[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 3.5.2007

SEC(2007) 550

COMMISSION STAFF WORKING DOCUMENT accompanying document to the

COMMUNICATION FROM THE COMMISSION TO THE COUNCIL, THE EUROPEAN PARLIAMENT, THE EUROPEAN ECONOMIC AND SOCIAL COMMITTEE, THE COMMITTEE OF THE REGIONS AND THE EUROPEAN CENTRAL BANK – Annual Statement on the Euro Area 2007 – {COM(2007) 231 final}

EUROPEAN

COMMISSION

DIRECTORATE-GENERAL FOR

Economic and Financial affairs

ANNUAL REPORT ON THE EURO AREA – 2007

(The complete and definitive version will be published as European Economy Main Report n°5)SEC(2007) 550

Annual Report on the Euro Area -2007

A report by the Commission services

SEC(2007) 550

http://ec.europa.eu/economy_finance/publications/european_economy/2007/eespecialreport0306_en.htm

Acknowledgements

This report was prepared in the Directorate-General for Economic and Financial Affairs under the direction of Klaus Regling, Director-General. Executive responsibilities were attached to Servaas Deroose, Director for the Macroeconomy of the euro area and the EU.

The principal contributors were Alfonso Arpaia, Joaquim Ayuso Casal, Carsten Brzeski, Jeannette Capel, Björn Döhring, Roland Eisenberg, Olivia Galgau, Laura Gonzalez Cabanillas, Oskar Grevesmuhl, Ulrich Jochheim, Martin Larch, Karolina Leib, Aurora Maria Mordonu, Laurent Moulin, Anja Naujokat, Moises Orellana Pena, Dario Paternoster, Mujtaba Rahman, Valérie Rouxel-Laxton, Heliodoro Temprano Arroyo, Michael Thiel, Georges Tournemire, Errikos Velissaratos, Magnus Vesterlund, Lucio Vinhas de Souza, Joachim Wadefjord, Pavlina Zaková and Marcin Żogała. Marcin Żogała, Georges Tournemire and Wilhelm Schöllmann had special responsibility for Chapter 1, 2 and 3 respectively.

The report benefited from comments by staff of the Directorate General for Economic and Financial Affairs, including John Berrigan, Giusppe Carone, Declan Costello, Adriaan Dierx, Elena Flores Gual, Fabienne Ilzkovitz, Jose Eduardo Leandro, Jan Host Schmidt, Massimo Suardi and Peter Weiss.

Statistical assistance was provided by Danila Conte.

Secretarial support was provided by Françoise Briard and Daphné Corne.

Jeannette Capel and Joost Kuhlmann edited and coordinated the production of the report.

Directorate-General for Economic and Financial Affairs

Economy of the euro area and EMU

European Commission

B-1049 Brussels

or by e-mail to joost.kuhlmann@ec.europa.eu

Contents

SUMMARY………………………………………………………………………………………..vii

1. MACROECONOMIC DEVELOPMENTS AND POLICIES 1

2. Macroeconomic developments 1

3. Monetary policy and developments 5

4. Fiscal policy and developments 8

5. Conclusions 14

6. A DYNAMIC, SMOOTHLY FUNCTIONING EMU 17

7. Economic adjustment in the euro area remains sluggish 17

8. First lessons from the euro area's adjustment process 20

9. Recent improvements in adjustment capacity 22

10. Completing financial market integration 26

11. Product market reforms remain necessary 28

12. Wage developments and competitiveness adjustment 33

13. Conclusions 36

14. THE EXTERNAL DIMENSION 37

15. The euro's exchange rate and global imbalances 37

16. The euro as a global currency 40

17. China, India and Russia – key economic powers 42

18. Projecting a strong voice on the world stage 46

19. Conclusions 48

List of tables

Table 2.1 | Contribution to productivity growth | 20 |

Table 2.2 | Price dispersion in the euro area | 29 |

Table 2.3 | Entry and exit of companies in selected countries | 30 |

Table 2.4 | The elasticity of wages with respect to expected inflation | 34 |

Table 2.5 | Growth in real wages (RW) and labour productivity (LP) across cycles | 35 |

Table 3.1 | Major currencies' share in gross issuance of international debt securities | 41 |

Table 3.2 | Currency shares in foreign exchange reserves | 42 |

Table 3.3 | Trade relationships between euro-area and China/India/Russia | 44 |

Table 3.4 | Foreign Direct Investment between the euro area and China/India/ Russia | 44 |

Table 3.5 | External representation of the euro area: an overview | 47 |

List of graphs

Graph 1.1 | Contribution to GDP growth, euro area | 1 |

Graph 1.2 | The euro-area labour market | 3 |

Graph 1.3 | Headline and core inflation, euro area | 5 |

Graph 1.4 | ECB minimum bid rate and 3-month market rate | 5 |

Graph 1.5 | Euro exchange rates | 5 |

Graph 1.6 | Real interest rates in the euro area | 6 |

Graph 1.7 | Retail interest rates in the euro area | 6 |

Graph 1.8 | Monetary developments in the euro area | 6 |

Graph 1.9 | Contributions to euro-area HICP inflation | 7 |

Graph 1.10 | Fiscal policy stance in the euro area | 8 |

Graph 1.11 | Current structural balance and medium-term objective (MTO) | 9 |

Graph 1.12 | Change in the structural balance of euro-area Member States | 10 |

Graph 1.13 | Number of numerical fiscal rules in force in the euro-area Member States | 12 |

