COUNCIL DECISION of 21 December 1988 adopting the annual report on the economic situation in the Community and laying down economic policy guidelines for 1989 (88/655/EEC)

THE COUNCIL OF THE EUROPEAN COMMUNITIES,

Having regard to the Treaty establishing the European Economic Community,

Having regard to Council Decision 74/120/EEC of 18 February 1974 on the attainment of a high degree of convergence of the economic policies of the Member States of the European Economic Community (1), as amended by Decisions 75/787/EEC (2) and 79/136/EEG (3), and in particular Article 4 thereof,

Having regard to the proposal from the Commission,

Having regard to the opinion of the European parliament (4),

Having regard to the opinion of the Economic and Social Committee (5).

HAS ADOPTED THIS DECISION:

Article 1 The Council hereby adopts the annual report on the economic situation in, and economic policy guidelines to be followed by the Community, which are contained in parts A to C of the report attached to this Decision and lays down the economic policy guidelines to be followed by the Member States, contained in part D of the said report.

Article 2 This Decision is addressed to the Member States.

Done at Brussels, 21 December 1988.

For the Gouncil The President V. PAPANDREOU (6) OJ No L 63, 5. 3. 1974, p. l6.

(7) OJ No L 330, 24. 12. 1975, p. 52.

(8) OJ No L 35, 9. 2. 1979, p. 8.

(9) OJ No G 326, 19. 12. 1988.

(10) Opinion delivered ANNUAL ECONOMIC REPORT 1988 to 1989

PREPARING FOR 1992 ANNUAL ECONOMIC REPORT 1988 to 1989 Preparing for 1992 (page) Summary and conclusions Main economic indicators 1985 to 1989 6 A. The economic situation and outlook 1. The external environment 8 2. The Community economy in 1988 and 1989 11 3. Convergence, stability and growth 13 B. Problems, opportunities and challenges in the Community economy 1. Exploiting the potential of the internal market 17 2. Towards greater economic and social cohesion18 2.1. Narrowing income gaps within the Community 19 2.2. The social dimension of the internal market 21 3. Towards more employment creation 21 C. Policy for growth and greater confidence 1. Structural and labour market policies 25 2. Monetary policy 26 3. Budgetary policies 27 4. The need for increased policy coordination 29 D. Country situations, prospects and policies Belgium 30 Denmark 33 Germany 35 Greece 38 Spain 40 France 42 Ireland 44 Italy 46 Luxembourg 48 Netherlands 50 Portugal 52 United Kingdom 54 Statistical Annex Graphs 58 Tables 68 ANNUAL ECONOMIC REPORT 1988 to 1989 PREPARING FOR 1992 SUMMARY AND CONCLUSIONS Favourable economic prospects for the Community and world economy 1. The economic prospects for the Community have significantly improved in recent months. In 1988 the Community benefited from an unexpected dynamism of its own, in the whole Organization for Economic Cooperation and Development (OECD) area and from world trade. In the Community, growth (1988: 3 1/2 % on average) is likely to be the strongest since the end of the 1970s: the increase in investment (7 %) the highest for over two decades; the inflation rate (3 1/2 %) should be about that of the 1960s. Despite some moderation in economic growth in the rest of the world, growth is likely to be strong in 1989 (about 2 3/4 %). The inflation trend should only increase slightly. The rate of unemployment has started to decrease but it is still at too high a level.

2. The international framework for the conduct of monetary policy in the Community has changed significantly. With an improvement in the United States trade deficit early in the year and an increase in interest rates in spring the exchange rate of the dollar against European currencies had by autumn almost reached its level of January 1987, just before the Louvre accord. Partly to control the rise in the dollar and partly in response to the exigencies of internal stability European central banks were led, to different degrees, to tighten conditions on their own money markets.

3. International cooperation allowed significant progress to be made towards greater stability in the world economy. But it needs to be pursued with determination because important risks remain: (a) in 1989 the reduction in balances of payments disequilibria is likely to lose some of its vigour at a time when the accumulation of United States foreign debt is continuing; (b) the persistance of the disequilibria continues to create risks for the stability of the international monetary system: (c) the situation in developing countries is not improving and is affected by the recent rise in interest rates.

Encouraging elements and some matters of concern 4. Three aspects of the economic situation are encouraging:

- The dynamism of the economies of Spain, Portugal, Italy and the United Kingdom is now spreading to their partners whose exports, and also investment, are more bouyant. Thus, for example, in France and Germany growth should be about 3 % in 1988 and should only dip slightly in 1989 (compared with 2 % in 1987).

- Growth is more and more being led by investment. Many factors are contributing to this: greater profitability, a historically high level of capacity utilization, a favourable international environment and preparation by private firms for 1992.

- The Community has achieved a degree of stability and convergence of inflation rates unequalled since the 1960s. However, progress is still necessary, especially in Portugal and Greece.

5. Despite these satisfactory trends there are four areas of concern: (a) the risk of renewed inflation; (b) excessive budgetary deficits in some countries; (c) an increase in the intra-Community disequilibria in external balances; (d) an unemployment rate that is still on average in the Community more than 11 % of the active population.

6. The strengthening of potential growth must remain a priority for all Member States. However, the consolidation of the current good growth performances may require, over the coming months, different actions in different Member States. As growth in the more dynamic countries is expected to slow down as a result of inflationary pressures and/or a deterioration of external accounts, economic policies in the other countries should accentuate the shift to domestic growth by a strengthening of supply and demand conditions.

Realizing the medium-term objectives 7. Faster growth is now giving the Community the chance to realize in the best conditions its major objectives: to benefit from the completion of the internal market, strengthen economic and social cohesion and reduce unemployment.

8. The irreversible character of the completion of the internal market in 1992 was confirmed by the Council of Hanover. Significant progress has already been realized. In recent months, public opinion and enterprises have become more and more aware of the opportunities offered by this project. It is essential that these hopes are not disappointed when the decisions implementing the important measures of the White Paper are taken during the coming years.

9. To produce its full effects, the completion of th structural policies, including an effective competition policy also necessary in their own right.

10. The success of the internal market will also have significant macroeconomic effects. Studies by the Commission services indicate that the completion of the internal market will in the medium term improve significantly growth, budgetary and external positions and will have favourable effects on inflation. So that the productivity gains which will be realized are rapidly transformed into higher growth and employment, it will be important to fully benefit from the alleviation of constraints by reducing domestic disequilibria and actively strengthening the conditions of supply and demand.

11. With the reform and the increase of the Structural Funds, already under way, and the increased activity of the Community financial instruments, the Community has acquired the means to strengthen economic and social cohesion. A new model of ´partnership' between the Community and the beneficiary countries must be created. Not only is the efficient utilization and additionality of these resources at programme level essential but economic policies in the countries concerned must ensure that the overall supply conditions improve and especially that the efficiency and the share of productive investment relative to GDP are increased.

12. Even if the completion of the internal market in the last analysis results in significant gains in welfare and employment, the restructuring which it will imply during the transition phase gives rise to certain anxieties. The social dimension of the internal market needs to be given attention, in particular: (i) the implementation of policies to facilitate re-employment; (ii) the convergence towards the higher social standards, for instance, by minimum security and health regulations at the work place; (iii) the strengthening of the social dialogue at Community level.

l3. The reduction in unemployment remains the priority task common to all Member States. Already employment is increasing at a historically high rate. This trend needs to be reinforced. In many countries there are signs of greater labour market adaptability, especially in the form of part-time work. The direction of the cooperative growth strategy for more employment remains valid: it involves, at the macroeconomic level further improvement in the profitability of capacity increasing and employment creating investment. Continued moderation in wage costs, in conjunction with the new favourable demand prospects would contribute to this. It also involves concentrating attention on the elimination of unnecessary administrative obstacles which hinder employment creation and on greater mobility and skill improvements, particularly by sustained training efforts.

The narrow path towards a consolidation of growth 14. The potential for non-inflationary growth can be strengthened by making European economies even more adaptable. Greater flexibility of markets and their positive effect on the behaviour and initiative of entrepreneurs is in itself a source of progress. In a situation where on the one hand it is necessary to avoid excessive pressures on productive capacity and on the other to further improve employment performances, structural policies are still very important.

15. The stabilization, and then the appreciation of the dollar on the foreign exchanges, led the monetary authorities to give more attention to the objectives of domestic stability. Recent increase in money market interest rates in the Community has strengthened the credibility of monetary authorities. To the extent that longer-term expectations of inflation and/or depreciation of the currencies have been reduced, long-term interest rates could be stabilized or decrease on a sound basis; some evidence of this emerged in some countries in early autumn.

In the countries participating in the exchange rate mechanism domestic inflationary pressures generally remain under control and further tightening of monetary policy does not seem necessary in the immediate future. Yet, the risk and main challenge to monetary policy could arise from renewed instability of the dollar.

l6. For budgetary policies, medium-term objectives continue to be of primary importance. In the context of the achievement of the internal market discussions concerning the approximation of indirect taxes and taxation of capital income must be pursued so as to reach rapid agreement on these subjects. Other medium-term objectives include the convergence of general government balances, still excessive in some Member States, and the need to use budgetary policy to improve the conditions of supply and demand.

17. The increasing interdependence between Member States makes greater coordination of economic policy even more important. Furthermore, an increasingly high degree of stability in exchange rates related to converging underlying economic fundamentals would improve the functioning of the internal market. Monetary cohesion would be strengthened by an enlargement of the exchange rate mechanism at the appropriate time to those countries not yet participating, management of monetary policies in greater cooperation and strengthening the role of the ecu. However monetary cohesion in the Community cannot be permanently ensured unless Member States follow compatible policies in other areas, particularly budgetary policy. In this context it is important to strengthen the consensus on the principal economic policy objectives: (a) stable prices and downward convergence of inflation rates; (b) medium term compatibility of payments balances; and (c) the contribution of internal and external stability to the growth and employment objectives of the Community and its Member States.

