as Germany, France and Italy. Unless reforms are made, pension costs could force governments to increase already burdensome tax levels, limit their freedom of maneuver in reordering budget priorities and squeeze spending on other vital services. Such developments would both heighten social tensions and make several European countries even less attractive places in which to do business.
Although these threats are now fully appreciated, so far few major countries have made much progress toward pension reform. France and Italy have not even begun to address the need for systematic reform, according to the CER.
Without pension reforms it is hard to imagine the French government being able to achieve even such short-term priorities as privatizing its giant, state-owned gas and electricity utilities, Electricité de France and Gaz de France. Workers in both groups have already signaled that they oppose changes to their bounteous pension arrangements.
Germany too has made only a cautious start on pension reform. In 2001 it began cautiously to trim benefits and capped future social security contribution rates, a sure sign of its worries about the impact the pensions crisis could have on the state's fiscal stability. With trade union backing, it also created incentives to join private pension schemes. But its citizens are not embracing the opportunity with much enthusiasm, especially after the stock market crash, in which German share prices fell as steeply as in the Great Depression.
It is not only in continental Europe that pension systems are in chronic ill health. Former Prime Minister Margaret Thatcher's pension reforms have progressively eviscerated the value of Britain's state pensions. Now the collapse in share prices has accelerated the corporate stampede away from generous, company-sponsored, defined-benefit em-ployee pension schemes. So the UK too faces a looming crisis characterized by inadequate, rather than over-generous, pension provisions.
It would be wrong, however, to paint a uniformly dark picture of progress on the Lisbon agenda. The World Economic Forum, for example, says that by most measures, the Nordic economies are already world class performers when measured against its series of competitiveness yardsticks. The International Institute of Management and Development (IMD) ranks Finland second and Sweden eighth on its competitiveness scorecard.
And progress has been made on some of the vital pan-European initiatives highlighted by the Lisbon agenda. Last November, following the election of the new French government, a deal was struck for the full liberalization of EU energy markets by 2007 which should lead to lower electricity prices for companies and households.
In the meantime, Eurostat, the EU statistics office, estimates that companies in Italy can pay twice as much for electricity as they would in Sweden. State monopolies still dominate the market in France, Belgium, Greece and Ireland. Full-blooded competition is still some way off.
The liberalization of telecommunications has been a big success. The average price of national calls within Europe has more than halved in the last five years and international call charges are down by a third since 1997. Former state-owned telecommunications companies have, however, managed to preserve their dominant positions in several countries, such as France and Germany, which suggests that competition is not as free and open as it should be.
The dire financial straits of France Telecom and Deutsche Telekom, caused by paying too much for overseas acquisitions and third generation mobile phone licenses, are also likely to dull the French and German governments' appetite for encouraging unfettered competition.
Since March of this year, trans-European railroad networks are supposed to be fully liberalized for freight (but not for passenger) traffic. Again, however, it seems that several countries are resorting to what many see as underhand methods, such as voicing bogus safety concerns, to evade the competitive pressures that reformers want the new regime to exert.
Progress is patchy in other areas, too. A top Lisbon priority was to create a single market in financial services to improve the allocation of capital, and mobilize savings. After a monumental power struggle between the European Parliament, the Commission and the Council, significant advances have been made in financial market regulation, with changes introduced to make it easier to implement and update reforms.
The Commission says that 31 of 42 reforms envisaged under the EU's Financial Services Action Plan have now been completed. These include agreements on an EU company statute, a financial market abuse directive, a directive on stock market prospectuses and legislation to permit occupational pension funds to operate across borders.
Frits Bolkestein, the EU Commissioner in charge of the single market, freely admits, however, that some of the toughest issues, including a directive on mergers and takeovers (a battleground for over a decade) still lie ahead. Nor will it be easy to remove legal obstacles to cross-border sales of retail financial services. Even if progress were made, different tax regimes in each country would work against the creation of a level pan-European playing field.
But perhaps the biggest challenge is the most intangible. If Europeans are to create the world's leading knowledge-based economy, they will have to undertake the research necessary to create marketable technology and commercialize it successfully. That will mean establishing a favorable environment for entrepreneurs. In a knowledge-based economy, Europeans may have to be more indulgent of greed as a stimulus for fast-growing companies than they have been in the past. Bankruptcy laws, and society in general, may have to become more tolerant of commercial failure, so as to allow entrepreneurs to learn from their mistakes.