Graph 1.14 | Statutory base of fiscal rules at different levels of general government | 12 |

Graph 1.15 | Enforcement mechanisms of numerical fiscal rules in force | 13 |

Graph 1.16 | Relation between numerical fiscal rules and budgetary outcomes | 13 |

Graph 1.17 | Cyclical behaviour of primary government expenditure | 14 |

Graph 2.1 | Annual GDP growth in the euro area | 17 |

Graph 2.2 | Inflation dispersion for euro-area Member States HICPs | 18 |

Graph 2.3 | Current account balances for selected euro-area Member States | 18 |

Graph 2.4 | Labour productivity in the euro area (country breakdown) | 19 |

Graph 2.5 | Labour productivity in the euro area (7-sectors breakdown) | 19 |

Graph 2.6 | Total factor productivity in the euro area (country breakdown) | 20 |

Graph 2.7 | Potential patterns of adjustment in a monetary union | 21 |

Graph 2.8 | Structural indicators earmarked for the Growth and Jobs strategy | 23 |

Graph 2.9 | Actual and trend labour productivity growth, euro area | 25 |

Graph 2.10 | Cross-border holdings of debt securities issued by euro-area residents | 27 |

Graph 2.11 | Proportion of variance in local equity returns explained by euro-area and US shocks | 27 |

Graph 2.12 | Standard deviation of euro-area government bond yield spreads | 28 |

Graph 2.13 | Euro-area Product Market Regulation indicators | 32 |

Graph 2.14 | Research and Development and innovation performance | 32 |

Graph 2.15 | Launching of new goods and services in national and EU markets | 32 |

Graph 2.16 | Wage indicators in the euro area | 33 |

Graph 2.17 | Unit labour costs in the euro area | 33 |

Graph 2.18 | Real effective exchange rate developments | 34 |

Graph 2.19 | Relative unit labour cost elasticity to output gap in the manufacturing sector | 35 |

Graph 2.20 | Relative wage elasticity to output gap in the total economy | 35 |

Graph 3.1 | Changes in EUR bilateral rates | 37 |

Graph 3.2 | Euro-area real effective exchange rate | 38 |

Graph 3.3 | Central bank policy rates | 38 |

Graph 3.4 | Evolution of current account balances | 39 |

Graph 3.5 | International debt securities, amounts outstanding (stocks) | 40 |

Graph 3.6 | Currency shares in the foreign exchange market | 41 |

Graph 3.7 | GDP growth rates of China, India and Russia | 42 |

Graph 3.8 | Degree of openness of China, India and Russia | 42 |

Graph 3.9 | Foreign exchange reserves of China, India and Russia | 43 |

Graph 3.10 | Current account balances of China, India and Russia | 43 |

List of boxes

Box 1 | Slovenia – The thirteenth euro-area Member State | 2 |

Box 2 | The economic consequences of a slowdown in the US economy | 4 |

Box 3 | Country-specific experiences with adjustment in EMU | 22 |

Box 4 | The euro-area fiche: assessment of reforms in euro-area Member States | 24 |

Box 5 | Energy policy and the euro area | 31 |

SUMMARY

This 2007 issue of the Annual Report on the Euro Area explores in depth the common economic challenges facing euro-area members.

Macroeconomic developments and policies (Chapter 1): In 2006 GDP grew strongly by 2.7%, up from 1.4% in the previous year. Domestic demand strengthened significantly, reflecting a much better performance of labour markets. Close to two million jobs were created and unemployment sank to a 15-year low. Despite pressure in energy prices up to August 2006, inflation remained contained at close to 2 %. Against this background, the ECB continued normalising interest rates. Services inflation remains the largest and most persistent component of core inflation. Hence, measures that address low productivity growth and limited competition in the services sector are likely to reduce overall inflation and support monetary policy. With respect to fiscal policy, there was an improvement in the euro-area's fiscal deficit (1.6% of GDP in 2006, compared to 2.5% in 2005). The benign economic conditions and the stronger-than-expected revenues have not been fully exploited to step up consolidation. Best practices from Member States show that fiscal institutions and appropriately designed fiscal rules can make a significant contribution to healthy fiscal policy and successful consolidation.

A dynamic, smoothly functioning EMU (Chapter 2): Persistent growth and inflation differences and continuing large current account imbalances in some Member States indicate that adjustment within the euro area is sluggish. Country experiences provide useful insights into the important role in the adjustment process of the competitiveness channel, notably that this channel has not always worked optimally due to sluggish wage and price responsiveness. Real interest rates, fiscal policies and financial markets also play a key role in a country's adjustment process. Experience shows that it is important to pay attention to the interaction of all these different elements to avoid unduly large swings in output and employment. The Commission's Annual Progress Report (APR) noted in its euro-area fiche that Member States have undertaken positive steps to foster growth and employment. However, Member States seem to be insufficiently aware of the euro-area dimension in planning their structural reform. This chapter discusses in more depth what role financial market integration, product market reforms and appropriate wage developments could play in smoothing the adjustment process.