Main economic indicators 1985 to 1989 - Community countries, USA und Japan a) GDP (;) at constant prices (% change on previous year) 1985 1986 1987 1988 ($) 1989 ($) B 1,4 2,3 1,8 3 2;/4 DK 4,2 3,4 -1,0 0 1=/4 D 2,1 2,6 1,9 3;/4 2;/2 GR 3,0 1,3 -0,4 2=/4 2 E 2,3 3,3 5,2 4=/4 4 F 1,7 2,1 2,3 3 2=/4 IRL 1,1 -0,3 4,1 3 3;/4 I 2,7 2,7 3,1 4 3;/4 L 3,8 2,9 2,4 2=/4 2;/2 NL 2,3 2,4 1,5 2;/4 2;/4 P 3,3 4,3 4,6 4 3;/2 UK 3,7 2,9 4,3 3=/4 2;/2 EUR 12 2,5 2,6 2,9 3;/2 2=/4 USA 3,1 3,0 3,4 4 2;/4 JAP 4,5 2,4 4,2 5;/2 3=/4 b) Domestic demand at constant prices (% change on previous year) 1985 1986 1987 1988 ($) 1989 ($) B 1,3 3,2 2,4 3 2;/4 DK 5,7 -3,2 -1;/2 =/4 D 1,0 3,7 3,1 3;/2 2;/2 GR 6,1 -0,5 0,2 3;/2 3 E 2,9 5,9 8,0 6;/4 5;/4 F 2,2 3,7 3,3 3 2=/4 IRL -1,3 0,8 -1,5 -;/4 1;/2 I 3,2 3,6 4,6 4;/2 3;/2 L 0,7 -0,9 6,1 ;/2 2;/2 NL 2,5 3,9 2,2 1=/4 2 P 0,8 8,4 9,5 6;/2 5;/2 UK 2,9 3,8 4,3 5;/4 3;/2 EUR 12 2,4 3,9 3,9 4 3;/4 USA 3,5 3,8 3,0 2=/4 2 JAP 3,8 4,0 5,1 7;/4 4;/4 c) Deflator of private consumption (% change on previous year) 1985 1986 1987 1988 ($) 1989 ($) B 5,2 0,8 1,6 1;/4 2;/2 DK 4,9 3,6 4,1 4=/4 3=/4 D 2,1 -0,2 0,5 1;/4 2;/2 GR 18,7 22,2 15,8 13;/4 12=/4 E 8,3 8,7 5,3 4=/4 4;/4 F 5,7 2,5 3,2 2=/4 2=/4 IRL 4,5 3,6 3,1 2 2=/4 I 9,3 6,1 4,8 5 4;/2 L 5,2 0,6 0,6 1;/2 2;/4 NL 2,5 0,2 -0,4 =/4 1;/4 P 19,0 12,0 10,2 9;/2 7 UK 5,2 3,6 3,8 4;/2 4=/4 EUR 12 5,9 3,6 3,3 3;/2 3=/4 USA 3,1 2,1 4,5 4;/4 5 JAP 2,1 0,6 -0,2 1 2 d) Balance on current transactions (% of GDP) (;) 1985 1986 1987 1988 ($) 1989 ($) B 0,7 2,6 1,9 1=/4 1=/4 DK -4,7 -5,1 -3,0 -2;/2 -2;/4 D 2,4 4,2 4,0 4 4;/4 GR -8,2 -5,4 -3,4 -2=/4 -3;/2 E 1,6 1,7 0,1 -=/4 -2 F 0,1 0,6 -0,3 0 ;/4 IRL -3,8 -2,4 1,3 2;/2 3;/2 I -0,9 0,8 -0,1 -;/2 -;/2 L 43,3 46,1 38,0 38;/2 36;/2 NL 4,3 2,8 1,7 1;/2 1=/4 P 1,7 3,9 1,8 0 -1=/4 UK 0,5 -0,8 -0,6 -3 -3;/4 EUR 12 0,7 1,3 0,8 ;/2 ;/4 USA -2,9 -3,4 -3,6 -2=/4 e) Number of unemployed as % of the civilian labour force (1) 1985 1986 1987 1988 (2) 1989 (3) B 13,6 12,6 12,3 11;/2 11 DK 8,7 7,4 7,6 8;/2 9 D 8,4 8,1 8,1 8 8;/4 GR 7,8 7,4 7,4 7;/2 7;/2 E 21,4 21,0 20,5 20 19;/2 F 10,5 10,7 10,8 10=/4 10=/4 IRL 17,9 18,2 19,2 18=/4 18;/4 I 12,9 13,7 14,0 15 14;/2 L 1,7 1,4 1,6 1;/2 1;/4 NL 13,3 12,1 11,5 11;/4 11 P 8,7 8,7 7,2 6;/2 6;/2 UK 12,0 12,0 10,6 8;/2 7;/4 EUR 12 11,8 11,9 11,6 11;/4 11 USA 7,2 7,0 6,2 5;/2 5;/2 JAP 2,6 2,8 2,8 2;/2 2;/2 f) General government lending and borrowing (%) (% of GDP) 1985 1986 1987 1988 ($) 1989 ($) B -8,3 -8,9 -7,2 -7;/4 -6;/2 DK -2,0 3,1 -2,1 1 1;/4 D -1,1 -1,3 -1,8 -2;/4 -1;/4 GR -13,6 -10,8 -9,5 -12 -13;/4 E -7,0 -5,7 -3,6 -3 -3 F -2,8 -2,9 -2,5 -2 -1=/4 IRL -11,1 -10,6 -9,1 -6;/2 -6 I -12,5 -11,4 -10,5 -10 -10 L 5,8 6,0 5,2 5;/4 6;/4 NL -4,7 -6,0 -6,3 -5;/4 -4;/2 P -10,1 -7,8 -8,4 -8 -7=/4 UK -2,7 -2,4 -1,4 -;/4 0 EUR 12 -5,2 -4,8 -4,2 -3=/4 -3;/2 USA -4,3 -3,5 -2,3 -1=/4 -1=/4 JAP -0,8 -1,5 -0,3 -;/4 ;/4 g) Total employment (annual % change) 1985 1986 1987 1988 ($) 1989 ($) B 0,8 1,0 0,3 1;/4 =/4 DK 2,9 2,3 1,1 -;/4 ;/4 D 0,7 1,0 0,7 ;/2 =/4 GR 1,0 0,1 -0,1 1 =/4 E -1,4 1,9 3,0 2;/2 2 F -0,4 0,3 0,1 ;/2 ;/2 IRL -2,2 -0,4 -0,1 0 ;/2 I 1,4 0,8 -0,1 ;/2 ;/2 L 1,4 2,6 2,7 2 1;/2 NL 1,3 1,8 1,2 =/4 1 P -0,3 0,0 2,7 1=/4 1 UK 1,6 0,4 1,7 2 1 EUR 12 0,6 0,8 0,9 1 1 USA 2,4 1,7 2,6 2;/4 1;/2 JAP 0,7 0,9 1,0 1;/2 =/4 h) Real compensation of employees per head (& ) (annual % change) 1985 1986 1987 1988 ($) 1989 ($) B -0,4 3,0 1,6 1 1;/4 DK -0,3 1,0 4,0 -;/2 -1 D 0,9 4,1 2,4 1=/4 0 GR 3,3 -5,4 -2,9 3;/4 1 E 1,7 -0,4 2,1 1=/4 1=/4 F 0,9 1,5 0,1 1 1 IRL 1,8 1,5 1,9 1;/4 1 I 0,8 1,5 3,8 2 2=/4 L -1,4 4,3 3,3 2 2=/4 NL -1,1 1,4 1,6 1 -;/4 P 2,8 4,5 3,3 1;/2 2=/4 UK 1,4 3,6 3,0 3 3 EUR 12 0,9 2,3 2,1 1=/4 1;/2 USA 1,1 1,6 -0,4 1 -;/4 JAP 1,3 3,1 3,3 3;/4 2;/2 Source: Comm A. THE ECONOMIC SITUATION AND OUTLOOK 1. The external environment The international economic environment and the economic situation in the European Community are characterized by a buoyancy in production activity and trade coupled with low recorded inflation rates that have not been seen for a long time. The years of structural adjustments in most industrial economies have made them more resilient. Despite the October 1987 stock-market crash and continuing concern about the international payments imbalances growth in industrial countries is strong (3,9 % in 1988). The delayed favourable effects of the oil price fall in 1986 and the rapid growth of monetary liquidity in 1987 (first through foreign exchange intervention and later in the year to assist financial institutions after October 1987) are all reflected in a growth performance which is better than that expected at the beginning of the year and is even accompanied by evidence of overheating in some countries. Despite some moderation, GDP growth in the OECD area should still be close to 3 % in 1989, the seventh year of continuing expansion in activity.

This favourable development has been common to all major industrialized countries. The American economy has been growing very strongly - though unevenly - since 1983. Capacity limits are now being reached in some industries and the unemployment rate is only slightly higher than during the 1960s. Yet, despite this and the massive dollar devaluation for over three years (March 1985 to March 1988: 38 % in effective terms), the rate of inflation in 1988 has remained at about 41/2 %. Monetary policy was tightened in early summer, following first signs of overheating of the economy. Some slowing down is likely to occur in 1989, given the somewhat less pronounced growth of both domestic demand and exports.

In Japan, domestic demand growth during the past 12 months has averaged almost 71/2 % in real terms. At the same time, the Japanese economy seems to have adjusted to the considerable yen appreciation (March 1985 to March 1988), 60 % in effective terms) of the last three years and export prospects have improved. Thus, despite an expected deceleration of domestic demand growth in 1989, the Japanese economic performance will remain very strong.

Economic growth in the developing countries is likely on average to be in the range of 3,5 to 4 % in both 1988 and 1989. However, this average conceals great diversity. The Asian newly industrialized economies (NIEs), major exporters of manufactured products, continue to enjoy growth rates of GNP exceeding 7 %. Oil-exporting countries are only now recovering from the loss in export revenues in the wake of the oil price collapse of 1986. GDP growth of exporters of raw materials does not seem to have accelerated very markedly, despite the strength of activity in industrial countries and the substantial rise in non-oil commodity prices which increased at an annual rate of 17 % in the last six months of 1987 and 27 % in the first six months of 1988. This has brought a welcome improvement in the terms of trade of these countries. TABLE 1 Real GDP, domestic demand and world trade (annual percentage changes) I-1987 II-1987 I-1988 1987 1988 (;) 1989 (;) a) GDP EUR 12 2,5 3,5 3,8 2,9 3,5 2,8 USA 3,9 5,0 4,0 3,4 3,9 2,3 Japan 3,7 6,0 6,4 4,2 5,6 3,8 OPEC 0,0 1,1 2,6 Asiatische Schwellenlaender 11,8 8,5 7,5 Sonstige Schwellenlaender 2,8 1,3 3,4 Sonstige Entwicklungslaender 4,0 5,0 4,6 b) Domestic demand EUR 12 3,6 4,3 4,1 3,8 4,0 3,2 USA 2,8 4,8 2,5 3,0 2,8 2,0 Japan 3,9 7,7 8,9 5,1 7,4 4,2 (;) September to October 1988 forecasts of the Commission services.

