f, <f COMMISSION OF THE EUROPEAN COMMUNITIES 
Brussels, 12.02.1997 
COM(97)27 final 
1997 ANNUAL ECONOMIC REPORT 
Growth, employment and convergence 
on the road to EMU 
(presented by the Commission) 
'*§ 
\l 4 
lit 
il: 

1997 Annual Economic Report 
PART A: COMMUNITY-WIDE TRENDS 
SUMMARY AND CONCLUSIONS i 
CHAPTER 1: THE CURRENT ECONOMIC SITUATION AND THE OUTLOOK TO 1998 1 
1.1. DISAPPOINTING GROWTH AND JOB PERFORMANCE IN THE FIRST HALF OF THE 1990s l 
/././. 1990-93: Overheating and recession 2 
1.1.2. Mid-1993 to mid-1995: Soundly-based recovery 3 
1.1.3. Abrupt slowdown and extended growth pause from mid-1995 to mid-1996 4 
1.1.4 Main causes of the 1995/96 growth pause 4 
1.1.5 Macroeconomic obstacles to growth 8 
1.2. PROGRESSIVELY STRENGTHENING UPTURN IN 1996-98 10 
1.2.1. An accelerating and well-balanced rebound in activity has taken hold 10 
1.2.2. Positive growth forces 13 
1.2.3. Uncertainties and short-term risks 17 
1.3. GRADUALLY IMPROVING EMPLOYMENT OUTLOOK 18 
1.3.1. Recent and prospective trends in employment and unemployment 18 
1.3.2. Recent labour market performance of selected countries 21 
1.4. ENCOURAGING INFLATION OUTLOOK 25 
BOX 1: REGIONAL UNEMPLOYMENT IN THE COMMUNITY 28 
CHAPTER 2: KEY STRUCTURAL CHALLENGES FACING THE COMMUNITY 31 
2.1. TECHNOLOGICAL PROGRESS 31 
2.2. GLOBALISATION 35 
2.2.1. Trade 36 
2.2.2. Foreign direct investment 40 
2.2.3 Financial capital movements 43 
2.2.4. Economic implications 43 
2.3. COMPETITIVENESS ! 45 
2.4. CAPITAL-LABOUR SUBSTITUTION AND EMPLOYMENT GROWTH 49 
2.4.1. Substitution of labour by capital 49 
2.4.2. Substitution andwage developments 52 
2.5. POLICY IMPLICATIONS 56 
BOX 2 : THE IMPACT .AND EFFECTIVENESS OF THE SINGLE MARKET - THE 1996 REVIEW 58 
BOX 3: WAGE DISPERSION IN THE COMMUNITY IN 1994 60 
BOX 4: ECONOMIC GROWTH AND THE ENVIRONMENT 61 
CHAPTER 3: CONSOLIDATING AND RESHAPING PUBLIC FINANCES 63 
IN THE COMMUNITY 
3.1. LONG-TERM TRENDS IN PUBLIC FINANCES IN THE COMMUNITY ..64 
3.1.1. Government spending 64 
3.1.2. Government receipts 66 
3.2. BUDGETARY DEVELOPMENTS IN 1996 AND OUTLOOK FOR 1997 AND 1998 69 
3.2.1. Accelerated progress in the reduction of budget deficits 69 
3.2.2. The pace and size of consolidation efforts 71 
3.2.3. The composition and durability of consolidation efforts 73 
3.2.4. Trends in government debt-to-GDP ratios 75 
3.3. THE ECONOMIC IMPACT OF BUDGETARY CONSOLIDATION IN THE COMMUNITY 76 
3.3.1. Short-term growth impact of budgetary consolidation in 1996-97 76 
3.3.2. Budgetary policy in a medium-term perspective 80 
BOX 5: AUTOMATIC STABILISERS IN THE COMMUNITY 84 
BOX 6: PENSION EXPENDITURE AND LIABILITIES IN THE COMMUNITY 86 
CHAPTER 4: EXCHANGE-RATE STABILITY AND INTEREST-RATE CONVERGENCE IN 
THE COMMUNITY .%. 89 
4.1. OVERVIEW 89 
4.2. UNEVEN APPRECIATION IN THE US DOLLAR 90 
4.3. APPRECIATING DOLLAR AND EMU OPTIMISM FAVOUR MONETARY STABILITY IN THE 
COMMUNITY 92 
4.3.1. Strong dollar reflected in intra-EC exchange-rate movements 92 
4.3.2. Appreciation of other EC currencies against DEM accompanied by convergence in 
short-term interest rates 94 
4.3.3. Long-term interest rates also converge, helped by EMU optimism 96 
4.4. EMU PROSPECTS CONFIRMED IN ECU MARKET AND FORWARD INTEREST RATES 98 
4.5. EASING MONET.ARY CONDITIONS COMBINES WITH BUDGETARY CONSOLIDATION TO REBALANCE 
THE MACROECONOMIC POLICY MIX 100 
4.5.1. Monetaiy conditions ease over the year 100 
4.5.2. Monetary easing provides scope for continued budgetary consolidation 102 
A^ 
Tables 
1. Growth and employment, EUR, USA and Japan 1 
2. Recovery and slowdown in the Community 3 
3. Real GDP growth 11 
4. Improved economic policy-mix 13 
5. External environment 17 
6. Employment growth 19 
7. Unemployment rate 20 
8. Recent labour market performance of selected countries 22 
9. Inflation 25 
10. Nominal compensation per employee 26 
11. Long-term trends in total factor productivity growth 32 
12. Geographical structure of extra-Community trade 38 
13. The regional structure of extra-EC imports of manufactured products 40 
14. Foreign direct investment 41 
15. Structure of foreign direct investment in the EC 43 
16. Export performance, total goods 45 
17. Macroeconomic competitiveness in the Triad 47 
18. Output, employment, productivity and capital-labour substitution , 50 
19. Employment potential, EUR 52 
20. Size of public finances in the EC, US and Japan 64 
21. Receipts and expenditure of general government, EUR 65 
22. General government net lending or net borrowing 70 
23. Cyclically-adjusted general government balances 72 
24. General government receipts and expenditure 73 
25. General government expenditure 74 
26. Gross public debt 76 
27. Five-vear forward rate on five-year loans 99 
AC-
This performance is clearly worse than that of the Community's main international 
partners. The US economy, helped by higher growth and a more responsive labour 
market, has created jobs at an average rate of 1.2 per cent per year over the first half of 
the 1990s. And although Japan experienced a severe recession and average growth over 
the period was only slightly higher than in the Community, the Japanese economy 
managed to create jobs at a rate of 0.7 per cent per year. 
The comparatively poor performance of the Community over the 1990s reflects the fact 
that the Community economy has repeatedly come up against important macroeconomic 
constraints on growth. 
1.1.1 1990-93: Overheating and recession 
Graph 1 Production capacity and GDP, EUR 
:i5o; index: 
90: 
; %•••: change per year ; In 1988-90, the macroeconomic 
policy-mix in the Community on 
average became too expansionary 
relative to available production 
potential. Insufficient efforts 
were being made to reduce 
budgetary imbalances while 
average monetary conditions had 
been eased in the wake of the 
October 1987 stock market crash. 
With business expectations 
buoyed also by the prospects for 
the implementation of the Internal 
Market, output growth 
accelerated to around 4 per cent 
per year on average in 1988-89. 
This was considerably faster than 
the potential growth rate of the 
Community and with no spare 
capacity available it led to an 
overheating in the economy. The 
debt-financing of massive 
unification-related expenditure led to a high budget deficit and rising inflationary pressures 
in Germany. For the Community as a whole, the current account balance turned from a 96 J I I L. I, I I L 
85 9Û 
* Ratio of actual to potential GDP. 
Source: Commission services. 
Part A : Community-wide trends 
i.iuo 
SUMMARY AND CONCLUSIONS 
The Community is on course towards a successful transition to EMU... 
Since the adoption of last year's Annual Economic Report, substantial progress in institutional 
preparations for EMU and a reinforced commitment to budgetary adjustment in many Member 
States has brought important benefits. Both short- and long-term interest rates have converged 
towards lower levels and exchange rate stability has improved. Thus, progress towards EMU is 
helping Member States to overcome some of the most important obstacles to sustained growth 
and job creation in recent years, namely high real interest rates and monetary turbulence. 
Against the background of a widespread easing of monetary conditions and the increased 
credibility of budgetary consolidation in many Member States, the prospects for a sustained pick­
up in economic activity and employment in the Community have improved considerably. 
...helped also by progress in institutional preparations. 
On the institutional front, the Community has achieved substantial progress with preparations for 
stage three of EMU. This concerns the technical preparations for the introduction of the euro 
and arrangements guiding currency relations between the euro and the currencies of Member 
States that may not be in a position to participate in the single currency from 1 January 1999. 
Equally importantly, agreement has been reached on the framework for ensuring budgetary 
discipline and co-ordination in the third phase of EMU (the Stability and Growth Pact). 
Prospects for exchange rate stability have also been enhanced by the entry of the Finnish 
markka and the Italian lira into the exchange rate mechanism of the EMS. 
This institutional progress has played an important role in underpinning confidence in EMU. It is 
essential that the Community continues to work determinedly to ensure that all the conditions for 
a successful transition to the third stage of EMU on 1 January 1999 are put in place in a timely 
fashion. 
A gradually strengthening upturn in economic activity is underway 
Following the set-back to economic growth in the second half of 1995 and in early 1996, the 
Community economy now appears to be back on a more favourable track. Activity has 
recovered in virtually all Member States and for the Community as a whole the pace of 
expansion is expected to pick up to around trend rate in 1997 and above-trend in 1998. This will 
contribute to some improvement in the employment situation. However, the labour force will 
also increase and, while unemployment is likely to decline gradually during 1997 and somewhat 
faster in 1998, overall levels will remain high. Recent inflation trends are encouraging in most 
Member States and the outlook is for continued convergence of inflation rates at a low level. 
A good basis has been laid for achieving strong investment-supported economic growth and 
sustained job creation over the medium term. Supply-side fundamentals -- in terms of 
reinforced prospects for moderate wage increases and sound investment profitability - are 
better than during the period of high growth and job creation in the second half of the 1980s, and 
better also than during the recovery in 1994 and early 1995. The forecast pick-up in investment 
will ensure a sufficiently rapid expansion of productive capacity to keep pace with growing 
demand. And the stance of economic policies has become more conducive to a soundly-based 
and sustained expansion of output, investment and employment. 
Sound rebalancing of the macroeconomic policy-mix has taken place 
In 1996 and in their budgets for 1997, a large majority of Member States have taken significant 
measures to reduce their budget deficits to 3 per cent of GDP or below as a step towards 
moving close to budget balance or achieving a surplus over the medium term. While some 
countries have relied to some extent on one-off measures which will need to be complemented 
by lasting budgetary improvements, the overall scale and composition of the consolidation 
efforts underlines the strong resolve of Member States to place their public finances on a sound 
footing. Budgetary positions would already have improved more by now had it not been for the 
slowdown in economic growth in 1995/96. 
Budgetary consolidation is necessary and desirable in its own right. The-need to make headway 
in fulfilling the conditions for the introduction of the single currency has provided a unique 
opportunity to achieve large gains in the credibility of these adjustment efforts. During 1996, this 
led to a very significant reduction in interest rate premia in a number of Member States. The 
most striking examples are Spain, Italy, Sweden and Portugal where long-term interest rate 
differentials relative to the lowest-yielding currencies have fallen substantially. In addition to 
strengthening the growth prospects of the economy and stimulating investment, lower interest 
rates provide a significant boost to deficit reduction by lowering the government debt service 
burden. 
Budgetary consolidation forms an integral part of the overall rebalancing of the economic policy 
mix in the Community. Reduced inflationary pressures and the prospects for moderate wage 
increases have paved the way for a significant easing of monetary conditions. Against the 
background of healthy supply-side fundamentals and a favourable international setting, the net 
growth impact of budgetary consolidation and lower interest rates in the Community is consistent 
with healthy economic growth in 1997-98. Even if economic activity should fail to pick up to the 
extent foreseen, there should be no let-up in budgetary consolidation efforts. Slippages from 
budgetary targets would put at risk the favourable trends in interest and exchange rates and 
therefore undermine the prospects for stronger economic growth. 
Avoiding macroeconomic obstacles to growth ... 
The poor growth and employment performance of the Community over the first half of the 1990s 
has often been incorrectly blamed on factors such as globalisation or the introduction of new 
technologies. In fact, it was mainly the result of macroeconomic obstacles to growth within the 
Community: 
(i) Insufficient expansion of productive capacity: In the late 1980s/early 1990s inflationary 
pressures built up in the Community as demand expanded too fast relative to productive 
capacity; 
(ii) Distorted economic policy-mix: A distorted policy-mix led to an overburdening of monetary 
policy. Indeed, too lax budgetary policies (since 1988) and wage developments (since 
1990) inconsistent with the objective of price stability caused a rise in interest rates which 
resulted in a slowdown in growth and job creation and the 1992/93 recession; 
(iii) Monetary turbulence: currency crises, which to a considerable extent reflected insufficient 
credibility of economic policies in several countries and a lack of policy co-ordination in the 
Community, have had a disruptive influence on economic growth both in countries whose 
currencies appreciated and in countries whose currencies depreciated. The most recent 
example was the currency turmoil of spring 1995 which, together with the rise in long-term 
interest rates and the depreciation of the US dollar, aborted the otherwise sound recovery 
which had started in mid-1993. 
If the Community is to achieve a sustained period of healthy economic growth capable of 
ensuring a significant and lasting reduction in unemployment, it has to find lasting solutions to 
these macroeconomic obstacles to growth. 
... means enhancing the Community's growth potential... 
Strong medium-term economic growth must be supported by investment to ensure that 
productive capacity increases in line with rising demand. In the short run, economic growth can 
and should exceed potential output growth in order to take up idie productive capacity and to 
absorb the, generally small, cyclical component of unemployment. However, over the medium 
term economic growth cannot exceed the potential growth of the economy without creating 
capacity tensions and therefore resulting in rising inflation. With the current investment rate, the 
Community economy would, in the longer run, barely be able to grow at more than 2% per cent 
per year. On the basis of historical trends, this would result in a slow increase in employment. 
In view of the high level of unemployment in the Community and the huge potential for an 
increase in labour force participation, considerably faster and durable economic growth and job 
creation is required. High growth in fixed investment, as much as better quality of investment, is 
needed in order to achieve potential output growth in the 3 to VA per cent range over the 
medium term. 
Investment conditions are now favourable from a macroeconomic point of view but they must be 
assisted by a balanced and credible policy mix over the medium term. On this account, the 
strengthening of the policy framework inherent in the process leading to EMU is a major positive 
factor. 
...ensuring a balanced and credible policy-mix over the medium term... 
The objective of achieving a government financial position close to balance over the medium 
term has been adopted by the Community in successive Broad Economic Policy Guidelines 
since 1993. This objective has been given increased credibility and importance within the 
framework of the "Stability and Growth Pact" agreed by the Dublin European Council in 
December 1996 in order to ensure budgetary discipline in stage three of EMU. Member States 
are committed to taking further steps, in the years after 1997, to ensure a continued 
improvement in their budgetary positions in order to attain the medium-term objective of close to 
balance or a surplus in normal circumstances. 
This objective is an essential condition, not only to ensure the viability and reap all the potential 
benefits of EMU, but also to achieve sustained, investment-supported growth in output and 
employment over the medium term. The latter requires a rise in government savings to 
maintain a proper balance between overall savings and investment, and low interest rates. The 
medium-term objective of close to balance or surplus will also create room for budgetary policies 
to adapt to cyclical disturbances without causing the deficit to exceed 3 per cent of GDP during 
"normal" cyclical downturns. Finally, it will be instrumental in reversing the upward trend in 
government interest payments, thereby reducing the crowding-out of non-interest expenditure 
and facilitating tax reductions while preparing for the budgetary consequences of the 'ageing" of 
populations. Once the average budget deficit in the Community has been reduced to 3 per cent 
of GDP by 1997, the achievement of budget balance in the course of subsequent years will be 
facilitated by the return to healthy economic growth. 
While budgetary consolidation measures need to be adapted to country-specific circumstances 
in terms of their extent, timing and design, they should be credible and socially-balanced and 
adhere to the main guiding principles stipulated in successive Broad Economic Policy 
Guidelines, including the 1996 Recommendation. This means giving prominence to expenditure 
restraint as opposed to further increases in the overall tax burden; shifting government spending 
priorities towards productive activities such as investment in infrastructure, human capital and 
active labour market initiatives; improving the efficiency of public services; and reducing the 
overall tax burden as possible, especially that on labour, but conditional upon firstly placing the 
budget deficit on a firm downward path. 
For the first time since the adoption of the Broad Economic Policy Guidelines in 1993, average 
wage increases in the Community are now forecast to remain at levels which are fully consistent 
both with the maintenance of price stability and with the achievement of a further improvement 
in investment profitability in the Community, while also allowing a moderate increase in real 
wages. Continued respect of these conditions is essential. The strongly enhanced credibility of 
the monetary and budgetary policy framework in EMU will help to avoid the emergence of 
excessive price and wage pressures. 
Continued appropriate wage developments combined with sound budgetary policies would 
facilitate the realisation of price stability and durably lead to a balanced policy mix and to lower 
interest rates in the Community. The discussions at Community level of the Commission's 
communication on "Action for employment in Europe - A Confidence Pact" are helping to avoid 
the risk of conflict between the three major macroeconomic variables. 
... and preserving monetary stability. 
Progress towards EMU acts positively on exchange rate stability and reduces risk premia on 
interest rates. The achievement of EMU in 1999 will, by definition, eradicate the obstacle to 
growth stemming from intra-EC currency turbulence for participants and should also have 
positive effects for the ,:pre-ins" as they continue to make progress with economic convergence. 
With widespread use of the euro in intra- and extra-European trade, the Community will also be 
less vulnerable to the volatility of the US-dollar exchange rate. 
Technological change and globalisation are not the causes of unemployment 
The unsatisfactory job performance of the Community economy during the first half of the 1990s 
has sometimes been linked with the effects of rapid technological advances and increased 
globalisation. However, such views often fail to take into account the wider economic impact of 
these phenomena. 
Technological and organisational advances, the move towards a knowledge-based economy and 
improved international resource allocation have been and will continue to be the key driving 
forces behind long-term improvements in productivity, economic growth, employment and living 
standards in the Community. However, such changes imply continuous changes in the structure 
of output and employment and tend to reduce demand for low-skilled labour. 
In order fully to reap the potential benefits from technological progress and globalisation, it is 
essential that macroeconomic growth is strong enough to absorb the resources freed by higher 
productivity. On the structural side, it is necessary: 
(i) that efficiently functioning goods and services markets facilitate adjustment by allowing for 
swift changes in relative prices, and that sectoral changes occur smoothly and in a socially 
acceptable manner; 
(ii) that improved education and training increase the supply of high-skilled labour and that 
measures are taken to enhance employment of the low-skilled. 
Enhancing the efficiency of product and services markets 
In order to increase confidence and the propensity to invest, it is essential that Member States 
and the Community intensify their efforts to improve competition in the markets for goods and 
services. This involves in the first place the full completion of the European single market which 
has so far contributed to a rise in the level of GDP of up to 1.5 per cent and created up to 
900 000 jobs. Further action is needed, however, to complete the legislative framework in areas 
such as taxation and company law and the liberalisation of the telecom and energy markets. 
Even more importantly, it is necessary to ensure the effective application and enforcement of 
existing Cpmmunity law and competition policies, and to reduce the burden of over-regulation, 
particularly but not exclusively at the national level, which still impedes the operation of the 
single market. 
The creation of a flexible economy also needs determined action in other important areas, 
including the realisation of the transeuropean transport and communication networks, the 
intensification of research and development, the promction of the information society and the 
removal of barriers to entry and excessive regulation facing SME's. These policies will 
strengthen the endogenous growth forces, lead to positive advancements in the overall 
productivity of the Community economy and increase the effectiveness of macroeconomic 
policies. 
The employment effects of policies to improve competitiveness and the functioning of product 
and services markets depend crucially, however, on the possibility of exploiting this potential 
through higher overall growth. EMU will help pave the way for strong and durable employment-
creating growth. 
Need for greater labour cost flexibility and employment 
Over the last two decades, the annual average increase in labour productivity in the Community, 
of the order of 2 per cent, has resulted in more or less equal proportion from the incorporation of 
technological progress and a substitution of labour by capital at the macroeconomic level. By 
comparison, nearly no macroeconomic substitution has taken place in the United States despite 
an only slightly lower pace of technological progress. The substitution of labour by capital in the 
Community reflects three trends. Firstly, relatively more investment has been aimed at 
replacing labour rather than expanding capacity. Secondly, within the international division of 
labour the Community has specialised in high-skilled and capital-intensive production. Thirdly, 
certain labour-intensive, low-productivity employment opportunities have ceased to exist in the 
Community. 
Capital-labour substitution is a means of achieving high growth in economic activity and rising 
living standards. In the current situation of persistently high unemployment in the Community, 
however, this creates a twofold problem. 
Firstly, relative to stable labour productivity growth, macroeconomic growth in the Community 
has been insufficient to create an adequate number of jobs although as highlighted above, 
conditions for strong growth are improving. 
Secondly, the trend towards capital-labour substitution can be seen to reflect an imbalance in the 
relative prices of capital and labour and an insufficient degree of adjustment in the labour market 
in particular. Following the first oil price shock, high wage and non-wage labour costs as well as, 
in some cases, rigid employment security rules have reduced the attractiveness of labour as a 
production factor and have compelled enterprises to keep up a strong substitution of labour by 
capital in order to safeguard their competitiveness. However, labour markets in the Community 
have adjusted gradually. Since the early 1980s, productivity increases obtained through capital-
labour substitution have broadly ceased to be reflected in higher real wages, leading to a 
considerable improvement in profitability. These developments are laying the ground for 
economic growth sustained by capacity-widening and employment-creating investment as 
demand prospects brighten, but they impact only slowly on the employment-intensity of growth. 
Another, more rapid route towards a more employment-intensive pattern of growth would be to 
encourage a downward widening of the wage cost scale as in the United States. Reducing wage 
costs at the low end would enable activities with low productivity to remain and/or to become 
profitable. For social and political reasons, an emulation of the US-approach which has led to a 
significant drop in real wage income for low-skilled labour is neither feasible nor desirable in the 
Community. Hence the need for strong, investment-supported macroeconomic growth assisted 
by pragmatic solutions, as laid down in the strategy adopted by the Essen European Council in 
December 1994, aimed at a higher employment-content of growth without impairing 
competitiveness. 
In order to preserve, in a reformed and streamlined fashion, the key ingredients of the European 
social model, the following pragmatic approaches are worth pursuing. The social partners' wage 
agreements should provide for more differentiation according to qualifications, and between 
regions and, to some extent, sectors. Non-wage labour costs (or payroll taxes) at the lower end 
of the wage scale should be lowered with the government revenue losses being compensated for 
by a stricter control of increases in overall government spending and/or increases in other taxes 
(e.g. environmental levies). In a similar vein, temporary entry-wages for the low-skilled, youth or 
long-term unemployed could usefully be introduced. Furthermore, more flexibility in working 
time arrangements, tailored to the specific needs of firms and workers, the greater use of 
voluntary part-time work and the promotion of local employment initiatives are likely to foster 
both new jobs and higher participation in the labour market. 
More generally, as emphasised in the 1996 Joint Employment Report "Employment and growth 
in the Community - The way forward" approved by the Dublin European Council, there is a 
continued need to improve the responsiveness of Member States' labour markets to changes in 
the economy through a modernisation of the organisation of work, increased geographical and 
professional mobility and productivity-related labour cost differentiation. In particular, it is 
essential to reinforce education and training so that the work force is able to adapt to evolving 
technological changes. These efforts are also necessary in order to avoid labour market 
bottlenecks and a resumption of wage inflation as unemployment is reduced. 
With the realisation of the single market and EMU, the Community is increasingly becoming an 
economic entity. Supply-side fundamentals are healthy and improving further, thereby 
underpinning the ongoing recovery. In EMU, sound budgetary policies and moderate wage 
developments will facilitate the maintenance of stable monetary conditions. This fundamental 
change in the overall macroeconomic policy mix will be favourable to growth. 
These factors provide the basis for transforming the current recovery into strong and durable 
economic growth supported by higher investment, thus avoiding capacity constraints and 
inflationary tensions. An extended period of sound economic growth of the order of 3 to VA per 
cent per year would progressively absorb the high employment potential of the Community and 
significantly reduce unemployment. Stronger economic growth and job creation is also required 
to realise the full benefits of the single market, globalisation and technological progress. 
Against such a background, the consolidation and restructuring of public finances would be 
facilitated and the unavoidable structural adjustments would be eased. The necessary structural 
policies in the goods, services and labour markets would also be more effective in helping 
overcome rigidities, avoid inflationary pressures and make growth more employment-creating, 
especially with respect to low-skilled labour, without impairing competitiveness. 
These considerations underline the need for adopting measures in line with the conclusions 
adopted by the European Councils in Florence and Dublin. 
1. THE CURRENT ECONOMIC SITUATION AND THE OUTLOOK TO 1998 
Following the set-back to economic expansion in the second half of 1995 and early 1996, 
the Community economy now appears to be back on a more favourable track. A rebound 
in economic growth is underway, helped by a sound rebalancing of the macroeconomic 
policy-mix and an EMU-related gain in the credibility of the economic policy framework 
in the Community which has led to strongly reinforced convergence in long-term interest 
rates. Against the background of good fundamentals and sound economic policies, output 
is expected to grow at around its trend rate in 1997 and above trend in 1998. 
The rebound in economic activity should lead to progressive improvements in 
employment. In the short term, unemployment is likely to remain high but it is expected 
to decline gradually during 1997 and somewhat faster in 1998. Inflation trends are 
favourable in almost all Member states and the outlook is for continued convergence of 
inflation rates at a low level, underpinned by generally moderate wage increases. 
1.1 Disappointing growth and job performance in the first half of ihe 1990s 
The outlook for a strengthening of economic activity must be seen against the background 
of an unsatisfactory growth and employment performance over the first half of the 1990s. 
During the last six years, average GDP growth in the Community has been only 1.5 per 
cent per year (Table 1). This lack-lustre performance is much lower than the average 3.3 
per cent growth rate achieved in the latter half of the 1980s, and it is lower also than the 
average 2 per cent growth rate registered during the years 1974-85 even though this 
period was characterised by severe adverse 
supply shocks. 
Low growth has been reflected in 
disappointing employment trends. Over the 
years 1991-96, employment in the 
Community has fallen by an average 0.4 per 
cent per year, amounting to a total of 4!/2 
million jobs lost since 1990 (3V£ million 
excluding the new German Lander). As a 
result, almost half the 10 million jobs 
created during the growth period 1986-90 
have since been lost. Table 1 
Growth and employment 
EUR, USA and Japan 
(average annual percentage change) 
EUR 
USA 
Japan 
EUR 
USA 
Japan Real GDP growth 
1974-85 
2.0 
2.3 
3.4 
Emp 
1974-85 
0.0 
1.8 
0.7 1986-90 
3.3 
2.8 
4.6 1991-96 
1.5 
2.3 
1.7 
oyment growth0 
1986-90 
1.3 
2.1 
1.0 1991-96 
-0.4 
1.2 
0.7 
!) National accounts definition. 
Source: Commission services. 
\/iii 
Graphs 
1. Production capacity and GDP, EUR 2 
2. Long-term interest rates 5 
3. Exchange rates relative to the DEM 6 
4. Profit share 7 
5. Short-term interest rates 7 
6. Extra-Community exports 8 
7. Investment and unemployment, EUR 9 
8. Interest rates and output, EUR 14 
9. Profitability, investment and GDP growth, EUR 15 
10. Employment 19 
11. Inflation 25 
12. Gross value added and employment per sector, EUR 34 
13. Employment by type of manufacturing industry, EUR 34 
14. Elasticity of world trade with respect to world output 36 
15. Share in world exports of goods 37 
16. Foreign direct investment in EUR 42 
17. Export performance and real effective exchange rates, EUR 46 
18. Labour productivity levels 48 
19. Employment, productivity and capital-labour substitution 51 
20. Wage developments, EUR 53 
21. Trends in earnings dispersion 54 
22. Implicit tax rates on labour employed and other factors of production, EUR 67 
23. Actual and cyclically-adjusted net borrowing of general government, EUR 71 
24. Budget deficit and households savings rate (Sweden, Italy) 79 
25. USD exchange rates 91 
26. Exchange rates: DEM versus ERM currencies 93 
27. Exchange rates: DEM versus non-ERM currencies 93 
28. Short-term interest rates in Germany 94 
29. Short-term interest rate differentials in ERM Member States 95 
30: Long-term interest rates in Germany and the United States 96 
31. Long-term interest rate differentials among ERM Member States 97 
3 2. Long-term interest rate differentials among non-ERM Member States 97 
3 3. Exchange rate and interest rate differential between theoretical and market ECU 98 
34. Monetary conditions index 100 
35. Yield curves in larger Member States 101 
surplus of 0.6 percent of GDP in 1987 to a deficit of 0.9 percent of GDP in 1991. Over 
the same period, average inflation accelerated from 3V4 per cent to 5lA per cent while 
average nominal wage increases accelerated from SVi to VA per cent. 
In response to rising inflationary pressures, monetary conditions throughout the 
Community were progressively tightened from 1988 onwards, but budgetary policies were 
very lax. This distorted policy-mix led to a slowdown in growth in most countries in 
1990-91, although the positive short-term demand effects of unification delayed the 
downturn in Germany. Conflicting demands on economic policies caused severe tensions 
in currency markets. In the winter of 1992/93, the Community economy slid into 
recession. Over just two years, almost 5 million jobs were lost (4 million excluding the 
new German Lander). 
1.1.2 Mid-1993 to mid-1995: Soundly-based recovery 
As inflationary pressures gradually subsided, monetary conditions were eased in almost all 
Member States in late 1992 and throughout 1993. Against the background of healthy 
fundamentals — in terms of lower price and wage pressures and relatively sound corporate 
profitability — recovery took hold in the middle of 1993 driven by a strong international 
economy, lower interest rates and an improvement in the competitiveness of the 
Community. 
From the end of 1993 
until the first quarter 
of 1995, the 
Community economy 
expanded at a healthy 
average pace of 
around VA per cent 
(annualised rate). The 
recovery was soundly 
based, led mainly by 
buoyant exports and 
healthy investment 
growth. The growth 
of private consumption 
gradually rose to some 
2 per cent (at an annualised rate) for the Community as a whole. As is normal during Table 2 
Recovery and slowdown in the Community0 
(half-yearly data; percentage change at annualised rate) 
Final internal demand 
-of which: Investment 
Private consumption 
Exports ) 
Final demandJ) 
Stockbuilding4) 
Real GDP 
Employment^ 93H1 
-2.9 
-10.2 
-1.9 
-0.9 
-2.6 
-0.5 
-1.6 
-2.1 93H2 
0.2 
-2.8 
1.3 
6.9 
1.3 
-0.2 
1.3 
-1.4 94H1 
1.9 
3.8 
1.6 
9.2 
2.8 
1.4 
3.3 
-0.1 94H2 
2.0 
4.5 
1.7 
9.4 
2.9 
1.1 
3.4 
0.5 95H1 
2.1 
3.8 
2.1 
9.3 
2.9 
-0.6 
2.4 
0.7 95H2 
0.9 
-0.6 
1.2 
1.8 
1.0 
0.9 
1.2 
0.5 96H1 
1.9 
0.9 
2.5 
4.2 
2.2 
-0.8 
1.7 
-0.3 
!) EUR5 = Germany. France, Italy, Spain and the United Kingdom. 