The external dimension (Chapter 3): In 2006 the euro's real effective exchange rate appreciated by 3.5% in 2006, while bilateral movements vis-à-vis the US dollar and the yen were more pronounced. Global current account imbalances widened further in 2006. Given the risks this poses to the global economy, the IMF launched multilateral consultations on this issue. The euro has emerged as the second-most important international currency behind the US dollar. Given the increasing global role of the euro area, the institutional arrangements for its external representation remain inadequate although some improvements have been made recently. Furthermore, the EU's economic relationships with China, India and Russia are flourishing, making the macroeconomic dialogue and other forms of cooperation with these countries increasingly important.

20. MACROECONOMIC DEVELOPMENTS AND POLICIES

1. Economic activity in the euro area gained momentum in 2006 . The strengthening recovery triggered adjustment of macroeconomic policies. This chapter describes macroeconomic developments in 2006 and discusses some challenges that the euro area is confronted with at the macroeconomic level. Section 1.1 sets the scene, describing economic developments last year. Section 1.2 takes up issues of monetary policy. It presents monetary developments during 2006 and looks into services inflation in more detail. Turning to fiscal policy, section 1.3 starts with fiscal developments over the last year. Subsequently, consideration is given to factors that contribute to successful consolidation. The last section concludes.

1.1 MACROECONOMIC DEVELOPMENTS

2. On 1 January 2007 the euro area welcomed its thirteenth member: Slovenia . Slovenia is the first of the ten Member States that joined the EU on 1 May 2004 to enter the euro area. After it reached a high degree of nominal convergence (as assessed by the Commission and the ECB[1]) the Ecofin Council allowed Slovenia to adopt the euro as from 1 January 2007.

3. The year 2006 saw a significant acceleration in economic activity in the euro area . Following fairly weak growth in the early phase of this cyclical upswing, GDP grew by 2.7%, up from 1.4% in 2005. This was the best performance since 2000 and is clearly above the long-term average.

4. Domestic demand was the main factor driving the remarkable growth performance . After a sustained period of sluggishness, domestic demand picked up, reflecting buoyant investment spending and a turn-around in household spending (Graph 1.1). The former, which was rather subdued in the initial stages of the cycle, finally reached levels comparable to previous recoveries. This reflected favourable financing conditions, reduced spare capacity, and upbeat business confidence against the background of an improving outlook for growth.

Graph 1.1: Contribution to GDP growth, euro area

[pic]

Source: Commission services.

Box 1: SLOVENIA – THE THIRTEENTH EURO-AREA MEMBER STATE

1. Slovenia has achieved a high degree of nominal convergence with the euro area . Average inflation declined to 2.5% in 2006. The general government deficit has stayed below 3% since 2002 and the debt has stayed slightly below 30% of GDP. During its participation in ERM II since June 2004, the tolar exchange rate stayed close to the central parity. The short-term interest rate differential vis-à-vis the euro disappeared by the end of October 2006. The spread for long-term interest rates has been close to zero since spring 2006.

2. Slovenia's economy has converged rapidly to the euro area also in real terms . In 2006, Slovenian GDP per capita in Purchasing Power Standards (PPS) reached 79% of the euro area. Slovenia has maintained robust growth at around 4% since 2004, which accelerated to 5.2% in 2006. Labour productivity in Slovenia – now at approximately 75% of the euro-area average – is growing rapidly. Slovenia's labour market situation compares favourably with that of the euro area: Slovenia’s employment rate is above the euro-area average (66%) and its unemployment rate is lower (6.1%).

3. The euro brings considerable benefits to Slovenian economy . The euro strengthens macroeconomic stability in Slovenia, which is a pre-condition for long-term economic growth and job creation. Slovenia also benefits from low interest rates in the euro area, which support investment and consumption. The lack of transaction costs and exchange-rate risk is beneficial for households and businesses: it is now easier and cheaper to travel and do business abroad, but it also makes Slovenia a more attractive trading and investment partner. This is a significant advantage as the Slovenian economy relies heavily on imports and exports.

4. The advantages of the euro are accompanied by policy challenges . Firstly, the euro-area's common monetary policy calls for alternative adjustment mechanisms to safeguard competitiveness in the face of asymmetric economic shocks. Wage flexibility and high labour productivity growth are important in this regard. Secondly, fiscal policy plays an important role in a monetary union since sound public finances create sufficient room for the automatic stabilizers. In the longer term, sustainable public finances are crucial in view of the costs of an ageing population. Moreover, in a catching-up economy as Slovenia additional challenges might occur. It has to be ensured therefore that rapid real convergence associated with high credit growth and price-level convergence do not interfere with price stability and do not endanger Slovenia's competitiveness.