I-1987 II-1987 I-1988 1987 1988 (;) 1989 (;) c) World trade World imports (excluding EC) 0,6 11,6 7,0 5,0 7,6 5,7 EUR 12 export markets 6,2 8,2 6,1 (;) September to October 1988 forecasts of the Commission services. For the European Community, the vigorous performance of the world economy represents a welcome stimulus to its own exports, which is reinforcing its own domestic-demand led economic growth. In fact, world imports (excluding the Community's export markets. Because of a faster expansion in 1988, which implies a considerable growth of the Community's export markets, Because of a faster expansion in imports net external trade will however continue to contribute negatively to GDP growth in the Community (for the third year in a row). Thus the international adjustment process will continue to take place at a relatively high level of growth in both trade and GDP.

The above developments have important consequences for the conduct of economic policy, particularly monetary policy. From 1985 up to early 1988, monetary authorities in the main industrial countries had generally attached a high priority to external goals in support of the international adjustment process. Exchange rate considerations therefore played an important role in the management of interest rates and of foreign exchange reserves. The climate changed in mid-1988. The dollar exchange rate stabilized when it became clear that the world economy had robustly resisted the impact of the stock-market crash and the international adjustment process was finally reducing the nominal United States trade deficit. (During the first eight months of 1988, the deficit ran at approximately US $ l8 billion less than in the same period of 1987.) Markets eventually revised their appreciation of the economic climate, showing concern about higher price pressures. As the danger of a revival of inflation became apparent, domestic goals gained importance and monetary policy was somewhat tightened, at first in the United States. The restructuring of financial portfolios together with higher interest rates eventually triggered a recovery of the dollar in the second quarter of 1988.

By late September the dollar exchange rate was more than l0 % higher than at the end of last year in effective terms (18 % higher with respect to the deutschmark and l0 % higher in relation to the yen) a little lower than the rate prevailing on average in the second and third quarters of 1987. In fact the dollar exchange rate vis-à-vis the main European currencies was at the beginning of autumn close to that prevailing at the time of the Louvre agreement of February 1987.

Central banks have reacted to the change of market sentiment about the US dollar and the more restrictive United States monetary policy by selling dollars on the foreign exchanges and by raising short-term interest rates. In the context of faster-than-expected growth as well as a perceptible deterioration in the terms of trade, authorities in Germany and the United Kingdom considered this desirable for domestic reasons. But, in other Member States, fears have been manifested that the induced rise in interest rates could have a negative impact on growth (see C.2).

TABLE 2 Nominal short-term interest rates (three month money market rates) End January 1988 End April 1988 End September 1988 Average EMS 5,7 5,7 6,8 D 3,3 3,4 5,3 UK 8,7 8,5 12,3 USA 5,8 6,1 7,5 Japan 3,9 3,9 4,1 The reduction of international current account imbalances is making progress, not only in real but also in nominal terms. Trade flows are adjusting to the new configuration of exchange rates and the resulting recovery in United States competitiveness. But the pace of the adjustment is slow. Moreover, up to now the geographical counterpart of the improvement in the United States deficit has largely not been located in the main surplus countries (Japan, Germany, and the Asian NIEs) but in other OECD or less-developed countries (LDCs). Certainly the bilateral positions of the first group of countries vis-a-vis the United States are deteriorating. But this is being compensated by an improvement of the trade balances in relation to their other trading partners as a whole. In the Community, in particular, the reduction in the overall surplus with the rest of the world therefore reflects rapidly deteriorating current account positions by Member States other than Germany, particularly those with faster domestic demand growth than the Community average.

TABLE 3 Current account balances 1985 1986 1987 1988 (4) 1989 (5) a) billion US $ EUR 12 18,4 50,4 42,4 24 16 USA -116,4 -141,4 -154,0 -135 -131 Japan 49,2 85,5 87,1 79 86 OPEC 3,7 -26,4 -9,5 -21 -22 Asian NIEs 10,1 22,8 29,1 34 33 Other LDCs -34,5 -32,4 -22,9 -27 -32 b) as % of GDP (6) EUR 12 0,7 1,3 0,8 ;/2 ;/4 USA -2,9 -3,4 -3,4 -2=/4 -2;/2 Japan 3,7 4,3 3,6 2=/4 3 Further more, on the assumption of current or forecast output trends,current policy and current real exchange rates, the adjustment process in the industrialized countries, particularly between the United States and Japart, could lose much of its impetus in late 1989 and beyond. The question thus arises of whether, on the basis of the forecast net export performance, the United States trade deficit is indeed being reduced at a pace sufficient to signal to markets thait the current account imbalances will eventually be resolved without disruption.

In this regard, the continuing build-up of United States external indebtedness is of particular concern as a significant debt servicing cost will be added to the required United States payments adjustment. The longer the current account imbalance is maintained, the larger will be the improvement needed in the merchandise trade balance to compensate for the deterioration in the invisible account.

Economic policy in all major countries is therefore facing the well-known twin goals. The speed of international adjustment has to be sufficient to preserve confidence in the final outcome and thus maintain stability in foreign exchange and securities markets. From an international standpoint as well as from the Community's point of view a period of stability for the dollar at prevailing rates would be desirable. A renewed depreciation of the dollar will prevent the adjustment of real trade flows, which is currently under way, being reflected fully in further reduction of the nominal United States trade deficit because of higher import prices (J-curve effect). Furthermore this would increase the inflationary risk in the United States which could also result in higher interest rates. On the other hand a further appreciation of the dollar would increase inflationary pressures in the economies of the trading partners of the United States and would threaten the continuation of the real adjustment process of the world economy. In order to support the adjustment process, the reduction in the United States current account deficit should go hand in hand with a reduction in the federal budget deficit. At the same time, monetary policy can no longer give exclusive priority to the international adjustment process, since, in the United States and several other countries, anxieties concerning inflation are gaining ground.

Furthermore, adjustment policies have to be accompanied by determined efforts to resist protectionist pressures and to promote world trade. The Uruguay round of multilateral trade negotiations provides the opportunity for such efforts. The ministerial meeting in Montreal in December must give political impetus to the negotiating process so that the Uruguay round can achieve effective liberalization of trade in goods and services. At the same time, all participants must continue to respect the standstill commitments entered into at the launching of the round; recent United States trade legislation causes concern in this respect.

With respect to the second major imbalance facing the world economy, the debt problem of the developing countries, the debt service/export ratio will probably increase in 1988,

particularly due to the recent rise in interest rates. Furthermore, the situation of the highly indebted Latin American and of some middle income African countries as well as the poorest African countries is still difficult and is likely to remain so, even in the medium term. These countries therefore continue to be vulnerable.

A medium-term solution to the debt problem of middle income countries continues to require adequate adjustment policies in the debtor countries, sufficient external financing as a complement to domestic resources, a continued favourable international growth environment and forms of debt reduction on a voluntary basis. For some of the poorest developing countries, the implementation of the Toronto summit's decision within the framework of the Paris Club and as a complement the conversion of official development assistance loans into grants as well as the result of the annual meeting of the IMF and World Bank in Berlin are encouraging.

2. The Community economy in 1988 and 1989 Like other major industrial countries, the economy of the European Community has shown a remarkable dynamism since the second half of 1987. This dynamism has been fuelled by a significant acceleration in investment. In 1988, average growth will be almost 3 1/2 %, the best performance since 1978/79: yet at that time inflation was on average three times today's level. One has to go back more than two decades to find a combination of output growth and low recorded inflation as desirable as today. This performance is all the more remarkable in that it is following a steady and exceptionally long, though moderate, expansionary phase. Since 1981, average growth of real output in the Community has continued to accelerate and, since 1984, it has equalled or been above 2,5 %.

Prospects for 1989, on the whole, remain favourable. Growth could slow down slightly (from 3 1/2 % to 2 3/4 %) as the exceptionally favourable factors, particularly the mild winter of 1987/88, cannot be expected to recur. Furthermore the international environment is expected to be somewhat less favourable; private consumption could increase less rapidly due to a deterioration in the terms of trade; in some countries monetary policy and/or budgetary policy will have moderating effects. Yet the improvement in supply conditions and demand prospects will once again favour investment. Growth could slow down in countries like Spain, Italy and the United Kingdom who up to now have been the driving force of intra-Community trade. This should result in an alleviation of balance of payments and inflationary pressures. The impetus which these countries have given to economic activity is benefiting their Community partners, who are now picking up some momentum. In these circumstances, it should be possible to avoid a cyclical downturn, which would put a brake on investment, and an acceleration in inflation, equally prejudicial to the maintenance of sustained growth.

TABLE 4 Determinants of GDP growth in the Community of 12 (at constant prices) 1984 1985 1986 1987 1988 (;) 1989 (;) - GDP growth at constant prices 2,4 2,5 2,6 2,9 3;/2 2=/4 - Contribution to growth of ($) - net exports +0,5 +0,1 -1,2 -1,2 -1 -;/2 - domestic demand (including stocks) +1,9 +2,4 +3,8 +3,9 +4 +3;/4 - Exports of goods and services (annual % change) 7,7 4,7 1,5 3,7 5;/4 5;/4 - Private consumption (annual % change) 1,4 2,5 3,9 3,8 3;/2 3 - Gross fixed capital form. (annual % change) 1,3 2,1 3,1 4,6 7 5;/4 (;) September to October 1988 forecasts of the Commission services.

($) Change as % of GDp of the preceeding year. The structure of demand has changed over the recent past. In 1984 and 1985 growth was primarily led by exports. In 1986, this momentum came from an increase in private consumption following the improvement in the terms of trade as a consequence of (i) the fall in oil prices and (ii) the appreciation of European currencies with respect t now in the recovery has been relatively moderate, is tending to be the most dynamic component of domestic demand. It is equally important that the upturn in investment is occurring in all Community countries.

Many factors explain this upturn in business capital formation:

(a) The economies of the industrialized countries are beginning to reap the benefits of structural policies and of greater adaptability of markets. The significant improvement in the profitability of capital and self-financing of enterprises, first induced by moderate wage developments, was accelerated in 1986 and 1987 by the reduction in energy prices as well as by the pick-up of sales.