2) Goods and services; exports includes intra-EC exports. 
3) Excluding intra-Community trade; Commission services estimate. 
4) Contribution to GDP-growth. 
5) Labour force survey; seasonal adjustment by Commission services. 
Source: Commission services. 
the early phase of an economic recovery, growth was fuelled also by a cyclical turnaround 
in stockbuilding. Given the rapid expansion of investment in equipment (up by 6.7 per 
cent in 1995), the Community appeared to be on track towards transforming the recovery 
into strong and sustained medium-term growth of economic activity and employment. 
This short period demonstrated once again the European economy's capacity to create 
jobs as long as economic growth continued at a healthy pace. Overall employment 
increased by over 1 per cent between the first quarter of 1994 and the third quarter of 
1995. The average rate of unemployment in the Community declined from around 11.3 
per cent to 10.7 per cent of the labour force. 
1.1.3 Abrupt slowdown and extended growth pause from mid-199 5 to mid-199 6 
This broadly favourable growth performance was abruptly interrupted in the second 
quarter of 1995. The slowdown was particularly sharp in countries whose currencies 
appreciated during the currency turmoil in the spring of 1995. Germany and France, in 
particular, experienced 3 to 4 quarters of stagnation. By comparison, growth initially 
continued at a higher pace in most countries whose currencies had depreciated, but a clear 
slowdown soon appeared also in these countries. 
For the Community as a whole, the healthy growth of investment came to a sudden halt 
and the growth of exports was markedly reduced as both intra- and extra-European trade 
slowed. With a lag of one to two quarters, private consumption growth stagnated as 
employment prospects deteriorated in countries whose currencies had appreciated while 
inflation and interest rates had increased in countries whose currencies had depreciated. 
Overall, the growth of final demand (excluding stockbuilding) decelerated from close to 3 
per cent over the previous VA years, to just 1 per cent in the second half of 1995 (see 
Table 2). 
1.1.4 Main causes of the 1995/96 growth pause 
The principal factors accounting for the abrupt and widespread economic slowdown were 
the rise in real long-term interest rates during 1994 and the weaker dollar that caused the 
exchange rate movements in the course of 1994 and, especially, the first months of 1995. 
The insufficient credibility of budgetary policies in many countries played a key role in 
both regards. In addition, the deterioration in European cost competitiveness and a 
slower growth on export markets had a dampening effect on Community exports. Finally, 
the strong contribution to growth from stockbuilding in the early phases of the recovery 
was sharply reduced (from nearly 1 percentage point in 1994 to % percentage points in 
1995). 
Rise in long-term interest rates 
On average in the Community, 10-year benchmark bond yields rose by around 250 basis 
points between January 1994 and January 1995. Evidence from countries where index-
linked bonds are traded suggests that real interest rates rose by at least 1 percentage point, 
and in some countries real rates are likely to have risen by considerably more. 
Graph 2 Long-term interest rates 
(Monthly data) 
EUR, Germany and USA 
1992 . •. 1993 ••;:; 19S4 1995 1996 
Germany, Italy, Sweden and Spain These trends were partly related to a 
similar rise in US bond yields and partly 
to internal factors in the Community. 
The international rise in real interest 
rates was the result inter alia of 
prospects for a substantial rise in the 
demand for loanable funds reflecting an 
upturn in investment which was not 
adequately off-set by credible prospects 
for reduced government borrowing. As 
far as the Community is concerned, 
little fiscal consolidation took place in 
1994-95. In cyclically-adjusted terms, 
the average fiscal deficit in the 
Community was reduced by a mere lA 
of a percentage point of GDP per year 
in 1994 and 1995. The initial failure 
credibly to tackle large budget 
imbalances led to widening risk premia 
and a marked tendency for long-term 
interest rates to rise most in countries 
with high public deficit and debt ratios and/or historically weak inflation performances. 
While rates in Germany and several neighbouring countries rose by around 180 basis 
points, the increase was larger in France and the United Kingdom (around 250 basis 
points) and long rates in Italy, Spain and Sweden continued rising in the first months of 
1995 which brought the cumulative increase in yields to between 400 and 450 basis points 
(Graph 2). 
The rise in real long-term interest rates exerted a restraining influence on activity in most 
industrial economies (GDP-growth in the United States decelerated from 4 per cent in 
mid-1994 to less than 2 per cent in the first half of 1995, not least due to higher interest 1991 1392 1993 
Source:. Commission services. 
rates). In the Community, higher real interest rates played a major role, together with 
specific factors in some countries, in the slowdown in construction investment. Other 
interest-sensitive components of demand, including equipment investment, stockbuilding 
and consumer durables, were also negatively affected. 
US-dollar weabiess and intra-European currency turmoil 
Graph 3 
110 Exchange rates relative to the DEM 
(weekly data) 
January 1994 A. 100 
1994 1995 
January 1994 s 100 ::1996: The Community economy was further hit 
by substantial weakening of the US-dollar 
during 1994 and a steep fall in early 
1995. Overall, the US currency fell by 
some 20 per cent relative to the DEM 
(Graph 3). The weaker dollar, in 
combination with a "flight to quality" 
following the collapse of the Mexican 
peso in early 1995, led to severe strains 
on intra-European exchange îates. 
By contrast to some previous episodes of 
currency turmoil, these exchange rate 
movements did not reflect a need to 
correct competitive imbalances. The 
turmoil negatively affected the currencies 
of Member States whose economic 
policies, in particular budgetary policies, 
were not yet perceived as sufficiently 
credible by the markets. The Italian lira, 
which had already been weakening during 1994, fell sharply in the first months of 1995 
and both the pound sterling and the Swedish krona fell considerably in trade-weighted 
terms. Within the ERM, the central rates of the Spanish peseta and the Portuguese 
escudo were devalued in March. The German mark and currencies closely linked to the 
DEM appreciated by up to 6 per cent in trade-weighted terms. Relatively high wage 
settlements for 1995 in some industrial sectors in Germany limited the scope for interest 
rate reductions and thus contributed indirectly to the international strength of the DEM. 1994 1995 
Source: Commission services. 1996: 
The exchange rate fluctuations exerted a negative impact throughout the European 
Community. In most countries whose currencies appreciated, cost competitiveness and 
profitability deteriorated sharply (in Graph 4 the profitability of the export sector is 
proxied by the industrial sector). Moreover, in several of these countries, short-term 
interest rates had to be raised to fend off speculative pressures (Graph 5). Exports 
prospects worsened and investment was rapidly scaled back. Output growth came to a 
standstill, and in some countries even turned temporarily negative. 
Graph 4 [ Profit share* 
(annual percentage change, quarterly data) 
«change Germany 10 
1992 1993 1994 1995 1996 
**ahâ» Italy 
1992 1993 1994 1995 1996 
* Gross operating surplus as a share of gross value added, annua^ 
percentage change. 
Source: National data. | [Graph 5 | short-term interest rates 
{Weekly data) 
12 % Germany, France, Belgium, Denmark and Spain 
Spain 
1995 1996 
source: Commission services. 
In countries whose currencies depreciated, short-term interest rates were raised — in many 
cases considerably ~ to limit the extent of currency depreciation and to prevent the 
emergence of an inflationary spiral. In addition, long-term risk premia rose significantly 
in most depreciating countries (Graph 2). This meant that budgetary consolidation had to 
be carried out in much more difficult circumstances. The result was a clear economic 
slowdown also in these countries as domestic demand was severely restrained and the 
initial export boost gradually waned. 
Slowdown in external demand 
While the European recovery had 
benefited from very high export growth 
in 1993 and 1994, there was a 
slowdown in extra-EC exports during 
1995 (Graph 6). This was caused by 
two main factors. Firstly, the 
appreciation of the Community 
currencies relative to other international 
currencies, in particular the US-dollar, 
caused a deterioration in average cost 
competitiveness and a loss in 
international market shares. Secondly, 
the slowdown in the US economy led to 
an easing of previously strong US 
import growth. Extra-EC export 
growth decelerated to around 7 per cent 
for the year on average (against 10 per 
cent in 1994). Graph 6 1 Extra-Community exports 
(quarterly and annual data) 
% change y/y 
;xi\ Extra-EC exports 
1992 1993 1994 
Source: Commission services. 
1.1.5 Macroeconomic obstacles to growth 
The poor growth and employment performance of the Community over the first half of 
the 1990s has often been incorrectly blamed on factors such as globalisation or the 
emergence of new technologies (see Chapter 2). It was in fact mainly the result of 
macroeconomic obstacles to growth within the Community: 
(i) Insufficient expansion of productive capacity: in the late 1980s/early 1990s 
inflationary pressures built up in the Community as demand expanded too fast relative 
to production capacity; 
(ii) Distorted economic policy-mix: A distorted policy-mix led to an overburdening of 
monetary policy. Indeed, too lax budgetary policies (since 1988) and wage 
developments (since 1990) inconsistent with the objective of price stability caused a 
rise in interest rates which led to a slowdown in growth and job creation and the 
1992/93 recession; 
(iii) Monetary turbulence: currency crises, which to a considerable extent reflected an 
insufficient credibility of economic policies in several countries and a lack of policy 
co-ordination in the Community, have had a disruptive influence on economic growth 
both in countries whose currencies appreciated and in countries whose currencies 
depreciated. 
Graph 7 Inyestmeritand unemployment, EUR 
% at labour fores ' 
1960 1965 i 1970 
Source: : Commission services. 1975 1980 1985 1990 1995 
If the Community is to achieve a sustained period of healthy economic growth capable of 
ensuring a significant and lasting reduction in unemployment, it has to find lasting 
solutions to these macroeconomic obstacles to growth. 
This means, in the first place, that it is essential to maintain a high degree of credibility of 
economic policies in order to prevent monetary and financial turbulence. Secondly, the 
economic recovery must be supported by a strong rise in investment in order to secure a 
sufficiently rapid expansion of productive capacity in line with increasing demand. Even if 
the relationship between investment and unemployment is complex, Graph 7 reveals for 
the Community as a whole a clear negative correlation between these two variables. This 
illustrates that higher investment is an inescapable requirement for creating the physical 
working posts needed to reduce unemployment. Thirdly, budget deficits must be reduced 
to release savings for the necessary rise in investment, thereby preventing a rise in real 
interest rates which would stall the expansion of output. Equally important, all the players 
involved must contribute to maintain wage developments in line with price stability 
requirements and the need to increase employment. 
EMU offers an important opportunity to overcome these obstacles to sustained growth 
and job-creation. The convergence process has contributed strongly to the achievement 
of a more balanced policy-mix and has decisively strengthened the credibility of the 
stability-oriented economic policy-framework. In addition, the risk of currency 
instabilityleading to unwanted tensions and widening interest rate premia will be 
eliminated among the countries participating in the single currency. Such risks will also be 
reduced for Member States which may not initially adopt the euro provided convergent 
economic policies continue to be pursued. 
1.2 Progressively strengthening upturn in 1996-98 
The upswing in the Community economy resumed during the course of 1996 and growth 
is expected to strengthen in 1997 and 1998. This broadly favourable outlook is 
underpinned by the sound rebalancing of the economic policy-mix which has taken place 
in the Community, by an EMU-related improvement in the credibility of the economic 
policy framework, and by favourable supply-side fundamentals ~ in terms of adequate 
wage increases and sound investment profitability — which appear to be even better than 
during the recovery in 1994 and early 1995. In addition, the expansion of economic 
activity among the Community's international partners and the growth of world trade is 
expected to remain supportive. 
1.2.1 An accelerating and well-balanced rebound in activity has taken hold 
The pace of final demand quickened from around 1 per cent (annualised rate) in the 
second half of 1995 to around VU per cent in the first half of 1996. As stocks were pared 
back, output growth accelerated significantly less but the rate of expansion for the year as 
a whole is estimated to have been 1.6 per cent on average for the Community. Under the 
impact of continued positive growth forces, output growth is forecast to strengthen to 2.2 
per cent in 1997 and 2.8 per cent in 1998. 
The recovery is expected to be well-balanced and broadly-based. Exports are likely to be 
dynamic, accelerating gradually from 4 per cent in 1996 to around 6!/2 per cent in 1998. 
This growth will be driven by healthy extra-EC exports and a rebound in intra-EC trade 
sustained by strengthening demand, stable exchange rates and continued progress in trade 
integration among Member States. Private consumption expanded at a healthy pace {VA 
per cent) in the first half of 1996 helped by a rebound in purchases of consumer durables. 
Some slowing is likely over the short term but in line with moderate real wage growth, 
gradually improving employment prospects and a decline in precautionary savings, 
consumer spending is likely to accelerate from just below 2 per cent in 1997 to close to 
VA per cent in 1998. 
10 
With exports and consumption rising and excessive stock levels gradually being run down, 
capacity utilisation in industry has bottomed out and is starting to rise. This is likely to 
give a boost to investment in equipment which already started to recover in the first half 
of 1996. Underpinned by sound business profitability and low interest rates, investment in 
equipment is likely to grow by around 5 per cent in 1997, accelerating to almost 7 per 
cent in 1998. Construction activity was generally weak in the first part of 1996, but there 
were clear signs of a subsequent rebound and construction investment is forecast to 
accelerate to a growth rate of just over 3 per cent in 1998. 
In Germany, the economy rebounded more 
strongly than expected during 1996 helped by a 
significant easing of the DEM effective exchange 
rate, lower interest rates and improving business 
expectations underpinned by moderating wage 
demands. Between spring and autumn 1996, the 
forecast for output growth has been revised 
upwards by nearly a full percentage point to 1.4 
per cent in 1996. The economy is expected to 
improve further in 1997-98 with exports 
continuing to provide a positive driving force and 
investment in equipment expanding at an 
accelerating pace. Private consumption is likely to 
grow modestly in 1997, but as employment 
prospects gradually improve, consumer 
expenditure should rise somewhat faster in 1998. 
Overall, output growth is expected to reach 2.2 
per cent in 1997 and 2.8 per cent in 1998. 
In France, the economy is stimulated by a pick-up in exports in line with strengthening 
international demand. Despite a cautious attitude among consumers, private consumption 
performed better than expected in 1996. Due to a large stock correction, output trailed 
significantly behind demand in the first half of 1996, but activity accelerated in the second 
half. Improving demand prospects, good fundamentals and a rise in capacity utilisation 
are expected to lead to a pick-up in investment in equipment. Lower long-term interest 
rates should underpin a recovery in construction. GDP-growth is expected to accelerate 
to 2.1 per cent in 1997 and to 2.7 per cent in 1998. Table 3 
Real GDP growth 
(per cent per year) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1995 
1.9 
2.8 
1.9 
2.0 
2.8 
2.2 
10.7 
3.0 
3.4 
2.1 
1.8 
2.3 
4.2 
3.0 
2.4 
2.4 1996 
1.4 
2.1 
1.4 
2.4 
2.1 
1.1 
7.8 
0.8 
2.3 
2.5 
1.0 
2.5 
2.3 
1.7 
2.3 
1.6 1997 
2.2 
3.1 
2.2 
2.5 
2.7 
2.1 
5.8 
1.4 
2.8 
2.8 
1.6 
2.8 
3.7 
2.1 
3.0 
2.3 1998 
2.7 
3.0 
2.8 
2.8 
3.2 
2.7 
5.2 
2.6 
3.8 
3.0 
2.5 
3.2 
3.1 
2.5 
3.0 
2.8 
Source: Commission services November 
1996 economic forecasts. 
11 
In Italy, the strengthening of the currency since mid-1995 has had a negative knock-on 
effect on exports and investment. Furthermore, high interest rates during 1995 and early 
1996 meant that budgetary consolidation had to be carried out in difficult conditions 
which restrained domestic demand. However, helped by reduced inflationary pressures, 
prospects for agreement on a social pact entailing adequate wage increases and with 
greatly improved prospects for budgetary consolidation following the adoption of the 
budget for 1997, interest rates have fallen very considerably. The downturn in the 
economy is likely to have come to an end, and a gradual recovery is foreseen with output 
rising by 1.4 per cent in 1997 and 2.6 per cent in 1998. 
In the United Kingdom, the economy has resumed above-trend growth following a 
substantial stock correction in the first half of 1996. Higher growth has been underpinned 
by earlier interest rate reductions and a strong pick-up in exports. Consumption is 
expanding rapidly, helped by rising employment, moderate real wage gains, and an 
improvement in the housing market, all of which are expected to lead to a fall in the 
household savings rate. At the same time, buoyant investment growth is set to continue. 
The expansion of activity is forecast at around 3 per cent per year in 1997-98. 
In the Netherlands and Denmark, domestic demand expanded at a healthy pace in 1996. 
Helped also by improving export prospects, output growth is forecast to accelerate from 
2XA and 2 per cent in 1996, respectively, to a pace of around 3 per cent per year in 1997-
98. In Belgium and Austria, the prospects for domestic demand growth are more 
subdued over the short term, but exports are set to grow at a healthy pace and output 
growth is expected to improve gradually, reaching 2Vi to 2% per cent in 1998. In Spain 
and Portugal, buoyant exports and gradually strengthening investment and consumption 
should cause economic activity to expand by around 2VA per cent in 1997 and somewhat 
more in 1998. In Sweden, double-digit investment growth this year is expected to taper 
off, but as private consumption picks up and export growth continues, the rate of growth 
in the economy should improve. In Finland, buoyant domestic demand will be the main 
factor in sustaining healthy output growth. In Ireland, where growth and job creation 
have been very strong, the economy is likely to slow down but output growth is forecast 
to remain the highest in the Community. In Greece, the improvement in economic 
performance is likely to continue and output growth is set to proceed at a pace of 2XA to 
23/4 per cent sustained mainly by buoyant investment growth. 
12 
1.2.2 Positive growth forces 
Healthy rebalancing of the macroeconomic policy-mix 
In recent years, and in particular in the course of 1996, the Community has achieved a 
very significant improvement in the macroeconomic policy-mix as well as an important 
gain in the credibility of the medium-term economic policy framework. Significant 
measures have been taken in virtually all Member States to improve the state of the public 
finances in 1996 and in 1997. Helped by an improved outlook for the maintenance of 
moderate wage increases and sounder public finances, abating inflationary pressures have 
allowed monetary conditions in the Community to be eased significantly. This rebalancing 
has made the economic policy-mix more conducive to a soundly-based and sustained 
expansion of output, investment and employment. 
Table 4 
Improved economic policy-mix 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
NL 
A 
P 
FIN 
S 
UK 
EUR 
1) Relative 
2) Relative 
Source: Cc Real effective 
exchange rate1* 
(Unit labour costs) 
(1993 = 100) 
Q2 
1995 
109.1 
104.8 
106.4 
112.5 
92.9 
103.8 
93.0 
82.6 
106.0 
109.6 
106.0 
117.1 
96.2 
95.1 
100.32) Q4 
1996 
102.5 
103.7 
99.4 
122.5 
94.5 
101.9 
95.2 
102.8 
100.0 
105.5 
108.3 
116.4 
115.2 
102.7 
106.42) Change in short-
term interest rates 
since Jan. 1994 
(3-month interbank) 
April 
1995 
-1.7 
0.7 
-1.2 
-3.4 
0.6 
1.5 
0.8 
2.4 
-0.5 
-0.8 
-0.3 
0.9 
1.5 
1.3 
0.5 December 
1996 
-3.9 
-2.7 
-2.6 
-7.5 
-2.4 
-2.9 
-0.2 
-1.2 
-2.2 
-2.2 
-4.6 
-2.0 
-2.9 
0.9 
-1.9 Change in long-term 
interest rates since 
Jan. 1994 
(10-year benchmark) 
January 
1995 
1.9 
3.0 
1.9 
n.a. 
3.9 
2.6 
2.7 
3.6 
2.1 
2.0 
3.0 
3.7 
4.2 
2.5 
2.6 December 
1996 
-0.6 
0.6 
0.1 
n.a. 
-1.0 
0.1 
-0.5 
-1.0 
0.1 
-0.2 
-1.8 
0.2 
0.0 
1.4 
0.0 Annual change 
in cyclically-
adjusted budget 
balance 
1996 
1.0 
0.3 
0.0 
0.8 
2.3 
1.2 
-0.7 
1.0 
1.4 
2.0 
1.1 
1.6 
3.8 
1.1 
0.9 1997 
0.3 
0.6 
1.2 
1.1 
1.3 
0.8 
0.8 
3.4 
0.0 
1.8 
1.0 
0.0 
0.5 
0.7 
1.3 
to 23 industrialised countries, 
to 9 industrial non-EC countries. 
)mmission services . 
13 
Progress towards EMU has significantly enhanced the credibility of the economic policy 
framework in virtually all of the Member States. The agreement on a "Stability and 
Growth Pact" for the third stage of EMU at the European Council in Dublin in December 
1996 reinforces the prospects for sound budgetary policies over the medium-term. The 
anti-inflationary stance of monetary policies required by the EMU provisions in the Treaty 
is increasingly affecting economic operators and in particular price and wage setters as 
they adapt their behaviour to a low-inflation environment, thereby contributing to wage 
trends which are consistent with the need to enhance employment. 
All of these developments have already had large beneficial effects. Exchange rates have 
broadly returned to the levels observed before the currency turmoil in the spring of 1995, 
and within the ERM there has been a large degree of exchange rate stability. Long-term 
interest rates have dropped significantly and there has been vastly greater convergence in 
yields. While the drop in interest rates during the year 1995 was broadly parallel to a 
coinciding fall in yields in the United States, developments in 1996 have been 
characterised by a high degree of decoupling from US interest rates. Notably those 
Member States which have announced significant adjustment measures in their budgets for 
1997 have achieved a significant reduction in long-term interest rate premia. 
Thus, the economic preparations for 
EMU are providing Member States with 
a significant credibility gain. This is 
likely to underpin private sector 
confidence and amounts to a positive 
growth factor in its own right. 
The stance of monetary policy has a 
powerful influence on short-term 
growth prospects (Graph 8). To the 
extent that any direct demand-
restraining impact of budgetary 
consolidation in coming years were to 
be less than fully off-set by an increase 
in private sector confidence and Graph 8 
Interest rates and output, EUR4 
70 72 74 76 IB 80 82 84 86 
Source: Commission services. 90:92: : 94: 96: 
14 
improved expectations, monetary policies would both have the necessary room and the 
capability to maintain adequate demand growth without prejudice to the objective of 
maintaining low inflation. 
Furthermore, provided the credibility of the economic policy framework is maintained or 
even strengthened, the Community on average is likely to make further headway towards 
a reduction in the level of real long-term interest rates. This will stimulate investment and 
reduce overall cost and price pressures, thus contributing to a balanced growth of private 
sector demand and activity as well as a reduction in the currently high levels of non-
cyclical unemployment. 
Graph 9 
:*20 
no Profitability, investment 
and GDP growth, EUR 
1960=100 Profitability and investment 
Gross fixed capital formation, 
real % p.a. (rhs) 
Net return on net capital stock 
_. Jibs 15 Wage trends and corporate profitability consistent with pick-up in investment 
Against the background of falling inflation, increased credibility of monetary policy and 
high unemployment, wage settlements have moderated in most countries over the last 
year. For the first time since the adoption of the Broad Economic Policy Guidelines in 
1993, average wage increases in the Community are now forecast to remain at levels 
(around 3 per cent per year in 1997 and 1998) which are fully consistent both with the 
maintenance of price stability and with the achievement of a further improvement in 
investment profitability in the Community, while also allowing a moderate increase in real 
wages. As recommended in the Broad 
Guidelines, this trend should be 
maintained over the medium term. 
Indeed, a further improvement in 
profitability is necessary to sustain 
indigenous investment within the 
Community and to help attract foreign 
investment. Competition to provide 
good business conditions in order to 
attract companies, investment and jobs 
has become ever sharper. The rate of 
business profitability is an important 
medium-term determinant of investment 
(Graph 9). The average level of 
profitability is higher than at any time 
since 1970 but real interest rates are 
i«:L_________-_ _"_ -._ _ -__-
Gross fixed capital formation • I960 1965 1970 1975 1980 1986 1990-1995 
15 GDP and investment 
(realttp.a.J 
GDP growth 
1960 1965 : 1970 1975 
Source: Commission services. 1980 1985 1990 1995 
15 
also higher than in the 1960s. Strong profitability is not in itself sufficient to 
ignite a recovery in investment. But in line with rising capacity utilisation and improving 
demand prospects — as exports and consumption are expected to pick up — the healthy 
level of profitability is likely to lead to an early and strong recovery in investment. 
Greater exchange rate stability reduces uncertainty and thus also influences investment 
decisions positively. 
Continued favourable external environment 
The Community is expected to continue to benefit from a strong expansion of trade with 
its international partners. In overall terms, the expansion of Community export markets is 
forecast to remain buoyant in the coming years (around 8 per cent per year). However, 
the appreciation of the Community's real effective exchange rate in the course of 1994-96 
is expected to have a moderating influence on international export market shares also in 
the years ahead. Nevertheless, the overall pace of extra-EC exports is likely to remain 
relatively strong in 1997-98 at around 7 per cent per year. 
In the United States, the expansion of economic activity remains healthy. Although the 
economy is operating at employment and capacity utilisation levels which have previously 
been associated with an upturn in price and wage pressures, so far there has been few 
signs of such pressures. Thus, in the absence of any unexpected upturn in inflation, the 
economy is forecast to expand at rates of 2V4 to 2Vi per cent in 1997-98, close to the 
potential growth rate of the economy. With high utilisation of domestic resources, strong 
growth of investment in equipment and a high marginal propensity to import, US demand 
from overseas is expected to grow by 7 to TA per cent per year in 1997-98 (up from 6% 
per cent in 1996). 
In Japan, the recovery is expected to proceed in the coming years. The shift towards 
higher import content in domestic demand in recent years, which has been enhanced by 
liberalisation measures aimed at opening up the Japanese market, is expected to continue 
in the near future. Together with healthy domestic demand growth, this is likely to keep 
Japanese import growth at high rates in 1997-98. 
16 
Notwithstanding a predicted 
deceleration in the growth of their 
imports, Community trade with 
emerging market economies in Asia, 
Latin America and Central and Eastern 
Europe is expected to continue to 
expand vigorously. Under the impact 
of continued reform and rapid 
productivity gains, relatively strong 
GDP growth in the economies of 
Central and Eastern Europe is 
expected to be maintained or 
strengthened in 1997-98 with few 
exceptions. Also in Asia and Latin 
America, strong growth is expected to 
continue in 1997-98. Table 5 
External environment 
(real annual percentage change) 
World excl. EC 
USA 
Japan 
DAE3) 
CCEEs excl. FSU4) 
Extra-EC markets 
USA 
Japan 
DAE3) 
CCEEs excl. FSU4) 
Extra-EC exports Weights 1995 1996 1997 1998 
Real GDP 
lOO.O1' 
26.9 
10.0 
6.6 
2.5 3.6 
2.0 
0.8 
8.0 
5.4 4.2 
2.4 
3.8 
7.1 
3.9 4.3 
2.3 
1.8 
7.2 
4.1 4.6 
2.4 
2.8 
7.2 
4.5 
Imports 
100.09 
17.8 
5.8 
11.5 
9.4 9 
8.9 
11.4 
15.1 
17.5 
7 7.5 
6.8 
10.5 
10.2 
10.9 
6 8 
7.5 
6.7 
9.5 
9.3 
7 8 
7.2 
9.8 
9.4 
8.9 
7 
"Relative weights based on GDP in 1995. 
2) Relative weights based on extra-EC exports in 1995. 
3) Dynamic Asian Economies: Hong Kong, Korea, Malaysia, Singapore, 
Taiwan and Thailand. 
CCEEs excl. FSU: Albania, Bulgaria, Czech republic, Slovakia, 
Hungaria, Poland, Romania and Slovenia. 
Source: Commission services; November 1996 forecasts. 
1.2.3 Uncertainties and short-term risks 
The uncertainties surrounding the economic outlook appear to have declined considerably 
since the beginning of 1996. The main risk to the broadly favourable outlook would seem 
to reside in the possible emergence of doubts on the determination of governments to 
accomplish the process of budgetary consolidation in terms of full implementation of the 
1997 budgets. If the credibility of policies aimed at nominal convergence were to suffer in 
some Member States and if budgetary outcomes were to disappoint relative to stated 
objectives, this could lead to renewed pressure on interest rates and exchange rates with 
potentially damaging effects on output and employment in the Community at large. 
However, the firm commitment to the achievement of the economic conditions for EMU -
- as reflected in political declarations, in budgetary measures already decided upon and in 
the state of the advancement of the technical preparations ~ to a large extent attenuate 
this uncertainty. 
Tensions might also surface if insufficient growth and job creation in some countries were 
to give rise to perceptions of internal policy dilemmas in the Community. This could be 
the case if consumer and investor confidence failed to pick up as expected in some 
17 
Member States. Also, budgetary consolidation might result in smaller-than-expected 
confidence gains if the measures taken were perceived to be only short-term and ad hoc in 
nature rather than expressing a firm commitment to sound public finances and addressing 
the problem of very high public expenditures and taxes relative to GDP. 
On the other hand, if the credibility of economic policies and of moderate wage trends is 
maintained, growth and job creation could turn out to be stronger than forecast. The 
prospect of strong economic benefits from EMU could lead to a significant boost to 
private sector expectations and confidence, similar to the positive impact which the 
Internal Market programme had in the late 1980s. This could unleash higher investment, 
lead to a reduction in precautionary savings in most Member States, and help the 
Community to achieve a robust growth and employment creation performance. 
An additional uncertainty could lie in the risk of a reawakening of wage pressures towards 
the end of the forecasting period. Although wage trends consistent with low inflation and 
enhanced investment and employment now seems to be more firmly established, the 
developments in 1994-95 in some countries have shown that inappropriate wage demands 
may resurface at an early stage of recovery. As highlighted in their recent joint opinion on 
the stance of economic policies, the social partners at the Community level recognize the 
need to avoid excessive wage settlements. Too high wage increases would fuel 
inflationary pressures which in turn would induce a dampening response from the 
monetary authorities, put upward pressure on long-term interest rates and undermine the 
ability of the European economies to promote higher levels of employment. 
1.3 Gradually improving employment outlook 
1.3.1 Recent and prospective trends in employment and unemployment 
A detailed analysis of the latest labour market trends and the policy issues which have to 
be addressed in the Community is presented in the Commission's Employment in Europe 
Report 1996 and in the 1997 Joint Employment Report prepared for the Dublin European 
Council. The key features of the labour market outlook in the Community are briefly 
outlined in the following section along with an overview of the labour market experiences 
of a number of countries which have achieved a significantly better performance than the 
majority of other Member States in recent years. 
Employment 
The relatively strong rate of expansion of 
economic activity during 1994 and early 1995 
brought with it a moderate improvement in the 
employment situation. For the year 1995, total 
employment growth amounted to 0.5 per cent or 
some 750.000 jobs in the Community as a whole. 
However, this improvement was brought to a 
standstill when economic growth started faltering 
in the second half of 1995 and in early 1996. 
Reflecting a weak trend in Community-wide 
employment in the first part of 1996 as well as a 
gradual improvement in job prospects in the 
second half of the year — in line with strengthening 
economic activity — employment growth for 1996 
as a whole amounted to a meagre 0.1 per cent. 
