Following signs of economic recovery in the recently released Commission economic forecasts, the EU economy 2003 review, published today, reveals evidence that the forces that underpinned strong growth in the USA are also present in the EU. Several EU Member States have outperformed the USA in terms of labour productivity since the mid-1990s. The aggregate EU productivity gap therefore reflects the particularly poor performances of a number of the larger Member States. The 2003 EU Review provides an in-depth analysis on (1) macro-economic developments in the euro area, (2) drivers of productivity growth, (3) education, training and growth, (4) wage flexibility and wage interdependencies in EMU, and (5) international capital flows.
Pedro Solbes, EU Commissioner for Economic and Monetary Affairs, said: “The analysis confirms the importance of a forceful implementation of a comprehensive reform strategy in order to create a more flexible, dynamic and investment-friendly business environment. It should aim at reducing the regulatory burden, further integrating markets, promoting human capital investment and enhancing the innovation potential of the economy. Together with better functioning markets, and more risk-oriented financing mechanisms, this will set the conditions for a significant increase in the EU's growth rate.”
Macroeconomic developments in the euro area
Despite signs of a pick-up in economic activity in the second half of 2003, the euro area is set to record economic growth significantly below potential for the third year in a row. Market forces that usually initiate recovery seem to have worked less efficiently or strongly, implying that the economy, which recovered in early 2002, was not resilient to further adverse events. The fact that the slowdown has persisted for three years suggests that supply-side dynamics have been important and the growth weakness cannot solely be attributed to demand shocks. This underlines the need to pursue the Lisbon strategy with more vigour.
While macroeconomic policies were responding to the growth slowdown, there is some evidence that the somewhat expansionary stance of fiscal policy did not contribute much to stimulate economic activity. Available evidence suggests that the impact of the tax cuts enacted in several EU Member States since 2001 did not yield the hoped-for increase in private consumption and investment.
Private consumption was less buoyant than could be expected because of an in view of the cyclical situation atypical increase in the households' saving ratio. This suggests that so-called non-Keynesian effects related to a lack of credibility of fiscal policy exerted a negative effect on economic activity.
Drivers of productivity growth
A new growth pattern has emerged in the US and a number of EU Member States since the mid-1990s. Seven Member States (Belgium, Greece, Ireland, Austria, Portugal, Finland and Sweden) have outperformed the USA in terms of hourly labour productivity since the mid-1990s. Three of the seven, namely Ireland, Finland and Sweden were also capable of combining both strong productivity and high labour utilisation rates.
The EU as a whole, however, has proved incapable of reversing the long-run decline in its productivity growth performance whereas the USA has enjoyed a notable recovery in its trend. The EU in fact achieved a sharp increase in its contribution of labour to growth, which was accompanied by equally sharp reductions in the contribution of productivity. No policy trade-off should, however, be implied since boosting employment rates through bringing low-skilled workers into employment only leads to a temporary reduction in measured productivity growth, with no effect on the long-run productivity growth of the existing workforce.
Half of the 1 percentage point decline in EU labour productivity growth experienced over the 1990s emanates from deterioration in total factor productivity (TFP). This should probably be seen as the greatest source of concern for policy makers. Improvements in TFP are generally attributed to a more efficient resource utilisation emanating from enhanced market efficiency; from technological progress resulting from investments in human capital, R&D and information technology; or from the natural catching-up process of the less developed EU countries through increased business investment in general.
On a positive note, Information and Communication Technologies (ICT) contributed positively to growth. Just like in the USA, ICT also contributes to both capital deepening and TFP in the EU (although the extent of the gains in the USA is larger). The origin of the deterioration in EU productivity over the 1990s stems therefore from developments in the non-ICT, more traditional, group of industries, including services. Labour productivity growth seems to be dominated by just five, out of a total of fifty-six, analysed industries. All of these are among the ICT-producing and intensive ICT-using areas of the respective economies.
A model-based analysis shows that EU-US productivity differentials are indeed related to some fundamental structural differences at the individual country level. Five areas were identified as being quantitatively important and relevant in an EU context, namely the level of regulation, the structure of financial markets, the degree of product market integration, the size of knowledge investment and the ageing of the labour force.
Education, training and growth
Education has been a major influence on economic growth, with empirical estimates suggesting that it might have accounted for as much as 0.3 to 0.5 percentage points of annual GDP growth. Greater efficiency in the use of resources would increase the rate of return to investment in education.
At tertiary level, for example, high drop-out rates and studies that often last well beyond the standard duration are equivalent to years spent outside the labour market without tangible benefits in the form of higher attainment. A good case might be made for broadening access to pre-school education or for increasing upper-secondary participation, especially since these investments have long-lasting economic benefits.
Since upper-secondary and tertiary participation cannot grow limitlessly, adult education and training is likely to offer the greatest scope for increasing educational attainment in the long term. Lifelong learning could also help older workers to remain longer in the labour market. Experience suggests that tax incentives, subsidies and co-financing schemes to encourage training will need to be designed and evaluated much more carefully than in the past.
Wage flexibility and wage interdependencies in EMU
Conventional wisdom has it that wage formation mechanisms in Europe are characterised by a high degree of rigidity and slow adjustment to shocks. Regarding actual developments, on the positive side, overall wage discipline has been preserved and risks that the inflation overshoot would lead to extended second-round wage effects have been averted. On the negative side, with nominal wage growth rather invariant to the cyclical situation, the slowdown in labour productivity growth translated into significant increases of nominal unit labour costs in 2001 and 2002. Hence, wage flexibility appears to have provided little, if any, support to the expected cyclical recovery so far. However, in line with findings from other studies, formal econometric analysis suggests that wage inflation persistence in the euro area is not higher than in the USA.
The convergence of wages and unit labour costs has not waited for the internal market, let alone EMU, to be completed. Available sectoral evidence suggests that convergence was in fact stronger in the 1980s than in the 1990s. Higher goods market integration and stronger interdependencies in wage setting across countries can affect the way in which shocks are absorbed and transmitted in EMU. Model simulations show that this partly depends on the nature of the shocks. Increased wage interdependency does not lead to major differences in the absorption of supply shocks. However, it entails a more protracted adjustment to demand shocks. Simulations show that it takes approximately one more year for the output adjustment process to work out if wage interdependencies are present.
International capital flows
Many emerging economies liberalised their capital flows in the 1990s, while maintaining weak financial institutions and pursuing macroeconomic and financial policies that turned out to be inconsistent with exchange rate stability. In the area of financial sector development and supervision, in particular, there are striking differences between acceding countries and many other emerging markets. Here the acceding countries have gradually implemented the EU acquis for regulation and supervision and have opened their markets to large-scale foreign ownership. With sound financial institutions and by pursuing adequate macroeconomic and financial policies, the acceding countries can avoid the negative experiences in other regions, thereby setting the pre-conditions for strong real convergence in a setting of financial stability.