(b) Demand has been, and is expected to remain strong. In manufacturing industry the rate of capacity utilization is now reaching record levels in many countries. With capacity utilization higher than any time since the previous cyclical peak (1979), and the improved profitability, there is now evidence of a strengthening of capital formation and apparently a progressive and welcome shift from labour-saving to capacity-augmenting investment.

(c) It is also possible that rising expectations in the business sector in relation to 1992 may be beginning to have a positive influence on investment trends. There has, in the course of 1988, emerged clear signs of a ´1992 effect' in merger and take-over activity in the Community, and there are some tendencies for multinational companies to redirect investment location strategies in favour of the Community.

(d) The improvement in the international environment and the acceleration in world trade have both helped to improve the business climate.

In general, inflation in the Community remains under control (+3 1/2 % in 1987 and 1988). It did, however, undergo an acceleration, partly due to exceptional or technical factors in some countries in recent months, notably the United Kingdom and Spain. Some pick up of inflationary expectations was noticed by the authorities in Germany, although from a very low level of recorded inflation. In addition, the disinflation process in Italy, after years of good results seems to be slowing down.

The perception of greater inflationary risks has a number of origins, but on the whole, the risk of renewed inflation in the Community in the months ahead should not be overestimated. This notwithstanding, vigilance is necessary, to different degrees in different countries, because the sustained increase in spending and the higher rates ot capacity utilization may combine elements of demand-pull and cost-push price pressure.

(a) In the Community domestic prices are no longer benefiting from an improvement in the terms of trade, as was the case in recent years. The terms of trade have already deteriorated due to the effect of the recent appreciation of the dollar and the increase in raw material prices (excluding oil). Furthermore, average prices of non-oil raw materials, though only representing about 7 % of Community imports, have undergone significant increases during the first half of 1988 (about + 27 % in dollar terms). Yet, the recent new reduction in oil prices has to a large extent compensated for the increases in other raw material prices. According to forecasts the terms of trade will remain stable on average in the Community. The risk of a further deterioration will remain limited as long as exchange rates remain stable and there is no new significant increase in raw material prices.

(b) The growth acceleration is accentuating the domestic price pressures, especially in those countries where the rate of capacity utilization has been quite high for some time (United Kingdom, Italy and Spain). In these countries, there is a risk that wage cost developments will contribute to additional cost pressures. Yet on average, in the Community, the increase in nominal unit labour costs should remain moderate throughout the forecast period.

(c) During 1987, developments in world exchange markets and the large interventions employed to at least partly finance the United States current account deficit were accompanied by strong monetary expansion in Europe and Japan while monetary growth in the United States was very restrained. This move towards a more expansionary stance in Europe and Japan helped stabilize exchange rates and, after the October 1987 crash, the financial markets; to a certain extent it responded to an increase in desired liquidity holdings in a period of financial innovation, deregulation and decelerating inflation and it helped maintain growth. This effectiveness of the monetary policy measures was in no small part due to the credibility that the monetary authorities had built up over a number of years. The recent increases in short-term rates should moreover allow this credibility to improve further and show the determination of the monetary authorities to preserve their stability achievements. In addition these increases should bring a deceleration in the growth of the monetary aggregates.

The unemployment rate, which has fallen slightly since the middle of the decade still remains a fully reflected in a reduction in unemployment (7). This is for several reasons - firstly the jobs created are not always suitable for the registered unemployed and secondly, since 1986, the participation rate has increased. Due to both these circumstances, despite more favourable employment performances, the share of the long-term unemployed in the total number of unemployed continues to increase while youth unemployment still remains too high. Overall, despite the better growth dynamics in the Community unemployment remains the major problem confronting the European economy.

TABLE 5 Unemployment rate (%) 1973 1979 1982 1985 1988 (;) 1989 (;) EUR 9 ($) 2,4 5,2 9,3 11,1 10,5 10,1 EUR 12 : : 9,4 11,8 11,3 10,9 USA 4,9 5,8 9,7 7,2 5,5 5,5 Japan 1,3 2,1 2,4 2,6 2,5 2,6 (;) September to October 1988 forecasts of the Commission services. ($) The Community excluding Greece, Spain and Portugal. 3. Convergence, stability and growth The average Community increase in growth since the beginning of this decade has been accompanied by greater convergence towards lower inflation rates. But significant divergences are persisting with respect to budgetary positions. New ones are developing in the field of external balances of Member States.

As expected, the convergence of inflation rates of those countries participating in the EMS exchange rate mechanism is particularly significant. No country participating in the exchange rate mechanism has an inflation rate above 5 % . This is also true for Spain and the United Kingdom, so that the major gap between the participating and non participating countries has closed significantly. Portugal and Greece however continue to experience inflation rates sharply in excess of the Community average.

TABLE 6 Convergence of inflation rates (private consumption deflator) 1980 1984 1986 1987 1988 (;) 1989 (;) a) Weighted average EUR 12 13,5 7,1 3,6 3,3 3,5 3,7 WKM ($) 12,0 6,5 2,4 2,5 2,7 3,1 Nicht-WKM ($) 17,0 8,5 6,6 5,2 5,2 5,1 b) Maximum and minimum inflation rates within the ERM ($) Maximum 19,6 11,4 6,1 4,8 4,9 4,6 Minimum 6,0 2,0 -0,2 -0,4 0,9 1,3 Difference 13,6 9,4 6,3 5,2 4,0 3,3 (;) September to Octobcr 1988 forecasts of the Commission services.

($) Countries participating/non-participating in the exchange rate mechanism of the EMS.

(;) See Ghapter B.3.

This convergence of inflation rates has allowed monetary cohesion in the Community to strengthen. Bilateral parity adjustments in the EMS have become less frequent. No realignment has taken place since January 1987. The greater convergence first created a solid base for the strengthening of the EMS mechanism with the Basle/Nyborg accords; since then, the agreement itself has strengthened the EMS. This makes new advances in the monetary area possible. An enlargement of the number of countries participating in the exchange rate mechanism is desirable, at the appropriate time.

Up to 1985 this convergence was achieved in spite of the strong revaluation of the dollar. Since 1986 it was assisted by the oil price fall and the devaluation of the dollar. This development has been rapidly internalized in a slower increase in internal costs. However, the downward convergence in inflation fundamentally reflects the greater consensus in the European economies regarding the objective of stability. The concentration on this objective has made monetary policies more and more compatible with each other. In addition, nominal wage developments have supported the disinflation process. Even ifthe convergence of budget deficits remains insufficient, their increasingly non-monetary financing has largely contributed to the process of disinflation. However, this has been achieved at the price of a rapid increase in public debt and very high interest rates in high deficit countries.

The downward convergence of inflation rates has not been fully reflected in a downward convergence of nominal interest rates. Among the countries participating in the exchange rate mechanism, for example, the average money market rate in Germany for the first nine months of 1988 was 2,6 points lower than in Belgium, 4 points lower than in France and 7,3 points lower than in Italy, even though the rates of inflation in Belgium and France are almost equal to that of Germany, and in Italy it is only about 2,5 points above. Similar differences exist with respect to the long-term interest rates in the different countries.

This can have several origins: (a) a more or less longstanding tradition of stability which goes hand in hand with a more or less rapid reduction of medium-term inflationary expectations; (b) a differential evolution of fundamentals notably budget and external balances which nourish expectations of inflation or exchange rate changes.

In fact, in these two areas, budget deficits and external balances, important divergences persist or are developing. These divergences are a potential source of instability for exchange rates, even if, in the short term, it is always possible to compensate for these effects by intervention and by appropriate interest rate differentials. They increase the risk of conflict between the domestic objectives of monetary policy and the exchange rate discipline of the EMS. In addition, the divergent external balances could make it more difficuIt to define a common position vis-à-vis third currencies, notably the dollar.

TABLE 7 Convergence of net general government borrowing (-) or lending (+) (% of GDP) 1980 1984 1986 1987 1988 (;) 1989 (;) a) Weighted average EUR 12 - -5,3 -4,8 -4,2 -3,8 -3,4 WKM ($) -4,0 -5,4 -5,0 -4,8 -4,5 -4,1 Nicht-WKM ($) - -5,1 -4,1 -2,9 -2,1 -2,1 b) Maximum and Minimum within the ERM Maximum -8,5 -11,5 -11,4 -10,5 -10,0 -10,0 Minimum -0,8 -1,9 +3,1 +2,1 +0,9 +1,4 Difference 7,7 9,6 14,5 12,6 10,9 11,4 The significant differences in the budgetary positions of Member States are being reduced only slowly in 1988. Even if these differences in the level of budget deficits are accompanied by different household saving behaviour, they nevertheless complicate the task of monetary policy in the pursuit of the objectives of internal and external stability.

TABLE 8 l HDLa 6 Gross household saving and net borrowing (-) or Iending (+) of general govenmment in 1987 ( % of GDP) UK - Saving 9,8 11,l 7,8 12,9 8,O 8,3 13,6 20,19,O 9,O 22,8 3,S - Net borrowing of general government -72 +21 -18 -9S -36 -25 -91 -IOS +52 -63 -84 -14 - Difference 2,6 l. "2 6,O 3,4 4,4 5,8 4,5 9,6 14,2 2,7 14,4 2,l Excessive public debt as a percentage of GDP also carries with it serious drawbacks and is creating problems for monetary cohesion and the conduct of monetary policy. (a) It is contributing to the maintenance of high real interest rates prejudicial to productive investment and the pursuit of sustainted growth. (b) The share of irreducible interest repayments in public expenditure is increasing and is reducing the room for manoeuvre for the necessary restructuring in favour of productive expenditure and a reduction in direct tax rates. (c) The credibility of stabilization policies may eventually be affected, this is also increasing the risk premium on long-term interest rates. It is therefore essential for those countries where the budget deficit is still excessive that they follow medium-term strategies to allow them to regain sustainable budgetary positions.

The evolution of external balances presents both a positive and a disquieting aspect. All of those countries, with the exception of Greece, who in recent years had worrying external positions, as at the beginning of this decade did Belgium, Ireland, Portugal and, more recently Denmark, have experienced a significant improvement.

But a significant divergence between the externtal balances of the countries participating in the EMS exchange rate mechanism and the others is developing; furthermore, within the exchange rate mechanism, the gap between the surplus and deficit countries is growing particularly as the German surplus is not yet declining. Simultaneously, intra-Community trade imbalances are widening. In particular, between 1985 and 1987 the intra-Community trade surplus (excluding energy) of Germany increased by about ECU 10 billion and the intra-Community trade deficit of France deteriorated by about ECU 3,8 billion.