Slovenia: convergence to the euro area (Index euro area=100) | Recent macroeconomic performance, Slovenia (annual percentage change) |

[pic] | 2004 2005 2006 GDP growth 4.4 4 5.2 Inflation 3.7 2.5 2.5 Current account deficit (% of GDP) -2.6 -2 -1.9 Budget balance (% of GDP) -2.3 -1.4 -1.6 |

Source: Commission services. | Source: Commission services. |

5. Slovenia is a small open economy . Slovenia contributes 0.4% to euro area GDP and 0.6% to its population. This Annual Report aims to include Slovenia in the euro area aggregates – also for the years before 2007 – wherever possible.

5. Private consumption gathered pace last year, benefiting from solid labour market performance . The initially weaker development of private consumption compared to previous recoveries mirrored employment growth, which remained sluggish for several quarters after the turn-around in economic activity in mid-2003. In addition, wage growth remained subdued for a prolonged period in some euro-area Member States, particularly in Germany. This was welcome as a means to restore competitiveness. However, it also acted as a break on the growth of household income and, thereby, on private consumption. In 2006, however, employment growth picked up significantly and contributed to a much more robust expansion of private consumption both by increasing the number of people in employment and by strengthening consumer confidence.

6. Two million new jobs were created in the euro area in 2006. After moderate employment growth since 2002 the situation in the labour market improved considerably in 2006. Employment growth accelerated to around 1.5% in 2006 in the euro area, yielding an increase of close to 2 million new jobs. Since the introduction of the euro more than 10 million jobs have been created in the euro area, more than in the USA over the same period. In 2006 the unemployment rate dropped and reached 7.3% in March 2007 (Graph 1.2), the lowest level in 15 years. While the fall in the unemployment rate is largely attributable to the strong cyclical upswing, available estimates also point to a clear fall in the structural rate of unemployment.[2] It is currently estimated at around 7.8%, suggesting that earlier labour market reforms are starting to bear fruit.

7. Exports contributed positively to GDP growth last year . Notably, in the fourth quarter exports grew very strongly across euro-area countries. As a result, net exports were the main contributor to euro-area growth in the last quarter of 2006. The impact of the appreciation of the euro during 2006 on euro-area export growth was thus fairly contained. This happened in spite of a slowdown in the economic activity of some key trading partners over the last year, particularly the USA, and seems to be due to a large extent to the broadening of world growth and the concomitant shift in the geographical composition of euro-area exports. In particular, the euro area's trade exposure to the USA has declined in recent years and as a result the direct effect from the US slowdown remained limited (see Box 2).

Graph 1.2: The euro-area labour market

[pic]

Source: Commission services.

8. Summing up, in 2006 the euro area witnessed a clear pick-up in economic activity. While this reflects the strengthening of the cycle, some indicators suggest that structural improvements may also be under way. This is, for instance, the case for developments in labour productivity (see Chapter 2) and estimates of the structural rate of unemployment.

9. Economic prospects for the euro area appear to be promising . The strong and broad recovery in 2006 bodes well for 2007. Downside risks to the outlook seem to have diminished over the last year and the external environment is more supportive than expected. However, domestic demand, i.e. private consumption and investment, show most momentum and are expected to be the main driver of the ongoing recovery in 2007.[3]

Box 2: THE ECONOMIC CONSEQUENCES OF A SLOWDOWN IN THE US ECONOMY

1. The US economy is going through a temporary dip . Signs of a slowdown in the US economy have become evident in the course of 2006. The slowdown has its origin in the housing sector. The outlook for the US economy depends crucially on the speed at which the housing sector will cool down and on how strong the spill-over effects to the rest of the economy will be. So far, the slowdown has not affected other parts of the economy. Consumer spending is held up by wage and employment growth and supported by the recent fall in energy prices. Therefore, the risk of a "hard landing" in the USA appears low at the moment.

2. The US impact on the euro area goes beyond the direct trade effect . Euro-area exports to the USA will be directly affected by a US slowdown. But because of the size of the US economy and the global role of the US dollar, there will also be an indirect trade effect. The economies of third countries will be affected by the US slowdown and euro-area exports to these countries might suffer as a result. Finally, the magnitude of the trade channel effects depends strongly on the responses of exchange rates to lower demand from the USA. In case of a depreciation of the dollar, the negative effect of a US slowdown on the euro-area economy via trade effects would be higher. However, the importance of the US market for the euro-area economy has decreased over time, reflecting the growing importance of the recently-acceded Member States, oil-producing countries and Asia (see table).