On all of these scores, with the outstanding exception of the Nordic countries, Europe has a lot of catching up to do. In a recent report, the European Roundtable of Industrialists warns that it will be difficult to reach the target, set at the Barcelona Summit, of raising research and development spending in Europe from 1.9 percent to three percent of gross domestic product. The report points out that more and more companies are investing in research and development facilities in the United States and Asia, rather than in the European Union.
It is not just a question of money. The European Union suffers from a shortage of scientists and engineers. Many of its universities are not primed to work with business in commercializing new technology. Cambridge University is an exception. But, even though it can call on a vigorous local venture capital market, it lacks the nearby presence of the big companies needed for the development of a world class "cluster" of high tech businesses. Perhaps only Munich can lay claim to this potential.
Moreover, Europe's fledgling venture capital industry, the incubator that fosters the growth of new high-tech businesses, has suffered a body blow with the stock market collapse. This was symbolized most vividly by the Deutsche Borse's decision last year to shut down the Neuer Markt, its specialized stock market for high-tech companies. Institutional investors, burned by the market crash, are also deserting the share market. The BVK, Germany's venture capital trade association, says that the value of deals among its 200 members plunged by almost half to only €2.6 billion last year.
The fact that the Commission is planning to allocate some €17.5 billion to European researchers over the next four years is an indication that policy makers are fully aware of the need to stimulate innovation. Public financing, however, is no guarantee of success. Hence the plaintive reminder from the March Brussels summit meeting that "boosting the interaction between industry and research institutions is at the heart of realizing our entrepreneurial potential."
The agreement that has just been reached to establish an EU-wide patent will be important in cutting business costs, but is not a decisive breakthrough, just one link in the chain leading to the commercialization of scientific discoveries. The same can be said of the renewed priority being attached to reducing the regulatory burden on job-creating small businesses and making it easier and cheaper to start a company, badly needed though it is. A Commission study in 2002 found that in Austria, Spain and Greece it can take six weeks and cost €1,500 to set up a new company. Reforms have since been put in place. Once again, however, indicating concern about the desultory pace of progress, the Brussels communiqué stressed the need for the "rapid implementation" of the EU Action Plan for improving the regulatory environment.
All these incremental steps toward trying to stimulate research and business innovation are important, but they are only small parts of a big, complex and not very easily manipulated puzzle.Between 1996 and 2000 the booming U.S. economy alone accounted for 40 percent of additional real demand for goods and services in the global economy. Europe profited mightily from America's seemingly insatiable appetite, both through exports and from the sales and profits of U.S.-based, European owned companies.
The United States is now running a $500 billion annual current account deficit. It is facing what may be an extended period of low growth and probably a sharp reduction in the value of the dollar in order to rebalance its economy. So EU companies will have to find other markets if Europe's economy is to enjoy the growth rates needed to underpin the Lisbon reforms. Domestic demand will have to pick up.
The impending admission of ten new EU members in 2004 will also make it harder to meet the Lisbon targets. The accession countries are mostly far behind the current member states in reaching the required goals.
On the other hand, the catching-up process that the new members are undertaking, and the evidence of economic vitality they have shown, suggest that they could inject some much needed dynamism into the Union.
A big question, however, is how EU leaders, both political and corporate, will respond to a possible extended economic slowdown and the fallout from the war in Iraq. Will the bitter political divisions that the war engendered spill over onto the negotiating table when compromises have to be reached to implement the Lisbon agenda? Will continuing economic difficulties sap the will to press ahead? Will the backsliding that the Commission has noted, particularly the controversy over fiscal policy, harden into intransigence and poison the European Union's macro-economic debate, including discussions of monetary policy and reforming the ECB?
If the answers to some of these questions appear to be Yes, and corporate executives begin to lose faith in the reform process, the outlook will seem even bleaker for the ambitious goals that the leaders set in Lisbon three years ago – just as the American stock market bubble was about to burst over their heads.
Stewart Fleming is a freelance writer in Brussels. He was previously a financial reporter for the British daily newspaper, The Guardian. He has also served as New York Bureau Chief, Frankfurt Bureau Chief, U.S. Economics Editor (Washington) and U.S. Editor (Washington) of the London Financial Times. He may be reached at sj.fleming@SKYNET.be