TABLE 9 Convergence ofexternal balances ofcurrenttransactions (/n of GDP) (a) Weigirted eve,age EUR 12 -l,2 O,3 1,3 O,8 O,5 O,3 ERM ($) - I,7 O,5 2,O 1,S 1,S 1,6 Non-ERM ($) O,2 -O,2 -O,2 -O,4 -2 3. 3 O (b) aXirun and rninirnurn HvitIin te fR ($) Maximum -l,3 4,2 4,4 4,O 4,O 4,2 Minimum - 1 l,8 - 6,O - 5,2 - 3,O - 2,5 - 2,3 Difference 10,5 10,2 9,6 7,O 6,5 6,S (;) Scptember to October 1988 forecasts of the Commission services.

($) Govntries participating % non-participatingin rhe exchange rare mechanism of the EMS.

1980 1984 1986 1987 1988 (;) 1989 (;) c) Average of ERM ($) surplus and deficit countries in 1988 Surplus countries (=) - - 4,0 3,6 3,6 3,8 Deficit countries (=) - - 0,0 -0,4 -0,3 -0,4 Difference - - 4,0 4,0 3,9 4,2 (;) September to October 1988 forecasts of the Commission services. The existence of such imbalances in the medium term is partly the corollary of the catching-up process of the poorest countries, where the need for and the capacity of investment are relatively stronger. Deficits in these countries are sustainable in the medium term on condition that the deterioration of the current balance corresponds on the domestic place to a strengthening of productive investment and goes hand in hand with sound external financing. This for example is the case in Spain and Portugal where the deterioration in current transactions has accompanied a strong uptake in productive investment financed by private capital inflows. Hence, the level of deficits in these two countries remains sustainable. Furthermore, it is normal and even desirable that countries with a higher level of development experience surpluses on their current accounts and export capital to the less prosperous countries in which investment will be fostered and the catching-up process assisted.

TABLE 10 Growth in GDP and domestic demand (% of GDP) 1985 1986 1987 1988 (;) 1989 (;) a) GDP growth EUR 12 2,5 2,6 2,9 3;/2 2=/4 ERM ($) 2,2 2,5 2,2 3;/4 2=/4 Non-ERM ($) 3,2 3,0 4,3 4 3 b) Growth in domestic demand EUR 12 2,3 3,8 3,8 4 3;/4 ERM ($) 2,1 3,7 3,3 3;/4 2=/4 Non-ERM ($) 3,0 4,3 5,8 6;/2 4 (;) September to Octobcr 1988 forecasts of the Commission services. Since 1984, the evolution of the relative external positions between the exchange rate mechanism participating countries and those not participating appears mainly to be associated with growth differentials. On average for the four countries not participating in the exchange rate mechanism, domestic demand will have risen by about 21 % between 1984 and 1988 as against 13 % for their partners in the exchange rate mechanism.

On current trends, the growth dynamic as it is now taking shape in the different countries in 1989 is a first step towards renewed equilibrium. The growth differentials between those countries participating in the exchange rate mechanism and those not participating are narrowing. However, for the latter group of countries, the growth of domestic demand remains significantly above that of GDP, which indicates that the external balance will continue to deteriorate in terms of constant prices. On the other hand, the external balances (in constant prices) of those countries participating in the exchange rate mechanism, with the exception of Italy, will scarcely deteriorate or may slightly improve. Two factors help to explain this contrasting evolution: (a) The EMS countries are continuing to benefit from a sustained expansion of imports of their partners where domestic supply is beginning to be constrained by a relatively higher rate of capacity utilization. (b) The acceleration in productive investment throughout the Community and the world is particularly profitable for countries like Germany who are traditional exporters of equipment goods.

Between the countries participating in the exchange rate mechanism, the evolution of domestic demand generally played a less important role. The increase in domestic demand in four countries, Belgium, France, Germany and the Netherlands, between 1984 and 1988 was between 10,5 and 13 %. It was stronger in Italy (about 17 %). In Ireland and Denmark, domestic demand needed to be controlled in order to improve the serious external position. During this period the evolution of real effective exchange rates of the different countries vis-a-vis their EMS partners remained more or less stable, or, in particular with the effective appreciation in the exchange rate of the deutschmark, they played a role in the direction of reestablishing equilibrium in external positions.

Despite the marked differences in current account positions of ERM countries, the EMS exchange rate mechanism has remained relatively stable due to capital flows and better monetary policy coordination but this could change depending on market expectations and reactions to increasing imbalances. But in order to maintain the current growth dynamic in the Community and at the same time reduce these imbalances it is necessary that the growth process in the EMS surplus countries and particularly in Germany remains or becomes increasingly led by domestic demand. Recent economic developments in Germany suggest that this is already under way. In addition to contributing to a reduction in payments imbalances it would also assist the growth and investment process in these countries and increase stability within the EMS. Furthermore it would allow the Community to make a greater contribution to the international adjustment process.

B. PROBLEM5, OPPORTUNITIES AND CHALLENGES IN THE COMMUNITY ECONOMY The economic situation has improved considerably. This situation, the most favourable for a long time, is giving the Community the chance to realize to a greater extent and more quickly its fundamental objectives: preparing for 1992, strengthening economic and social cohesion and reducing unemployment.

The internal market programme will in itself give or is even already giving a strong impetus to productivity and growth. But as enterprises prepare themselves to face new realities, output patterns, geographical location and the utilization of factors of production will change. Therefore, while the ultimate benefits of 1992 in terms of growth and employment have been estimated to be significantly positive, there is some concern, especially about the transition towards the completion of the internal market. These uncertainties will be better overcome the more that the achievement of the internal market is accompanied by policies resolutely oriented towards growth and employment as well as towards a reinforcement of economic and social cohesion in the Community.

1. Exploiting the potential of the internal market In the course of the last year, the programme to complete the internal market by 1992 made considerable progress in relation to (i) the understanding of the size and nature of the potential economic gains that it offers as well as to (ii) the legislative actions needed for its implementation. Both are reflected in the heightened awareness and expectations of the private sector.

The legislative actions have been numerous. In the area of finance, the Council has agreed on a timetable and procedure for eliminating capital controls in all Member States. Agreements were also reached on opening the non-life insurance market for larger risks. Commission proposals for the banking sector have been tabled and proposals for securities markets are under preparation. Progress has been made in the areas of public procurement, transport services and technical norms. Measures for the approximation of indirect taxes are under discussion.

Completion of the large internal market is first and foremost a huge programme for improving supply-side conditions, whose success will be effected by markets and firms, that is at the microeconomic level. Studies completed in the last few months show that the realization of the internal market will result in considerable gains for the Community in terms of potential GDP growth (;). These gains will arise from a number of sources: reduced production costs following the abolition of barriers affecting trade; better exploitation of economies of scale due to the increased market size which will also facilitate the development of larger and therefore (;) Notably ´The Gosts of Non-Europe', researches published in European Econony No 35, March 1988, under the title ´The Economics of 1992'.

more competitive European firms; greater efficiency within firms; reduced monopoly power and more dynamic investment and innovations as a result of increased competition and budgetary savings resulting from the opening of public markets.

These potential benefits can only accrue if a rigorous competition policy is implemented to ensure (i) that the positive effects of greater competition are not diminished by State aids and subsidies and (ii) that the free movement of goods and services is not impeded by individual firms in a dominant market position or by groups of firms acting in concert to restrict such competition.

Due to their size, the microeconomic gains will have significant macroeconomic consequences, which in particular depend on the reaction of firms and consumers. For example, faced with cheaper inputs and factor productivity gains, firms could reduce prices to their customers (consumers, firms or public administrations) or increase wages. They could use their additional profits to reduce their indebtedness more quickly or to self-finance their investments. Consumers could react to a higher level of real income by raising the savings ratio or by increasing consumption.

The studies mentioned above confirm that the reactions of the private sector to the completion of the internal market notably by an increase in investment will,in the medium term, allow the achievement of a significantly higher level of GDP and employment and lower inflation. But much depends on the way in which the public authorities react to the easing of the macroeconomic constraints, notably the reduction of the budget deficit, the improvement in the external position and a slowdown in inflation. It seems essential in this respect that the budgetary room for manoeuvre created by the internal market will be used (i) in those countries where the budgetary situation remains difficult, to reduce more rapidly the budget deficit and (ii) in the other countries it should be actively used to improve the conditions of supply and demand by reducing the tax burden and increasing economically profitable public investment.

In this way, the productivity gains resulting from the completion of the internal market, at the macroeconomic level, can be accompanied by an even greater acceleration in GDP growth so that a favourable development in employment can take place. In such a context the increase in total demand can remain sufficiently dynamic and profitability of investment sufficiently high. Better macroeconomic conditions for growth and the completion of the internal market will thus reinforce each other.

It would not, however, be opportune to wait for the 1992 deadline to strengthen the consensus on the macroeconomic policies required for the European economies to increase potential output and sustain growth. In fact:

- Firms are already incorporating the ´internal market' factor into their strategies. The more that they can rely on macroeconomic policies being defined in clear and credible terms, the more energetic they will be in doing so.

- Restructuring at firm, sectoral and market level, already underway, is necessary if the productivity gains expected from the internal market are to be achieved. In the context of slow growth, it is possible that this could lead to job losses initially. This risk could be avoided and new jobs could more than compensate for the job losses due to restructuring by maintaining the Community economy on a sufficiently dynamic growth path. The inertia and opposition to the necessary restructuring will be easier to overcome the more the realization of the 1992 objective results in an increase in employment and a reduction in unemployment. The acceleration of growth and employment observed in 1988 puts this problem in a favourable light - a growth dynamic that needs to be maintained and strengthened over the medium term.

These various movements in the public and private sectors confirm that the 1992 programme has achieved, in the words of the European Council of Hanover, the stage of irreversibility. The rising awareness of the private sector still, however, must continue to be translated into even-stronger growth of investment and thence the capacity for faster non-inflationary growth. It may be expected that this will follow, on condition that the public authorities ratify these expectations with (i) further agreements in the next 12 months on several important outstanding proposals in the 1992 programme, (ii) complementary actions in several associated domains, such as structural, social and external trade policies, and (iii) support for a consistent, growth-oriented macroeconomic policy.