Table: Geographical distribution of euro-area exports of goods (%) 2000 2002 2004 2006 Industrialised non-EA 55.6 54.2 51.1 47.8 DK, SE, UK 25.1 24.6 23.8 21.7 USA 17.2 16.9 14.9 14.4 Other (1) 13.3 12.7 12.4 11.6 EU-11 (2) 14.5 15.3 16.7 18.5 Candidate countries (3) 3.1 2.7 3.4 3.5 CIS (4) 2.4 3.4 4.2 5.1 Dev. Countries 24.3 24.4 24.6 25.1 MENA (5) 7.4 7.9 7.9 7.6 Sub-Saharan Africa 2.7 2.7 2.6 2.8 Latin America 5.0 4.3 3.8 4.2 Asia 9.2 9.5 10.2 10.5 (1) Japan, Canada, Norway, Switzerland, Iceland, Australia, New Zealand. (2) 2004 and 2007 accession countries excluding Slovenia. (3) Croatia, Turkey, Former Yugoslavian Republic of Macedonia. (4) Commonwealth of Independent States. (5) Middle East and North Africa. Source: IMF. | 3. A US slowdown would also have spill-over effects through corporate and financial linkages. The US activities of euro-area companies are considerable. A lower profitability of US affiliates would have an adverse effect on the balance sheets of the euro-area parent companies. This is likely to have an additional dampening effect on investment in the euro area. A reassessment of global risks, a shift in preferences of international investors and other financial linkages could also have an impact through financial asset prices. A stronger-than-expected slowdown would likely lower the value of US assets, including those held by euro-area companies and households. This would dampen investment and consumption in the euro area. 4. However, lower import prices and interest rates may mitigate the impact of the US slowdown on the euro-area economy. First, lower world demand growth will reduce global price pressures, thereby reducing import prices. This will impact real incomes, profit margins and the monetary policy. Second, a decline in the growth of domestic demand in the USA will lead to higher global savings, thereby exerting downward pressure on interest rates, supporting domestic demand in the euro area. |

5. There are a number of reasons why a US slowdown would have a more limited effect on euro-area growth now than in 2001-2003 . First, the slowdown in the USA has this time not been sparked by a common adverse shock as was the case in 2000-2001 (the dot-com bubble burst). Second, the relative importance of the USA for euro-area exporters has declined. Third, the slowdown in the USA is mainly affecting the construction and housing sector, while the import demand of investment goods should hold up comparatively well. Fourth, euro-area growth is expected to be increasingly based on domestic demand in the coming years. Favourable financing conditions, good employment growth and higher profitability all point to continued solid growth of domestic demand. Finally, structural reform efforts in past years may have contributed to stronger potential growth and thereby also to the resilience of the euro-area economy to external shocks.

1.2. MONETARY POLICY AND DEVELOPMENTS

10. Despite a surge in energy prices, inflation remained contained . Increasing energy prices kept headline HICP inflation above 2% until August 2006. Since then, the substantial drop in oil and energy prices in the subsequent months helped to bring inflation down below 2%. For the year as a whole, headline HICP inflation averaged 2.2%, unchanged from the previous year. In contrast, core inflation (HICP excluding energy and unprocessed food prices) remained fairly steady throughout the year at about 1.5%, suggesting the absence of significant second-round effects from the energy price hikes (Graph 1.3). This is all the more significant as it took place in a situation of cyclical acceleration and strong labour demand.

Graph 1.3: Headline and core inflation, euro area

(Harmonized Index of Consumer Prices)

[pic]

Source: Commission services.

11. The gap between core and headline inflation narrowed in 2006 . Between late 2001 and end-2004 headline and core inflation stayed at a comparable level. From late 2004 onwards, the difference widened on the back of the fall in core inflation components, in particular non-energy industrial goods inflation and processed food inflation. In mid-2005 headline inflation rose sharply, pushed by the oil price hikes, and brought the gap between headline and core inflation to around 1 percentage point. Only in the course of 2006 did the gap narrow reflecting a sharp fall in headline inflation but also a slight rise in core inflation. Services inflation continues to make the highest and most persistent contribution to core inflation (for more discussion on services inflation see below).

12. The ECB continued raising interest rates in 2006 . Since December 2005, the ECB’s Governing Council has increased interest rates seven times, by a total of 175 basis points, to presently 3.75%. The last rate hike was decided in March 2007 (Graph 1.4). These decisions were motivated by upside risks to price stability, identified in both the economic and monetary analyses.

Graph 1.4: ECB minimum bid rate and 3-month market rate

[pic]

Source: Commission services.

13. Monetary conditions in the euro area tightened somewhat last year . This was driven by the above-mentioned policy rate increases and the appreciation of the real effective exchange rate of the euro by around 3.4% in 2006. The appreciation was even more accentuated in nominal terms against major currencies (Graph 1.5). Exchange rate developments are discussed in more detail in Chapter 3.

Graph 1.5: Euro exchange rates

[pic]

Source: Commission services.

Graph 1.6: Real interest rates in the euro area

[pic]

Source: EcoWin, Commission services.

14. Despite recent interest rate hikes, both real and nominal interest rates are still at low levels (Graph 1.6). The short-term interest rate is slowly approaching a level that might be considered to be neutral. Although the calculation of the neutral interest rate is associated with a high degree of uncertainty, most academic studies find a level between 2% and 3% for a real short-term neutral interest rate in the euro area. Recent analyses even suggest that the natural (real) rate in the euro area might have declined to slightly below 2%.[4]

Graph 1.7: Retail interest rates in the euro area

[pic]

Source: Commission services.

15. Other factors also point towards continuing favourable monetary and financing conditions . Although long-term interest rates climbed up throughout 2006, they are still at relatively low levels. Hence financing conditions remain favourable. Retail long-term interest rates both for households and companies increased only slightly in 2006 (Graph 1.7). Moreover, money and credit growth remain strong, and liquidity in the euro area is still ample by all plausible measures (Graph 1.8).