However, as the recovery of economic activity is 
expected to take firmer hold in 1997-98, and 
helped by low wage increases in almost all 
Member States, employment creation is expected Table 6 
Employment growth 
(per cent per year) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1995 
0.4 
1.6 
-0.3 
0.9 
1.7 
1.2 
4.4 
-0.4 
2.5 
1.9 
-0.3 
-0.6 
1.1 
1.6 
0.7 
0.5 1996 
-0.1 
0.7 
-0.8 
1.2 
1.3 
-0.2 
3.4 
0.3 
1.1 
1.5 
-0.7 
0.5 
1.2 
-0.6 
0.4 
0.1 1997 
0.2 
0.8 
-0.0 
1.3 
1.6 
0.3 
2.5 
0.1 
1.7 
1.6 
-0.3 
0.6 
1.9 
-0.2 
1.1 
0.6 1998 
0.3 
0.7 
0.7 
1.3 
2.0 
0.9 
1.7 
0.5 
2.3 
1.6 
0.0 
0.7 
1.5 
0.5 
1.1 
0.9 
Source: Commission services November 
1996 economic forecasts. 
Graph 10 Employment 
(quarterly data) 
105 
103 
UK 
-f-
France 
Germany / 
95 
1993 1996 
105 1993Q1 » 100 
1993 1994 
Source: Commission services. to quicken somewhat to 0.6 and 0.9 
per cent in 1997 and 1998, 
respectively, corresponding to the 
creation of 2.2 million jobs over the 
two years. 
The employment outlook varies 
considerably across Member States, 
mainly, but not exclusively, reflecting 
differences in the outlook for output 
growth. In Ireland, employment is 
expected to grow at a rate of over 2 
per cent per year on average in 1997-
98 (after almost 4 per cent per year in 
1995-96). Job growth in 1997-98 is 
also expected to be high in Greece, 
19 
Spain, Luxembourg, the Netherlands and Finland (around 1XA to 2 per cent per year) as 
well as in the United Kingdom and Denmark (around 1 and VA per cent per year, 
respectively). 
In contrast, disappointing employment trends in 1996 are likely to have a.negative carry­
over effect on job growth in 1997 in Germany, Austria and Sweden, where employment is 
expected to fall slightly further, as well as in Belgium, France and Italy where job creation 
is expected to be very modest. However, in line with strengthening economic activity, 
employment growth is expected to pick up in 1998 when virtually all Member countries 
are expected to achieve positive job growth. 
Unemployment trends 
The gradual decline in the rate of unemployment in the Community since March 1995 
came to a halt in late 1995 and early 1996. The average rate of unemployment in the 
Community rose somewhat in the second half of 1996 and the jobless rate amounted to 
10.9 per cent of the labour force for the year as a whole. 
Table 7 
Unemployment rate 
(per cent of civilian labour force) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1995 
9.9 
7.1 
8.2 
9.1 
22.9 
11.5 
12.4 
11.9 
2.9 
7.3 
3.8 
7.3 
17.2 
9.2 
8.8 
10.9 1996 
9.9 
6.2 
9.0 
9.1 
22.0 
12.3 
12.5 
12.1 
3.1 
6.8 
4.2 
7.3 
16.0 
9.8 
8.3 
10.9 1997 
9.9 
6.0 
9.1 
9.0 
21.5 
12.4 
12.0 
12.3 
3.0 
6.3 
4.5 
7.1 
14.9 
9.4 
7.8 
10.8 1998 
9.8 
5.7 
8.7 
9.0 
20.7 
11.9 
11.7 
12.1 
2.9 
5.8 
4.6 
6.8 
14.2 
9.0 
7.4 
10.4 
Source: Commission services November 
1996 economic forecasts. The moderate strengthening of employment growth 
in the Community in the coming years is expected 
to be sufficient to achieve only a modest reduction 
in unemployment. With the prospects of finding 
employment becoming more positive, the growth of 
the labour force is expected to revert to its 
medium-term trend of around XA per cent per year. 
For the Community as a whole, the average 
unemployment rate is expected to decline slowly to 
10.8 per cent in 1997 and somewhat faster to 
around 10.4 per cent in 1998. 
Some countries are likely to see a significantly 
faster reduction in unemployment. The rate of 
joblessness is forecast to fall considerably in the 
United Kingdom — where it is already the lowest 
among the Community's largest Member States — 
20 
and in the Netherlands. This is the case also in Spain, Ireland and Finland although the 
level of unemployment will remain very high in these three countries. A more moderate 
but continuous reduction in unemployment is likely to be achieved in Denmark, Sweden 
and Portugal. 
By contrast, the rate of unemployment is expected to remain unchanged or to rise further 
over the near term in Belgium, Germany, France, Italy and Austria. However, with the 
possible exception of Austria, the upward trend in unemployment is expected to be 
reversed in the course of the year and the jobless rate is expected to decline in 1998. In 
most cases, this is expected to reduce unemployment to below its 1996 level. 
1.3.2 Recent labour market performance of selected countries 
In contrast to the disappointing job performance of the Community as a whole, a number 
of Member States have achieved a considerable improvement in employment and/or a 
large reduction in unemployment over the last two to three years (Denmark, Spain, 
Ireland, the Netherlands and the United Kingdom)1. From a macroeconomic point of 
view, the performance of these economies in terms of output growth, employment 
creation and labour force trends has been very different. In Ireland, strong employment 
growth has been driven mainly by a rapid expansion in output. In Denmark and the 
United Kingdom, healthy GDP-growth has been accompanied by positive but not 
exceptional job creation and the reduction in unemployment has partly been due to a 
reduction in the labour force and/or increased part-time employment. In Spain and the 
Netherlands, more modest output growth has coincided with relatively strong net job 
creation (Table 8). 
Particularly high economic growth has been the main factor behind the large gain in job 
numbers in Ireland. Strong growth has been facilitated both by a strengthened supply side 
— including significantly improved profitability, better competitiveness and a continued 
upgrading of average work force qualifications— and macroeconomic policies aimed at 
securing low inflation, sound public finances and low interest rates. This has been 
underpinned by Community assistance under Structural and Cohesion Funds. An 
important element has been the tripartite agreements between employers, unions and the 
government to maintain moderate wage increases, helped by a lower income tax burden 
and carrying the benefit of significant job creation. Wage moderation, in combination 
1 In addition, the unemployment rate has fallen by more than 2 percentage points in Finland between 
1994 and 1996. However, Finland is to some extent a special case reflecting the ongoing adjustment to 
exceptional factors which occurred during the late 1980s. 
21 
Table 8 
Recent labour market performance of selected countries 
(1994-96) 
Unemployment 
Unemployment rate 1993 
1996 
Change since 1993 
Employment and labour force 
Labour force growth 
Employment growth2 
GDP, wages and productivity 
GDP 
Labour productivity 
Real wage costs per head3 
Real unit labour costs4 
Capital/labour substitution5 
Participation and employment 
Participation rate 1993 
1996 
Employment rate 1993 
1996 Ireland Denmark UK NL Spain Rest of 
EUR EUR15 
-- per cent of the labour force — 
15.6 
12.5 
-3.1 10.1 
6.2 
-3.9 10.4 
8.3 
-2.1 6.61 
6.8 
0.21 22.81 
22.0 
-0.81 9.5 
10.4 
0.9 10.9 
10.9 
0.0 
— average growth rate 1994-96; per cent per year — 
2.1 
3.6 -0.9 
0.6 -0.2 
0.4 1.3 
1.2 0.5 
0.8 0.1 
-0.2 0.1 
0.1 
-- average growth rate 1994-96; per cent per year — 
8.6 
4.8 
1.1 
-3.5 
-0.4 3.1 
2.5 
2.0 
-0.5 
-0.1 2.8 
2.5 
0.8 
-1.6 
0.5 2.7 
1.5 
0.1 
-1.3 
%0.4 2.3 
1.5 
-0.9 
-2.4 
0.7 2.0 
2.3 
0.8 
-1.5 
0.8 2.3 
2.2 
0.6 
-1.6 
0.7 
— in per cent of working age population (aged 15 to 64) — 
60.8 
62.5 
51.2 
55.0 82.2 
79.3 
73.9 
74.5 75.2 
73.8 
67.3 
67.7 67.8 
69.8 
63.4 
65.3 58.8 
58.7 
45.6 
46.1 65.7 
65.4 
59.5 
58.7 66.7 
66.3 
59.5 
59.2 
1 The unemployment rate peaked in 1994 at 7.2 per cent in the Netherlands and 24.1 per cent in Spain; it 
changed by -0.4 and -2.1 percentage points, respectively, between 1994 and 1996. 
2 National accounts definition (for the Netherlands: full-time equivalent basis). According to labour force 
surveys, the average growth of employment over the 1994-96 period was slightly higher on this basis in Spain 
( 1.0 per cent), the Netherlands (1.4 per cent) and the United Kingdom (1 per cent). 
? Nominal compensation per employee deflated by the GDP deflator. 
4 Real labour costs per head divided by labour productivity per head. 
5 A positive figure indicates substitution of capital for labour in the production process (a higher capital/labour 
ratio). Over short periods, the concept is influenced by cyclical effects. See chapter 2 for medium-term 
analysis of the role of capital-labour substitution in the Community's employment performance. 
Source: Commission services. 
with a shift in the composition of growth towards indigenous sectors, has helped arrest 
the previous trend towards capital-labour substitution in the economy. The average 
annual rate of substitution of labour by capital has declined from 1.4 per cent per year 
over the 1974-85 period to 0.4 per cent in the second half of the 1980s and 0.1 per cent 
per year in the first half of the 1990s. At the same time, high capacity-expanding 
investment has led to a fast incorporation of technical progress. Thus, helped also by 
improving skills and qualifications, labour productivity growth has remained high. 
Agreement on a renewal of the tripartite agreement is expected to underpin continued 
wage moderation and high employment growth in the coming years. 
22 
The large reduction in unemployment in Denmark since 1993 has resulted not just from 
improved job creation in line with stronger economic growth but predominantly from a 
decline in the labour force due to the introduction of government subsidised leave 
schemes (mainly for the purposes of education or child care) and an increase in the 
number of workers taking early retirement. While the employment rate in Denmark 
remains among the highest in the Community there is also a high proportion of the 
working age population which receive transfer incomes in the form of unemployment 
benefits, social security benefits, early retirement benefits, disability benefits, leave 
schemes etc. These schemes represent a considerable cost and reduce effective labour 
supply. Recent tightening of some schemes and positive labour market reforms are 
intended to reduce passive dependency and enhance job creation. In recent years, real 
wage costs have risen somewhat faster than in other countries whose currencies are linked 
to the DEM. If sustained and robust employment gains are to be made in the coming 
years it is essential to avoid excessive labour cost increases. 
In the United Kingdom, the reduction in unemployment since 1993 has resulted partly 
from growing employment, in line with higher output growth and reflecting an increase in 
part-time work, and partly from a reduction in the labour force. Labour force 
participation has failed to pick up as in previous economic upturns inter alia because of an 
upsurge in the number of young people entering higher education. Notwithstanding the 
considerable reduction in unemployment, there has as yet been no significant upturn in 
earnings growth. Wage increases have been moderate and real wage costs (compensation 
per employee deflated by the GDP deflator) have been growing at a pace considerably 
below the growth in productivity. This may indicate that the structural reforms carried 
out in the United Kingdom since the early 1980s have helped increase labour and product 
market flexibility and thus to reduce price and wage pressures. If robust and sustained 
employment gains are to be made in the years to come it is essential that favourable wage 
trends are maintained. 
In the Netherlands, the favourable job performance since 1994 is a continuation of a 
relatively strong employment creation trend since the mid-1980s. In addition, while 
increased part-time employment accounted for almost half of the job creation between 
1983 and 1994, this factor did not contribute significantly to the increase in job numbers 
in the last two years. Since 1983, employment growth has been underpinned by a policy 
of wage moderation based on a consensus between unions, employers and the 
government. Compared to other Member countries, moderate nominal and real wage 
growth in the Netherlands has reduced the substitution of capital for labour, lowered the 
23 
employment threshold of growth and resulted in comparatively strong job creation. These 
trends have reasserted themselves during the current economic upturn. Continued wage 
moderation has been underpinned by an almost universal consensus on the necessity of 
wage restraint, the maintenance of a stability-oriented macroeconomic framework and by 
rapid increases in the labour force. Structural improvements in the labour market have 
included lower taxes and social security contributions, particularly for low income/low 
skilled workers, efforts to limit the growth of the legal minimum wage, reduced access 
and generosity of disability benefits, and increased flexibility in the implementation of 
wage agreements at the sectoral or firm level. 
In Spain, economic growth in line with the average of the Community has coincided with 
comparatively strong job creation since 1994. The favourable job performance has been 
helped by moderate wage increases — contributing to a fall in real wage costs per head in 
1994 and in 1995 « and by labour market reforms which have eased restrictions on 
working time, dismissals, job demarcation lines and, to some extent, wage setting. A 
large part of the recent increase in employment has taken place in temporary and part-time 
jobs. Although this may have reduced the unemployment risk for non-temporary workers 
and reinforced their insider power, recent wage trends are encouraging and wage costs are 
expected to grow only slightly faster than prices in 1996. 
Just as the reasons for the relatively favourable labour market performance in these 
selected countries vary considerably, so too do the reasons for the less favourable 
performance in the majority of the remaining Member States. One important factor is that 
economic growth has been considerably lower in most other countries as compared to 
Denmark, Ireland, the Netherlands and the UK. At the same time, the rate of job creation 
relative to economic growth has generally not improved to the same extent as in Spain 
and the Netherlands. In some countries, labour shedding has continued despite recent 
wage moderation, partly reflecting the previous build-up of excessive labour cost levels 
and/or low economic activity. In sum, cyclical divergences and varying degrees of labour 
market reform has so far prevented the benefits of improved fundamentals from fully 
asserting themselves in a number of Member countries. 
24 
1.4 Encouraging inflation outlook 
Progress with the achievement of a 
high degree of price stability has 
been examined in detail in the 1996 
Report on Convergence presented by 
the Commission in accordance with 
Article 109J of the Treaty on 
European Union. The recent trends 
and the short-term outlook for 
inflation convergence are briefly 
reviewed in this section. 
Member States have been making 
considerable headway towards price 
stability and inflation convergence 
which is an essential requirement for 
the adoption of the single currency. 
Average inflation (as measured by 
the private consumption deflator) in 
the Community decelerated to 2.6 
per cent in 1996 and inflation 
dispersion among the Member States 
narrowed significantly. 
In' Belgium, Denmark, Germany, 
France, Ireland, Luxembourg and the 
Netherlands, having been in the 
narrow band of the ERM, as well as 
in Austria, broadly sound wage 
trends and low import price increases 
promoted price stability in 1996. 
Inflation (private consumption 
deflator) remained at or below 2 per 
cent in all those countries. Table 9 
Inflation 
(percentage change) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR ncPs° 
1995 
1.4 
2.3 
1.6 
9.0 
4.7 
1.7 
2.4 
5.4 
1.9 
1.1 
2.0 
3.8 
1.0 
2.9 
3.0 
3.0 Nov. 
19962) 
1.9 
2.3 
1.3 
8.3 
3.6 
2.1 
2.1 
4.2 
1.4 
1.4 
1.8 
2.9 
1.1 
1.1 
3.0 
2.6 Private consumption deflator 
1995 
1.6 
2.1 
1.9 
9.3 
4.7 
1.7 
2.0 
5.8 
2.0 
0.9 
2.3 
4.2 
0.2 
2.7 
2.6 
3.0 1996 
2.0 
2.0 
1.8 
8.5 
3.6 
1.9 
2.0 
3.9 
1.7 
1.9 
2.0 
3.3 
0.9 
2.5 
2.6 1997 
2.1 
2.4 
1.7 
6.9 
2.9 
1.4 
2.2 
2,9 
2.1 
2.0 
1.9 
3.0 
1.6 
2.3 
2.4 
2.2 1998 
2.0 
2.7 
1.8 
5.8 
2.7 
1.5 
2.6 
26 
2.1 
2.0 
2.0 
2.9 
2.0 
2.6 
2.5 
2.2 
1J Interim indices of consumer prices. 
2) Measured by the percentage change in the arithmetic average 
of the twelve monthly indices relative to the arithmetic 
average of the twelve monthly indices of the previous period. 
Source: Commission services and November 1996 economic 
forecasts. 
Graph 11 Inflation 
(annual change) 
Greece 
Average of the other Member States 
94 95 96 
Source: Commission services. 
25 
Furthermore, among the countries where monetary policy is conducted with reference to 
an inflation target, the rate of price increases remained low at around 2.5 per cent in the 
UK, and reached a level of less than 1 VA per cent in Sweden and Finland, helped by a 
significant appreciation of their currencies from previous lows. 
Also the four remaining Member States, in which inflation ranged from 4.2 per cent to 9.3 
per cent in 1995, have made significant progress towards price convergence (Graph 11). 
In Portugal, the inflation rate dropped to 3.3 per cent and in Italy and Spain, the rate of 
price increase slowed to 3.6 per cent in Spain and 3.9 per cent in Italy in 1996. In Greece, 
the rate of inflation declined to 8.5 per cent. In the countries whose currencies had 
depreciated significantly in early 1995, the tightening of monetary conditions and 
enhanced prospects for sounder budgetary positions brought about the subsequent 
exchange rate appreciation. Together with prudent wage agreements this helped bring 
down inflation rapidly in late 1995 and early 1996. 
The credibility of anti-inflationary policies has 
increased everywhere and the objective of low 
inflation is now widely accepted throughout the 
Community. Against this background, price 
convergence is expected to strengthen further in 
the coming years. The average rate of inflation in 
the Community is forecast to decelerate further to 
2.2 per cent in 1997 and in 1998. These rates are 
historically low and close to what is normally 
meant by price stability. 
In Germany and in the countries whose monetary 
policies are closely linked to that country, inflation 
is expected to remain below or around 2 per cent 
in 1997-98 with two exceptions: in Denmark and 
Ireland, continued strong domestic demand and 
wage cost increases in excess of those of other 
countries whose currencies are closely linked to 
the DEM (around or above 4 per cent per year) 
could lead to an acceleration of inflation to above 2lA per cent Table 10 
Nominal compensation 
per employee1* 
(percentage change) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1995 1996 1997 1998 
2.5 
3.6 
3.6 
12.7 
3.0 
2.3 
1.1 
5.2 
3.8 
2.0 
3.8 
5.3 
4.7 
3.1 
2.9 
3.4 1.6 
4.1 
2.6 
11.1 
3.9 
2.2 
4.0 
6.2 
3.4 
1.0 
2.9 
5.8 
4.0 
6.6 
3.3 
3.4 2.6 
3.8 
2.5 
9.2 
3.2 
2.2 
4.2 
4.1 
3.8 
2.3 
2.4 
5.0 
3.2 
4.3 
4.1. 
3.2 2.6 
4.2 
2.5 
7.5 
3.0 
2.5 
4.3 
3.1 
3.6 
2.9 
3.2 
4.0 
2.9 
2.9 
4.3 
3.1 
l) Total 
Source: wages and indirect wage costs. 
Commission services, November 
1996 economic forecasts. 
26 
In the United Kingdom, Sweden and Finland, continued prudent monetary policies are 
expected to secure the maintenance of inflation.in the range of 2 to 2lA per cent, helped in 
the latter two countries by a significant reduction in the pace of nominal compensation of 
employees. Italy, Spain and Portugal are all expected to achieve a further reduction of 
inflation to a rate of around 2VA per cent by 1998 against the background, inter alia, of 
decelerating wage costs. In Greece, the inflation rate is forecast to drop to around SVA per 
cent by 1998. 
27 
Box 1 : Regional unemployment in the Community 
Unemployment rates across Member States differ widely, ranging from 3 per cent in 
Luxembourg to nearly 22 per cent in Spain (1995 data). At the level of individual regions, the 
disparity across the Community is even larger. In 1995, among the nearly 100 regions for which 
harmonised regional unemployment data are available, the unemployment rate ranged from less 
than 4 per cent in the central region of Portugal to nearly 32 per cent In the south of Spain 
(Table B1.1). 
Table B1.1 
Regional unemployment in the Community -1995 
(NUTS1 regions) 
B DK WD EL IRL NL FIN UK EUR 
Highest regional rate 
National rate 
Lowest regional rate 
Ratio: high/low 12.9 
9.9 
6.9 
1.9 12.3 
7.1 
4.5 
2.7 11.2 
6.6 
5.5 
2.0 11.0 
9.1 
7.4 
1.5 31.8 
22.9 
18.5 
1.7 15.3 
11.5 
8.7 
1.8 15.8 
14.3 
13.5 
1.2 25.9 
11.9 
6.0 
4.3 8.9 
7.3 
6.9 
1.2 11.4 
7.3 
3.9 
2.9 21.2 
17.2 
15.2 
1.4 12.0 
9.2 
7.7 
1.6 11.0 
8.8 
6.7 
1.6 31.8 
10.9 
3.9 
8.2 
Source: Commission services. 
n 1995, the unemployment rate was below 6 per cent of the labour force in 10 of the around 100 
regions (Table B1.2). To some extent, the low-unemployment regions were concentrated in a 
limited number of areas: the south of Germany, the adjacent north of Italy, the south of the 
Netherlands, regions in the north-east and south-west of Denmark, and the north and centre of 
Portugal. This picture has been relatively stable during the past ten years. Noticeable 
exceptions are regions in the south and east of Sweden and most of Finland which used to be 
low unemployment regions, as well as the Ile de France (Paris) and south-eastern regions of the 
UK which saw a deterioration in the unemployment situation at the beginning of the 1990s. In all 
of these cases, the deterioration resulted not from specific regional causes but rather from an 
increase in nation-wide unemployment. 
At the opposite end of the spectrum, around 20 regions experienced an unemployment rate 
above 15 per cent in 1995. These regions were concentrated in Spain, the south of Italy and 
parts of Ireland and Finland. With the exception of Finland, the regions which suffered most from 
high unemployment were broadly the same throughout the last ten years. 
Graph B1.1 Dispersion of regional unemployment 
12 unemployment rate in the Community standard deviation 
Standard deviation of regional unemployment rates (rhs) 
EUR 15 unemployment rate (Ihs) 
1983 1985 
Source: Commission: seryvces . 1987 1989; 1991 1993 3 
1995 
28 
In addition to the inertia of the geographical concentration of unemployment there has been a 
widening of the unemployment dispersion between regions over the last few years. One way of 
measuring the dispersion is the standard deviation of the regional unemployment rates1. This 
standard deviation is positively correlated with the cyclical fluctuations in the Community 
unemployment rate (Graph Bt.1). 
This picture of worsening regional imbalances has been valid 
for most Member States between1983 and 1995 which are 
comparable years in terms of their position in the business 
cycle (Table B1.3). The change in the dispersion is 
positively correlated with the change in the national 
unemployment rate. In some countries where substantial 
labour market reform has been implemented (Netherlands, 
United Kingdom), the dispersion of unemployment and the 
national employment rates have both decreased. 
Notwithstanding the persistent gap between high and low 
unemployment regions in most countries, unemployment 
was highly cyclical in both types of regions (for selected 
countries, see Graph B1.2). In most countries, the peaks and 
troughs of the jobless rate in high unemployment regions 
have tended to follow those of the low unemployment 
regions with a lag of around one year. This shows that high 
unemployment regions remain responsive but also 
dependant on the level of activity in low unemployment 
regions. This is mainly because of demand linkages: high 
and rising levels of activity in low unemployment regions 
generate increased 
demand from these regions. Furthermore, more 
companies choose to expand in regions with abundant 
labour supply. And with the increased probability of 
finding a job in regions with low and falling 
unemployment more workers are willing to move from 
high unemployment to low unemployment regions. 
The persistence of regional unemployment imbalances 
in most Member States generally reflects a relatively 
low responsiveness to changes in the economic 
environment and a relatively high rigidity of regional 
wage structures in particular. With limited wage 
flexibility, productivity differentials between regions are 
often not adequately reflected in wage cost differentials. 
Therefore, reducing regional unemployment disparities 
may require a higher degree of regional wage flexibility. 
Both the relocation of activity towards less favoured 
regions, the mobility of workers between regions and 
the avoidance of excessive nation-wide wage increases 
in the face of wage pressures in low unemployment 
regions would all be facilitated by a higher degree of 
regional wage differentiation in accordance with 
regional differences in productivity levels. I Table B1.2 
Distribution of regional 
unemployment rates 
Number of regions 
Jobless rate Average ^ ggc 
1983-95 
<5% 7 4 
5 - 6% 9 6 
6 - 7% 10 13 
7 - 8% 14 13 
8 - 9% 13 11 
9 -11% 15 15 
11-13% 10 10 
13-15% 2 6 
15-17% 8 4 
17-20% 7 5 
20-25% 1 8 
> 25% 1 2 
Total | 97 97 
Table B1.3 
Dispersion of regional 
unemployment rates 
B 
DK 
WD 
EL 
E 
F 
IRL 
I 
NL 
P 
FIN 
S 
UK 
EUR Standard 
deviation 
19831 
0.81 
2.08 
1.71 
2.02 
3.28 
1.45 
0.58 
2.77 
1.31 
3.18 
1.87 
0.55 
2.79 
4.06 1995 
3.40 
2.01 
1.84 
2.23 
4.69 
1.89 
0.86 
7.14 
0.58 
1.97 
2.38 
1.29 
0.87 
5.70 National 
unemployment 
rate 
19831 
11.9 
9.5 
6.9 
7.8 
21.4 
7.6 
14.G 
8.5 
11.7 
8.6 
3.7 
1.4 
11.1 
9.1 1995 
9.9 
7.1 
6.6 
9.1 
22.9 
11.5 
14.3 
11.9 
7.3 
7.3 
18.1 
9.2 
8.8 
10.9 
1 1988 for EL and NL, 1986 for P, 1989 
for FIN, 1990 for S. 
1 The standard deviation is sensitive to the degree of regional disaggregation. For a measurement of the 
standard deviation at NUTS2 level, see the Commission's "First Cohesion report" (Nov. 1996). 
29 
Graph B1.2 Cyclical trends in regional unemployment rates 
% Western Germany ^ France 
:i683;-;;:;::;i?85:::;.;;;:i98r::;::;;l?»;i.;':;;;-;i8?|i::;;::;:i9»;;;;;;;;i?».; 
Italy 
: !983 " : 1985: : : : : : 1987: :.:::: 1989. : : : : : 1991: :•..::: : 1993: : : : : : : 1995: : 
The Netherlands 
1983 1985 1987 1989 19B1 1993 1995 
Source; Commission services. 
30 
2. KEY STRUCTURAL CHALLENGES FACING THE COMMUNITY 
The unsatisfactory performance of the Community economy during the first half of the 
1990s has sparked new concerns about the effects of certain long-term structural trends 
affecting the Community. One is the emergence of new technological advances which, it 
is often felt, not only tend to be skill-biased but also labour-saving, reducing the demand 
even for skilled workers. Another trend is the increased globalisation of the world 
economy which has given rise to fears that jobs are being siphoned out of the Community 
by the newly industrialised countries, especially in Southeast Asia, and that under these 
market forces, low-skilled workers in the Community face either downward pressure on 
wages or high unemployment. These apprehensions have been exacerbated by the 
relocation activities of Community-based firms towards emerging newly-industrialised 
countries. 
While these concerns and fears are understandable, they tend to be built upon an 
erroneous analysis of the economic impact of technological progress and globalisation. 
These factors have been and will continue to be the key driving forces behind long-term 
improvements in productivity, growth, employment and living standards in the 
Community. But in the short run they require sometimes painful adjustments in some 
sectors of the economy. The achievement of the potentially significant long-term gains of 
enhanced technological progress, greater globalisation and intensified efforts to improve 
competitiveness crucially hinges upon the fulfilment of two essential conditions: the 
inevitable adjustments must occur in a smooth and socially-acceptable manner and 
economic growth must be sufficiently strong to absorb the -resources freed by 
technological progress and globalisation. 
2.1 Technological progress 
The last three decades have seen the emergence of a new wave of technological advances 
in important areas such as electronics, computers, telecommunications and bio- and 
ecotechnologies. Most of these new technologies have ramifications for all sectors of the 
economy. In particular, information and communication technologies (ICT) are driving 
the ongoing process of structural change. Their impact on the economy is pervasive. 
They not only entail rapidly falling costs but they also bring about fundamental 
modifications in working methods and relations, the organisation of companies and the 
way in which knowledge is produced and distributed. 
31 
In macroeconomic terms, the role of technology in the economy can be assessed by the 
trend in total factor productivity (TFP) growth. The latter is defined as the proportion of 
output growth which is not accounted for by increases in inputs of labour and capital, the 
two most fundamental factors of pçpduction2. In this sense, improvements in TFP reflect 
the impact of technological progress, human capital endowments and' organisational 
efficiency incorporated in the economic process. TFP can therefore be interpreted as an 
indicator of the strength of the endogenous growth forces in the economy. 
Table 11 
Long-term trends in TFP growth1) 
EUR 
USA 
Japan 1961-73 
2.8 
1.6 
6.3 1974-85 
1.0 
0.4 
1.1 1986-95 
1.2 
0.8 
0.9 1986-90 
1.5 
0.6 
2.3 1991-95 
1.0 
0.9 
-0.5 
*) Total factor productivity: average labour and capital 
productivity weighted by factor income shares. 
Source: Commission services. As shown in Table 11, TFP 
growth in the Community, as well 
as among the Community's main 
partners, slowed down 
significantly between 1960-73 and 
1974-85. For the Community, this 
slowdown can to a large extent be 
explained by three factors: the 
substantial narrowing of the room 
to catch-up with the technological leader, the United States; the adverse impact of 
macroeconomic shocks resulting from large and abrupt changes in relative prices with 
slow adjustment to the new conditions in the post-1973 era; and the trend decline in the 
share of investment in GDP in the Community. 
During the last decade, despite significant changes in technology, especially in the field of 
information and communication, there has not been a pronounced rebound in TFP growth 
from the low rate experienced during the second half of the 1970s and the early 1980s. 
Nevertheless, since the launching and implementation of the Single Market Programme, 
the slowdown has been arrested and a slight recovery is even noticeable. The latter 
2 Total factor productivity has been calculated within a production function framework where the level 
of output is assumed to be determined by the level of input of two production factors, labour and 
capital, and a certain rate of technological progress (total factor productivity): Y = A(t)F(L,K) where 
Y is the level of output, L and K the inputs of labour and capital, and A(t) the effect of technological 
progress. Under the assumption of constant returns, the rate of technological progress can be 
calculated approximately as g = y - ak where g is the rate of technological progress (change in total 
factor productivity), y is the growth rate of the volume of GDP per person employed, a is the share of 
profits in GDP at factor cost and k is the growth rate of the capital stock per person employed. Thus 
total factor productivity is measured ex post as a residual item and includes factor inputs other than 
capital and labour. In the new growth theories, by contrast, technical progress is an endogenous 
element of the economic system that can be influenced by economic policies and investment in 
physical and human capital. 
32 
essentially reflects a partly cyclical pick-up in TFP growth in the second half of the 
eighties when buoyant investment characterised the Community economy. Over the last 
two decades, TFP in the Community grew at a broadly similar pace as in Japan and about 
twice as fast as in the United States. 
The failure of the rapid technological advance to show up in economy-wide TFP growth 
in the 1980s and 1990s (the so-called "productivity or Solow paradox") may be related 
largely to insufficient economic growth and, particularly, low investment. 
Otherexplanations have also been offered3, including problems in measuring technological 
change and productivity, especially in services; the need for complementary organisational 
investment and institutional changes; shifts in the nature of innovation, with more effort 
devoted to product differentiation rather than to productivity enhancement or radically 
new products; and lags for new technologies to ripple through the economy. 
None of these explanations puts into doubt, however, that technological progress and the 
move to a knowledged-based economy are the driving forces behind medium and long run 
growth of economic activity, productivity and living standards in the Community. 