2. Towards greater economic and social cohesion The strengthening of economic and social cohesion in the Community as well as the improvement in living and working conditions of the workforce are objectives of the Community as confirmed by the Single European Act (Articles 130 A and 117). This is why particular attention should be accorded to the regional and social dimension in the face of the changes which will occur in the European e 2.1. Narrowing income gaps within the Community The income gap between citizens from the various countries and regions of the Community is a complex and pressing issue. This catching-up process is, in its own right, one of the more fundamental economic and social objectives of the Community. Historical experience shows that it is possible to reduce in a significant way the per capita GDP disparities, measured in purchasing power standards (PPS), which exist between the different regions and countries. For example, between 1960 and 1973, the gap between the four poorest countries of the current Community of Twelve and the four richest narrowed by about one-third. It widened again following the first oil shock. But since mid-1980, this gap has again tended to narrow, in particular because of good growth performances in Spain and Portugal. Moreover, the disparities in GDP per head between the different regions within countries are very large. Such disparities exist in all countries. For example in Italy, the GDP per head is almost equal to the Community average, but that of the southern regions is 30 % below while that of the north-western regions is 30 % above. In these conditions, the strengthening of economic and social cohesion of the Community also necessitates a convergence towards the higher levels of GDP per head between regions within countries.

TABLE 11 Ratios of per capita GDP (PPS) in the Community (;) 1960 1975 1985 1987 1988 ($) 1989 ($) Four poorest countries (=) over four richest countries (%) 0,41 0,64 0,58 0,60 0,61 0,61 Four poorest countries over average for EUR 12 0,52 0,71 0,66 0,67 0,67 0,68 Eight richest countries over average for EUR 12 1,10 1,06 1,08 1,08 1,08 1,08 Index of GDP per head at constant prices (EUR 12) 100 166 200 210 223 (;) All statistics have been calculated on the basis of the current 12 Member States.

($) September to October 1988 forecasts by the Commission services.

(=) Greece, Spain, Ireland, Portugal.

(%) The composition of this group is variable and depends on the level of per capita GDP (PPS) in the year indicated. The trend differences in GDP and population growth imply that in the period immediately ahead no more than a small reduction in the disparity of average per capita incomes can be envisaged. An extrapolation of the trends of recent years, not taking into account the effect of the doubling of the Structural Funds, suggests that in 1992, average percapita GDP in the four poorest countries will still represent only some 65 % of average per capite GDP in the four richest countries (against 60 % in 1987).

The average GDP per head is not the only criterion by which the degree ofeconomic and social cohesion can be measured, even if it is the main one. In the area of unemployment, significant disparities exist not only between Community countries but also between regions. In Spain and Ireland, for example, unemployment stands at around 20 % of the active population compared to a Community average of 11 %. Furthermore, certain regions in southern Italy as well as in central and northern Europe are particularly affected by unemployment. It is also clear that high levels of underemployment of the workforce are often related to, if not the cause, of lower per capita GDP. The catching-up process should therefore be accompanied by a downward convergence of unemployment rates.

TABLE 12 Macroeconomic adjustment indicators in the poorest countries Inflation rate (Private consumption) Balance of current transactions with the rest of the world as % of GDP Real unit labour costs (Index) 1981 1988 (8) 1981 1988 (9) 1981 1988 (10) GR 23,4 13;/4 -0,7 -2=/4 100 100,0 E 14,3 4=/4 -2,7 -=/4 100 86,0 IRL 19,6 2 -14,7 2;/2 100 90,5 P 23,3 9;/2 -12,2 0 100 83,8 EUR 4 16,8 6;/4 -4,3 -=/4 100 88,0 EUR 8 11,4 3 -0,4 ;/2 100 94,0 EUR 12 12,1 3;/2 -0,7 ;/2 100 93,2 The less-favoured countries, in particular Spain, Portugal and Ireland, have in recent years made major strides in adjustment and consolidation: a fact which in itself should accelerate the narrowing of the gap. In Greece also some favourable developments have taken place but to a lesser extent. Inflation in Ireland (2 % in 1988), for example, is now less than the Community average and in Spain (41/2 %) it is just one percentage point above. Taking the four countries together: the inflation rate has declined by ll percentage points since 1981; the balance of current transactions is now close to equilibrium (-1/2 % of GDP) after having been well in deficit (- 4,3 % of GDP) in 1981; the adjustment of real unit labour costs has been particularly large, falling by about 12 % since 1981 compared to some 6 % on average in the Community.

The Decision of the European Council held in Brussel on 11 to 1f2 February 1988 to double the budgetary commitments of the Structural Funds between 1987 and 1993 show the Community's determination to make an active contribution to the catching-up process of the less-favoured countries and regions. The subsequent adoption by the Council of a framework Regulation on the tasks of the funds and their effectiveness and cooperation with the operations of the European Investment Bank establishes the main operating principles (Regulation (EEC) No 2052/88) The Community resources together with appropriate structural and macroeconomic policies can make an important contribution to the acceleration of the catching-up process. Infact, the increased Structural Funds and financial instruments could represent in Greece, Portugal and Ireland 4 to 5 % or even more of GDP. In Spain and Italy, they would represent a smaller percentage of national GDP, but concentrated on the poorest regions they will represent a similar percentage of the GDP of these regions. This opportunity must be seized by the beneficiary countries. In this regard, paying due attention to the effective use and additionality at programme level in the allocation of these resources to priority development needs is necessary but insufficient.

At the macroeconomic level the community support alleviates the balance of payments constraint of the recipient countries. The overall influence on medium-term economic growth essentially depends on the capacity of the recipient countries to attract private capital by credible management of economic policy and greater returns on investment and on the domestic counterpart to the easing of the external constraint. If this counterpart is found in an increase in the share of consumption in GDP in the countries concerned, the overall effect will be limited and the chance to fully exploit the opportunities offered will be missed. If, on the other hand, the macroeconomic counterpart of the increase in these Community resources is an equivalent increase in the investment share and an improvement in the efficiency of investment, the doubling of the Structural Funds will deliver its full benefits. In reality, micro- and macroeconomic behaviours are interdependent. There is no incentive for firms to invest more, unless profitability (and therefore also productivity) is high; otherwise the increased transfers would mainly lead to a substitution of sources of finance. Similarly, a dynamic environment broadens the range of opportunities available for more productive investment and better returns.

pt TABLE 12 Macroeconomic adjustmentindicators in the poorest countries E 14,3 43/4 -2,7 - 3/4 100 86,O IRL 19,6 2 - 14,7 21/2 100 90,S p 23,3 9!/2 - i2,2 O 100 83,8 EUR 4 16,8 61/4 -4,3 -3/4 100 88,O EUR 8 11,4 3 -O,4 1/2 100 94,O EUB 12 12,l 31/2 -O,7 1/z 100 93,2 The less-favoured countries, in particular Spain, portugal and Ireland, have in recent years made major strides in adjustment and consolidation: a fact which in itself should accelerate the narrowing of the gap. In Greece also some favourable developments have taken place but to a lesser extent. Inflation in Ireland (2 % in 1988), for example, is now less than the Community average and in Spain (41/2 %) it is just one percentage point above. Taking the four countries together: the inflation rate has declined by ll percentage points since 1981 : the balance of current transactions is now close to equilibrium (-1/ae % of GDP) after having been well in deficit (- 4,3 % of GDP) in 198 1 : the adjustment of real unit labour costs has been particularly large, falling by about 12 % since 1981 compared to some 6 % on average in the Community.

The Decision of the European Council held in Brussel on 1 l to 1 2 February 1988 to double the budgetary commitments of the Structural Funds between 1987 and 1993 show the Community's determination to make an active contribution to the catching-up process of the less-favoured countries and regions. The subsequent adoption by the Council of a framework Regulation on the tasks of the funds and their effectiveness and cooperation with the operations of the European Investment Bank establishes the main operating principles (Regulation (EEG) No 2052/88) The Community resources together with appropriate structural and macroeconomic policies can make an importantcontributiontotheacceleration of thecatching-up process.Infact,theincreased StructuralFundsandfinancial instruments could represent in Greece, Portugal and Ireland 4 to 5 / or even more of GDP. In Spain and Italy, they would represent a smaller percentage of national GDP, but concentrated on the poorest regions they will represent a similar percentage of the GDP of these regions. This opportunity must be seized by the beneficiary countries. In this regard, paying due attention to the effective use and additionality at programme level in the allocation of these resources to priority development needs is necessary but insufficient.

At the macroeconomic level the community support alleviates the balance of payments constraint of the recipient countries. The overall influence on medium-term economic growth essentially depends on the capacity of the recipient countries to attract private capital by credible management of economic policy and greater returns on investment and on the domestic counterpart to the easing of the external constraint. If this counterpart is found in an increase in che share of consumptiort in GDP in the countries concerned, the overall effect will be limited and the chance to fully exploit the opportunities offered will be missed. If, on the other hand, the macroeconomic counterpart of the increase in these Community resources is an equivalent increase in the investment share and an improvement in the efficiency of investment, the doubling of the Structural Funds will deliver its full benefits. In reality, micro- and macroeconomic behaviours are interdependent. There is no incentive for firms co invest more, unless profitability (and therefore also productivity) is high: otherwise the irtcreased transfers would mainly lead to a substitution of sources of finance. Similarly, a dynamic environment broadens the range of opport By easing the resource constraint both internal and external, the doubling of the Structural Funds creates the initial condition for a sustainable resumption of the catching-up process. It is therefore necessary that the less-favoured countries continue with and strengthen the implementation of bold adjustment policies so as to gain the maximum benefit from the resources assigned to them to reduce economic disparities.

2.2. The social dimension of the internal market Catching-up in economic terms must go hand in hand with catching-up in social terms, while maintaining basic social standards in the more advanced countries. Thus, apart from its regional aspects, the social dimension of the internal market is essential. Three elements, are important in this respect: (i) the social effects of the completion of the internal market; (ii) the convergence in the improvement of living and working conditions of the workforce (Article I 117 of the EEC Treaty) ; and (iii), social dialogue.

The productivity gains which wi1l flow from completion of the internal market will also entail structural changes in markets and firms. Policies must be implemented which take account of the social effects of this restructuring. In this respect investment in the best resource available to the Community, its people, is essential. A greater emphasis on vocational and in service training will make it easier for the employed to meet these changes and for the unemployed to re-enter working life.