Graph 1.8: Monetary developments in the euro area

[pic]

Source: Commission services.

More competition in services will lead to lower inflation.

16. Services inflation has a high impact on overall consumer inflation . The overall Harmonised Index of Consumer Prices (HICP) can be decomposed into its components to show price dynamics in different sectors of the euro-area economy. Energy inflation is by far the most variable component followed by unprocessed food. This explains why these two components are excluded in measures of core inflation. The other three components show more stability (Graph 1.9). Of these core components, services inflation has consistently made the highest contribution to overall inflation since 1999. Inflation in the services sector is in general higher than that in other sectors and is also higher than headline inflation. To some extent this can be explained by temporary factors such as reforms in health-care services or the rise in transportation costs due to oil price rises. However, the permanent character of higher inflation in services shows that structural factors are at work as well.

Graph 1.9: Contributions to euro-area HICP inflation

(Annual percentage changes)

[pic]

Source: Commission services

17. Services inflation is also persistent and contributes to inflation dispersion in the euro area . Services inflation is not only the highest but also the most persistent component of the HICP. Microeconomic research confirms that prices of services are stickier and adjust more slowly than prices of goods.[5] At the country level, it has also been found that the services-industry inflation differential is correlated with the overall HICP inflation differential vis-à-vis the euro-area average.[6] This means that countries with relatively high services inflation also tend to have overall inflation above the euro-area average, and vice-versa. This suggests that services inflation is an important contributor to inflation differentials among euro-area countries.

18. Slow productivity growth in services is the main cause of the high services inflation. For instance, productivity growth in industry averaged 2.3% and only 0.2% in services between 1999 and 2005. This can in part be explained by the need for a face-to-face relationship between providers and consumers of many services, and less scope for technological change than in other sectors. Wages, meanwhile, have tended to equalise among sectors. Different productivity growth and similar wage growth have led to higher unit labour costs in services and higher inflation in comparison to other sectors (see Chapter 2). The slow productivity growth in euro-area services stands out especially in comparison with the United States. It is widely recognised that the United States' productivity boom in the 1990s had its roots in the surge in productivity growth in the services sector, mainly in retail and in wholesale trade (see also section 2.1). The US experience also shows that the intrinsic slow productivity growth in services can be overcome.

19. The limited competition in a number of service industries exacerbates the situation . Besides the above-mentioned factors, the lack of competition is another explanation for weak productivity gains and price rigidity in a number of service industries. Many service sub-sectors are much less exposed to international (or even inter-regional) trade and foreign competition than goods. Many service sub-sectors are also still subject to overly constraining regulations. Restrictions on competition tend to reduce pressures to innovate and to put in place more effective production processes (see Chapter 2).

20. Completion of the single market in services is important. The services sector is the largest sector in the euro-area economy. It represents around 70% of GDP and employment. More than 40% of consumers' expenditure is spent on services. Moreover, services also provide an important input for other sectors of the economy. Yet, despite their overwhelming importance in the euro-area economy, the completion of the single market in services has lagged behind. For instance, much progress can still be made in the area of public procurement. The problem of insufficient competition in services has been recognised by Member States, with the Lisbon Strategy calling for more competition in services markets and a fully operational internal market for services. This is also the aim of the new Services Directive (see Chapter 2).

21. Competition-enhancing measures would help to reduce services inflation and overall inflation . By removing unnecessary regulatory restrictions at both state and regional levels, services markets would function better. National competition authorities need sufficient powers and resources, to monitor and prevent collusion, abuse of dominance and anticompetitive mergers on services markets and, perhaps, to review the impact of services legislation on competition. Consumer protection laws and powers also have a role to play. Since wage rigidities are an important determinant of price stickiness in services, higher labour market flexibility and more wage differentiation between sectors would help keep wage developments aligned with productivity growth. The example of the USA suggests that more could be done to boost productivity in services. The spread of new technologies, in particular ICT, in services could improve productivity and thereby lower inflation in the sector. As explained in Chapter 2, a better functioning services market would not only contribute to low inflation, but would also raise the euro area's capacity to adjust to shocks.

1.3. FISCAL POLICY AND DEVELOPMENTS

22. Revenue surprises contributed to a fall in the fiscal deficit for the euro area as a whole . In 2006 the nominal budget balance in the euro area improved. The deficit stood at 1.6% of GDP, down from 2.5% in 2005. This mainly reflected buoyant economic growth that led to better-than-expected budgetary revenue. The revenue-to-GDP ratio increased to 45.8% – higher than expected in early 2006. The level of budgetary expenditure was essentially stable but the expenditure-to-GDP ratio fell to 47.4% because of higher GDP growth.

23. The current buoyancy of tax revenues has gone hand in hand with a sharp rise of tax elasticities . Tax elasticities were well below their average in the past economic slowdown. Their current rise reflects a number of factors such as a steep recovery of corporate profits, rising oil prices, a recovery of tax-rich domestic consumption expenditure, a positive performance of equity markets and, in some countries, -rising house prices.