Technological progress implies a continued shift in the structure of output and 
employment, out of agriculture and manufacturing and into services and the new growth 
areas of communication, bio- and ecotechnologies, health care, leisure, and the 
environment. In particular, the use of new technologies eliminates certain low-wage, low-
productivity jobs of the unskilled and creates jobs that are more productive, high-skill and 
better paid. Such a transformation process has continuously taken place in the Community 
since its inception. 
As shown in Graph 12, over the last 25 years, employment in agriculture and industry has 
been on a downward trend. But in contrast with the steady fall in the number of persons 
employed in agriculture, employment in industry stabilised or even increased at times 
when macroeconomic growth was relatively strong. The job losses in agriculture and 
industiy have been compensated for by increased employment in the services sector. The 
latter upward trend was only temporarily interrupted during the 1992/93 recession, partly 
under the impact of a more competitive environment, for instance in financial services, and 
due to the cyclical vulnerability of many small and medium-sized enterprises. 
See OECD (1996), "Technology, productivity and job creation. Analytical report.", especially pp. 26-
29. 
33 
Graph 12 
Gross value added per sector *, EUR 
(constant prtcaa) 
index 1:970* WO 
1990 
Sectoral employment trends, EUR 
index 197Û» 100 
1975! 
* GVA for EUR excl. E.IRLL and P. 
Source: Commission services and DECD LFS. 1990:: Graph 13 Employment by type of 
manufacturing industry, EUR 
:tô70 - too 
1970 1974 1978 1982 1986 1990 1994 
197Q=KW 
1970 -1974 1978 1982 1986 1990 1994 
Source: OECD STAN database. 
Within the manufacturing sector, Graph 13 indicates that employment in the high-
technology manufacturing industries in the Community has expanded markedly during the 
1980s although these employment gains have been lost during the slow-growth period of 
the first half of the 1990s. By contrast, low-technology manufacturing industries have 
seen pronounced and steady job losses since the early 1970s. 
To reap the full benefits of the new wave of technological progress, it is necessary that 
four requirements are met. 
Firstly, efficient goods and services markets must allow for swift changes in relative 
prices. In sectors where productivity rises relatively fast under the influence of 
technological innovation, the opening-up of markets or deregulation, relative prices must 
fall in order to pass on the productivity gains to the rest of the economy. In this way, 
relative prices could increase in sectors with below-average productivity growth. Only 
under this condition will the more labour-intensive sectors be capable of creating 
profitable jobs. There is evidence that this requirement is relatively well respected in the 
34 
Community4. Competitive pressures and effective competition policies should ensure that 
this condition is even better fulfilled in future. 
Secondly, the unavoidable sectoral changes must occur smoothly and be socially 
acceptable. In the Community economy it appears that this condition is fulfilled albeit 
with some difficulties. Increased professional and geographical mobility as well as a 
lowering of non-wage labour costs and temporary entry wages targeted at low-skilled 
workers could help cushion the adjustments resulting from technological progress, 
globalisation and falling subsidies for ailing sectors and industries. 
Thirdly, the move towards a knowledged-based pattern of production of goods and 
services must be assisted by policies to improve human capital formation in the 
Community in general and by measures to enhance the employability of the low-skilled in 
particular (for instance through lower non-wage costs, lower taxes, temporary entry 
wages, better education and training, etc.) 
Fourthly, the production potential created by technological progress and enhanced 
competition must actually be absorbed by higher economic growth, exceeding the 
productivity trend. If the resources freed are not put to use, the overall balance between 
job creation and job destruction will not be sufficiently positive to employ the growing 
labour force and to reduce unemployment. Deficient economic growth has been the 
Community's major problem, underscoring the need to resolutely eliminate the obstacles 
to macroeconomic growth highlighted in Chapter 1. 
2.2 Globalisation 
Technological progress, competition and globalisation are mutually reinforcing. 
Globalisation can be defined as the process by which markets and production in different 
countries are becoming increasingly interdependent due to the dynamics of trade in goods 
and services and flows of capital and technology. It is not a new phenomenon but the 
continuation of developments that have been in train for some considerable time. Indeed, 
a greater integration of the world economy has been actively pursued since the end of the 
second world war. The well-recognised case for globalisation is that it has played, and 
will continue to play, a major role in the rise in living standards by improving the 
allocation of resources and by exerting discipline on economic policies. Since its 
For a more detailed analysis of the relationship between productivity and employment growth, see 
Box 6 in AER1996, European Economy, n° 61, p. 64. 
35 
inception, the Community has had an important effect on this process. European 
integration may not only be considered as an integral part of this process, it also adds 
another dimension. The quest for further integration through inter alia the creation of a 
customs union, the completion of a single market and the forthcoming economic and 
monetary union has been accompanied by important institutional developments and a 
sharing of sovereignty in certain policy areas. 
Over the last two decades, globalisation has gained additional momentum. Driven by 
various powerful forces, the economic links between the industrialised countries have 
intensified significantly since the mid-1970s. Chief amongst these forces are the 
impressive reductions in communication and transport costs, the progressive world-wide 
reduction of barriers to trade (including since the Uruguay Round agricultural products 
and with the GATS agreement a first liberalisation of services), the continued 
liberalisation of capital movements and, finally, changes in enterprise organisation and 
strategy. In addition, hitherto inward-looking developing countries have gradually opened 
up their markets and have increasingly become integrated in the world economy. The 
most recent development in this context is the opening of the former state-controlled 
countries of central and eastern Europe (CCEEs) and the Former Soviet Union (FSU). In 
the medium to longer run, this trend is bound to accelerate and to encompass a larger, 
more populated group of countries. 
The scale of globalisation can be 
assessed on the basis of trends in 
international trade and capital flows. 
2.2.1 Trade 
During 1950-73, the volume of world 
trade (in goods and services) increased 
at an annual rate of nearly 8 per cent, 
while world GDP rose annually by 5 per 
cent in volume. In the decade following 
the abandoning of the fixed exchange 
rate regime under Bretton Woods and 
the first oil price shock, the rate of 
expansion of both world trade and 
world GDP slowed down substantially. Graph 14 
Elasticity of world trade with 
respect to world output * 
-1.5 
1970: 1975 1980 : 1985 1990 : 1995: 
* World trade includes goods and services and is calculated as the 
average of annual percentage change for real world exports and 
imports. The elasticity is calculated as the annual percentage change in 
world trade divided by the annual percentage change in world GOP 
(both in real terms). 
Source: IMF. 
36 
However, since 1983, the pace of world trade has accelerated again (average annual rate 
of 5.7 per cent) thereby well outpacing the expansion of world GDP (which rose at only 
3.4 per cent per year). Since the beginning of the 1990s, the elasticity of world trade to 
world GDP has even jumped to above 2 (see Graph 14). As a corollary, the ratio of 
exports (goods and services) to GDP for the world as a whole has risen considerably. 
Having doubled between 1950 and 1973 to 16 per cent, it reached almost 25 per cent in 
19955. 
j Graph 15 
35! m Share in world exports of goods' 
EUR 
1963 1968 1973 1978 1983 
" Expressed in nominal terms; excluding intra-EC exports. 
Source: Commission services, foreign trade statistics. 1988: 1993! 
The Community has participated actively and positively in this globalisation process. It has 
also withstood the increased competitive pressures relatively well. Since the early 1970s, 
the Community's share in world merchandise exports has shrunk but it remains high at 
about 24 per cent (excluding intra-EC trade). To the extent that the drop in its world 
market share reflects the emergence of new trading partners on the world scene and 
increased trade integration amongst member countries, this is not a worrying 
phenomenon. In this respect, it is noteworthy that the bulk of the rise of the share in 
world trade of the Asian countries6 came primarily at the expense of the other developing 
countries. 
5 Including intra-EC trade. 
6 The share of the Dynamic Asian Economies in world exports has increased from 5 to 6 per cent in the 
early 1970s to about 15 per cent at present. 
37 
Table 12 
Geographical structure of extra-Community trade 
(goods, extra-EC) 
As % of nominal GDP 
19761) 19822) 19953) % change p. a. in value 
82/771) 87/822) 95/873) %of 
total 
1995 
Exports to: 
• Total 
• OECD 
of which: 
USA 
Japan 
• Non-OECD 
of which: 
DAEs4> 
China 
Rest of Asia5) 
CCEEs6) 
Imports from: 
• Total 
• OECD 
of which: 
USA 
Japan 
• Non-OECD 
of which: 
DAEs 
China 
Rest of Asia 
CCEEs 
Trade balance 
• Total 
• OECD 
of which: 
USA 
Japan 
• Non-OECD 
of which: 
DAEs 
China 
Rest of Asia 
CCEEs 10.9 
4.6 
1.2 
0.2 
6.2 
0.3 
0.1 
0.2 
0.9 
12.1 
4.9 
1.9 
0.5 
7.2 
0.5 
0.1 
0.3 
0.8 
-1.3 
-0.3 
-0.7 
-0.3 
-1.0 
-0.2 
0.0 
-0.1 
0.1 11.5 
5.0 
1.7 
0.3 
6.4 
0.4 
0.1 
0.5 
0.7 
12.9 
5.7 
2.2 
0.7 
7.2 
0.6 
0.1 
0.3 
1.0 
-1.4 
-0.7 
-0.4 
-0.5 
-0.7 
-0.1 
0.0 
0.1 
-0.3 9.8 
4.9 
1.6 
0.5 
4.9 
1.1 
0.2 
0.4 
1.0 
9.6 
5.1 
1.6 
0.8 
4.5 
0.9 
0.4 
0.4 
1.0 
0.3 
-0.2 
-0.1 
-0.3 
0.5 
0.1 
-0.2 
0.0 
0.0 12.5 
13.0 
17.9 
14.6 
12.1 
17.7 
10.5 
25.9 
5.7 
12.6 
14.3 
13.5 
18.8 
11.4 
14.7 
12.0 
13.3 
15.9 
(7) 
-1.2 
-0.4 
-0.5 
-0.4 
-0.8 
-0.2 
0.0 
0.0 
-0.1 3.3 
9.3 
10.9 
15.5 
-2.5 
11.3 
18.7 
3.7 
1.4 
0.8 
5.6 
0.9 
12.4 
-3.9 
10.3 
14.2 
5.8 
0.8 
(V) 
-0.5 
-0.1 
0.2 
-0.5 
-0.4 
-0.1 
0.0 
0.1 
-0.3 8.7 
4.9 
3.3 
10.2 
12.9 
16.4 
11.3 
8.5 
16.4 
8.2 
5.9 
7.2 
4.8 
10.7 
9.3 
21.5 
10.0 
13.2 
(7) 
-0.5 
-0.4 
-0.1 
-0.5 
-0.1 
-0.1 
-0.1 
0.0 
-0.1 100.0 
49.7 
15.8 
5.0 
50.3 
10.6 
2.2 
4.0 
10.7 
100.0 
53.2 
17.1 
8.8 
46.8 
9.4 
4.3 
3.9 
10.9 
1 ) EUR9: EUR15 excluding EL, E, A, P, FIN and S 
2) EUR10: EUR15 excluding E, A, P, FIN and S. 
3) EUR12: EUR 15 excluding A, FIN and S. 
) Hong Kong, Korea, Malaysia, Singapore, Taiwan, and Thailand. 
5) Afghanistan, Pakistan, India, Bangladesh, Maldives, Sri Lanka, Nepal, Bhutan, 
Myamnar, Laos, Vietnam, Kampuchea, Indonesia, Brunei, Philippines, Mongolia, Macao 
") Albania, Bulgaria, Czech republic, Slovakia, Hungary, Poland, Romania, Ex-USSR and 
Slovenia. 
7)Average trade balance over the period in % of GDP. 
Source: Commission services. 
38 
The Community has a comparatively low share of extra-EC exports directed towards the 
Asian markets which have been growing quickly and are likely to continue to do so in the 
foreseeable future. In 1995, Community exports to Asia (including China) represented 
only 17 per cent of total extra-EC exports against 20 per cent and 44 per cent for the 
United States and Japan respectively. It should be noted, however, that Community 
exports to these countries have risen strongly since the late 1980s (see Table 12). 
Furthermore, the share of Community exports directed towards the CCEEs, which also 
constitute high-growth markets, is significantly higher than that of the United States and 
Japan. 
However, there is some cause for concern. The Community exhibits a comparatively low 
degree of specialisation in the strong-demand, high-tech sectors. The share of the high-
demand sectors in total extra-EC exports amounted to 30 per cent in 1994 which 
compares with 39 per cent in the United States and 34 per cent in Japan; the share of the 
high-tech sectors in total extra-EC exports (in 1993) amounted to 23 per cent against 
about 37 per cent in the United States and Japan. 
One of the most prominent features of the recent globalisation process is the emergence of 
newly industrialised countries as major suppliers and exporters of internationally traded 
goods (especially manufactures). Imports from Asian countries to the EC rose 
dramatically during the last decade, resulting in a sharp increase in their share in extra-EC 
imports. While imports from Asian countries only accounted for 1.3 per cent of 
Community GDP in 1995, these countries are increasingly establishing themselves as 
serious competitors in EC markets. In 1995, they accounted for around 18 per cent of 
total EC imports from the rest of the world (Table 12). 
Table 13 shows that the growth of Asian exports to the Community is not restricted to 
traditional, low-skilled sectors such as clothing and textiles. High-skilled, capital-intensive 
sectors such as machinery and transport equipment and high-tech products represent a 
rising share of Asian exports to the Community. Greater global mobility of financial 
capital and easier access to technology since the early 1980s have contributed importantly 
to this trend. Moreover, restricted market access for "sensitive" products (e.g. textiles 
and clothing, steel and iron) may have encouraged the shift in Asian countries towards a 
greater specialisation in more sophisticated market segments. As a result, part of the 
adjustment burden in the EC has been shifted towards sectors in which EC countries have 
not until very recently faced direct competition from Asian exports. 
39 
Table 13 
The regional structure of extra-EC1' imports of manufactured products *i) 
Total % of total imports of manufactured goods from 
each country or group of countries. 
% of total extra-EC 
imports of 
manufactured goods Machinery 
transport 
equipment Chemicals Clothing . 
and textile Hi-tech 
USA 
Japan 
Developing 
countries2) 
of which: 
DAE 
China 
Other Asia 
CCEEs 1980 
1995 
1980 
1995 
1980 
1994 
1980 
1995 
1980 
1995 
1980 
1995 
1980 
1995 22.9 
21.6 
8.6 
12.4 
27.4 
36.4 
7.6 
12.2 
0.9 
5.7 
2.5 
4.6 
5.2 
11.6 26.4 
30.8 
37.6 
47.4 
4.7 
13.7 
3.1 
30.8 
0.8 
9.6 
1.5 
4.1 
9.8 
14.0 9.1 
8.9 
3.5 
5.0 
6.2 
4.7 
0.4 
1.7 
13.5 
5.8 
1.1 
2.9 
12.7 
7.3 4.3 
2.2 
3.1 
1.4 
23.7 
23.7 
31.3 
11.1 
44.1 
23.9 
42.2 
50.2 
16.9 
17.5 24.3 
33.5 
38.9 
36.1 
7.4 
17.3 
20.2 
34.3 
1.9 
21.3 
2.9 
8.6 
3.6 
9.0 
^EUR 9 for 1980 and EUR 12 for 1995. 
2) African-, Caribbean- and Pacific countries signatories of the Lomé convention, Central and South America, 
Middle East, DAEs, China, Other Asia, CCEEs. 
Source: Commission services. 
Growth in Community exports to and imports from other regions in the world have 
remained roughly in balance. At the same time, the Community's trade balance against 
the developing countries has shifted from a deficit of the order of 1 per cent of GDP just 
after the first oil price shock to a modest surplus at present. On the other hand, trade with 
the new "emerging" economies of Asia and the CCEEs has been broadly in balance during 
the last two decades. 
2.2.2 Foreign direct investment (FDI) 
Since the second half of the eighties, world-wide FDI flows have grown very rapidly, both 
absolutely and relative to trade flows and output growth. Annual flows jumped from an 
average of $50 billion during the period 1981-85 to an average of $155 during the period 
1986-90, reaching $200 billion in 1990. In the early 1990s, in line with the slowdown of 
40 
the world economy and weak corporate balance sheets in a number of industrialised 
countries, FDI flows dropped substantially but have recovered remarkably strongly from 
1994 onwards. According to UNCTAD7, the level of global FDI flows reached $315 
billion in 1995. Over the last 10 years, global FDI flows rose in nominal terms on average 
more than twice as fast as world GDP. 
The Community has been both a major 
source and destination for FDI flows. 
Although there was a setback in the early 
1990s under the impact of the economic 
slowdown, the level of both inward and 
outward FDI flows was high by historical 
standards (see Table 14). The 
Community (including intra-EC flows) 
was the source of 42 per cent of global 
FDI flows in 1995 and absorbed 36 per 
cent of inflows. 
Following the launch of the Single 
Market Programme in the mid-eighties, 
the Community has become an 
increasingly attractive destination for 
both traditional investors like the United 
States and Japan and also the newcomers 
of Southeast Asia as they sought to 
strengthen their position in the internal 
market. The abolition of non-tariff 
barriers, the simplification of 
administrative formalities, the prospect of a large and growing market demand and the 
scope for economies of scale seem to have provided strong incentives to invest in the EC. 
The Single Market Programme has also provoked unprecedented amounts of FDI 
between EC member countries. As a proportion of total EC FDI outflows, intra-EC FDI 
flows soared from 20 per cent in 1983 to 59 per cent in 1994. Table 14 
Foreign direct investment (Mrd $) 
Inflows 
% World 
% GFCP) 
Outflows 
% world 
% GFCP) 
Net flows 
Inflows 
% GFCP) 
Outflows 
% GFCP) 
Inflows 
% GFCP) 
Outflows 
% GFCP) 1975 1980 1985 1990 1995 
EUR15 
(extra + intra) 
9.9 
45.9 
2.6 
9.9 
36.0 
2.6 
0.0 21.3 
40.9 
2.8 
27.0 
46.8 
3.6 
5.7 15.4 
31.1 
2.9 
25.5 
42.6 
4.8 
10.1 97.4 
47.8 
7.0 
133.0 
55.4 
9.5 
35.6 111.9 
35.5 
7.0 
132.3 
41.6 
8.3 
20.4 
USA 
2.6 
0.9 
14.2 
5.1 16.9 
3.1 
21.9 
4.0 19.2 
2.5 
15.2 
1.9 47.9 
5.1 
27.2 
2.9 60.2 
4.9 
95.5 
7.8 
Japan 
0.2 
0.1 
1.8 
1.1 0.3 
0.1 
2.4 
0.7 0.6 
0.2 
6.4 
1.7 1.7 
0.2 
48.0 
5.1 0.5 
0.0 
21.3 
1.5 
l) Gross fixed capital formation. 
Source: UNCTAD. 
7 UNCTAD (1996), World investment report, Geneva. 
41 
As regards outward investment flows from the EC to non-EC countries, a large 
proportion (about 60 per cent in 1994) is directed towards other industrialised countries. 
This figure is on a declining trend, down from about 75 per cent in the mid-eighties. 
Among the developing countries, the Asian countries are increasingly important recipients 
of investment from the EC. The same holds for China whose share in EC FDI outflows 
has grown strongly in recent years. It is noteworthy that the size of EC FDI outflows is 
small relative to gross fixed capital formation in the Community (about 2 to 3 per cent for 
total extra-EC FDI outflows)8. 
Graph 16 
Foreign direct investment in EUR12 
Mrd ECU Extra- and intra-EC flows Direct investment abroad is a normal 
element in corporate growth strategies that 
enables a company to exploit its particular 
strength on a broader scale. From this 
perspective, FDI outflows to dynamic, 
fast-growing economies might be an 
indicator of a competitive edge. It is only 
when this relocation is not matched with 
broadly equivalent FDI inflows or when it 
is accompanied with weak domestic 
investment that the attractiveness of a 
country as a production site may be in 
question. So far, the Community has done 
fairly well in international competition for 
direct investment as witnessed by both the 
strong growth in inflows and its moderate 
surplus in net FDI flows. It seems that 
Community location and foreign 
production are complementary given the 
strong, albeit declining, correlation between the direction of exports and FDI outflows. 
Furthermore, there are no signs that the foreign transfer of production is predominantly 1984 1386 1986 1987 "1988 1989 1990 1991 1992 1993 1994 
Source: Commission services. 
This analysis is confined to Community-wide trends which mask important differences between 
countries. For instance in Germany the size of FDI inflows has traditionally been low relative to 
outward FDI. Whereas during the 1980s substantial net FDI outflows were the mirror-image of a 
solid surplus on the current account, the widening gap since unification when the current account 
turned negative has fueled the current debate on the attractiveness of Germany as a production site. 
The strong appreciation of the DEM over recent years has undoubtedly played a role, though 
structural weaknesses in the German economy have significantly added to current concerns in this 
field. Conversely, following the deregulation and privatisation of the early 1980s, the United 
Kingdom experienced a sharp increase in inward FDI in the late 1980s, especially by Japanese firms. 
42 
determined on wage-cost grounds, even if this might 
be the case for some labour-intensive sectors such as 
clothing, footwear or toys. 
2.2.3 Financial capital movements 
Not only have FDI flows risen significantly over the 
last 20 years, but also international financial capital 
movements have expanded enormously under the 
combined impact of financial deregulation and 
innovation. For instance, cross-border transactions in 
bonds and equities soared in major industrial 
countries from less than 10 per cent of GDP in 1980 
to between 150 and 250 per cent in 1995. The 
world-wide volume of foreign exchange trading has 
also risen very fast, with the daily turnover now 
amounting to $1500 bn. It should be noted that these 
transactions primarily concern movements in stocks 
of financial assests (including government bonds) 
which have been built up over time and which react 
instantaneously to even marginal differences in yields. Table 15 
Structure of foreign direct 
investment in the EC 
(MrdECU) 
From: 
-USA 
- Japan 
-Asia3) 
- Others 
To: 
-USA 
- Japan 
-Asia3) 
- China 
- CCEEs 
- Others 
Intra-EC 19841} 1990" 19942) I 
Extra-EC inflows 
3.0 
0.4 
2.8 9.2 
5.4 
18.2 8.5 
1.4 
0.5 
9.5 
Extra-EC outflows 
11.5 
0.3 
0.0 
5.6 
4.2 7.2 
0.9 
0.2 
12.2 
39.3 6.4 
0.3 
2.4 
0.5 
3.3 
8.6 
37.4 
(1) EUR12. 
(2)EUR15. 
(3) Asia: Thailand, Malaysia, Indonesia, 
Singapore, Philippines, South Korea, 
Taiwan, Hong Kong and India. 
Source: Commission services. 
The liberalisation of financial markets also contributes to a better allocation of resources. 
Since holdings of financial assets are very sensitive to shifts in sentiment in international 
financial markets, they exert a strong discipline on exchange rates and economic policy. 
Ignoring market signals inevitably leads to turbulence on currency and bond markets 
which in turn — as shown in Chapter 1 — constitutes an important obstacle to 
macroeconomic growth. 
2.2.4 Economic implications 
There is little evidence that globalisation in itself, and especially increased trade and 
investment with developing countries, is a major cause of unemployment in the 
Community. On the contrary, increased trade is a major source of economic growth and 
rising living standards due to improved allocation of resources. 
43 
First of all, it should be borne in mind that the degree of openness of the Community to 
the world economy is relatively small and broadly similar to that of the United States and 
Japan. In 1995, the degree of openness9 in the Community was about 10 per cent, 
compared with 12 per cent in the United States and 9 per cent in Japan. This implies that 
the globalisation of trade direcly affects only a limited part of the Community economy. 
Secondly, it should be noted that the majority of the EC's economic links are within the 
Community and with its major industrial partners. This means that globalisation is 
primarily taking place between countries with broadly similar economic structures, factor 
endowments and wage and productivity levels. Hence, the primary impact of international 
trade and FDI flows on employment creation is within the Triad (i.e. between the 
Community, the United States and Japan). The intensification of economic links between 
industrial countries should not be perceived as a disadvantage but rather as a boon for the 
Community's prosperity. This has been the motivation for a variety of EC policies, 
notably the new Market Access Initiative, which seek to maximise the benefits accruing to 
the Community from globalisation. 
Thirdly, the size of the Community's trade with low-wage economies is still small: extra-
EC imports from low-wage countries amount to less than 3 per cent of Community GDP 
at present and the Community's trade with these economies is broadly in balance. It is 
sometimes argued that even a balanced trade account with these countries could involve 
overall job losses for the Community because imports from low-wage economies tend to 
have a higher (low-skill) labour-intensity than the Community exports to these countries. 
However, this argument does not take account of the dynamic effects resulting from a 
better resource allocation nor of the fact that cheap imports mean an increase in 
Community real incomes and internal demand. Overall, this trade embodies the exchange 
of low-skilled work against high-skilled and better paid work. 
Fourthly, the extent of outward relocation of certain types of economic activity should not 
be exaggerated nor is it necessarily undesirable. A job created in the low-wage countries 
cannot be equated with a job lost in the Community and it cannot be assumed that this 
foreign production and employment could be relocated to the Community. Rather than 
displacing Community exports, sales-oriented investment abroad can open up markets and 
lead to additional exports by competitive Community industries. Community businesses 
are exploiting these opportunities as can be seen from the Community's continued trade 
surplus with the CCEEs and the newly industrialised countries of Asia. 
9 Aritmetic average of exports and imports of goods and services as a percentage of nominal GDP. 
44 
Nevertheless, the globalisation of product and financial markets accelerates sectoral 
change and exerts downward pressures on the wages of low-skilled labour. It also 
exercises powerful pressures on the Community economy to apply new technologies, to 
maintain and improve competitiveness, to optimise the allocation of resources and to 
conduct sound economic policies. 
2.3 Competitiveness 
Technological progress and globalisation puts constant pressure on Member States to 
maintain and improve their competitive position. Competitiveness is a complex and 
ambiguous concept that is often confused with other notions, for instance profitability. 
At the firm level, the meaning of competitiveness is clear-cut: an enterprise is competitive 
if it can sell its products at the market price and be profitable in the medium and long 
term. 
At the country level, the notion of 
competitiveness is less straightforward. For 
a country, the ultimate policy objective is to 
improve its citizens' living standard's and 
well-being. In this context, the external 
performance of a country is generally 
considered important because it is a useful 
indicator of the long-term ability to raise 
productivity and to turn international 
economic growth into domestic jobs. In this 
respect, a country's competitiveness is often 
assessed on the basis of trends in its export 
performance. As shown in Table 16, the 
Community has experienced a steady, 
moderate decline in export markets shares 
since the mid-1980s. As regards the other regions listed in the table, it is noteworthy that 
Japan also has suffered from continued, marked losses in export market shares whereas 
the United States (in the second half of the 1980s ) and the Asian economies (since the 
early 1980s) have enjoyed considerable gains. Table 16 
Export performance, total goods 
% gain or loss of market share in real terms1), 
(annual average change) 
EUR 
USA 
JAP 
Non-OECD 
of which: 
- DAEs(3) 
- Rest Asia 1981-85 
1.6 
-2.8 
1.6 
-1.4 
3.0 
2.5 1986-90 
-1.9 
4.3 
-3.9 
1.0 
3.3 
2.4 1991-95 
-0.1 
-0.2 
-7.8 
1.6 
1.7 
5.5 1996(2) 
-1.6 
1.7 
-5.9 
1.9 
3.1 
3.6 
* > Measured as the ratio between export volume 
growth and export market volume growth. 
2) Estimated. 
3) DAEs excl. Thailand and Malaysia. 
Source: OECD. 
45 
Graph 17 
;i4tt; Export performance and real effective exchange rate, 
EUR 
1997 =100 
1978 1980 1982 1984 1985 1988 1990 1992 1994 
' Relative to 6 Industrial nan. member countries; double export-weights. Deflatonnomlnal unit labour costs, 
** Measured as the ratio b*tw*en export volume growth and export market volume growth. 
Source; Commission services and OECD. 1996: 
The evolution in export market shares can in part be explained by movements in 
international cost competitiveness (as measured by real effective exchange rates). In this 
context, Graph 17 reveals that the deterioration in export performance over the last 
decade in the Community has partly been a consequence of the substantial appreciation of 
its real effective exchange rate. A negative correlation between the two variables is 
apparent at the time of the hike in the value of the Community currencies in the mid-1980s 
and the early 1990s. 
Though trends in export performance and cost competitiveness may contain interesting 
insights, they only shed a partial light on the competitiveness of a country. In 
macroeconomic terms, and viewed in a medium to long-term perspective, a convenient, 
comprehensive definition of the notion of competitiveness10 is as follows: A country is 
internationally competitive if concurrently: 
- its productivity increases at a rate which is similar to or higher than that of its major 
trading partners with a comparable level of development; 
- it maintains external equilibrium in the context of an open free-market economy; and 
- it realises a high level of employment. 
10 See also Competitiveness Policy Council (1993), "v4 competitiveness strategy for America". 
46 
Table 17 shows that according to this definition the Community's record is mixed. The 
Community has had higher labour productivity growth than the United States and, in 
recent years, Japan while maintaining external equilibrium, but its employment 
performance is significantly worse than in its two main trading partners. 
Table 17 
Macroeconomic competitiveness in the Triad 
EUR 
USA 
Japan 
EUR 
USA 
Japan 
EUR 
USA 
Japan 
EUR 
USA 
Japan 1961-73 1974-85 1986-95 1986-90 1991-95 
Labour productivity growth (% pa.) 
4.4 
1.9 
8.2 2.0 
0.5 
2.7 1.9 
0.8 
2.0 1.9 
0.6 
3.6 1.9 
1.1 
0.6 
Current account (% of GDP) 
0.3 
0.5 
0.6 -0.3 
-0.4 
0.9 -0.2 
-1.9 
2.7 0.1 
-2.5 
2.8 -0.4 
-1.3 
2.7 
1960 1973 1985 1990 1995 
Employment rates (%)x) 
67.0 
62.7 
74.3 64.8 
66.7 
70.8 59.1 
68.5 
70.6 62.2 
72.6 
72.6 59.6 
73.0 
73.9 
Unemployment rate (%) 
2.4 
5.5 
1.7 2.6 
4.9 
1.3 10.0 
7.2 
2.6 7.8 
5.5 
2.1 10.9 
5.4 
3.3 
l) Ratio of employment to the working population (15-64 years). 
Source: Commission services. 
All industrial countries have been affected by a structural break in apparent labour 
productivity growth in the wake of the first oil price shock. In the Community, labour 
productivity has risen at a stable rate of 2 per cent per year on average over the last 
twenty years, thereby increasing about three times as fast as in the United States. In 
Japan, which showed the strongest performance over the period 1960-90, labour 
productivity growth fell dramatically in the first half of the 1990s, to rates well below 
those experienced in the Community and even the United States. Japan's recent record 
reflects labour hoarding during the strong and protracted economic downturn in the early 
1990s. 
47 
The better labour productivity growth 
performance of the Community has 
resulted in a steady catching-up with the 
productivity level of the United States (see 
Graph 18). The economy-wide 
Community productivity level (on a 
purchasing-power-standard basis) relative 
to the United States increased from 45 per 
cent in 1960 to 82 per cent in 1995, still 
well above the Japanese level despite the 
latter's leadership in some manufacturing 
industries. However, over this period, the 
Community did not succeed in narrowing 
the gap in living standards with the United 
States to a similar degree. GDP per head 
of population relative to the United States 
increased from 55 per cent in 1960 to only 
71 per cent in 1995. This essentially 
reflects divergent trends in employment 
rates in both economies (see below). Graph 181 Labour productivity levels 
GDP at constant 1990 prices per person employed 
(PPS; USA-1D0) 
100 
1960 1965 1970 1975 1980 1985 1990 1995 
GDP per person employed at current prices 
and exchange rates. 