The completion of the internal market will intensify competition between firms of countries with quite different working and social conditions. These differences largely correspond to levels of productivity and capital efficiency which vary just as widely. In these circumstances, it is essential first to create economic conditions which will engender an upward convergence of social standards. The lower real wage levels and less onerous social regulations in the less advanced countries are comparative advantages which enable them to make progress in the catching-up process. In addition, minimum health and safety standards at work and the pursuit by Member States according to Article 118 A of the EEC Treaty of the objective of harmonizing conditions in this area, while maintaining the improvements already made, will contribute to better working and living conditions as well as to the avoidance of distortions in competition between the firms of different Member States. In this context, greater job mobility with maintenance of benefits when changing jobs as well as other guaranteed rights should also be sought.

Strengthening the social contract at the enterprise level could include rights for workers to be involved in the running of their companies and in sharing the benefits arising from higher productivity, broader-based management and a better climate at the work place. In this regard, attention should be given to the advantages that could arise from the adoption by firms on a voluntary basis of a European company statute, allowing companies to operate across the frontiers without violating existing corporate laws and which foresees the implementation of worker participation schemes in the countries concerned.

In the framework of the social dialogue at Community level the social partners have on several occasions in the last few years expressed their support for the general thrust of economic policy of the Community. This agreement represents a precious achievement. This consensus must now be strengthened if the remaining tasks are to be accomplished successfully. As provided for in Article 3 of Council Directive 74/121 EEC of 18 February 1974 on stability, growth and full employment in the Community (11), the Governments of the Member States, according to their own arrangements, should confer with the representatives of the main economic and social groups on the broad lines of economic policy. The contribution of the social partners in the area for which they are competent is vital to the shaping of the social dimension of the internal market. For its part, the Commission. will continue to contribute to the development of Community level dialogue between management and labour which, according to Article 118 B of the Treaty establishing the European Economic Community as amended by the Single European Act, could lead to relations based on agreement, if the two sides consider it desirable. In this respect the development of closer cooperation between the social partners of different Member States in bordering regions could be an encouraging first step towards an awareness of the European dimension in industrial relations.

3. Towards higher employment growth Unemployment remains the major challenge for the Community. It more than doubled during the 1970s, from 2,8 million in 1973 to 7,l million people in 1979 (from 2,4 % of the labour force to 5,2 %). It has doubled once again between 1979 and 1985, now extending, despite a slight fall in 1988, to 15,4 million people or 11,3 % of the labour force (see Table 5 in A. 2). Furthermore long-term unemployment continues to grow and already exceeds 50 % of total unemployment. The rate of youth unemployment, on average in the Community, is still over 20 %. Thanks to the stronger net supply of jobs, the trend of unemployment which has been rising for over two decades gradually started to be reversed in 1987, although experience differs quite markedly among Member States.

Since 1985 the annual rate of employment creation in the Community on a per capita basis reached a historically high level (close to 1 %). The volume increased less, however, since much of the increase has taken the form of part-time employment. In 1988 employment creation remains above the Community average in countries such as Spain (2,6 %), the United Kingdom (I,9 %), Luxembourg (1,7 %) and Portugal (1,7 %). Longer-lasting and more sustainable growth (than that experienced in the 1970s) is thus also becoming even more employment-creating.

TABLE 13 Economic growth and employment (anual average rates of change, in %) 1973/1960 1975/1973 1979/1975 1984/1979 1985 1986 1987 1988 (;) 1989 (;) EUR 12 GDP 4,8 0,4 3,4 1,2 2,5 2,6 2,9 3,4 2,8 employment 0,3 -0,4 0,3 -0,5 0,6 0,8 0,9 1,1 0,9 USA BIP 4,0 -0,9 4,1 2,4 3,1 3,0 3,4 3,9 2,3 employment 1,9 -0,5 3,6 1,3 2,4 1,7 2,6 2,3 1,6 Japan GDP 9,6 0,7 5,1 3,9 4,5 2,4 4,2 5,6 3,8 employment 1,3 -0,1 1,0 0,9 0,7 1,0 1,0 0,8 (;) September to October 1988 forecasts of Commission services.

This performance is nonetheless still unsatisfactory in at least two respects (i) when compared with that of other industrialized countries and (ii) when compared to Europe's own post-war history. For example in the United States and Japan, the rate of job creation has been adequate to restore or to maintain an unemployment rate very close to the one prevailing a decade ago, before the second oil shock. Therefore, by international standards, Europe has a long way to go.

While other industrialized countries are approaching full employment, a mechanical extrapolation of the growth trend of the years prior to 1988 suggests that the unemployment rate in 1992 in the Community would not be much below one-tenth of the labour force. Unemployment represents an under-utilization of the labour resource. This resource must be transformed into a basis for growth as it was in the post-war period. About 15 to 18 million people engaged in agriculture with low marginal productivity and low incomes moved into industry and services where pay was better. Thanks to the realized rapid growth of income and to the strong development of trade and innovation, the resulting capital accumulation turned into jobs, demand and even faster growth.

The development of unemployment has been affected by changes in demography and participation rates. These two factors have moved in opposite directions. The annual increase in the population of working age (15 to 64) in the Community on the one hand has certainly slowed down from l % at the beginning of the 1980s to 1/4 % today, but it will still contribute to a growing labour supply in the near future. Overall participation rates of the population of working age in the Community on the other hand declined between 1975 and 1985 from 64,4 % to 63,3 %, due to a marked decline in male participation from 87,5 to 80,8 %, which outweighed the steady increase in female participation from 45,3 to 49,O %. Thus the overall decline in participation has slowed down somewhat the increase in unemployment. In recent years, however, male participation appears to have stabilized while female participation seems to continue its upward trend. Therefore overall participation is now recovering. This is a positive phenomenon, but it renders the reduction of unemployment in the Community more difficult.

Differences between participation rates in Member States are vast; they range from 53 % in the Netherlands to more than 83 % in Denmark. This is to a large extent due to wide discrepancies in female participation, where Spain with only 34 % and Denmark with more than 78 % (in 1986) provide the extreme cases. Furthermore, the estimated overall Community participation rate of 641/4 % in 1988 is significantly lower than in other industrialized countries (e. g. 721/2 % i All this indicates that with regard to labour supply there is a significant potential for stronger and sustained economic growth in the Community. The increase in employment in general and in particular the growing willingness of women to seek employment could also provide a broader basis for the sharing of the burdens of taxation and social security, which will become more and more important in the medium and longer term to compensate for the ageing of the Community's population. To take full advantage of this potential, employment growth must be centre stage in the Community's economic policy.

In order to appreciate recent developments in the Community's labour market three points deserve particular attention.

First, the process of sectoral change continues. Employment in agricuIture is declining further; it now provides only 8 % of total Community employment. Industry has also continuously shed employment for more than a decade. Today, with higher overall growth rates, this seems to have come to an end. The current expansion of net employment is, however, still provided virtually by the service sector alone.

TABLE 14 Employment creation by sector in the Community 1974 (;)/1958 1986/1974 1987 1988 ($) 1989 ($) Shares in total employment in 1958 1974 1986 Agriculture -4,4 -3,0 -2,0 : : 22,8 11,5 8,1 Industry 0,5 -1,7 -0,0 0,2 0,2 39,1 39,5 32,5 Services 1,7 1,6 2,1 : : 38,1 49,0 59,4 Total 0,2 -0,1 0,9 1,1 0,9 100 100 100 (;) EUR 5: Belgium, Germany, France, Ireland, Italy.

($) September to October 1988 forecasts of Commission services.

Second, part-time work has increased considerably and continues to do so. On average, for the Community, part-time employment as a proportion of total employment has increased to about 14 %. In the past few years three-quarters of the net employment created in the Community has been part-time. Recent information concerning Spain confirms that an even higher proportion of new jobs created since early 1987 have been part-time in nature. The increase in part-time employment, to the extent that it is voluntary, is a sign of a healthy labour market. To the extent, however, that it is involuntary (13 % of all part-time employed, according to the 1986 Community labour force survey) it indicates a degree of underemployment.

Third, an indicator of progress made in the Community towards achieving healthier labour markets is the relative evolution of real per capita labour costs and productivity (real unit labour costs). On average, this ratio has fallen in the Community, by over 6 % since 1981. This fall has been particularly large in the poorest countries (except for Greece, see B.2.1).

TABELLE 15 Real unit labour costs (;) (index 100 in 1981) 1960 1973 1981 1988 ($) 1989 ($) EUR 12 96,0 97,0 100 93,2 92,8 EUR 4 (=) 92,5 94,3 100 88,0 87,7 EUR 8 (=) 95,5 97,1 100 94,0 93,5 (;) Real per capita labour costs divided by productivity (GDP over total cmployment).

($) September to Octobcr 1988 forecasts of Commission services.

(=) EUR 4. Greece, Spain, Ireland, Portugal; EUR 8: other Member Stares.

(;) OECD, Economic Outlook, June 1988.

This trend in real unit labour costs is favourable for a variety of reasons. First, it helps to boost profitability of fixed capital and hence to set an important precondition for a higher propensity to invest. The decline in real unit labour costs indicated in Table 15 also implies that the share of profits in value added has developed very favourably which does, however, not represent a proportionate increase in profitability. Because today a larger amount of capital is required per person employed, profitability of capital has not yet regained the level of the 1960s, a period of almost full employment in the Community.

Secondly, the income of capital relative to that of labour is moving in a direction which slows down the tendency for labour to be substituted by means of capital-deepening investment. Whereas, for example, between 1960 and 1974 an annual average growth of the capital stock of more than 5 % accompanied a rate of net employment creation of O,3 %, this ratio was 3 % to - O,3 % between 1974 and 1983 and 2,3 % to O,7 % after 1983. The moderate real wage growth of the 1980s thus shows sigificant effects. In order to further accelerate employment creation it has to be continued to an extent which may differ between Member States.

The employment content of investment could also be improved by broader efforts to stimulate higher capital productivity along with lower capital/labour ratios. Higher capital productivity would help to avoid capacity constraints in sectors where demand is already strong. It would also improve the competitiveness of European firms and thus create additional demand. In sectors and enterprises where demand is particularly strong this could, for example, be achieved by longer operating hours of equipment, which would allow the employment of more labour per unit of capital. Today's restrictions on operating and opening hours both by law and collective agreements should give way to a more flexible approach. The appropriate implementation would have to be determined by pragmatic decentralized negotiations between the social partners. The cost reductions resulting from longer operating hours of equipment could in part be used to compensate employees for less attractive working hours with additional reductions of individual working time, which would then still be neutral to the level of total costs. This would further increase the employment content of economic growth.