24. The fiscal stance was broadly neutral in 2006 . The fiscal policy stance can be approximated by changes in the cyclically-adjusted primary balance (CAPB) that shows the budgetary correction net of cyclical factors and interest payments. 2006 saw a broadly neutral stance after a moderate tightening in 2005. In 2006 the CAPB increased slightly, by 0.3%, which falls short of the 0.5% benchmark improvement envisaged for "good times" by the revised Stability and Growth Pact. The consolidation effort was also much lower than in 2005 in spite of the much better economic situation (Graph 1.10).[7]

25. In some countries there is a risk of a pro-cyclical policy . The slower pace of fiscal adjustment in the euro area stems mainly from the deterioration of structural balances in countries that have already achieved their medium-term objectives (MTO). Given the good economic performance, a looser fiscal stance might result in pro-cyclical fiscal policies in those countries and contribute to overheating of the economy. Moreover, the structural adjustment in 2007 is expected to remain below 0.5%, suggesting that Member States do not take full advantage of the current good economic conditions.

Graph 1.10: Fiscal policy stance in the euro area

[pic]

Note: Commission forecasts for 2007 and 2008 data.

Source: Commission services.

26. There are worrying similarities between the current situation and the past recovery . The current configuration of rapid economic growth and positive surprises in tax revenue closely resembles the situation that prevailed at the turn of the decade. Major policy mistakes were made then. In 1999-2001, several Member States did not make use of the good economic conditions to achieve healthy public finances. These countries subsequently found themselves in an uncomfortable position when the cycle entered a less favourable phase. The absence of budgetary margins to let automatic stabilisers operate resulted in either a breach of the reference value, or pro-cyclical fiscal policy, or both. The inappropriate fiscal stance of those years has been widely recognised as being at the roots of the difficulties with the implementation of the original Stability and Growth Pact.

27. The policy mistakes of 1999-2001 should be avoided . It is essential that the spirit of the 2005 SGP reform be upheld in the current benign economic environment. The revised Pact contains clear provisions on the need to strengthen consolidation efforts when growth conditions are favourable, with particular reference to tax revenue. In such periods, Member States which have not yet reached sound fiscal positions are expected to strive for significant improvements in their structural balance.

28. Currently, four euro-area Member States have excessive deficits: Germany, Greece, Italy and Portugal. On 30 January 2007, the Council decided that the excessive deficit procedure against France should be closed as its budget deficit remained below 3% also in 2006. In Germany, the economic recovery has helped to bring the budget deficit below 3% of GDP one year ahead of schedule. In Greece, there has been a strong correction in 2006 which has led the budget deficit to remain at 2.6% of GDP. Portugal and Italy have also recorded a significant structural improvement in 2006, masked in the case of the latter by the effect of one-off measures.

Graph 1.11: Current structural balance and medium-term objective (MTO)

[pic]

Note : Ireland has an MTO of "close to balance", the Netherlands has an MTO "between -0.5% and -1% of GDP" and Portugal has an MTO of "at least -0.5% of GDP"

Source: Commission services.

29. Most Member States have set their MTOs at levels consistent with the principles of the reformed Stability and Growth Pact. Some countries have set more ambitious targets, exceeding the minimum levels required, mainly for consistency with their national strategy to face sustainability challenges (Graph 1.11). In most Member States the current structural balances still differ significantly from the MTO. Three broad groups of Member States can be identified (Graph 1.12):

(i) Member States which had already achieved their MTOs recorded deteriorations in their structural balances in 2006.

(ii) Member States with a deficit of below 3% of GDP which had not yet reached their MTOs posted a fiscal adjustment of less than the 0.5% of GDP benchmark in 2006. The adjustment effort is planned to be stepped up in 2007 and 2008.

(iii) Member States with deficits of above 3% of GDP have, on average, planned significant consolidation efforts over the years 2006-2008.

Graph 1.12: Change in the structural balance of euro-area Member States

[pic]

Source: Commission services.

30. On 20 April 2007, the Eurogroup adopted orientations for fiscal policies in euro area Member States, recalling the commitment to actively consolidate public finances in good times and to use unexpected extra revenues for deficit and debt reduction. With a view to improving the coordination of fiscal policies in the euro area, euro area Finance Ministers discussed national budgetary developments in 2007 and the preliminary policy outlook for 2008 and their implications for the euro area. Firstly, they committed to build on the better-than-expected budgetary outcomes in 2006 and to pursue more ambitious budgetary targets than those set in the 2006 Stability Programmes. Secondly, they agreed to implement budgets for 2007 as planned, avoiding expenditure overruns, and using unexpected extra revenues to reduce government deficit and debt. Thirdly, it was agreed that fiscal policy plans for 2008 should be carefully designed so as to accelerate adjustment towards the medium-term budgetary objectives for Member States which have not reached it and for those which have reached it to avoid fuelling macroeconomic imbalances.

Achieving successful fiscal consolidation

31. Sound fiscal policy remains a necessary pre-condition for sustained growth, investment and employment creation. Low budget deficits and government debt foster low and stable inflationary expectations and help maintain low interest rates. Unsustainable public finances in one Member State could lead to higher interest rates and financial instability in the rest of the euro area. Hence, sound fiscal policy supports a stability-oriented monetary policy and is a prerequisite for the success of the monetary union. Against this backdrop, fiscal consolidation is essential for countries with a high deficit and a high debt level. Fiscal consolidation then also creates room for manoeuvre for the working of automatic stabilisers.