(ECU; USA=100) 
140 
1 1 I ! I 1 
1960 1965 1970 1975 1980 1985 1990 1995 
Source: Commission services. 
Community output per person employed measured in current prices and exchange rates is 
now similar to that in the United States but well below the Japanese level. This means 
that, at prevailing exchange rates, a worker in the Community on average creates a similar 
amount of economic wealth as a worker in the United States. 
Historically, the Community has never experienced real problems concerning the external 
equilibrium. From 1960 until the late 1980s, the Community's current account was 
generally broadly balanced or in slight surplus. .This good performance is somewhat 
concealed in Table 17 (which presents period averages) by the short-lived but non-
negligible deficits on the Community's current transactions with the rest of the world at 
the time of the two oil price shocks. In the wake of the overheating of 1989-90 and 
German unification, the current account turned temporarily negative but since 1995 the 
Community has again shown a surplus of the order of VA per cent of GDP. Conversely, 
the United States has run significant current account deficits since the early 1980s whereas 
Japan has experienced a strong external surplus, reflecting a significant structural excess 
of national saving over domestic investment. 
48 
Compared with its two major trading partners, the Community economy displays dismal 
employment performance. In the Community, employment was not a major worry until 
the early 1970s. But since then, apart from the growth period of the second half of the 
eighties, the rate of job creation has been too slow and below the comparatively modest 
rise in the labour force. The United States, by contrast, has enjoyed rapid employment 
growth since the early 1960s, broadly in tandem with a strong increase in the labour force. 
As a result, .the two regions experienced opposite trends in the employment ratio (i.e. 
employment relative to the working age population). Starting from a level somewhat 
below that in the Community, the employment rate in the United States rose to around 73 
per cent at present whereas it declined to below 60 per cent in the Community. 
2.4 Capital-labour substitution and employment growth 
2.4.1 Substitution of labour by capital 
Against the backdrop of rapid technological progress and increased globalisation, constant 
efforts to maintain and reinforce competitiveness are required. The Community and its 
two main trading partners have been confronted with similar adjustment problems but the 
results for the labour market have been strikingly different. A major explanation for the 
divergent employment trends on both sides of the Atlantic seems to reside in the interplay 
of labour productivity, capital-labour substitution and growth11. 
As discussed in the previous section, over the last 35 years the Community has 
continuously experienced stronger labour productivity growth than its principal trading 
partner, the United States, and recently even outperformed Japan. However, it appears 
that almost half of the increase in labour productivity has resulted from substitution of 
labour by capital. 
Labour productivity growth can be decomposed into growth of embodied technological 
progress (total factor productivity) and capital-labour substitution. Table 18 indicates that 
in the Community about 3 points of the annual increase in labour productivity of 4lA per 
cent in the period 1961-73 can be attributed to an increase in total factor productivity and 
the remainder or VA points to the substitution of labour by capital. During the two 
decades following the first oil price shock, labour productivity rose at a stable annual 
rateof 2 per cent. Only a little over half of this can be explained by technologicalprogress. 
Nearly half of labour productivity growth is caused by substitution of labour by capital. 
11 No comparison is made with the Japanese performance as its approach is too specific, culturally and 
socially, to be applicable to the Community. 
49 
Table 18 
Output, employment, productivity and capital-labour substitution 
(annual % change) 
EUR 
USA 
Japan 
EUR 
USA 
Japan 
EUR 
USA 
Japan 
EUR 
USA 
Japan 
EUR 
USA 
Japan 1961-73 1974-85 1986-95 1986-90 1991-95 
1. Technical progress = Total factor productivity = endogenous growth 
2.8 
1.6 
6.3 1.0 
0.4 
1.1 1.2 
0.8 
0.9 1.5 
0.6 
2.3 1.0 
0.9 
-0.5 
2. Macroeconomic capital-labour substitution 
= labour-saving growth (2 = 3-1) 
1.5 
0.3 
1.8 1.0 
0.1 
1.6 0.7 
0.1 
1.1 0.4 
0.0 
1.2 1.1 
0.2 
1.1 
3. Apparent labour productivity = GDP per person employed 
= economic growth without employment (3 = 1 + 2) 
4.4 
1.9 
8.2 2.0 
0.5 
2.7 1.9 
0.8 
2.0 1.9 
0.6 
3.6 1.9 
1.1 
0.6 
4. Employment = employment-creating growth (4 = 5-3) 
0.3 
1.9 
1.3 0.0 
1.8 
0.7 0.4 
1.7 
0.9 1.3 
2.1 
1.0 -0.5 
1.2 
0.7 
5. Actual GDP growth (5 = 1+2+4 = 3+4) 
4.7 
3.9 
9.7 2.0 
2.3 
3.4 2.3 
2.5 
2.9 3.3 
2.8 
4.6 1.4 
2.3 
1.3 
A strikingly different picture is noticeable in the United States. During 1961-73 and 
1974-95, the growth in labour productivity was about one third of that in the Community, 
and capital-labour substitution contributed only a marginal fraction. The US economy has 
thus been expanding its input of capital and labour broadly in parallel. It is noteworthy 
that since the mid-1980s the rate of TFP growth in the United States seems to have risen 
from the very low rate experienced in the previous decade, in part reflecting a strong 
expansion of investment. 
50 
Graph 19 Employment, productivity and 
capital-labour substitution 
(Index 1960* 100) 
«$« : •:«:• .::: 7o::::::.::rs.::::::(«1; :;:: 85: ^••:- 91 
ReaJ compensation 
per worker 
85 : : : :. so ' ' :••.iS : Total factor productivity 
EUR 
I960: ••: '-«5 •::.. . 70 . .:.:..:7*: 
' Source: i : : : ; •: Commission isérvicés.: 
In itself, capital-labour substitution is not a distressing phenomenon. A high degree of 
capital-labour substitution allows continued high growth in economic activity and living 
standards. But with a large part of the available labour reserve unemployed, as has been 
increasingly the case in the Community since the first oil price shock (see Table 18), a 
twofold problem emerged: 
- a lack of adjustment in the labour market compelled enterprises to keep up a strong 
substitution of labour by capital in order to safeguard their competitiveness through 
productivity increases; 
- macroeconomic growth was insufficiently strong relative to the given and stable labour 
productivity growth to create an adequate number of jobs. 
51 
The potential labour reserve, amounting to about 17 million persons if the average 
employment rate of the period 1961-73 is taken as a yardstick or to some 26 million if the 
benchmark is the employment rate in the Scandinavian countries, the USA and Japan, 
constitutes an important growth potential. But this implies that adequate policies should 
be implemented to take advantage of this labour reserve. 
Table 19 
Employment potential, EUR 
(1960-95, in mio) 
1. Population in working age 
groups (15-64 years) 
2. Activity rate in % (= 3 /1) 
3. Active population (=4 + 5) 
4. Unemployment 
5. Total employment 
6. Employment rate (=5/1) 
7. Potential employment at 1961-73 
average employment rate (66.2%) 
8. Employment gap 1 (=5-7) 
9. Potential employment at 70% 
employment rate3) 
10. Employment gap 2 (= 5 - 9) 1960 
193.8 
68.9 
133.4 
3.1 
130.4 
67.3 
128.4 
2.0 
135.6 
-5.3 1973 
208.4 
66.9 
139.5 
3.5 
136.0 
65.2 
138.1 
-2.1 
145.9 
-10.0 1985 
229.7 
65.7 
150.9 
14.8 
136.2 
59.3 
152.2 
-16.0 
160.8 
-24.6 1990 
234.2 
67.2 
157.5 
12.0 
145.4 
62.1 
155.2 
-9.7 
163.9 
-18.5 19911) 
235.4 
67.3 
158.3 
12.7 
145.6 
61.9 
155.9 
-10.3 
164.8 
-19.1 19912) 
246.0 
67.7 
166.6 
13.6 
153.0 
62.2 
163.0 
-10.0 
172.2 
-19.3 1995 
249.0 
66.6 
165.9 
17.9 
148.1 
59.5 
165.0 
-16.9 
174.3 
-26.2 
J) 1960-91 with West Germany, 
2) 1991-95 with unified Germany. 
3) Comparable to highest employment rates registered in Northern Europe, USA and Japan. 
Source: Commission services. 
2.4.2 Substitution and wage developments 
As highlighted above, in the Community substitution of labour by capital explains about 
half the growth in labour productivity. In the United States, which has had an only 
slightly weaker pace of technological progress, nearly no macroeconomic substitution has 
taken place. The question therefore arises of whether it is possible to slow down this 
substitution process without impairing competitiveness. 
A first answer to this question is provided by developments in relative factor prices at the 
macroeconomic level. Following excessive wage increases in the wake of the two oil 
price shocks, which laid the ground for the upsurge in unemployment, macroeconomic 
wage behaviour in the Community has become increasingly appropriate. Since 1982, with 
the exception of 1990-92, the trend in total wage costs (including social security 
contributions) per head has kept in line with the fall in inflation. The growth of unit 
labour costs has remained below increases in the GDP price deflator and the rise in real 
52 
wages has stayed about 1 percentage point behind overall labour productivity growth 
(Graph 20). This evolution has led to a remarkable improvement in the profitability of 
capital (see Graph 9 in Chapter 1) and constitutes a solid foundation for higher, 
investment-driven economic growth as demand prospects brighten. As a consequence, 
appropriate macroeconomic wage developments are important to reduce unemployment 
through investment-supported growth (in line with the macroeconomic part of the Broad 
Economic Policy Guidelines). However, econometric analyses suggest that favourable 
aggregate wage trends slow down the macroeconomic substitution of labour by capital 
only very gradually. 
Graph 20 Wage developments - EUR 
(annual change) 
62 64 66! 68 70 72 74 76 78: 80 82 84 86 88 90 92 94 96 98 
Real compensation per employee, Tre(1d |abou(. 
GDP deflator productivity (avg 61-73) 
62: 64 66 68 70 72 74: 76 78: 80: 82 84 86 88 90 92 34; 96 98 
62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 
Source: Commission services. A faster way to weaken the 
substitution process is a 
downward widening of the 
wage (cost) scale. The 
market forces acting in this 
direction are strong and will 
probably strengthen as a 
result of globalisation, 
especially with the opening 
up of the CCEEs and the 
Former Soviet Union. In the 
case of a very dispersed 
wage structure, economic 
growth becomes more 
employment-creating 
because the wide wage 
spread enables activities with 
low productivity to remain 
and/or to become viable. 
53 
Graph 21 Trends in earnings dispersion 
{men.OWOD 
1979 1983 1987 
20 
15 
10 
::;'5: 
o 
::.5; 
-io: 
-15 1991 
Change between 1979* and 1995** 
ratios of the upper and lower deciles of the 
earnings dispersion, relative to the mean ___ 1995 
ES3D1 BSD9 During the 1970s and 1980s, in 
the United States the wage scale 
for male workers underwent a 
downward widening of more than 
30 per cent12. This means that 
the relatively small increase in 
average real wages observed in 
the United States (annual average 
rate of growth of around lA per 
cent during the period 1974-90) 
was accompanied by a dramatic 
fall in real wages at the lower end 
of the earnings distribution. It can 
be argued that the large degree of 
wage dispersion in the United 
States has been the price to pay 
for high employment. The 
downward wage flexibility has 
ensured a closer match between 
relative wages and the widening 
of labour productivity differentials (resulting from technological progress and 
globalisation). 
Although this tendency may have tended to weaken somewhat in the United States in 
recent years, the wage distribution remains very wide and continues to influence the 
employment-intensity of output growth positively. Furthermore, the United States is 
implementing policies aimed at more investment, higher productivity growth and higher 
wages for the unskilled. In this context, evidence suggests that the bulk of the jobs which 
have been created in recent years in the United States are not low-paid, low-quality jobs 
but rather they have been concentrated in highly skilled activities. Indeed, 68 per cent of 
the net growth in full-time employment between 1994-96 was found in job categories 
paying above-median wages13. France Germany Italy Japan UK USA 
* Germany 1983 = 100, 
** Data for Italy available until 1992, France 1994, Germany 1993, 
Japan 1994. 
Source: OECD. 
12 See BURTLESS, G. (1993), "The contribution of employment and hours changes to family income 
inequality", American Economic Review, Papers and Proceedings, Vol. 83, n° 2, pp. 131-135. 
13 US Council of Economic Advisers (1996), "Job creation and employment opportunities: The United 
States labour market, 1993-96 ". 
54 
Conversely, in the Community, the earnings distribution either remained broadly 
unchanged or widened only slightly despite the changes in the pattern of labour demand. 
The exceptions to this general situation have been the United Kingdom and, to a lesser 
extent, Italy since 1991 (see also Box 3). A major explanation for the discrepancy in the 
degree of earnings inequality between the United States and the Community are 
differences in labour market institutions. These differences reside essentially in a much 
greater reliance on market forces in the United States than in the Community. For 
example, compared with the Community, minimum wages are low and unemployment 
benefits and other social transfers are markedly less generous in the United States. Other 
differences are less widespread collective wage bargaining, a smaller proportion of 
government employment and less support for education and job training in the United 
States than in the Community. 
For social and political reasons, an emulation of the US-approach is neither feasible nor 
desirable in the Community as it would mean a dramatic change in the European social 
model. For instance, the application of the US model to the Community would require a 
substantial lowering of unemployment compensation and social benefits. This would 
ceteris paribus imply a widening of the wage structure and generate greater income 
inequality. It would introduce in the Community the working poor syndrome — a form of 
exclusion just as harmful for the social fabric as unemployment. 
The above considerations do not mean, however, that some relief should not be sought 
through pragmatic solutions, in line with the strategy adopted by the Essen European 
Council aiming at a higher employment-intensity of growth. In particular, the following 
principles are worth pursuing in this context. The wage agreements of the social partners 
should provide for more differentiation according to qualifications, between regions and, 
to some extent, sectors. Non-wage labour costs (or income taxes) at the lower end of the 
wage scale should be lowered with the government revenue losses being compensated for 
by a stricter control of increases in overall government spending and/or increases in other 
taxes (e.g. environmental levies). In a similar vein, temporary entry-wages for the low-
skilled, youth or long-term unemployed could usefully be introduced. Such measures 
should be carefully targeted and gradually phased out. Furthermore, a higher flexibility of 
working time arrangements, tailored to the specific needs of firms and workers, greater 
use of voluntary part-time work and the promotion of local employment initiatives are 
likely to foster both new jobs and higher participation in the labour market. 
Hence, the solution to the Community's unemployment problem must primarily be found 
through high economic growth, structural reforms and microeconomic flexibility. 
55 
2.5 Policy implications 
Since the early 1960s, unemployment in the Community has risen from around 2lA per 
cent of the civilian labour force to about 11 per cent at present. During this period, 
employment has grown at an average annual rate of barely 0.3 per cent whereas both the 
activity rate and the employment ratio have been on a downward trend. The result has 
been that the Community presently displays a large reserve of unused labour. As 
discussed above, there is little evidence to suggest that the Community's dismal labour 
market performance is closely related to technological progress, globalisation and 
competitiveness. 
Nevertheless, the inherent consequences of technological advances and globalisation, viz 
fierce world-wide competition and far-reaching sectoral change, underscore the urgent 
need to implement measures to enhance competitiveness on the one hand and to 
modernise product and labour markets on the other. The policy requirements are those 
already presented in the White Paper on "Growth, competitiveness and employment" and 
in successive Broad Economic Policy Guidelines adopted since 1993. Recognizing this 
urgency, Member States have introduced, sometimes bold, reform programmes aimed at 
responding positively to the key structural challenges confronting their economies. 
Efforts should continue and be stepped up, especially in those areas where progress has 
been less visible or lacking. 
In order to safeguard and promote the EC's competitiveness and employment in a world 
of free trade and evolving technological change it is essential that Member States and the 
Community, in line with the Broad Guidelines for Economic Policies, intensify their 
efforts to modernise their markets for goods and services. This involves in the first place 
the full completion of the European Single Market, the importance of which has clearly 
been highlighted in the Commission's recent evaluation14. According to this study, the 
Single Market Programme has so far contributed to a rise in the level of GDP of up to 1.5 
per cent and created up to 900 000 jobs due to increased trade and competition. Further 
action is needed to complete the legal framework in areas such as taxation and company 
law and the liberalisation of the telecom and energy markets. Even more importantly, it is 
necessary to ensure the effective application and enforcement of existing Community law 
and reduce the burden of over-regulation, particularly but not exclusively at the national 
level, which still impedes the operation of the single market. The creation of a flexible 
14 European Commission, (1996), "The impact and effectiveness of the Single Market", COM(96) 520 
final. 
56 
economy also needs enhanced structural reforms in other important areas, including the 
realisation of the transeuropean transport and communication networks, the promotion of 
research and development, the promotion of the information society and the removal of 
barriers to entry and excessive regulation facing SME's. These policies will all strengthen 
endogenous growth and lead to strong improvements in the overall productivity of the 
Community economy. Provided the appropriate policy framework is put in place, there 
need not be any contradiction between sustained, investment-supported growth and the 
preservation of a healthy environment (see Box 4). 
As emphasised in the 1996 Joint Employment Report from the Council and the 
Commission "Employment and growth in the Community - The way forward" approved 
by the Dublin European Council, there is a continued need to further improve the 
responsiveness of Member States' labour markets to changes in the economy through a 
modernisation of the organisation of work, increased geographical and professional 
mobility and productivity-related labour cost differentiation. In particular, it is essential to 
reinforce education and training so that the skills of the workforce are able to adapt to 
evolving technological and other changes. These efforts are also necessary in order to 
avoid labour market bottlenecks and a resumption of wage inflation as unemployment 
comes down. Furthermore, pragmatic solutions to increase the labour-content of growth 
(see sub-section 2.4.2) should be pursued actively. They not only contribute to increased 
employment but they also help to cushion the painful adjustment efforts. 
15 See "The composition of unemployment from an economic perspective", European Economy, n° 59, 
1995 and "Grown, employment and employment-intensive growth", European Economy, n° 62, 1996. 
57 
Box 2: The impact and effectiveness of the Single Market 
- the 1996 Review 
The Single Market Programme (SMP) is the most ambitious and comprehensive supply-side 
programme ever launched. It aimed to remove all remaining non-tariff barriers to trade between 
EC Member States. The Commission's recent evaluation - The Impact and Effectiveness of the 
Single Market Programme (COM(96) 520 final) presented in October 1996 - and a more 
detailed analysis to be published in a forthcoming edition of European Economy entitled 
Economic Evaluation of the Internal Market1 offer some economic evidence of the impact of the 
Single Market so far. It concludes that there have clearly been positive effects on the 
Community economy, especially in the manufacturing sectors. Problems remain to be tackled, 
and vigilance is still essential to guard against any refragmentation of the Community market, 
but the Single Market is undoubtedly becoming a reality. 
The positive effects of the Single Market fall into three main areas: 
• changes in trade and foreign direct investment flows; according to theory, removing 
trade barriers between countries would expand trade between Member States and replace 
less efficient domestic production with imports produced more efficiently, thereby improving 
welfare. The SMP may also lead either to greater Member State specialisation on the basis 
of comparative advantage, increasing inter-industrial trade between Member States, or to the 
exploitation of scale economies, imperfect competition and product differentiation, increasing 
intra-industry trade (i.e., the simultaneous import and export of similar product lines, such as 
cars for cars). The former carries efficiency gains as Member States specialise in activities 
where they are relatively more efficient, and consumers benefit from lower prices, but it can 
also be accompanied by painful industrial restructuring. By contrast, intra-industry trade 
offers the consumer a wider variety of products, and producers lower adjustment costs. 
Meanwhile, by changing the attractiveness of the EC relative to other sites around the world 
as a location for multinationals' production facilities, the SMP was also expected to have an 
impact on foreign direct investment flows (FDI); 
• changes in Member States' production structures, levels of competition and the 
consequent impact on prices; it was expected that many of the beneficial effects of the 
SMP on the Community economy would result from competitive forces unleashed by 
integration, stimulating greater efficiency, with lower costs and prices, and increased product 
variety. Driving these forces were expected to be the exploitation of scale economies and 
increased competition. As a result, inefficient firms would be eliminated and industry 
restructured. Greater competition would also ensure that lower production costs resulting 
from efficiency gains would translate into lower consumption prices. 
• changes in EC total factor productivity, growth, employment and convergence; the 
SMP can be expected to have a positive impact on the accumulation of production factors, 
leading to higher growth rates in the EC. First of all, the static, efficiency gains of the SMP 
translate into higher incomes, which may generate investment and raise growth in the 
medium-term. Secondly, the SMP could improve the benefits and reduce the costs of 
producing innovations in the EC, boosting growth in the long run. 
1... Changes in trade and foreign direct investment flows 
Analysis estimates that the SMP impact of lifting trade barriers has increased trade volumes 
between Member States of manufacturing products by 20-30%. Moreover, from 1985 to 1995, 
the share of intra-EC imports in total manufacturing imports increased by 6.7 percentage points 
from 61.2% in 1985 to 67.9% in 1995. For services during the same period, the share of intra-
EC imports in total imports of services increased 3.1 percentage points from 46.9% in 1985 to 
50.0% in 1995. Such increases in trade amongst Member States have not, however, come at 
the expense of trade with third countries - extra-EC manufacturing imports have increased their 
share of consumption over the period 1980-93 from 12 to 14%, and it is estimated that 70% of 
this increase is down to the SMP. 
1 Economic Evaluation of the Internal Market, European Economy - Reports and Studies, 1997, 
Office for Official Publications of the European Communities, Luxembourg. 
58 
At the beginning of the 1980s, intra-Community trade could be classified as mainly inter-industry 
(around 45% of total manufacturing trade) corresponding to specialisation based on Member 
States' comparative advantages. Due to the SMPr this started to decline in the mid-1980s whilst 
the share of intra-industry trade rose. However, intra-industry trade can be further sub-
differentiated: either as trade in similar products in terms of both prices and quality, or in trade 
in products differentiated by price and quality (e.g., one country exporting brand-name 
expensive shirts and the other inexpensive low quality shirts). The rise in intra-industry trade 
has predominantly been the latter type (from less than 35% of total manufacturing trade in 1985 
to more than 42% in 1994), whilst the former type has remained broadly stable (around 20% of 
total intra-EC manufacturing trade). In other words, Member States' production structures 
appear to be converging as a result of specialising in increasingly similar sectors but different 
price-quality niches. This facilitates the move to EMU. 
Meanwhile, the SMP impact on FDI seems to have been even more positive than its impact on 
trade. The EC absorbed 44.4% of FDI inflows from all countries in the world at the beginning of 
the 'nineties, compared to 28.2% in the period 1982-87. Between 1984 and 1992, intra-EC FDI 
increased four times faster than intra-EC trade. 
2. Changes in Member States' production structures, levels of competition and the 
consequent impact on prices 
Industrial restructuring inside the EC has been characterised by an explosion in the number of 
mergers and acquisitions (M&A). This growth has been particularly strong in cross-border 
activity, although the bulk of M&A operations have remained domestic (over 70% of operations 
for the EC-15 between 1990 and 1995), indicating that restructuring is taking place, at least 
initially, through changes to domestic market structures. Between 1988 and 1992, manufacturing 
was the more active target for M&As. Latterly, services have taken the lead, in accordance with 
the delayed introduction of SMP measures in these sectors. This has led to greater industrial 
concentration at the EC level (but not at the Member State level). Many industries have 
experienced increases in concentration exceeding five percentage points, especially 
technologically intensive industries. 
Such increases in concentration could result in reduced economic welfare were it to stifle 
competition. The promotion of an active competition policy is therefore particularly important. 
However, evidence on price cost margins and business perceptions seems to indicate that the 
efficiency gains associated with large size have been passed on to consumers thanks to 
increased competition. The key to this seems to be the intensification of cross-border trade. 
3. Changes in EC total factor productivity, growth, employment and convergence 
Community income in 1994 is estimated to have been 1.1 to 1.5 percentage points higher than it 
would have been in the absence of the Single Market. Outlying Member States have, in 
general, benefited most from this improvement. In other words, there has been convergence of 
Member States' real per capita income levels. Levels of employment are also higher with 
somewhere between 300,000 and 900,000 extra jobs created thanks to the SMP, although the 
effect has been overshadowed by unfavourable economic conditions unconnected with the 
Single Market. The significant growth in the Structural Funds corroborated the growth impact of 
the SMP. 
To arrive at these conclusion, the Economic Evaluation of the Internal Market distills the 
economic findings of almost 40 studies carried out for the 1996 Single Market Review - a two 
year long major Commission research project on the SMP launched in response to a request 
from the Council at the end of 1992. Around half the studies were devoted to analysing 
developments in some relevant manufacturing and service sectors (i.e., sectors where the 
Community market in 1985 was highly fragmented by those significant non-tariff trade barriers 
targeted for elimination in the Single Market Programme), the other half to horizontal issues 
(e.g., the development of prices around the Community thanks to the Single Market, progress in 
eliminating the most important non-tariff barriers, and the impact on trade both within the 
Community and with third countries, amongst others). Most of the studies were carried out by 
independent consultants, each one supervised by an evaluation committee made up of 
Commission Services. To complement the essentially quality control role of the evaluation 
committees and to enhance the objectivity of the studies, an advisory panel of independent 
academic experts from around the Community was constituted. These experts also played a 
key advisory role during the drafting of the Economic Evaluation of the Internal Market. 
59 
Box 3: Wage dispersion in the Community in 1994 
The new EC Household Panel-94 survey provides a good opportunity to get a recent and fairly 
detailed picture of the dispersion of gross wages in the EU. Table B3.1 presents data on the 
distribution of gross earnings for full-time workers in 1994. By surveying these measures of wage 
inequality, some major conclusions seem to emerge: 
• overall wage disparity is markedly high in E, F, L, A, UK and, especially, IRL and P, which 
are well above the Community average. The presence in this group of countries with high 
and low employment growth seems to suggest that at the macroeconomic level, the degree 
of wage dispersion is only one, albeit important, factor explaining employment growth. 
• relatively wide disparity affects both the higher and lower wage deciles for the same 
countries except for P and F, where the lower half of the earnings scale appears to be 
relatively compressed (most likely, because of the incidence of relatively high wage 
minima). 
• the distribution of gross wages is markedly compressed in B, DK, I, NL, FIN and S, in 
particular as regards the lower wages in the case of B, DK and S. A greater homogeneity of 
the economic structure of these countries, alongside with historical and social reasons, helps 
in explaining the narrower wage hierarchy. 
Table B3.1. 
Wage dispersion in the EC 
B 
DK 
DO) 
GR 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR12 
US ECHP 
Overall 
Dispersion 
(D9/D1) 
2.42 
2.10 
2.95 
2.50 
3.64 
3.20 
4.18 
2.13 
3.38 
2.33 
n.a. 
4.20 
n.a. 
n.a. 
3.73 
3.05 
n.a. OECD(96) 
Overall 
Dispersion 
(D9/D1) (3) 
2.25 
2.17 
2.32 
n.a. 
n.a. 
3.28 
n.a. 
2.80 
n.a. 
2.59 
3.66 
. 4.05 
2.38 
2.13 
3.38 
n.a. 
4.39 ECHP 
Upper-Half 
Dispersion 
(D9/D5) 
1.64 
1.53 
1.76 
1.60 
2.04 
1.98 
2.00 
1.52 
1.94 
1.62 
n.a. 
2.63 
n.a. 
n.a. 
1.94 
1.83 
n.a. OECD (96) 
Upper-Half 
Dispersion 
(D9/D5) 
1.57 
1.57 
1.61 
n.a. 
n.a. 
1.99 
n.a. 
1.60 
n.a. 
1.66 
1.82 
2.47 
1.70 
1.59 
1.87 
n.a. 
2.10 ECHP 
Lower-Half 
Dispersion 
(D5/D1) 
1.47 
1.37 
1.68 
1.56 
1.78 
1.62 
2.08 
1.40 
1.74 
1.44 
n.a. 
1.60 
n.a. 
n.a. 
1.92 
1.66 
n.a. OECD (96) 
Lower-Half 
Dispersion 
(D5/D1) 
1.43 
1.38 
1.44 
n.a. 
n.a. 
1.65 
n.a. 
1.75 
n.a. 
1.56 
2.01 
1.64 
1.40 
1.34 
1.81 
n.a. 
2.09 
Key: (1 ) OECD data referring to Western Germany only. 
(2) Average 5 yearly change of the decile ratios D9/D5 and D5/D1 respectively, since 1989. 
(3) (D9/D1) = (D9/D5)*(D5/D1) 
Note: Based on (provisional) data of the ECHP-94, the earnings dispersion have been calculated on 
normal gross monthly earnings (for NL : net monthly earnings) for full-time employees. Figures are ratios 
of upper/lower deciles in the distribution of earnings. The ratios for EU12 have been calculated as the 
sum of the dispersion rates for each Member States, weighted with the respective share in total 
employment (from Labour Force Survey 1994). 
Source: Commission services and OECD. 
60 
Box 4: Economie growth and the environment 
Would sustained economic growth automatically lead to increased environmental degradation? 
Empirical work indicates that there is no linear relationship between economic growth and its 
impact on the environment. Although an increase in the production of goods and services would 
a priori lead to an increase in resource use and in pollution, countervailing forces - like 
technological progress, structural change, and increasing preferences for a clean environment -
frequently compensate for this increase. Economic growth necessitates investment and, if an 
adequate environmental policy framework is put in place, the new capital stock will be 
characterised by higher resource efficiency and cleaner technologies. Under the same 
conditions, growth will facilitate structural change implying a gradual phasing-out of traditional 
polluting heavy industries and an increase in more environmentally-friendly service activities. 
Hence, the often perceived trade-off (including a high level of employment) between economic 
growth and environmental protection does not have to be accepted as unavoidable. Moreover, it 
should not be forgotten that GDP as traditionally measured largely ignores the economic costs 
of environmental depletion and pollution. Policy makers have a number of concepts and 
instruments at hand that allow the integration of both concerns. There are even convincing 
indications that economic growth and sound environmental policy making are mutually 
supportive. In any case, an economy cannot remain prosperous in the long run if it has run 
down its natural environment and resource base. However, it has to be underlined that a 
decoupling of economic growth from rising environmental pressures can only be achieved if 
environmentally effective and economically efficient policy actions are taken, i.e. an appropriate 
environmental policy framework is established. 
Elements of an appropriate policy framework are (1) providing economic actors with the right 
price signals for environmentally sustainable behaviour, (2) designing environmental policy 
measures in the most cost-effective way possible taking into account local environmental 
conditions and the likely impact on the functioning of the Single Market, (3) seeking to integrate 
environmental objectives into other policies. 
By providing the appropriate price signals, i.e. by internalising environmental costs into 
market prices, market-based policy instruments such as environmental taxes or tradable 
emission permits have a number of advantages over traditional regulatory policies. For 
instance, they give a permanent economic incentive for reducing pressures on the environment 
and hence push for innovative and cost-effective long-run solutions. They also tend to compress 
the costs of policy measures by simultaneously exploiting several channels for reducing a given 
environmental problem. For example, a carbon tax to limit global warming reaches emission 
reductions on functioning markets by providing incentives for improvements in equipment 
energy efficiency, behavioural changes (e.g. driving a car less often), and favourable structural 
change (e.g. towards 'clean' sectors of the economy). However, introducing price signals for 
environmental protection makes little sense if existing prices are distorted, e.g. if existing 
taxes or tax provisions and subsidies produce unintended and unwanted environmental effects. 