The basic direction of policy to successfully tackle the Community's large-scale unemployment remains uncontroversial. At present the more favourable economic performance provides a good opportunity for the adjustment necessary to sustain the higher growth path and to make it more resistant to possible shocks. But the conditions for more employment-creating growth and investment have to be further improved along the lines of the Community's cooperative growth strategy for more employment (12).

At the macroeconomic level, the conditions for a further rise in profitability and sustained trend of job-creating investment must continue to be strengthened. In this connection, moderate increases in real wages coupled with the now more favourable outlook for demand remains indispensable. At the microeconomic level, structural policies have an essential role to play in increasing the adaptability of the markets in goods, services, capital and labour, in encouraging entrepreneurial initiative and thus in improving the efficiency of the Community economies. The lifting of unnecessary administrative barriers, notably where these stand in the way of a major improvement in the employment situation, has a high priority. In order not to call into question fundamental rights in the fields of social security, of social protection and of working conditions, appropriate regard must be given to the social dimension and the process of structural adjustment must be accompanied by a wide social dialogue (see B.2.2). Furthermore, with some parts of the unemployed in danger of losing contact with the labour market and with structural change continuing a special need has developed to focus on employability (see C.l).

With the full implementation of the macro- and microeconomic policies outlined above and the completion of the internal market, the Community would have the chance to transform its 1988 growth rate of about 3 1/2 % into a lasting medium-term growth path of this order of magnitude or even better. If this could be realized, employment could expand at a rate of about 1 1/2 % per year in the Community. Such an increase of employment would - in spite of a still growing labour supply due to demographic factors and increasing participation rates - be sufficient to reduce the Community unemployment rate by about 1 percentage point per year.

C. POLICY FOR GROWTH AND GREATER CONFIDENCE The renewed investment, which is underway, increases the chances of realizing the objective of sustained, durable and non-inflationary employment-creating growth. The current favourable trend needs to be reinforced over the coming months. However, some aspects of the problem are different in the various countries. In some countries external demand has outstripped domestic supply, giving rise to inflationary pressures and/or a deterioration in the external account. In these circumstances it is important that growth is restored to (;) See annual economic reports 1985/86, 1986/87 and 1987/88 published in European Economy Nos 26, 30 and 34.

more sustainable rates. The running should now be taken up by those countries where growth has been slower and weaker and who now have better conditions for internal growth. This will also contribute to a renewed equilibrium in the external accounts of the different countries.

1. Structural and labour market policies Structural policies are required in their own right to improve the adaptability and efficiency of the Community economies and thus to make a non-inflationary rise in output and employment sustainable, while simultaneously pursuing the Community's social and environmental objectives. The objective behind efforts to increase flexibility is not to destroy social achievements but to create even more employment. Furthermore structural policies must accompany the completion of the internal market in order to ensure that its full benefits are actually forthcoming.

Competition policy must be stringently enforced by rigorous application of the legislation, by the introduction of a control of concentration with a Community dimension and by strict control of State aids. Moreover, the public and private sectors should be treated in a non-discriminatory manner. In this context it is desirable that complete transparency is assured in the relations between public enterprises and the State.

Emphasis must continue to be placed on research and development and on improving the technological competitiveness of European firms. Here the Community has a particular role to play as it encourages and coordinates national research efforts and develops a genuine European approach to research and technology by supporting Community-wide collaboration projects in a variety of sectors, inter alia information and communications technology (Esprit II and RACE). It aims in particular at a strengthening of the technological foundation of the internal market. In this respect the framework programme for research (1987 to 1991) adopted in September 1987 is a success. One year after the adoption of this programme, it is clear that a new impetus has been given to Community research and technological development. In financial terms more than 90 % of the specific implementing programmes have already been submitted to the Council and more than 50 % have been adopted.

The Commission also intends to pursue its policy in favour of small and medium-sized enterprises (SME), as defined in its action programme, approved by the Council in November 1986. To further improve the information for SMEs on European affairs (regulation, norms, tender offers, research projects) the Commission together with the Member State is preparing an extension of the successful project of ´ECC infocentres'. A computerized information network (BCNet) to support cross border cooperation between SMEs has been installed.

With the completion of the internal market, a significant increase of demand for transport services is to be expected. The exchange of goods must not be impeded by lack of transport and communication facilities within the Community. In addition, the links between the peripheral regions and the centre of the Community have to be improved. The Commission is therefore focusing its efforts to support the medium-term improvement of Community infrastructure (;) on projects which are of particular importance to the process of the completion of the internal market and has submitted a draft Regulation to the Council on an ´Action programme in the area of infrastructure financing with regard to the completion of the internal market in 1992' ($). The draft Regulation suggests the introduction of a ´declaration of Community interest' for transport infrastructure programmes. This would give priority to these programmes with regard to the Community's financial instruments and would facilitate the attraction of private capital.

The ´declaration of Community interest' is also a major element of the Commission proposals for the development of new financing instruments. In order to help major European infrastructure projects to become a reality and to do this by stimulating the markets to offer the required finance, it has submitted a revised proposal for a ´Decision on the financing of major infrastructure projects of European interest' (=), which has been given approval by the European parliament and the Economic and Social Committee and is now under further discussion by the Council.

These intentions are complemented by an increased willingness of the European Investment Bank (EIB) to use its means to the full to encourage major European infrastructure investment. A striking example was the agreement of the EIB in September 1987 to make loans of some ECU 1,4 billion for the Channel tunnel project.

In the longer run the hope for Europe lies in the intellectual and technical potential of its population and notably the younger generation. Investment in human capital in general and in education and training in particular must, therefore, be high on the agenda of all Member States. Training for work is one of the sources of strength of the German economy; the United Kingdom and France have committed themselves to important efforts in this field. It is essential that in all other Member States as well substantial efforts be deployed in this field in the next few years, to the largest possible extent with the assistance of the Community.

(;) Basic principles have been put forward in the proposal for a ´Medium-term programme for transport infrastructure', Doc. COM (86) 340.

($) Doc. GOM (88) 340.

(=) Doc. GOM (87) 724.

The very special attention which labour markets have received in a member of Member States in the 1980s, together with the improved overall economic climate, have borne fruit. Labour markets throughout Europe are generally showing signs of greater adaptability (see B.3). Yet unemployment persists, with continuing increases in the average period of unemployment. Hence the need to improve the integration and re-integration into working life of the unemployed by a full range of measures, encompassing counselling and guidance, job search assistance, recruitment assistance and appropriate vocational training. All Member States have followed various specific labour market policies to address this problem, in particular for the young and long-term unemployed. A comprehensive overview of these policies is regularly provided by the Commission in its semi-annual follow-up on the Council resolution of 22 December 1986 (;). The necessity of the measures designed in the Commission's ´Memorandum on long-term unemployment' ($) and the special priority for the use of the growing Community Structural Funds to combat long-term unemployment are underlined by these developments in the labour market. Based on the Council decision on ´Action to combat long-term unemployment' (=), the Commission started an ´Action programme to assist the long-term unemployed' in summer 1988.

2. Monetary policy The framework for conducting monetary policies in the Community in 1988 has continued to be strongly inflvenced by international monetary developments:

(a) in 1987 monetary policies in Europe were geared to preventing an undershooting of the dollar, involving official financing of the United States external deficit and implying reduced interest rates and fast growth of the monetary aggregatesin Europe;

(b) the appreciation of the dollar during 1988 alleviated this external constraint and allowed the European authorities to give greater weight to domestic objectives.

The greater freedom for manoeuvre in monetary policy, most evident in recent months, has been directed to damping or reversing the upturn in inflation expectations that appeared to have occurred during the summer as a result of a number of factors:

- higher import costs, in dollar terms, in the first half of the year, aggravated by the dollars appreciation,

- fears of overheating in some Community countries and stronger-than-expected growth in the context of high capacity utilization in all of them,

(;) ´An action programme on employment growth'.

($) Doc. COM (87) 231.

(=) OJ No C 335, l. 12. 1987.

- continuing concern in some countries about above-target growth of the monetary aggregates and their possible detrimental effect on future wage and price-setting behaviour.

The combination of these factors, weighted in different ways in different Member States, thus led the monetary authorities, notably in the Federal Republic of Germany and the United Kingdom, to increase short-term interest rates. The actions taken appear to have had the desired effect of damping longer-term inflation expectations, as evidenced by the considerable flattening of yield curves since the summer. To the extent that longer-term expectations of inflation and/or depreciation of the currencies have been reduced, long-term interest rates could be stabilized or decrease on a sound basis; some evidence of this emerged in some countries in early autumn.

Among ERM participants, short-term interest rates have risen most in Germany. The rise started on the money market during the second quarter of 1988 and since June the Bundesbank has on several occasions raised its key rates. These movements initially marked a reversal of previous tendencies essentially imposed by external constraints but later reflected a fear that further deutschmark weakness could increase inflationary expectations via rising import prices, as well as a desire to rein back above-target growth of money supply. Some deceleration of M3 in Germany is already in evidence: the latest figures show growth only just above the top of the 3 to 6 % target range.

In other countries belonging to the exchange rate mechanism the increases in short term-interest rates have been somewhat smaller than in Germany. In these countries, the compatibility of domestic economic policies with final objectives has important repercussions on the conduct of monetary policy. In Italy, the budget situation is a serious problem for monetary policy: high short-term interest rates, which are required to stabilize the lira exchange rate, affect the fiscal budget consolidation via higher debt servicing costs. Without significant progress in the budgetary field the difficulties of the policy-mix could become even more obvious, further complicating the task of monetary policy. Other countries with budgetary problems might be faced with a similar, although probably less acute, dilemma.

In the United Kingdom, the authorities have reacted to ensure that the downward pressure on inflation is maintained by increasing rates on several occasions. The recent monetary tightening is Internally-generated inflationary pressures, at least in the countries participating in the exchange-rate mechanism of the EMS, seem at the moment to be contained: monetary growth is under control; the composition of overall growth has favoured investment, holding out the prospect of an increase in supply capacity; and unit labour costs are increasing only slightly. Moreover, non-oil commodity prices have stabilized since the summer and oil prices have slumped. Further, the tightening of monetary policies in these countries in recent months has already dampened expectations of inflation.

The risk to the outlook and the potential challenge to monetary policy could come from a renewed instability of the dollar. In such circumstances, the monetary authorities will have to coordinate their efforts. Active foreign exchange intervention has recently proved its effectiveness in calming wilder oscillations in market expectations of the dollar's exchange rate, and the importance of this monetary tool may need to be put further to the test should major exchange rate pressures develop. The exchange rate mechanism of