In the Report on the Development of Tax Systems - Taxation in the European Union (COM(96) 
546) presented in October 1996, the European Commission laid down its views on future 
environmental taxation in the Union. The documents highlights the necessity for national 
environmental tax schemes to be well designed and compatible with the functioning of the 
Single Market. It also identifies energy taxation as a domain of Community action which has an 
important bearing on C02 emission limitation. Consequently, the Commission is preparing new 
proposals for a future EU system of energy taxation. It aims at further harmonisation of energy 
excise rates as well as exploring how Member States can integrate environmental objectives 
into their energy taxation schemes. In the transport field, the Commission proposed a Council 
Directive in July 1996 on the charging of heavy goods vehicles for the use of certain 
infrastructures (COM(96) 331). An important objective of the legislative proposal is to provide a 
harmonised framework for Member States to better ensure recovery of costs associated with 
road use, including externalities, and to allow for greater differentiation in charges in line with 
costs. 
61 
Designing cost-effective environmental policy approaches is a major prerequisite for 
making environmental protection economically sustainable. The aim must be to provide 
environmental policy improvements at least cost to society. This can be done by using a 
thorough economic evaluation of the policy design, for instance by applying cost-benefit 
analyses or cost-effectiveness analyses. A recent example of such ex-ante policy evaluation is 
the Community Auto-Oil Programme - a collaborative exercise with the industry concerned -
which was completed in June 1996. This programme prepared a strategy for the control of road 
transport emissions mainly focusing on emission standards for passenger cars and quality 
standards for petrol and diesel fuels (COM(96) 248 final). Prior to defining the strategy, an 
extensive cost-effectiveness analysis considering technical and non-technical measures was 
carried out. 
Broadening the range of instruments in order to respond to local environmental conditions 
and at the same time foster a smooth functioning of the Single Market often increases the cost-
effectiveness of environmental policies. Clarifying the legal and institutional framework for 
policy mixes at national level is a prime area of Community action. For instance, in its 
Communication on Environmental Agreements (COM(96) 561) the Commission discusses a set 
of guidelines for an environmentally effective application of voluntary policy approaches. A 
similar Communication on environmental taxes and charges in the Single Market is currently 
being prepared. 
The integration of environmental policy concerns into other policy areas would allow the 
existing potential to improve economic efficiency to be tapped and this would improve the 
economic and environmental performance of the European economy simultaneously. For 
instance, a number of Member States are currently exploring the possibilities of reaping 
synergies in the field of ecological tax reforms and employment policies. In some 
countries such as Denmark^ the Netherlands, Belgium and Sweden so called 'Green Tax 
Commissions' have been set up to assess, to implement and to monitor such tax reforms. 
An important potential for synergies from policy integration exists in industry. In the 1996 
Competitiveness Report (SEC(96) 2121), a Working Document of the Commission services, it is 
stressed that sound environmental policies can open up business opportunities by enhancing 
economic efficiency and innovation. The report identifies a significant efficiency potential which 
could be tapped, for instance, in water and energy use. "Greening" of industry and the provision 
of environmental goods and services are associated with an expanding employment trend. Firm 
but economically sound environmental policies can provide the incentives for the supply of 
competitive and innovative environmental technologies and create a corresponding demand for 
such technologies on markets. Table B4.1. illustrates the magnitude of employment related to 
environmental protection in Germany in 1994 compared to 1990. 
Table B4.1. 
Estimation of employment effects through environmental protection in Germany 
1990 and 1994 
Environmental protection activities (e.g. 
nature conservation, water purification) 
Provision of environmental goods and 
services 
- direct 
- indirect 
Total 1990(1) 
in 1000 
255 
341 
203 
137 
597 1990(1) 
In % of total civilian 
employment 
0.9 
1.2 
0.7 
0.5 
2.1 1994(2) 
in 1000 
508 
448 
256 
192 
956 1994(2) 
in % of total civilian 
employment 
1.5 
1.3 
0.7 
0.6 
2.8 
(1) West Germany 
(2) United Germany 
Note: The figures have to be interpreted with caution. Especially the 1994 employment figures may be dominated by the 
impact of German unification. Furthermore, the definition of the "environmental protection sector" used in the underlying 
IFO survey does not correspond to the OECD/Eurostat definition. 
Sources: Ifo Schnelldienst 28/1996 and Commission services. 
62 
3. CONSOLIDATING AND RESHAPING PUBLIC FINANCES IN THE COMMUNITY 
A determined correction of existing fiscal imbalances is an indispensable macroeconomic 
and structural requirement for virtually all Member States today. This correction is 
required to provide the conditions for a strong and durable expansion of investment, 
output and employment over the short and medium term; to reduce the burden of 
government indebtedness and debt-servicing; and to ensure that budgetary policies can 
regain their flexibility in response to cyclical fluctuations without causing a continued 
escalation of government debt. Furthermore, the objective of achieving fiscal discipline is 
embedded in the wider aim of reducing the share of public finances in the economy, of 
creating an environment more conducive to business activity, and of improving 
competitiveness against the backdrop of increased globalisation. Finally, and equally 
importantly, it is necessary to ensure a successful transition to, and the lasting success of, 
EMU. 
In recent years, most Member States have made progress in reducing the budgetary 
imbalances that had built up over the two decades following the first oil price shock. 
However, more is clearly needed. While budgetary consolidation measures need to be 
adapted to country-specific circumstances in terms of their extent, timing and design, the 
main guiding principles have been stipulated in successive Broad Economic Policy 
Guidelines, including the 1996 Recommendation: 
• giving prominence to expenditure restraint as opposed to further increases in the 
overall tax burden; 
• shifting government spending priorities towards productive activities such as 
investment in infrastructure, human capital and active labour market initiatives; 
• improving the efficiency of public services; 
• reducing the overall tax burden, especially that on labour, but conditional upon firstly 
placing the budget deficit on a firm downward path. 
By basing their consolidation programmes on these principles, Member States will 
simultaneously ensure budgetary discipline and reap large efficiency and employment gains 
through the control and rationalisation of government expenditures and the reduction and 
shifting of the tax burden. The process of fiscal consolidation provides a valuable 
opportunity for Member States to scrutinise the design and structure of their respective 
expenditure programmes and taxation systems. 
63 
3.1 Long-term trends in public finances in the Community 
The current large fiscal imbalances in the Community are the result of certain long-term 
trends in spending and taxation which have to a large extent been common to all, or nearly 
all, Member States. 
3. J. 1 Government spending 
Over the last 35 years, the Community has 
witnessed a rapid growth in the share of public 
finances in the economy. General government 
expenditure, which represented 34 per cent of 
GDP in 1961, rose to above 52 per cent in 
1993, before falling back somewhat in recent 
years. While the rising share of government 
expenditure in GDP was a common 
phenomenon in all industrial countries at least 
until the early 1980s, it was more marked in the 
Community than in its major trading partners 
(see Table 20). 
Public spending in the Community in fact has 
climbed markedly in every downturn phase in 
economic activity, while the subsequent periods 
of recovery have failed to reverse this upward 
shift. 
The fastest-growing spending category since the early 1960s has been current transfers, 
the growth of which has accounted for more than half of the increase in the total 
government spending ratio in the Community (see-Table 21). At present, current transfers 
is the largest spending category representing almost one quarter of GDP and about half of 
total government expenditure. The rapid increase in current transfers have almost entirely 
been due to rising transfers to households whereas, as a proportion of GDP, direct 
subsidies to enterprises have remained broadly stable at around 3 per cent. 
The growth in household transfers was essentially due to the expansion of three major 
social policy areas: pensions, health care and unemployment compensation. The 
expansion of the welfare state during the 1960s and 1970s, which was characterised by a Table 20 
Size of public finances in the EC, 
US and Japan 
(%ofGDP) 
EUR 
USA 
JAP 
EUR 
USA 
JAP 
EUR 
USA 
JAP 1961 1973 1982 1996 
Total expenditure 
33.6 
30.3 
17.3 38.7 
32.9 
22.3 49.3 
38.9 
33.6 50.6 
36.7 
36.6 
Total current receipts 
34.3 
29.5 
19.7 38.2 
33.2 
22.8 44.3 
35.0 
30.0 46.2 
34.6 
31.6 
Net lending(+)/ borrowing(-) 
0.7 
-0.6 
2.4 -0.6 
0.3 
0.5 -5.1 
-3.9 
-3.6 -4.4 
-2.2 
-5.0 
Source: Commission services. 
64 
broadening of the coverage of programmes, a widening of the eligibility criteria and an 
increase in the levels of benefits, contributed to a marked increase in payments in these 
areas. In addition, demographic and economic developments (ageing, higher 
unemployment as well as rising costs and a high income elasticity of demand for health 
care) have played an important role. Since the mid-1980s, growing concerns regarding 
the pressures on government budgets and labour market disincentives have led to a 
tightening of transfer schemes in many Member States. This has resulted in a deceleration 
of the growth of these expenditures during the last decade but undiminished demands for 
welfare services and the renewed rise in unemployment in the -1990s have exerted 
continued upward pressure. To control the growth of social transfers in the future, 
policies need to be aimed at achieving sustained high economic growth and rising 
employment and, in order to prepare for mounting demographic pressures, at 
restructuring and/or streamlining pension, health care and unemployment schemes. 
Table 21 
Receipts and expenditures of general government - EURa) 
(in % of GDP) 
Total expenditure 
of which: 
1. Current transfers 
Ibis, of which: 
Households 
2. Actual interest payments 
3. Public consumption 
4. Net capital transfers 
5. Gross capital formation 
Current receipts 
of which: 
6. Indirect taxes 
7. Direct taxes 
8. Social security 
contributions 
9. Other current receipts 
Memory items 
10. Gross saving 
11. Net lending(+)/ 
borrowing(-) 
12. Gross public debtb) Levels 
1961 
33.6 
11.5 
3.1 
13.7 
0.8 
4.5 
34.3 
13.9 
8.7 
10.2 
1.5 
6.0 
0.7 
65.2 1973 
38.7 
16.0 
13.0 
1.7 
16.4 
0.9 
3.7 
38.2 
12.9 
10.7 
11.8 
2.8 
4.1 
-0.6 
35.3 1982 
49.3 
21.6 
17.9 
4.1 
19.6 
1.0 
2.9 
44.3 
13.2 
12.4 
14.7 
4.0 
-1.0 
-5.1 
45.6 1989 
47.2 
20.7 
17.1 
4.6 
18.2 
0.9 
2.8 
44.8 
13.5 
13.3 
14.6 
3.4 
1.2 
-2.4 
54.1 1993 
52.4 
23.7 
19.9 
5.4 
19.6 
1.1 
2.8 
46.3 
13.6 
12.9 
16.0 
3.7 
-2.5 
-6.3 
66.1 1996 
50.6 
23.3 
19.8 
5.4 
18.9 
0.6 
2.4 
46.2 
14.0 
12.8 
16.1 
3.4 
-1.3 
-4.4 
73.5 Changes 
73/61 
5.1 
4.5 
-1.4 
2.7 
0.1 
-0.8 
3.9 
-1.0 
2.0 
1.6 
1.3 
-1.9 
-1.3 
-29.9 82/73 
10.6 
5.6 
4.9 
2.4 
3.2 
0.1 
-0.8 
6.1 
0.3 
1.7 
2.9 
1.2 
-5.1 
-4.5 
10.3 89/82 
-2.1 
-0.9 
-0.8 
0.5 
-1.4 
-0.1 
-0.1 
0.5 
0.3 
0.9 
-0.1 
-0.6 
2.2 
2.7 
8.5 93/89 
5.2 
3.0 
2.8 
0.8 
1.4 
0.2 
0.0 
1.5 
0.1 
-0.4 
1.4 
0.3 
-3.7 
-3.9 
12.0 96/93 
-1.8 
-0.4 
-0.1 
0.0 
-0.7 
-0.5 
-0.4 
-0.1 
0.4 
-0.1 
0.1 
-0.3 
1.2 
1.9 
7.4 
a) 1961 : EUR 15 excluding Greece, Portugal, Austria, Sweden and Finland; 1973 : EUR 15 excluding Luxembourg, 
Greece and Portugal. 
") 1973 : EUR 15 excluding France and the Netherlands. 
Source: Commission services. 
65 
Interest pavments on outstanding public debt have been another important component of 
the rise in government spending. Having declined to below 2 per cent of GDP at the 
beginning of the 1970s, debt interest payments have risen rapidly thereafter to reach 5.5 
per cent of GDP at present. This strong rise reflects the interplay of an increased recourse 
to borrowing rather than taxation to finance the surge in government expenditure, a 
concomitant steep upward trend in the government debt to GDP ratio and high interest 
rates. The rising share of the debt service burden has severely hampered budgetary 
flexibility and increased the vulnerability of the budget to increases in interest rates. To 
reverse this trend it is essential to create a stable macroeconomic framework conducive to 
reductions in borrowing costs. 
Public consumption contributed importantly (about 6 percentage points) to the rise in the 
total government spending ratio during the 1960s and 1970s, but since then its share has 
been relatively stable, fluctuating around 19 per cent of GDP in the Community on 
average. 
In contrast to other spending categories, public investment as a share of GDP has been 
falling steadily over the last 35 years. Its present share of 2.5 per cent of GDP is just 
above half the level it attained in 1961. While to some extent this reflects the completion 
of major infrastructure systems, it also reveals the political reality that constraining public 
investment has proved easier than controlling current spending. The privatisation of 
certain public utilities may also have played a role. Savings on public investment may 
entail considerable long-term economic costs since these expenditures are an important 
contributor to productivity growth in the private sector as is highlighted by recent 
analyses on the potential benefits of realising the Trans-European Transport Networks16. 
3.1.2 Government receipts 
The growth of public expenditure in the Community has brought with it a significant rise 
in the overall tax burden (i.e. the sum of indirect taxes, direct taxes and social security 
contributions). Over the last three decades and a half, government receipts, as a share of 
GDP, have grown by 12 percentage points to reach 46 per cent in 1996. The bulk of the 
rise in the government receipts ratio occurred in the period 1960-82 while the tax burden 
remained broadly stable during the rest of the 1980s. In the early 1990s, a sharp rise in 
expenditure — partly caused by the economic downturn — was accompanied by a further 
16 See 'Trans-European Networks: 1996 Annual Report", COM(96) 645 final. 
66 
increase in tax pressure. While not fully successful, widespread government efforts since 
the early 1980s to stabilise or to reduce the tax burden reflect various factors. Firstly, 
greater awareness of the distortionary and employment-dampening effects of high taxation 
as well as voters' resistance have made many governments reluctant to introduce further 
tax increases. Secondly, both a flattening of the tax scales and the indexation of tax 
systems as well as reduced inflation have resulted in a reduction in fiscal drag. Thirdly, 
tax reforms, increased tax competition between countries and, in some cases, the growth 
in the underground economy may also have contributed to slower tax revenue growth. 
The growth of the tax burden has been accompanied by considerable changes in the tax 
structure. The main factors contributing to the overall growth of government receipts 
were social security contributions and, to a somewhat lesser extent, direct taxation. The 
fall in the average employment ratio (from 67 per cent of working age population in 1961 
to 59 per cent in 1996) implied a reduction in the number of persons paying taxes and 
contributing to social security funds while leading to an increase in the number of 
recipients. The strong increase in social security contributions was not sufficient to match 
the upsurge in social benefits. As a result, a growing proportion of the latter had to be 
financed through other fiscal resources, notably direct taxes. Indirect taxes remained 
almost unchanged as a proportion of GDP throughout most of the period but in recent 
years there has been a tendency to increase indirect taxes while reducing the relative 
importance of other government receipts. 
The changes in the structure of taxation have resulted in an increasing tax burden being 
imposed on employed labour with the opposite trend evident for other factors of 
production such as capital, energy and natural resources. Over the period 1980 to 1994, 
the Community's average implicit tax rate on employed labour (i.e. tax revenues divided 
by the tax base) increased from an already high level of 35 percent to over 40 per cent. 
Graph 22 Implicit tax rates on labour employed and 
other factors of production, EUR 
so 
45 
40 
35 
30 Other factors of production 
-V 
Labour employed 
1980 1982 1984 
Source: Commission services. 1986 1988: 1990 1992 1994 
67 
On the other hand, the implicit tax rate on the other factors of production fell from around 
44 per cent to a little over 35 per cent (see Graph 22). The upward trend in the taxation 
of labour is discouraging employment creation since it increases non-wage labour costs, 
adds to wage pressures and reduces incentives to work. High social security and income 
tax rates interact with transfer and benefit systems to produce high effective marginal tax 
rates on low-income workers, high reservation wages and high "wedges" between the cost 
of labour to employers and the net income received by employees. 
One factor underlying the changes in the structure of taxation has been the progressive 
erosion of tax bases in Member States, linked to factors of both domestic and international 
origin. At the domestic level, high levels of taxation and high tax wedges for labour-
income appear to have stimulated the development of the underground economy. 
Internationally, tax competition between countries has led to fiscal erosion of the mobile 
tax sources, such as capital, with international relocation of taxable bases responding to 
differentials in effective tax rates. These developments have provoked a change in the 
structure of the tax systems of many Member States, with the tax burden being shifted 
towards labour, which is relatively immobile, in order to recover the tax lost from the 
steady erosion of other more "exportable" sources of government revenue. 
There is broad agreement amongst Member States that the long-term trend towards 
higher taxation on labour must be reversed. This may be achieved both through targeted 
approaches (for instance reduction in non-wage labour costs for specific categories of 
workers such as the low-skilled, young or new entrants) and through general measures, 
notably a lowering of public expenditure as a share of GDP and a shifting of the tax 
burden towards other factors, especially energy and capital. Actions in this field must be 
compatible with and should contribute to the achievement of other objectives in the 
Community, namely stabilising Member States' fiscal systems and removing tax obstacles 
to the internal market whilst creating a tax environment conducive to a strong, 
employment-creating growth process and an efficient environmental policy.17 
17 The need for a comprehensive approach was underlined in the Commission's Communication 
"Taxation in the European Union" presented to the informal Ecofin Council in Verona in April 1996 
and in the Commission's "Second Report on Taxation in the European Union", October 1996. 
68 
3.2 Budgetary developments in 1996 and outlook for 1997 and 1998 
Efforts to achieve sound public finances have recently been stepped up throughout the 
Community. In their budgets for 1996 and for 1997, a large majority of Member States 
have taken significant steps to reduce their deficits to 3 percent of GDP or less as a step 
towards reaching budget balance over the medium term. The driving forces behind this 
process are twofold. First, the experiences of recent years have underlined the adverse 
consequences for interest rates, exchange rate pressures and ultimately economic growth 
which may result from excessive budget deficits and insufficient credibility of 
consolidation efforts. Second, the need to make headway towards the fulfilment of the 
convergence criteria for participation in EMU has provided an imminent focus for the 
budgetary adjustment efforts of Member States and has, in many countries, been seen as 
offering a unique opportunity for achieving significant up-front gains in the credibility of 
such efforts. 
As a result of these efforts and given the forecast for economic growth and interest rates, 
the average budget deficit in the Community is expected to be halved between 1995 and 
1998, falling to 2XA per cent of GDP. This represents a large step towards the re-
establishment of sound public finances. 
3.2.1 Accelerated progress in the reduction of budget deficits 
Almost all Member States made progress towards further reducing their budget deficits in 
1996. The only exceptions were Germany, where the deficit widened for the second year 
running, and Luxembourg where the surplus declined. Particularly large reductions in the 
deficit were achieved in Sweden, Spain and Finland but deficit reductions of 1 percent of 
GDP or more were achieved also in several other countries (Table 22). 
The budget deficit remained comfortably below 3 per cent of GDP in the three countries 
which are currently not subject to a Council Decision on the existence of an excessive 
deficit (Denmark, Ireland and Luxembourg). And in the Netherlands, the budget deficit 
was reduced to below the Maastricht reference value. 
According to the Autumn 1996 forecasts of the Commission services, virtually all Member 
States are expected to make additional headway in 1997. Progress is expected to be very 
significant in Italy (around VA percentage points of GDP) and it is forecast to be in the 
range of 1 to 1XA percentage points in almost all the remaining Member States. 
69 
Against this background of 
widespread and significant deficit 
reductions, no less than 12 Member 
States are expected to achieve a deficit 
at or below 3 percent of GDP in 1997. 
The only exceptions are Greece, 
where the budget deficit is high but 
declining, and Italy and the United 
Kingdom both of which are expected 
to have a deficit of around 3 Vz percent 
of GDP on current projections18. 
Among the countries whose deficit is 
below 3 percent of GDP, both 
Denmark and Ireland are likely to 
come closer to achieving budget 
balance. 
No budgets are yet available for 1998. 
In the forecast scenario for 1998, 
which is based on an extrapolation of 
expected trends in 1997, budget 
deficits are generally projected to 
decline further and all Member 
countries except Greece are expected 
to have deficits below 3 per cent of 
GDP by 1998. Table 22 
General government net lending (+) 
or net borrowing (-) 
(%ofGDP) 
B 
DK 
D1J 
EL2) 
E 
F3* 
IRL2) 
I4) 
L 
NLP 
A 
P 
FIN 
S 
UK2) 
EUR Level 
1995 
-4.1 
-1.6 
-3.5 
-9.1 
-6.6 
-4.8 
-2.0 
-7.1 
1.5 
-4.0 
-5.9 
-5.1 
-5.2 
-8.1 
-5.8 
-5.0 1996 
-3.3 
-1.4 
-4.0 
-7.9 
-4.4 
-4.0 
-1.6 
-6.6 
0.9 
-2.6 
-4.3 
-4.0 
-3.3 
-3.9 
-4.6 
-4.4 1997 
-2.9 
-0.3 
-2.9 
-6.5 
-3.0 
-3.0 
-0.9 
-3.3 
0.5 
-2.5 
-3.0 
-2.9 
-2.2 
-2.9 
-3.5 
-3.0 1998 
-2.5 
-0.3 
-2.4 
-5.3 
-2.8 
-2.9 
-0.5 
-3.0 
0.9 
-2.0 
-2.9 
-2.9 
-1.4 
-1.0 
-2.2 
-2.5 Change 
1996 
0.8 
0.2 
-0.5 
1.2 
2.2 
0.8 
0.4 
0.5 
-0.6 
1.4 
1.6 
1.1 
1.9 
4.2 
1.2 
0.6 1997 
0.4 
1.1 
1.1 
1.4 
1.4 
1.0 
0.7 
3.3 
-0.4 
0.1 
1.3 
1.1 
1.1 
1.0 
1.1 
1.4 1998 
0.4 
0.0 
0.5 
1.2 
0.2 
0.1 
0.4 
0.3 
0.4 
0.5 
0.1 
0.0 
0.8 
1.9 
1.3 
0.5 
^ Not including unification-related debt and asset 
assumptions by the federal government in 1995 (Treuhand, 
eastern housing companies and Deutsche Kreditbank), 
equal to DEM 229 bn. 
2) At the time of the elaboration of the Commission forecasts 
Greece, Ireland and the UK had not yet presented their 
budgets for 1997. The "no policy change" assumption was 
used also in 1997. According to new data for Greece the 
deficit for 1996 is estimated at 7.6%. 
3) Including for 1997 the payment by France Telecom to the 
French state of FRF 37.5 bn. 
4) Including for 1997 6 trillion ITL of reductions in transfers 
to state owned enterprises, but not including 6.5 trillion 
ITL of other operations whose conformity with ESA rules 
is currently being examined. 
^ Not including for 1995 a net amount of NLG 32.84 bn of 
exceptional expenditure related to the reform of the 
financing of the social housing societies. 
Source: Commission services. 
18 The Commission services' Autumn 1996 deficit forecast for Italy does not include ITL 6.5 trillion of 
deficit-reducing, operations whose conformity with the ESA rules is currently being examined. As 
regards the United Kingdom, the forecast does not incorporate measures announced in the November 
1996 Budget. These measures are expected by the UK authorities to result in an additional budgetary 
consolidation in the financial year 1997/98. 
70 
Graph 23 
% of GDP Actual and cyclically-adjusted net borrowing 
of general government, EUR 
Cyclically-adjusted 
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 
Source: Commission services. 
3.2.2 The pace and size of consolidation efforts 
For the Community as a whole, the deterioration in the cyclical position in 1996 had an 
adverse impact on spending and tax revenues. Therefore, while actual deficits were on 
average reduced by 0.6 percentage points of GDP in 1996, the general government 
balance adjusted for the budgetary impact of cyclical deviations of output from its trend 
(the "cyclically-adjusted" budget balance) improved somewhat more, by an estimated 0.8 
percentage points of GDP19. In 1997, changes in the cyclical position are expected to 
have a broadly neutral budgetary impact for the Community as a whole, and the expected 
deficit reduction of around 1.4 percentage points of GDP fully reflects a reduction in the 
cyclically-adjusted deficit. This represents an unprecedented effort and clearly highlights 
the strong resolve of Member States to place their public finances on a sound footing. 
19 Estimates of the cyclically-adjusted budget balance are surrounded by considerable uncertainty, 
relating both to the level of trend (potential) GDP and to the budgetary impact of cyclical deviations 
from trend (potential) GDP. The Commission sendees" method of cyclical adjustment takes a cautious 
approach in that it produces levels of cyclically-adjusted budget deficits which tend to be higher 
compared to those of other methods, such as those used by the OECD and the IMF. Given that these 
discrepancies mainly relate to differences in the estimated level of trend (potential) GDP, annual 
changes in the cyclically-adjusted deficit do not vary significantly across the various methods. 
71 
Table 23 
Cyclically-adjusted general government 
balances0 
(%ofGDP) 
Level 
1995 
B 
DK 
D2) 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK -3.7 
-1.5 
-3.5 
-8.3 
-5.8 
-4.6 
-3.2 
-7.1 
1.7 
-3.7 
-6.1 
-4.6 
-3.8 
-6.8 
-5.1 
EUR -4.7 1996 
-2.7 
-1.2 
-3.5 
-7.5 
-3.5 
-3.4 
-3.9 
-6.1 
1.3 
-2.3 
-4.1 
-3,5 
-2.2 
-3.0 
-4.0 
-3.8 1997 
-2.4 
-0.6 
-2.3 
-6.4 
-2.2 
-2.6 
-3.1 
-2.7 
0.9 
-2.3 
-2.3 
-2.5 
-2.2 
-2.5 
-3.3 
-2.5 Change 
1998 1996 1997 1998 
-2.5 
-1.1 
-2.0 
-5.7 
-2.3 
-2.9 
-2.4 
-2.8 
0.6 
-2.1 
-2.5 
-2.9 
-2.1 
-1.3 
-2.2 1.0 
0.3 
0.0 
0.8 
2.3 
1.2 
-0.7 
1.0 
-0.4 
1.4 
2.0 
1.1 
1.6 
3.8 
1.1 0.3 
0.6 
1.2 
1.1 
1.3 
0.8 
0.8 
3.4 
-0.4 
0.0 
1.8 
1.0 
0.0 
0.5 
0.7 -0.1 
-0.5 
0.3 
0.7 
-0.1 
-0.3 
0.7 
-0.1 
-0.3 
0.2 
-0.2 
-0.4 
0.1 
1.2 
1.1 The cyclically-adjusted budget deficit 
is estimated to be at or below 3 
percent of GDP in 13 countries by 
1997 according to the method used by 
the Commission services. For the 
Community as a whole, the total 
reduction in the cyclically-adjusted 
deficit between 1992 and 1998 is 
expected to amount to more than 3 
percentage points of GDP with most 
of it occurring in 1996 and 1997. 
For 1996 and 1997 taken together, the 
cyclically-adjusted budget deficit is 
expected to decline in all Member 
States (except Luxembourg). Four 
countries (Spain, Italy, Austria and 
Sweden) are expected to achieve 
extraordinarily large reductions in the 
underlying deficit ranging from VA to 
AXA percentage points of GDP over the 
two years. In addition, large 
reductions of between 1 and 2 
percentage points of GDP are 
expected in the eight other Member States where the actual deficit exceeded 3 percent of 
GDP in 1995. 
Several of these countries have concentrated the bulk of their consolidation efforts already 
in 1996. This applies in particular to Belgium, the Netherlands, Finland and Sweden 
where only moderate tightening is expected in 1997, if at all. In contrast, in Germany 
there was no underlying improvement in 1996 and consolidation efforts will occur 
exclusively in 1997, while in Italy a very ambitious budget for 1997 implies a particularly 
large effort in that year. -2.4 0.9 1.3 0.1 
J) General government balances adjusted for an estimate of the 
budgetary impact of the cyclical deviation of GDP from its 
trend level; Commission services' estimates. The 
methodology is explained in European Economy; n° 60, 
1995, pp. 35-90. 
2)See footnote 1 in table 19. 
Source: Commission services. 
72 
3.2.3 The composition and durability of consolidation efforts 
For the Community as a whole, 
budgetary adjustment in 1996 was 
achieved in broadly equal measure 
through reductions in the share of 
public expenditures in GDP and 
increases in the already high share 
of government revenues in GDP. 
Provided current spending plans 
for 1997 are adhered to, 
budgetary consolidation in that 
year is expected to be achieved 
mainly through expenditure 
restraint. The slight rise in tax 
pressure is likely to be reversed in 
1998. Thus, for the three years as 
a whole, the Community is 
expected to achieve a significant 
reduction in the share of public 
expenditure in GDP (of around 
2lA percentage points) while tax 
pressure is forecast to remain broadly unchanged. 
Both with respect to the balance between expenditure and revenue measures and with 
respect to the durability of consolidation measures, differences are discernible between 
Member States. Nevertheless, public expenditure as a share of GDP is expected to be 
reduced significantly in all Member States except Portugal and Luxembourg. The 
encouraging outlook for expenditure restraint is contingent upon strict spending plans 
being adhered to. Most of the expected reduction in expenditure growth reflects efforts 
to restrain the growth of public consumption and transfer payments. In general, these 
measures appear likely to have lasting effects. 
In several countries where the debt-to-GDP ratio has been placed on a downward path 
and where interest rates have fallen considerably, reduced debt-servicing is likely to make 
a significant contribution to budgetary consolidation in the years to come. In Italy, Table 24 
General government receipts and expenditures 
(%ofGDP) 
B 
DK 
D 
EL1' 
E 
FD 
IRL15 
I» 
L 
NL1* 
A 
P 
FIN 
S 
UK1J 
EUR Receipts 
1995 
50.3 
58.1 
46.3 
37.6 
39.7 
49.5 
35.4 
44.8 
40.8 
49.1 
46.9 
40.1 
53.5 
60.1 
37.8 
45.8 1996 
50.5 
58.8 
45.7 
38.0 
40.3 
50.6 
34.7 
46.3 
41.7 
48.3 
48.2 
40.4 
55.3 
63.0 
37.6 
46.2 1997 
50.1 
58.0 
46.0 
38.4 
40.5 
50.5 
34.3 
47.7 
41.2 
47.7 
48.7 
41.3 
54.3 
61.7 
37.7 
46.4 1998 
49.7 
56.4 
45.9 
38.7 
40.2 
50.2 
33.9 
47.1 
40.8 
47.0 
48.3 
41.1 
53.9 
60.5 
38.0 
46.1 Expenditures 
1995 
54.5 
59.7 
49.9 
46.7 
46.3 
54.3 
37.4 
51.8 
40.0 
53.2 
52.8 
45.3 
58.8 
68.2 
43.5 
50.9 1996 
53.8 
60.3 
49.7 
46.0 
44.8 
54.7 
36.3 
52.9 
40.7 
50.9 
52.5 
44.5 
58.7 
66.9 
42.3 
50.6 1997 
53.0 
58.2 
48.9 
44.9 
43.5 
53.5 
35.2 
51.0 
40.7 
50.1 
51.7 
44.3 
56.5 
64.6 
41.3 
49.4 1998 
52.1 
56.7 
48.2 
44.0 
43.0 
53.1 
34.3 
50.1 
39.9 
49.0 
51.2 
44.0 
55.3 
61.5 
40.2 
48.5 
l} See footnotes in table 19. 
Source: Commission services. 
73 
interest payments are forecast to fall by 3 percentage points of GDP between 1995 and 
1998. Interest payments are expected to decline significantly also in other Member States 
where the debt ratio is set to decline. In 1998, debt servicing is expected to decline in all 
Member States. 
Table 25 , 
General government expenditures 
(changes in % of GDP) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR Public 
consumption 
97/95 
-0.4 
-0.3 
-0.2 
0.2 
-0.9 
-0.2 
-0.7 
0.0 
0.4 
-0.4 
-0.6 
0.8 
-0.4 
-0.6 
-0.9 
-0.4 98/97 
-0.3 
-0.4 
-0.4 
-0.1 
-0.3 
-0.2 
-0.2 
-0.2 
-0.2 
-0.1 
-0.3 
-0.2 
-0.5 
-0.7 
-0.4 
-0.3 Public 
investment 
97/95 
0.0 
0.0 
-0.4 
-0.1 
-0.9 
-0.3 
0.0 
-0.1 
0.2 
-0.1 
-0.1 
0.5 
0.2 
-0.2 
-0.4 
-0.3 98/97 
0.0 
0.0 
-0.1 
0.1 
0.1 
0.0 
0.0 
0.1 
0.1 
0.0 
0.0 
0.3 
0.0 
-0.1 
-0.1 
0.0 Transfers to 
households 
97/95 
-0.3 
-1.2 
0.1 
0.3 
-0.6 
-0.1 
-0.9 
0.8 
0.0 
-1.7 
-0.4 
0.6 
-1.7 
-1.8 
-0.5 
-0.2 98/97 
-0.3 
-0.7 
-0.1 
-0.1 
-0.2 
-0.3 
-0.3 
0.1 
-0.4 
-0.8 
-0.3 
0.1 
^0.8 
-1.0 
-0.4 
-0.3 Transfers to 
companies 
97/95 
-0.3 
-0.6 
-0.3 
-0.1 
-0.2 
0.3 
-0.3 
-0.7 
-0.2 
-0.2 
-0.4 
-0.1 
-0.2 
-0.7 
0.0 
-0.2 98/97 
-0.1 
-0.1 
0.0 
0.0 
0.0 
-0.1 
-0.1 
0.1 
-0.2 
-0.1 
-0.1 
0.0 
-0.1 
-0.2 
-0.1 
0.0 Capital 
transfers 
97/95 
0.1 
1.0 
-0.1 
-0.2 
-0.2 
-0.5 
-0.1 
0.3 
.0.0 
-0.2 
-0.1 
-0.5 
-0.5 
-0.1 
-0.4 
-0.2 98/97 
0.0 
0.0 
0.0 
-0.1 
0.0 
0.4 
0.0 
0.4 
0.0 
0.0 
0.0 
-0.1 
-0.1 
0.0 
-0.1 
0.1 Interest 
payments 
97/95 
-1.0 
-0.8 
0.2 
-1.9 
-0.1 
0.1 
-0.8 
-1.6 
0.1 
-0.6 
0.3 
-1.1 
0.4 
-0.1 
0.2 
-0.1 98/97 
-0.2 
-0.3 
0.0 
-0.6 
-0.1 
0.0 
-0.3 
-1.5 
0.0 
-0.1 
0.1 
-0.3 
0.0 
-0.8 
0.0 
-0.3 Total 
97/95 
-1.5 
-1.5 
-1.0 
-1.8 
-2.8 
-0.8 
-2.2 
-0.8 
0.7 
-3.1 
-1.1 
0.2 
-2.3 
-3.6 
-2.2 
-1.5 98/97 
-0.9 
-1.5 
-0.7 
-0.9 
-0.5 
-0.4 
-0.9 
-0.9 
-0.8 
-1.1 
-0.5 
-0.2 
-1.2 
-3.1 
-1.1 
-0.9 
Source: Commission services. 
Reflecting reforms to contain social spending and in some cases falling unemployment, 
transfers to households are expected to decline as a share of GDP in nearly all Member 
States. As a proportion of GDP, government consumption is set to decline in virtually all 
Member States over the period 1995-1998, and especially so in Spain, Sweden and the 
United Kingdom. Public employment is likely to be reduced in several countries 
(Germany, Spain, Italy, Sweden, Austria, the United Kingdom) and to remain broadly 
stable in others (Belgium, France). Some Member States have made savings from 
reduced wage growth in the public sector. 
A number of countries are relying to a considerable extent on reductions or deferrals of 
public investment. This is the case particularly in Spain (albeit from a high level) and, to a 
lesser extent, in Germany, France and the United Kingdom. In some countries, such 
74 
reductions may be related to an increased efficiency in the use of public funds, but in 
general, savings on public investment may turn out to be temporary or otherwise prove 
costly in the long run. In the United Kingdom, this trend reflects a switch from public to 
private provisions. 
According to the assumptions underlying the Commission services' Autumn 1996 
forecasts, budgetary adjustment in some Member States has to some extent relied on one-
off measures, including in France capital transfers from French Telecom as part of 
restructuring and privatisation of the utility and treasury operations in Italy. Needless to 
say, the temporary nature of such measures does not contribute tô an improvement in the 
underlying fiscal position. 
In early 1998, when the decision will be made as to which countries have achieved a high 
degree of sustainable convergence required for participation in the third stage of EMU 
from 1.1.1999, an assessment will be made of the extent to which once-off measures in 
some countries in 1996-97 have been complemented by lasting improvements to 
budgetary positions. 
On the receipts side, tax pressure increased in a majority of countries in 1996 and in some 
cases it may increase further in 1997. Only in Ireland and the Netherlands is the share of 
public revenues in GDP on a firm downward path. On the other hand, the overall tax 
burden is expected to decline in almost all Member States in 1998. In some cases, 
revenue-enhancing measures have included increases in social security contributions which 
place a further burden on employment (e.g. Germany, Austria). However, many countries 
have increased various consumption taxes which can be expected to be less distortionary 
with respect to employment to the extent that wage demands are not adjusted upwards 
proportionately to compensate for higher prices. 
3.2.4 Trends in government debt-to-GDP ratios 
The average debt-to-GDP ratio in the Community increased by some 2 percentage points 
in 1996 to reach 1VA percent of GDP. However, the upward trend is likely to come to a 
halt in 1997 and the debt-ratio is expected to subside modestly in 1998. This is the result 
of the significant efforts made by virtually all Member State governments to reduce 
budget deficits as well as the expected recovery in economic growth and falling interest 
payments. In addition, privatisation efforts will play a role in reducing the debt-ratio in 
several Member States. 
75 
In France, Luxembourg and the 
United Kingdom, the debt-to-GDP 
ratio is expected to remain below 60 
per cent of GDP in the coming years. 
In Germany and Finland, the deficit 
ratio climbed above 60 per cent of 
GDP in 1996 and on current 
projections it may stay just above 
that level in 1997 and in 1998. 
In the majority of countries in which 
the gross debt-to-GDP ratio is above 
60 per cent, progress is expected to 
be made in reducing the debt burden 
over the years 1996-98. In Denmark 
and Ireland, the debt ratio is 
expected to rapidly approach the 60 
percent reference value (falling by 
614 and 16 percentage points 
respectively, to a level of around 65 
percent of GDP). In Belgium, 
Greece and Italy, where the debt-
ratio is particularly high, as well as in the Netherlands, Sweden and Portugal, the debt-
ratio is expected to fall by between 4 and 10 percentage points of GDP over the period 
1996-98. 
3.3 The economic impact of budgetary consolidation in the Community 
3.3. 1 Short-term gi'owth impact of budgetary consolidation in 1996-97 
The substantial scale of the planned reductions in the budget deficit in most Member 
States in 1996-97 has prompted fears among some commentators that the efforts to 
comply with the Maastricht fiscal criteria could have a significant restraining impact on 
output growth and employment creation over the near term. However, such fears fail to 
appreciate both the overall economic policy context within which budgetary consolidation 
is taking place and the urgency, irrespective of the Maastricht process, of the economic 
need to consolidate the public finances in the Community. Table 26 
Gross public debt 
(%ofGDP) 
B 
DK1} 
D 
EL2) 
E 
F 
DRL2) 
I 
L 
NL 
A 
P 
FIN 
S 
UK2) 
EUR Level 
1993 
137.0 
80.1 
48.2 
111.8 
60.5 
45.6 
94.5 
119.3 
6.2 
80.8 
62.8 
68.2 
57.3 
76.0 
48.5 
66.1 1995 
133.7 
71.9 
58.1 
111.8 
65.7 
52.8 
81.6 
124.9 
6.0 
79.7 
69.0 
71.7 
59.2 
78.7 
54.1 
71.3 1996 
130.6 
70.2 
60.8 
110.6 
67.8 
56.4 
74.7 
123.4 
7.8 
78.7 
71.7 
71.1 
61.3 
78.1 
56.2 
73.5 1997 
127.0 
67.8 
61.9 
109.3 
67.1 
58.1 
70.0 
122.3 
8.8 
76.8 
72.2 
69.0 
61.5 
77.6 
57.0 
73.7 1998 
123.9 
65.5 
61.9 
107.2 
65.8 
59.2 
65.4 
119.4 
9.2 
75.1 
72.2 
67.8 
61.7 
74.9 
56.5 
72.9 Change 
95/93 
-3.3 
-8.2 
9.9 
0.0 
5.2 
7.2 
-12.9 
5.6 
-0.2 
-1.1 
6.2 
3.5 
1.9 
2.7 
5.6 
5.2 98/95 
-9.8 
-6.4 
3.8 
-4.6 
0.1 
6.4 
-16.2 
-5.5 
3.2 
-4.6 
3.2 
-3.9 
2.5 
-3.8 
2.4 
1.6 
') Government deposits with the central bank, government 
holdings of non-government bonds and public enterprise 
related debt amounted to some 18 % of GDP in 1995. 
2) See footnote 2 in table 19. 
Source: Commission services. 
76 
In most Member States, budgetary consolidation is inescapable if the rise in public 
indebtedness and the upward trend in debt servicing is to be arrested. Continuing large 
budget deficits would be reflected in a rapid rise in interest payments in the coming years 
which would put additional upward pressure on taxation to the detriment of employment, 
and reduce the scope for more productive or desirable public expenditures. Therefore, the 
current need for a growth-enhancing stance of economic policies cannot and should not be 
provided by "expansionary" budgetary policies. In most Member States, budgetary 
consolidation is necessary and desirable on its own merits. Progress towards EMU 
strengthens the framework within which the necessary adjustments are being made. 
Furthermore, even over the short-term, any hoped-for benefits of reduced consolidation 
efforts would most likely prove illusory. A let-up in budgetary consolidation would have 
immediate and severe adverse consequences in financial markets, leading to a rise in 
interest rate premia and most likely causing renewed exchange rate turmoil. As was 
amply demonstrated following the currency movements in 1995 (see Chapter 1), the net 
impact of such turmoil on short-term growth in the Community would be negative and 
would add to existing problems of high and rising unemployment in most countries. 
Therefore, in practice there is no alternative to continuing the policy of budgetary 
restraint. 
The overall effect of the current and planned budgetary policies on demand and growth 
cannot be considered in isolation from the repercussions on interest and exchange rates, 
the stance of monetary and other economic policies and the international and cyclical 
conditions in which consolidation is undertaken. The direct restraining impact of 
budgetary consolidation in 1996-97 is likely to be off-set by a number of factors which fall 
under two broad headings. 
Firstly, budgetary consolidation forms an integral part of the overall rebalancing of the 
economic policy-mix which has taken place in the Community and which is reflected inter 
alia in lower interest rates and improved exchange rate stability. These benefits extend to 
virtually all Member States and have resulted in a particularly large reduction in interest 
rates in countries which formerly suffered from high risk premia. The most striking 
examples are Spain, Italy and Sweden where long-term interest rate differentials relative 
to Germany fell by around 380, 430 and 340 basis points, respectively, from their 1995 
peak until December 1996. In each case, the bulk of this fall was achieved in the wake of 
the announcement of credible and significant efforts to reduce budget deficits to 3 per cent 
of GDP or less in 1997 and to bring it down further in subsequent years. The decline in 
77 
interest rates significantly eases the burden on the public finances as well as on private 
sector activity in nearly all countries. Lower real interest rates are likely to support the 
"crowding-in" of investment. Since investment profitability is currently sound, and since 
current and prospective demand trends are being supported by monetary relaxation, 
investment appears to be set to take off in a relatively strong manner. 
Secondly, a credible and well-designed policy of budgetary consolidation is likely to result 
in an improvement in confidence among businesses as well as consumers. Especially in 
countries with large budgetary imbalances and/or where public expenditures have been 
rising fast, a general perception that substantial tax increases would follow ~ coupled with 
uncertainty about which measures were going to be taken and who would have to bear the 
burden of adjustment — have contributed to a cautious mood and precautionary savings in 
the private sector. In such cases, action to curb the rise in public expenditures and raise 
taxes by less than what had previously been expected may well result in an improvement 
in "confidence" in the private sector and may stimulate both consumption, investment and 
companies' willingness to hire more employees. 
With respect to private consumption, there is an accumulating body of empirical evidence 
which points towards the existence of confidence or "non-Keynesian" effects, particularly 
in cases where large budgetary imbalances are addressed through credible efforts to 
restrain the growth of public expenditures. The negative correlation between the 
cyclically-adjusted budgetary position and the household savings ratio during periods of 
large fiscal adjustments/expansions is illustrated by the two country examples in Graph 24. 
Furthermore, lower interest rates and reduced financial uncertainty provides a boost to 
asset prices (including share, bond and house prices) and raises private sector wealth 
which, at least in some countries, is likely to provide a substantial impetus to private 
consumption. 
78 
Graph 2-4 
:%ofQPPi Budget deficit and households savings rate 
Sweden % of household disposable Income 
Cyclically-adjusted budget deficit 
(Ihs) 
1882 1984 1886 
Source: Commission services and OECD. 
Italy 
% :Qf household: disposable ; income; 
Cyclically-adjusted budget deficit 
(Ihs) 
1982 1984 1986 
Source: Commission services and OECD. 
Against the background of low inflation, healthy fundamentals and a favourable 
international setting, the forecasts of the Commission services indicate that the current and 
expected stance of budgetary and monetary policies is consistent with a well-balanced 
pick-up in economic growth to around its trend rate in 1997 and above-trend growth in 
1998. This assessment is broadly in line with that of other international institutions and 
most private forecasters. 
Even if economic growth should fail to pick up to the extent foreseen, there should be no 
let-up in budgetary consolidation efforts. Slippages from budgetary targets would put at 
risk the favourable trends in interest and exchange rates and therefore undermine the 
prospects for stronger economic growth. 
79 
3.3.2 Budgetary policy in a medium-term perspective 
Achieving and maintaining sound and disciplined public finances in the Member States is 
necessary to create the appropriate conditions for strong and sustained output growth 
with improved employment creation over the medium term. The widespread recognition 
of this fact led the Community to adopt the objective of achieving a government financial 
position close to balance over the medium term in successive Broad Economic Policy 
Guidelines since 199320. This objective has been reiterated and given increased credibility 
and importance within the framework of the "Stability and Growth Pact" for ensuring 
budgetary, discipline in stage three of EMU. Thus, Member States are committed to take 
further steps, in the years after 1997, to ensure a continued improvement in their 
budgetary position in order to attain the medium-term objective of close to balance or a 
surplus in normal circumstances. 
It has sometimes been argued that this commitment to disciplined budgetary policy would 
have a restraining impact on economic activity in the years following 1997. However, 
such fears seem to be based on a misunderstanding of the medium-term growth effects of 
sound budgetary policies and ignore the fact that fiscal discipline is an essential condition 
to ensure the viability of EMU and to reap all the potential benefits of the single currency. 
In addition, once the average budget deficit in the .Community has been reduced to 3 per 
cent of GDP by 1997, the achievement of budget balance in the course of subsequent 
years will be facilitated by the return to strong medium-term growth. 
Indeed, pursuing a medium-term budgetary objective of close to balance or surplus is 
necessary in order to: 
(i) achieve sustained, investment-led, growth of output and employment over the 
medium term while maintaining a proper balance between savings and investment; 
(ii) create room for budgetary policies to adapt to cyclical disturbances without causing 
the deficit to exceed 3 per cent of GDP during "normal" cyclical downturns; 
(iii) reverse the crowding-out of non-interest expenditure and facilitate tax reductions; 
(iv) prepare Member States' public finances for the budgetary consequences of the 
"ageing" of populations. 
20 In line with the policy recommendations of the Broad Economic Policy Guidelines, four countries, 
namely Denmark, Finland, Sweden and the United Kingdom, have introduced the objective of 
eliminating the deficit or moving to a surplus in their convergence programmes. 
80 
Sound public finances are necessary for sustained medium-term growth and employment 
The central plank of the Community's strategy to ensure a sustained upturn in economic 
growth and job creation over the medium term is to create the right conditions for a 
significant pick-up in investment in order to ensure a sufficiently rapid expansion of 
productive capacity. Investment growth is forecast to pick up significantly in 1997 and 
1998 and, provided that the right conditions are maintained, it is expected to continue to 
expand over the following years. This upturn in investment needs to be accompanied by 
an upturn in national savings in the Member States, if it is not to be associated with a 
serious current account deterioration for the Community as a whole and with severe 
upward pressures on real interest rates. In particular given the relative constancy of the 
private sector savings rate (households plus enterprises) as a share of GDP in the 
Community, this increase in savings needs to come essentially from the achievement of 
sound public finances and the restoration of positive public savings21. 
Empirical evidence shows that the rising public sector indebtedness of the industrialised 
countries over the last two decades has been a major factor behind the observed rise in 
world-wide real long-term interest rates (estimates range from around 1 to 2.5 percentage 
points)22. Conversely, the expected lower budget deficits in the Community in the coming 
years, in line with the Maastricht Treaty and the enhanced framework for budgetary 
discipline under the Stability and Growth Pact, will lead to lower borrowing costs in the 
Community. Since the Community is a sufficiently large player in the world economy, it 
would also contribute to lower long-term interest rates world-wide. Improved prospects 
for budgetary discipline amongst the Community's international partners, and in particular 
in the United States, would likewise contribute to lower world-wide real long-term 
interest rates. 
21 See "Trends in and structure of gross national saving in the Community", European Economy, 
Supplement A, n° 11/12, 1992. 
22 See IMF, World Economic Outlook (May 1996) and Group of Ten (1995), "Saving, Investment and 
Real Interest Rates", October 1995, and references mentioned therein. 
81 
l*> 
Restoring the stabilisation function of budgetary policies 
In EMU, the use of budgetary policies for stabilisation purposes is likely to take on 
increasing importance, at least for those countries which have hitherto made use of some 
degree of independent monetary or exchange rate policies. At the same time, in order to 
ensure budgetary discipline, the Maastricht Treaty stipulates that the budget deficit in 
participating Member countries is not allowed to exceed 3 per cent of GDP except in 
"exceptional and temporary" circumstances. Such circumstances do not include normal 
cyclical downturns. 
Therefore, achieving budget balance or, according to national circumstances, a budget 
surplus during "normal" times is a necessary condition for restoring the flexibility of 
budgetary policies within a sound and credible medium-term framework. It will create 
sufficient room for budgetary policies to allow the automatic stabilisers to work without 
exceeding the 3 per cent of GDP reference value for the budget deficit during normal 
cyclical downturns and without this leading to a relentless upward trend in government 
indebtedness and debt servicing relative to GDP. Indeed, over the period 1960-96, the 
cyclical component of budget deficits for all but two Member States never surpassed 3 per 
cent of GDP on either side and even remained below 2 per cent of GDP in most Member 
States (see Box 5). Furthermore, the automatic stabilisers are likely to work more 
effectively when underlying budgetary positions are sound, because the risk of either 
negative financial market reactions or of undermining confidence is smaller. On past 
experience, countries with sound underlying budgetary positions have been able to use the 
automatic stabilisers and counter-cyclical budgetary policies in a positive way, while 
countries with large deficits and debt have repeatedly been forced to tighten budgetary 
policies at the height of a cyclical downturn. 
Reversing the crowding-out of non-interest expenditure and the upward trend in taxation 
Over the last two decades, the rise in government interest payments has "crowded out" 
other public expenditures. The achievement of budget balance or surplus in "normal" 
times will lead to a self-feeding virtuous circle of reduced deficits, reduced debt, and 
lower debt-servicing costs. By reducing the debt servicing burden, fiscal discipline will 
allow a restructuring of government expenditures towards productive types of spending 
such as infrastructures, education and active labour market policies. 
82 
The bid to restore sound and disciplined public finances offers the opportunity to 
introduce lasting measures and reforms to stem the upward pressures on public 
expenditures in many Member States. Reduced expenditure growth and lower debt 
servicing will make it possible to reverse the long-standing upward trend in taxation. 
Reducing taxation, in line with a lower share of public expenditure in GDP, will have 
positive supply side effects. Lower effective tax rates, and in some cases an increased 
targeting of social expenditure, will improve incentives to save and invest, to increase 
work effort and to create jobs, thereby contributing to higher employment. 
Preparing for the "ageing" of populations 
Generating higher public savings is urgent and necessary in order to prepare Member 
States' public finances for the great challenges associated with the ageing of populations 
in the 21st century and the consequent rise in dependency ratios. These demographic 
trends will put upward pressure on social spending, especially for pensions and health 
costs (see Box 6). In part, this must be compensated by efforts to tighten spending under 
these social policies whereas higher private sector savings related to the possible 
proliferation of private pension schemes may contribute to the attenuation of these 
budgetary pressures. 
83 
Box 5: Automatic stabilisers in the Community 
Cyclical fluctuations in economic activity significantly affect government budget balances: tax 
receipts weaken and social transfers increase during recessions and show reversed movements 
during expansions. These cyclically-induced changes in the budget balance in turn exert a 
stabilising influence on economic activity, i.e. they fulfil the role of automatic stabilisers. 
The Commission services have developed their 
own methodology for estimating the cyclical 
impact on government budgets1. These 
calculations show that in the Community the 
size of the automatic stabilisers, as measured 
by the cyclical component of budget balances, 
is quite important and varies substantially over 
time and across Member States (see Table 
B5.1). The automatic stabilisers are relatively 
higher and show a relatively higher degree of 
variability in the smaller Member States but 
also in Spain and the United Kingdom. The 
size and volatility of the cyclical component for 
the Community as a whole is dampened 
because it averages out the different cyclical 
positions of the Member States at a given 
moment. 
As can be seen from the minimum and 
maximum values of the cyclical components, 
over the period 1960-1996 the cyclical 
component for all but two Member States never 
surpassed the 3 per cent value on either side 
and even remained below the 2 per cent value 
for most Member States. Cyclical components 
around 4 to 5 per cent were only registered in 
Finland and Sweden at the beginning of the 
1990s. 
The extent of the automatic stabilisers is influenced by the degree of openness of the economy, 
the size of the government sector, the progressivity of the tax system, the generosity of the 
unemployment compensation schemes and the sensitivity of unemployment to fluctuations in 
output. Variations across Member States in these elements explain the observed disparities in 
the magnitude of the automatic stabilisers. 
Schematically, the influence of the above elements are captured by two factors: the size of the 
output gap, on the one hand, and the sensitivity of budgetary receipts and expenditures to 
cyclical fluctuations on the other. 
Cyclical fluctuations can be estimated by determining the trend output path2 and by subtracting 
these trend output estimates from the actual output levels. The output gap is then defined as the 
difference between the levels of actual GDP and trend GDP, expressed as a percentage of 
trendGDP. When the output gap is positive (negative), the cycle has a positive (negative) 
influence on the government balance. 
As can be seen in Table B5.2, the volatility of the output gap, as measured by the standard 
deviation, is relatively small for the Community a whole, as cyclical positions differ among Table B5.1. 
Size of the cyclical component of 
budget balances in the EC 
(1960-1996) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR Standard 
deviation 
1.0 
1.1 
0.9 
0.7 
1.3 
0.6 
1.0 
0.6 
1.2 
1.3 
0.8 
1.1 
2.1 
1.8 
1.3 
0.7 Minimum 
Value 
-1.8 
-2.3 
-1.6 
-1.0 
-2.1 
-1.2 
-2.2 
-1.2 
-2.8 
-2.8 
-1.4 
-2.4 
-5.2 
-3.8 
-2.7 
-1.2 Year 
1986 
1981 
1967 
1987 
1984-85 
1985 
1986 
1975 
1982-83 
1983 
1987 
1984 
1993 
1993 
1982 
1983 Maximum 
Value 
2.0 
2.5 
1.9 
1.6 
2.7 
1.5 
2.1 
1.1 
4.1 
1.8 
1.4 
2.4 
5.2 
3.2 
3.1 
1.6 Year 
1974 
1986 
1991 
1973 
1990 
1990 
1996 
1980-90 
1974 
1974 
1973-74 
1973 
1989 
1990 
1989 
1990 
1 See European Commission, "Technical note: the Commission services' method for the cyclical adjustment of 
government budget balances1", European Economy, n° 60, November 1995. 
! The trend estimation method used to produce the output gaps (Hodrick-Prescott filter) produces output gaps 
which are symmetric over the series, and therefore sum to zero on average over the period 1960-1996. In 
addition, the negative output gaps produced by this method are relatively small compared to those produced 
by other methods, such as for example the production function approach, and the method smoothes over 
structural breaks, such as those which occurred in FIN and S at the beginning of the 1990s. 
84 
Member States, but is relatively high in the "catching-up" countries (Greece, Spain, Ireland and 
Portugal) as well as in Luxembourg and the United Kingdom. The large variability of the output 
gaps in Finland and Sweden, as indicated by their minimum and maximum values, can be 
partially attributed to the deep recessions in these countries at the beginning of the 1990s. 
The cyclical sensitivity of budget receipts and expenditure are calculated separately. As regards 
receipts, the following categories are taken into account: corporate taxes (which vary most with 
the cycle due to the cyclical sensitivity of profits), personal income taxes, indirect taxes and 
social security contributions (which vary least with the cycle due to their regressive nature). The 
overall revenue elasticity with respect to GDP is close to 1.0 for the Community as a whole, and 
ranges from 1.38 for the United Kingdom to 0.77 for Italy, reflecting differences in Member State 
tax rates and tax structures. The application of the revenue elasticity to the tax to GDP ratio 
gives the marginal sensitivity of budgetary receipts to GDP. 
The estimated sensitivity of budget revenues to the cycle for the Community as a whole is 0.4 
for 1995. This means that each widening of a negative output gap by 1 percentage point 
reduces government budget revenues by 0.4 percentage points of GDP. The revenue sensitivity 
varies from 0.3 for Greece and Italy to 0.6 for Sweden. 
Government transfers to households to cover costs related to unemployment are the main 
government expenditure category which reacts automatically to cyclical variations. As a result, 
the sensitivity of government spending to cyclical fluctuations is significantly lower than that of 
budget revenues. The estimated sensitivity of budget expenditures to the cycle for the EC as a 
whole is -0.1 for 1995, which means that each widening of a negative output gap by 1 
percentage point increases government spending by 0.1 percentage points of GDP. The 
expenditure sensitivity does not vary widely among Member States: it ranges from -0.05 for 
France to -0.26 for Denmark. 
For the Community as a whole, the sum of the marginal revenue sensitivity to the cycle and the 
marginal expenditure sensitivity gives the marginal rate of change of the budget balance with 
respect to GDP. The sensitivity of the budget balance to the cycle lies around 0.5 for the 
Community as a whole. This means that each deterioration of a negative output gap by 1 
percentage point increases the average government deficit by 0.5 percentage points. The 
sensitivity of the budget balance to the cycle ranges from 0.4 for Greece to 0.85 for Sweden. 
Table B5.2. 
Size of the output gaps in the EC 
(1960-1996) 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR Standard 
deviation 
1.7 
1.8 
2.0 
2.1 
2.5 
1.4 
2.2 
1.8 
2.8 
1.6 
1.6 
2.9 
3.5 
1.9 
2.2 
1.4 Minimum 
Value 
-2.7 
-3.6 
-3.9 
-3.4 
-4.5 
-2.2 
-4.2 
-3.4 
-4.6 
-3.4 
-2.8 
-5.5 
-7.4 
-4.3 
-4.0 
-2.2 Year 
1986 
1981 
1967 
1962 
1960 
1985 
1966 
1975 
1967 
1983 
1987 
1984-85 
1993 
1993 
1982 
1983 Maximum 
Value 
3.9 
3.7 
4.2 
5.8 
5.3 
3.0 
4.2 
3.1 
8.6 
2.4 
3.2 
8.2 
9.0 
3.6 
5.1 
3.2 Year 
1974 
1986 
1991 
1973 
1974 
1990 
1978 
1980 
1974 
1974 
1974 
1973 
1989 
1990 
1988-89 
1973 Table B5.3. 
Cyclical sensitivity of budget revenue 
and expenditure in the EC (1995)* 
B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR Budgetary 
receipts 
0.5 
0.5 
0.4 
0.3 
0.5 
0.5 
0.4 
0.3 
0.4 
0.5 
0.4 
0.4 
0.5 
0.6 
0.5 
0.4 Budgetary 
expenditure 
-0.1 
-0.3 
-0.1 
-0.1 
-0.2 
-0.1 
-0.2 
-0.1 
-0.2 
-0.2 
-0.1 
-0.1 
-0.2 
-0.2 
-0.2 
-0.1 Budget 
balances 
0.6 
0.7 
0.5 
0.4 
0.6 
0.5 
0.5 
0.5 
0.6 
0.8 
0.5 
0.5 
0.6 
0.9 
0.6 
0.5 
* Fisures are rounded off. 
85 
Box 6: Pension expenditure and liabilities in the Community 
1. The prospects for public pension expenditure 
The demographic structure of European countries is changing considerably. The old-age 
dependency ratio (i.e. the ratio of the elderly to working age population) is increasing in most 
countries and reaching historically unprecedented levels. Although the long-term effects of the 
ageing process on public budgets are uncertain and depend on the way the economy and society 
will adapt to the process, a significant pressure towards higher public expenditure is very likely to 
occur in the coming decades. Public pension schemes will bear much of the strain since their 
expenditure is highly dependent on the age structure of the population. 
In order to evaluate these prospects, all Member States have carried out pension expenditure 
projections over recent years. These projections, which are not homogeneous in the coverage of 
pension expenditure, have been examined in a report recently published by the Commission 
services * The report focuses on the most recent unchanged policy projections produced by 
public institutions; it provides comparable estimates of the impact of pension expenditure on 
public sector accounts on the basis of national expenditure projections and 1995 ratios of total 
public pension expenditure to GDP. Graph B6.1 presents the weighted average2 of the increase 
in the ratio of public pension expenditure to GDP in the 11 Member States that produced 
projections up to the year 2030. 
Graph B6.1 
% of G DP Estimates of public pension expenditure 
growth in the EC* 
(weighted averages of expenditure growth in 11 Member States) 
o *-
1995 2000 2005 
Source: Commission services:: : 2015 2020 2025 2030 
Over the period 1995-2030, the ratio of pension expenditure to GDP in the 11 countries will 
increase by 3 to 4 percentage points (respectively under favourable and unfavourable economic 
assumptions). Expenditure pressures, although non-negligible, are expected to be relatively 
limited over the next 5 years. The outlook worsens in the first decade of the next century, when 
the expenditure to GDP ratio is expected to increase in most countries, and, even more, after 
the year 2010, when the baby-boom generation retires. In several countries expenditure 
pressures will peak in the period 2030-2040.3 
The efforts to reform European pension systems - In most countries present pension policies are 
quite different from those implemented in previous decades. The phase of extension of 
coverage and improvement of benefits is over. Since the mid-eighties most pension sctiemes 
have been reformed in order to reduce pension expenditure growth. Major reforms were 
See D. FRANCO and T. MUNZI, 1996, "Public pension expenditure prospects in the European Union: A survey 
of national projections", European Economy, No. 3. 
Weighted by 1995 GDP in units of Purchasing Power Standard. 
Over the last decade, several national projections have been revised upward. Some changes have been quite 
substantial. Past revisions do not give any indication about future revisions of present estimates. However 
they point to the usefulness of carrying out regular reviews of projections and analysing past projection errors. 
86 
introduced in Austria, Finland, Germany, Italy, France, Greece, Portugal, Sweden and the United 
Kingdom/According to national projections, in several Member States the effects of 
demographic trends (i.e., the increase in the old-age dependency ratio) will be substantially 
offset by reforms cutting eligibility and transfer ratios.4 While cost containment was the main 
objective of the reforms, they also aimed at making the pension systems more able to tolerate 
demographic change, more transparent as to their distributive effects, less distortive of 
individuals' choices. 
In spite of these reform efforts, in several countries the preservation of present benefit levels 
and eligibility rules will require a substantial increase in the national resources devoted to 
pension systems. Alternatively, the stabilisation of pension expenditure will require further 
substantial reform in pension benefit levels and restrictions in pension eligibility. 
In conclusion, while the adjustment of European pension systems to the new demographic 
scenarios is well underway, with reforms gradually affecting pension expenditure dynamics, the 
large expected changes in demographic structure require further policy changes. 
2. Pension liabilities 
Pay-as-you-go (PAYG) pension schemes give rise to unfunded liabilities. Within these schemes 
each generation provides the resources for paying the pensions of older citizens and later 
receives pensions financed by younger citizens. Therefore, at any point in time there exists a 
number of retired citizens who are entitled to a pension for the remainder of their life (and 
sometimes also of the life of their widowed spouse) and a number of working citizens who can 
claim a right to a pension in the near or distant future. 
Table B.6.1 
Public Pension Liabilities: Present value of accrued rights 
Country 
B 
DK 
D1) 
EL 
E 
F 
IRL 
I 
L 
NL 
P 
UK 
USA 
Japan 
Canada Van Den Noord - Herd (1993, 1994) 
% of 1990 GDP 
Gross Liabilities 
Retired 
54 
77 
94 
58 
42 
51 
42 Work 
force 
103 
139 
148 
81 
70 
112 
71 Total 
157 
216 
242 
139 
113 
163 
113 Existing 
assets 
23 
18 
8 Net 
liabilities 
157 
216 
242 
139 
89 
144 
105 ABP (1993) 
% of 1990 GDP 
Gross liabilities 
68 
69 
122 
118 
109 
69 
54 
107 
138 
137 
96 
42 IMF (1996) 
% of 1995 GDP 
221 
265 
357 
117 
108 
166 
94 
I; West Germany in Van Den Noord-Herd (1993, 1994) and ABP (1993). 
Sources: Kuné J. B. - Petit W. F. M. - Pinxt A. J. H., "The Hidden Liabilities of Basic Pension Systems in the European 
Community", CEPS Working Document, No. 80, November, 1993. Van den Noord P. - Herd R. "Pension liabilities in the 
seven major economies", OECD, Economics Department Working Papers, n. 142, 1993,. Van den Noord P. - Herd R., 
"Estimating pension liabilities: A methodological framework", OECD, Economic Studies, n. 23, 1994., pp. 131-166. IMF, 
Aging Populations and the Fiscal Consequences of Public Pension Schemes, 1996. 
Respectively the ratio of the number of pensions to the number of elderly citizens and (he ratu 
pension to the average wage. 
87 <-| (he ; i vera ne 
In recent years a number of studies have estimated the liabilities of PAYG schemes. Table 1 
reports some estimates of accrued pension liabilities, which represent the present value of 
pensions to be paid in the future on the basis of accrued rights.5 Estimates vary considerably 
and the ranking of countries changes. 
The relevance of pension liabilities - Estimates of pension liabilities represent a useful 
complement to conventional debt and deficit measures. 
a) They provide a measure of the cost of terminating PAYG pension schemes when 
complying fully with present benefits rules.6 
b) They bring a clearer understanding of the impact of fiscal policies (by representing a 
relevant part of households' assets, pension rights influence consumption and saving 
decisions). 
c) They are useful for the measurement of deficits on accrual basis; the estimates 
available for some countries show that over the last few decades accrual deficits have 
been much larger than conventional cash flow deficits. 
On the other hand, the ratio of accrued pension liabilities to GDP is not an indicator of pension 
schemes' sustainability. A high liabilities to GDP ratio does not necessarily imply an imbalance 
in PAYG pension schemes. Nor does it imply that an imbalance will occur in the future. Any 
judgement about the sustainability of pension schemes and the pressure they exert on public 
budgets requires estimates about the resources available to pay for the accrued pensions, 
namely about the evolution of employment and per capita income. The sustainability issue 
should be addressed with other indicators, such as the pension expenditure to GDP ratio and the 
contribution rate that assures the cash balance of pension sctfemes. 
Pension liabilities and public debt- Accrued pension rights differ in many ways from conventional 
public debt and there are practical as well as theoretical reasons for not including accrued 
pension liabilities in the deficit and debt statistics used in defining and evaluating current fiscal 
policy. 
i) While conventional public debt can be measured precisely and unambiguously at any 
point in time, pension liabilities are uncertain and depend on the specific assumptions 
adopted upon a variety of factors, such as life expectancy, price and wage trends, etc. 
Present value calculations are extremely sensitive to changes in assumptions. 
ii) Pension rights are not embodied in formal contracts. The debtor can modify both the 
timing and the amount of the payment. Over recent years in several countries benefit 
rule reforms have substantially reduced the future entitlements of current workers and 
pensioners. The assimilation of pension liabilities to financial liabilities might hamper 
further reforms. 
iii) While public bonds are usually bought freely on the market by individuals or companies, 
the acquisition of pension rights is usually compulsory. This means that a large pension-
debt does not determine any direct pressure on financial markets. It also implies that the 
debt is automatically renewed. The inclusion of pension liabilities in the debt and deficit 
measures would conceal the pressure of the public sector on financial markets. 
iv) Pension rights are not tradable. This implies that changes in the relative yield and the 
relative risk of pension rights comparatively to other assets have no effect on financial 
markets. Non tradability also implies that social security claims can be altered selectively, 
taking individual characteristics (e.g., income, demographics) into account. 
The inclusion of accrued pension liabilities in the public debt definition would require an 
analogous change in the deficit definition. Contributions would become loans to the public 
sector; pensions would be considered, in part, as loan repayments and in part as an implicit 
interest payment. 
The different definitions of pension liabilities and their role in the assessment of fiscal policies are examined 
in D. FRANCO, 1995; "Pension Liabilities - Their Use and Misuse in the Assessment of Fiscal Policies", 
Economic Papers, European Commission, N. 110. 
If there is a switch from a PAYG system to a funded system, and all new contributions are paid into the new 
system, accrued rights measure the amount of resources which have to be financed from general taxation. 
4. EXCHANGE-RATE STABILITY AND INTEREST-RATE CONVERGENCE IN THE 
COMMUNITY 
4.1 Overview 
Monetary developments in the European Community in 1996 were influenced by two 
main factors: (i) an overall - albeit unsteady - appreciation in the US dollar and (ii) an 
improved financial-market perception of the prospects for EMU. Both factors were 
reflected in stable exchange rates and converging interest rates. Monetary conditions in 
the EC eased overall, consistent with the cyclical position of the economy and a reinforced 
commitment to budgetary consolidation in many Member States ahead of the launch of 
EMU on 1 January 1999. 
The firmer US dollar was mainly attributable to the relative strength of the US economy. 
However, market sensitivity to a possible economic downturn and the consequences for 
monetary policy made for an uneven appreciation. As the dollar moved higher, the DEM 
eased against most of the other EC currencies providing scope for a narrowing of short-
term interest rate differentials relative to Germany. 
The generalised easing of the DEM against other EC currencies also reflected financial-
market sentiment on the prospects for EMU. EMU optimism was inspired by 
reaffirmation of political support for the project throughout the Community, visible 
progress in technical preparations for the changeover to the euro and a reinforced 
commitment to budgetary adjustment in many Member States. As confidence improved 
about the possibility of a significant number of Member States adopting the single 
currency from the outset, there was an intensification in the convergence of short and 
long-term interest rates toward the levels in the lower-yielding Member States. 
Given the overall improvement in monetary conditions and the effect of budgetary 
consolidation in lowering long-term interest rates, the macroeconomic policy mix has 
become more supportive of economic growth. The more aggressive approach to 
budgetary consolidation presents the prospect of a "virtuous circle" of falling interest rates 
supporting economic growth and greater credibility of budgetary adjustment efforts as the 
economy strengthens. Successful budgetary consolidation is, of course, the key element 
in sustaining these developments and it is essential that budgetary targets be realised if the 
currently favourable trends are to be sustained. 
69 
4.2 Uneven appreciation in the US dollar 
Early boost for dollar from US bond-market rally 
In the wake of a monetary easing in Germany on 14 December 1995, the dollar began the 
year on a rising trend against the DEM. By early February, the DEM/USD exchange rate 
was close to 1.49; this implied an appreciation of about 3.5% since the beginning of the 
year and of about 7% from a low of 1.39 DEM recorded in October 1995. The dollar 
gained more modestly against the Japanese yen in the early part of 1996, having surged 
higher in the final weeks of 1995 amid gloomy prospects for the Japanese economy. 
Demand for the dollar in the early weeks of the year was reinforced by buoyancy in US 
financial markets. With inflation expectations subdued by a relatively modest pace of 
expansion in the US economy, bond and equity prices were discounting the continuation 
of an accommodating monetary policy. Market expectations were validated on 31 
January, when US money-market rates - which had been falling steadily throughout 1995 -
were again steered lower by the Federal Reserve; however, this proved to be the only 
monetary easing by the Federal Reserve in 1996. Apart from interest-rate factors, activity 
in the US financial markets was also supported by continued capital inflows from Japanese 
sources in response to relatively high rates of return. 
Dollar underpinned by stronger economy as bond market ebbs 
By mid-February, the data suggested that the outlook for the US economy had brightened 
considerably. Financial-market expectations of inflation were revised upward and the 
prospect of a further monetary easing by the Federal Reserve faded. US money-market 
rates climbed and longer-term rates also moved upward as sentiment in the bond market 
deteriorated. Despite the loss of bond-market support, the dollar strengthened further 
against both the DEM and the yen as markets now began to discount a near-term 
monetary tightening by the Fed at the same time as a monetary easing by the Bundesbank . 
The DEM/USD exchange rate climbed to about 1.55 by early May and was hovering 
around 1.53 at the end of the second quarter; this implied an appreciation of more than 
6% in the first half of the year. Meanwhile, the JPY/USD exchange rate ended the second 
quarter above 109, implying an appreciation of more than 5% in the first half of the year. 
90 
1995 
Source: Commission services. 
Equity sell-off triggers temporary reversal in dollar rise 
The appreciation in the dollar was interrupted early in the third quarter of the year. An 
abrupt deterioration in sentiment toward the US currency was triggered by a significant 
one-off fall in US equity prices in July, although the US bond market was relatively 
unaffected. Demand for the dollar was further undermined by mixed signals on the 
strength of the US economy and a growing market perception that the interest-rate cycle 
in Germany had bottomed following a cut in the Bundesbank's key intervention rates in 
April. Speculation concerning a possible monetary tightening in Japan also weighed on 
the dollar, as the DEM/USD exchange rate moved below 1.48 and the JPY/USD 
exchange rate fell to 108 at the end of August. This episode of weakness was short-lived, 
however, and the dollar subsequently recouped much of its losses on new evidence of a 
robust expansion in the US economy. With market expectations of a near-term monetary 
tightening in the United States fully revived, the DEM/USD exchange rate ended the third 
quarter at close to 1.54 — helped also by a generalised strengthening of the other EC 
currencies against the DEM ~ while the JPY/USD exchange rate ended the quarter at 
about 111.6. 
Dollar ends the year strong despite uncertainty on US economy. 
The dollar consolidated its gains against the yen in the fourth quarter as the performance 
of the Japanese economy continued to disappoint the markets. The JPY/USD exchange 
rate ended the year at 116.1, up by about 11.5% relative to its level on 1 January. Against 
91 
the DEM, the dollar followed a more uneven trend as markets remained highly sensitive to 
prospects for the US economy and to the implications of official comments for the 
direction of monetary policy in the United States and in Germany. From mid-October, the 
dollar eased against the DEM amid a reassessment of the expected strength in the US 
economy and a perception that the European economies had bottomed out. However, 
renewed concerns at the pace of recovery in Europe emerged in late November and the 
DEM/USD exchange rate surged on market speculation of another monetary easing in 
Germany. Despite a temporary downward blip linked to a second sharp sell-off in US 
equities in early December, the DEM/USD exchange rate ended the year at about 1.55, up 
by almost 8% relative to 1 January. In nominal effective terms, the dollar appreciated by 
about 4%23 in 1996. 
4.3 Appreciating dollar and EMU optimism favour monetary stability in the 
Community 
4.3.1 Strong dollar reflected in intra-EC exchange-rate movements 
The appreciation of the US dollar in the course of 1996 contributed to an overall easing in 
monetary conditions in the EC. The strength of the dollar against the DEM was mirrored 
in other EC currencies, particularly in the "high-yielding" currencies. By the end of the 
year, the decline in the DEM against the other EC currencies had largely reversed the 
nominal effective appreciation which had resulted from the exchange-rate disturbances of 
Spring 1995. 
For presentational purposes, it is convenient to differentiate between Member State 
currencies on the basis of their participation or non-participation in the ERM. The trend 
in the exchange rates of ERM currencies which moved significantly against the DEM is 
illustrated in Graph 26. The high-yielding Italian lira24 (+11%) and Portuguese escudo 
(+3.3%.) experienced a significant appreciation, together with the Irish pound (+13.3%) 
which moved in line with sterling. The French franc (1.3%) also benefited from the 
generalised easing in the DEM, despite experiencing a bout of selling pressure linked to 
political uncertainties in August. The remaining ERM currencies25 were either stable or 
marginally weaker against the DEM over the year. 
23 Against 23 industrial countries. 
2A Which re-entered the ERM on 25 November, 1996. 
25 Including the Finnish markka, which entered the ERM on 14 October, 1996. 
92 
Graph 26 
110 
105 
80 Exchange rates : DEM versus ERM cu rrencies 
January 1995 = 100 
DEM nominal effective exchange raté* Spain 
1995 
* Relative to 23 industrialised countries. 
Source: Commission services. 1996 
Systemic conditions in the ERM generally improved in 1996. The spread between the 
strongest and weakest currencies in the grid -- which had already come down in late 1995 
~ narrowed progressively throughout most of the first three quarters. The spread fell 
from about 5.6% (Spain versus Ireland) in early January to a low of about 1.99% (Ireland 
versus France) on 27 September but widened again to about 2.29% (Ireland versus 
France) on 30 September. While the vast majority of ERM currencies remained inside or 
close to their former narrow fluctuation margins in the fourth quarter, a continued 
appreciation of the Irish pound resulted in a widening of the spread to a peak substantially 
above 9% before ending the year at 8.9% (Ireland versus France). The width of the 
spread reflected the strength of the Irish pound rather than the weakness of the French 
franc, which although at the bottom of the grid was still relatively close to its central 
parity against the DEM. Continued appreciation of the Irish pound within the grid could 
GraPh 2? 1 Exchange rates: DEM versus non-ERM currencies 
January 1995 = 100 
115 
110 
105 
100 
95 
90 
85 Sweden 
1995 
* Relative to 23 industrialised countries. 
Source: Commission services. 1996 
93 
pose a policy dilemma for the national authorities; the Irish economy has been accelerating 
at a rapid pace in recent years and the need for a further monetary tightening — implying 
a further widening of the spread — cannot be ruled out. Overall, however, spreads within 
the ERM narrowed so that most participating currencies ~ including the Finnish maarka 
and the Italian lira which did not participate for the full year — ended the year very close 
to or within the former narrow fluctuation margins of +1-2.25%. 
The non-ERM currencies ~ which are high yielding and relatively dollar-sensitive ~ also 
appreciated against the DEM. The traditional linkage between movements in sterling and 
the dollar, reinforced by evidence of a sustained recovery in the domestic economy, 
boosted the UK currency (+18.2%), while the Swedish krona (+3.5%) and the Greek 
drachma (+3.7%) also made steady gains over the year. 
4.3.2 Appreciation of other EC currencies against DEM accompanied by convergence 
in short-term interest rates 
The generalised appreciation of other EC currencies against the DEM was accompanied 
by a significant narrowing in short-term interest-rate differentials with respect to 
Germany. German short rates moved modestly lower over the year, with the three-month 
money-market rate falling by about 65 basis points to 3.1% over the year in line with 
monetary-policy developments. As indicated in Graph 28, the Bundesbank's key discount 
rate and Lombard rate were both lowered by 50 basis points to 2.5% and 4.5% 
respectively on 19 April; however, the pace of decline in German money-market rates was 
dictated by a fixed repo rate of 3.3% between 1 February and 22 August, before it was 
lowered to a fixed level of 3% until the end of the year. The relatively moderate pace of 
monetary easing by the Bundesbank reflected high rates of growth in the domestic money 
supply (M3), which expanded at a monthly rate above the target range of 4% -7%26 
throughout the year, falling from a peak of 12.8% in February to 8% in November. 
Graph 28 Short-term interest rates in Germany 
Lombard 
3 months 
1995 
Source:•':•'.'Commission services. 1996 
26 Relative to the average monthly growth rate in the fourth quarter of 1995. 
94 
j Graph 29 Short-term interest rate differentials 
in ERM Member States* 
1995 
* Differential on 3 month money market rate relative to Germany. 
Source: Qommission services. :l996ï 
The decline in short-term interest rates was more pronounced in other Member States, in 
most cases reflecting a more significant relaxation of monetary policy than in Germany. 
Over the year, the average differential ~ among all the other Member States27 ~ on 
three-month money market rates relative to Germany fell from about 230 basis points to 
about 145 basis points. There was, however, a significant variation between Member 
States. Graph 29 indicates that the decline in short rates among the ERM Member States 
was most striking in Italy, Spain and Portugal, where the differential on the three-month 
money market rate fell from 650 basis points to about 420 basis points, from 550 basis 
points to about 325 basis points and from about 500 basis points to about 335 basis 
points, respectively. Budgetary consolidation and other measures that have helped to 
bring inflation down have allowed central banks to reduce interest rates. In France, the 
differential fell from about 120 basis points to about 30 basis points. Ireland, where the 
differential widened from about 170 basis points to about 280 basis points, was a notable 
exception to the convergent trend among the ERM Member States. 
Among the non-ERM Member States, the differential on three-month money market rate 
in the United Kingdom with respect to Germany widened from about 280 basis points to 
about 340 basis points. The United Kingdom was the exception to a narrowing trend in 
short-term interest rate differentials among these Member States. The narrowing was 
particularly notable in Sweden, where the differential on the three-month money market 
rate fell from about 485 basis points to about 90 basis points. The Swedish experience 
reflected a particularly aggressive monetary easing by the Riksbank in the early part of the 
year, involving a long sequence of cuts in the key repo rate. 
27 Excluding Luxembourg and Greece. 
95 
4.3.3 Long-term interest rates also converge, helped by EMU optimism 
As with short rates, there was a significant convergence in bond yields toward the German 
level in the other Member States. This phenomenon was again relatively conspicuous 
among the high-yielding Member States. Graph 30 indicates that German long rates 
moved moderately upward over the first half of the year in line with a similar (but more 
pronounced) trend in the United States. The rise in US yields began with the reverse in 
bond market sentiment early in February and was largely sustained until early September, 
when yields began to fall in response to revised expectations of a monetary tightening by 
the Federal Reserve. German yields had been above the corresponding US levels since 
early 1995, but in mid-April the positive differential turned negative reflecting a partial 
decoupling between the US and German bond markets. The negative differential widened 
in subsequent months and the yield on the benchmark ten-year bond in Germany ended the 
year about 15 basis points lower than its level on 1 January (the corresponding US yield 
was about 70 basis points higher over the same period). 
Graph 30 
Long-term interest rates in Germany and the United States 
1995 
* Yield on benchmark 10-year bond. 
Source: Commission services. 1996 
Trends in bond yields in the other Member States varied. The average differential ~ 
among all other Member States28 — in the yield on benchmark ten-year bonds relative to 
Germany fell from about 160 basis points at the beginning of January to about 65 basis 
points at the end of December. As indicated in Graph 31, this decline mainly reflected a 
sharp fall in yield differentials in Italy (from about 445 to about 165 basis points) in Spain 
(from about 360 to about 105 basis points) and in Portugal (from about 375 to about 115 
basis points). In each case, the decline in yields reflected a lowering of inflation 
Excluding Luxembourg and Greece. 
96 
expectations and a firmer exchange rate against the DEM. Among the non-ERM Member 
States, the differential in the United Kingdom widened marginally over the first nine 
months of the year, on rising expectations that domestic monetary policy would be 
tightened in view of the strong cyclical position of the UK economy relative to that of 
other Member State economies (see Graph 32). 
Graph 31 Long-term interest rate differentials 
among ERM Member States* 
19Ô5 
* Yiefd differentials on benchmark 10-year bonds relative to Germany. 
Source: Commission services. WM 
Convergence in long-term interest rates toward the German level accelerated sharply in 
the final quarter. Inflationary pressures remained subdued throughout most of the 
Community. In Italy, Spain and Portugal, but also, to some extent in Greece, anti-
inflationary policies coupled with reinforced fiscal consolidation have succeeded in 
reducing inflation and stabilising expectations towards a lower rate of inflation. As shown 
in Graph 30, German long rates moved lower in the final quarter ~ once again helped by 
US developments ~ but the fall in other EC long rates was more dramatic. Final-quarter 
developments brought all EC ten-year bond yields within 200 basis points of the 
corresponding German yields for the first time since capital liberalisation was completed 
within the Community. 
Graph 32 Long-term interest rate differentials 
among non-ERM Member States* 
0;5 
1995 
* Yield differentials on benchmark 10-year bonds relative to Germany. 
Source: Commission services. 199$; 
97 
4.4 EMU prospects confirmed in ECU market and forward interest rates 
Despite the convergence in long-term interest rates, wide (albeit narrowing) differentials 
relative to Germany persisted in many Member States in the first three quarters of 1996. 
Moreover, a substantial negative differential between the theoretical exchange rate and the 
corresponding official rate in the ECU market was interpreted as implying some continued 
hesitation in the markets with respect to EMU. This was confirmed by differentials in 
forward interest rates, which'were discounting significant exchange rate movements in 
many Community currencies and the ECU well beyond the projected starting date of 
EMU. 
From September onward, there was a marked improvement in market sentiment toward 
EMU and the prospect of a significant number of countries participating in the euro zone 
from the outset. The more favourable market view of EMU was the combined result of 
several factors. Firstly, there was evidence of a strong political commitment to the 
project; as manifested in the agreement on the Stability and Growth Pact, on a new 
exchange-rate mechanism and on the legal framework for the euro reached in mid-
December. Secondly, the prospects for growth in the EC economy in 1997 brightened 
considerably. Finally, budgetary adjustment efforts were reinforced in most Member 
States with a view to complying with the relevant Maastricht criteria. The improvement 
in market sentiment toward EMU quickly became the main factor driving convergence in 
long-term interest rates toward the (declining) German level. The fall in German long-
term interest rates amid rising EMU optimism seems to confirm that there is no EMU-
specific risk premium on German bonds. Furthermore, the accelerated decline in 
differentials among the high-yielding Member States has been interpreted as striking 
evidence of an increased financial-market acceptance of a significant number of countries 
adopting the euro from the outset of EMU. 
Graph 33 
50 
-50 
-100 
-150 
-200 
-250 
-300 Exchange rate and interest rate differential between 
theoretical and market ECU basis points 
*MQWftitf<p^*rcw,»qQQM««tow<gfl?tf^^tfP^OgWBWMl#aul^^ 
Jan Feb Mar Apr May Jun July Aug Sep 
Source: Commission services. Oct Nov Dec 
98 
A further indicator of growing EMU credibility in the final quarter was the performance of 
the ECU market. Although trading volume remained modest, Graph 33 indicates that risk 
premia with respect to the exchange rate fell in the course of 1996, particularly in the 
fourth quarter. While the gap between the theoretical value of the ECU and the market 
value was 300 basis points at the beginning of the year, it had fallen to about 86 basis 
points by the end of the year. At the same time, the interest-rate spread which had been 
low throughout the year virtually disappeared. 
Finally, the growing credibility of the EMU project was evident in the movement of 
forward interest rates on all Member State currencies. Forward rates on contracts with a 
settlement date after the creation of EMU on 1.1.1999 should be the same for all 
currencies expected to participate in the euro zone from the outset. The existence of a 
significant divergence in such forward rates in any Member State can be considered as 
evidence of a "credibility gap" with respect to their participation in the euro zone. Table 
27 presents the differential relative to Germany (which is assumed to be a certain 
participant in the euro zone) in five-year forward rates on five year loans for a selection of 
Member States for which data is available. 
The forward rates are derived 
using estimated zero coupon yield 
curves in the relevant Member 
States.29 It is clear from the table 
that the relevant forward rates on 
the "hard core" currencies have 
been highly convergent for some 
time, but a significant divergence 
has existed in the forward rates of 
the other currencies. As with 
developments in spot markets, 
however, this divergence has been 
narrowing steadily since the 
beginning of the year and particularly in the final quarter. The differential in the ECU 
forward rate early in the year was seen as evidence of market scepticism about the EMU 
project itself but this differential had largely disappeared by the end of the year. 
Moreover, the convergence in forward rates on the various EC currencies offers 
confirmation of a growing financial-market acceptance of a significant number of 
participating Member States in the euro zone from the outset of the third stage of EMU. Table 27 
Five-year forward rate on five-year loans 
Differential vis-à-vis Germany in basis points 
Date 
B 
E 
FIN 
F 
I 
NL 
A 
S 
UK 
ECU Jan-Mar 
1996 
45 
239 
n.a. 
-6 
n.a. 
-7 
n.a. 
183 
94 
57 July 
1996 
43 
184 
n.a. 
-7 
198 
-5 
2 
n.a. 
123 
n.a. Oct. 
1996 
-2 
83 
62 
-24 
-4 
-4 
2 
96 
79 
4 Dec. 
1996 
-7 
21 
43 
-31 
42 
-10 
-5 
59 
82 
10 
29 Estimation of zero-coupon yield curves is not exact and, in consequence, the derived forward rates may 
be subject to measurement error. 
99 
4.5 Easing monetary conditions combines with budgetary consolidation to 
rebalance the macroeconomic policy mix 
4.5.1 Monetary conditions ease over the year 
The strength of the US dollar and the generalised decline in short-term interest rates 
throughout most of 1996 implied an improvement in monetary conditions within the 
European Community. Graph 34 indicates the movement in the Monetary Conditions 
Index or MCI30, (which combines the movements in short-term interest rates and 
exchange rates to indicate the change in monetary conditions within an economy) for the 
larger Member States. The movement in the MCI for Germany and France point to a 
significant relaxation in monetary conditions in 1996 relative to 1995. A similar trend was 
Graph 34 Monetary conditions index* 
20 
15 
10 
-5 ;Çhiange; relative to; 1990 \ 
1992 1993 1994 1995 
* Weighted average of changes in real 3 month interest rates and changes in the 
effective exchange rate relative to the base year (1990). A positive (negative) figure 
indicates a tightening (easing) of monetary conditions. 
Source: Commission services. 1996 
30 The MCI expresses changes in domestic monetary conditions relative to a pre-specified base period in 
terms of a weighted average of developments in short-term interest rates and developments in the 
effective exchange rate. The attractiveness of the MCI as a tool of current analysis is that it 
summarizes the (contractionary or expansionary) impact of movements in the principal transmission 
mechanisms of monetary policy to the economy: the interest rate and the exchange rate. An increase 
in the nominal short-term interest rate ~ implying an initial rise in real rates because of slow price 
adjustments — results in a decline in real money balances and so reduces demand in the economy. 
Similarly, an appreciation of the nominal exchange rate ~ implying a real appreciation in the short 
run — leads to a reduction in net exports and so imparts a contractionary impulse to demand in the 
economy. Of course, the opposite is true in the case of a reduction in short-term interest rates and an 
exchange rate depreciation. Movements in the MCI should, therefore, mirror movements in output 
growth over the policy horizon. The choice of base period for the MCI is arbitrary so that the absolute 
level of the index is not in itself significant and the component variables can be expressed in either 
nominal or real terms. The relative weighting of the two variables is derived as the ratio of the 
elasticity of real output with respect to the short-term interest rate and the elasticity of real output with 
respect to the exchange rate. 
100 
recorded in the MCI for most of the other ERM countries. On the other hand, movement 
in the MCI indicates a tightening in monetary conditions in Italy (where the exchange rate 
appreciated) and in the United Kingdom (where both short-term interest rates and the 
exchange rate firmed over the year). 
Graph 35 Yield curves in larger Member States 
1995 1996 
* Difference between yield on 10-year bond and 3-month money market rates. 
Source: Commission services. 
The scope for a further easing of monetary policy in most of the Member States will, of 
course, depend on developments in longer-term interest rates. While the favourable 
inflation environment was reflected in a general decline in EC bond yields, the pace of 
decline in yields in many Member States was somewhat less than that in short-term rates. 
In consequence, the easing of monetary policy in the Community for much of the year was 
reflected in a simultaneous lowering and steepening of yield curves as illustrated for the 
larger Member States in Graph 35. The "stickiness" in EC bond yields in this period was 
not attributable to latent inflationary pressures but to the failure of EC yields to decouple 
fully from corresponding yields in the United States. US yields followed an upward trend 
for much of the year on market expectations of a monetary tightening by the Fed. 
However, the graph also indicates a marked flattening in EC yield curves (except for Italy) 
in the fourth quarter, as German yields moved lower and EMU optimism favoured 
convergence in EC long rates. 
101 
4.5.2 Monetary easing provides scope for continued budgetary consolidation 
Many Member States have availed of the improved growth prospects helped by easier 
monetary conditions to rebalance the macroeconomic policy mix by intensifying budgetary 
consolidation. The credibility of budgetary consolidation efforts ~ and reinforced 
commitments to maintaining and intensifying such efforts in the future ~ was greatly 
enhanced by the prospect of a stronger economic performance. The credibility of 
budgetary adjustment efforts in most Member States was the determinant factor 
underlying the decline in long-term rates linked to EMU optimism in financial markets 
toward the end of the year. The macroeconomic policy mix is now more growth 
supportive. 
For many Member States, the more aggressive approach to budgetary consolidation 
presents the prospect of a "virtuous circle" of falling interest rates supporting economic 
growth and greater credibility of budgetary adjustment efforts as the economy 
strengthens. Successful budgetary consolidation is, of course, the key element in 
sustaining these developments and it is essential that budgetary targets be realised if the 
currently favourable trends are to be sustained. 
102 



ISSN 0254-1475 
COM(97) 27 final 
DOCUMENTS 
EN 10 17 
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ISBN 92-78- 15234-X 
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