32. Consolidation helps to face the budgetary challenge of ageing . Country-specific strategies are needed to face the upcoming massive impact of ageing on public finances. Age-related public expenditure in the euro area, which includes spending on pensions, healthcare and long-term care, is projected to increase on average by around 4% of GDP by 2050 under a no-policy change scenario. This, however, masks a variety of situations across euro area Member States, with some at risk of double digit increases over the next decades. Ideally, the country-specific strategies contain measures to reduce budget deficits and debt, as well as structural reforms to face the prospective increase of expenditure items related to ageing populations (pensions, healthcare and long-term care). It is crucial that Member States that have not attained their MTOs make rapid progress towards reaching them. In this context the present favourable cyclical conditions provide a window of opportunity of speeding up fiscal consolidation.

33. The success of fiscal consolidation depends on a number of factors. Effective fiscal consolidation can be defined as a relatively sharp improvement in a country's primary budget balance net of cyclical factors that is implemented over a given number of years. A consolidation episode is deemed to have been successful if the fiscal correction is sustained in time. Empirical evidence suggests that a number of specific factors increase the likelihood of success. The first group of factors relates to the composition of the adjustment, the economic environment and political factors. The second group relates to institutional factors such as fiscal rules.

Composition, economic conditions and other factors

34. Expenditure-based consolidations tend to be more successful . One of the most important factors affecting the success rate of fiscal consolidation is its composition. The potential for a durable budgetary adjustment is typically larger when driven by restraint in expenditure than when relying on higher revenue. There is also an additional benefit in terms of economic effects. Compared to revenue-based corrections, expenditure-based consolidations tend to have a less restrictive or even an expansionary impact on the economy. Cases in point are Spain in 1996-1997, the Netherlands, and Ireland in the early and mid-1990s and Finland in the mid- and late 1990s. This can be explained by a number of factors, of which three are mentioned here:

- Spending curbs are more likely than revenue increases to trigger lower interest rates (as revenue increases may have adverse effects on costs and prices); this in turn may lead to higher consumption and investment and finally have a positive impact on real GDP growth.

- Expenditure cuts can create room for tax cuts, which in turn have beneficial effects on wage-bargaining, investment, consumption and growth.

- Governments which tackle high expenditure demonstrate a commitment that paves the way for further substantial consolidation.

As regards the type of expenditure, adjustments that primarily rely on cuts in transfers and the government wage bill have a better chance of being successful than cuts in public investment, which are very often reversed and do not usually have any positive impact on output growth.

35. In practice, consolidation episodes are composed of both revenue and expenditure measures . When budgetary consolidation is brought about via one-off measures the chances of success are usually slim. In practice, many successful consolidation episodes involved a combination of revenue and expenditure measures. These often take the form of so-called switching strategies: the government begins the fiscal consolidation process by increasing taxes and/or cutting investment, and subsequently tackles the more politically sensitive current expenditures.

36. Economic factors influence the success of consolidations . Firstly, initial conditions play a significant role. Large initial deficits tend to prompt fiscal consolidation and are also positively correlated with the size, intensity, and length of the consolidation episode. The size of the fiscal correction is also enhanced by higher, rather than lower, interest rates. The role of economic growth is somewhat more complex. Consolidation episodes in weaker economic conditions often take longer and make only a relatively small annual correction. However, the overall improvement in the budget balance tends to be higher. In a similar vein, cautious forecasts of GDP growth (and implicitly of tax revenue) promote consolidation by reducing the probability of negative growth surprises and revenue shortfalls.

37. Structural reforms and political factors also play a significant role . Fiscal consolidation is generally more durable and hence more successful when it is accompanied by structural reforms that improve the public finances in the long run. Consolidation is boosted in situations in which both the population as a whole and all interest groups involved fully realise the need for reforms. Thus successful consolidations and any underlying reforms are commonly supported by strong political leadership by the Prime Minister and/or Finance Minister. They are also assisted by clear communication to the public via politicians, think tanks, and the media. Painful changes are often publicly justified by reference to the objective of preserving the welfare state. A case in point was Sweden in the early and mid-1990s.

Fiscal governance and fiscal rules

38. Fiscal policies in industrialised countries have not always been optimal . The economic literature provides abundant analysis of how taxes, government expenditure and government balance should be set over the business cycle for fiscal policy to be considered optimal and sustainable. However, experience shows that policy-makers have not always acted in line with these prescriptions. This has resulted in large and persistent deficits and growing public debts. Fiscal policy has also often turned out to be pro-cyclical, particularly in good economic times, in spite of the broad agreement that a neutral or counter-cyclical stance would be preferable.

39. Institutional settings contribute significantly to sound fiscal policies . There has been growing consensus in recent years among economists and policy-makers that the sources of the “deficit bias” and the “pro-cyclical bias” in the conduct of fiscal policy are rooted in the “political economy”. They include factors such as the system of incentives and rewards that shape the behaviour of fiscal authorities.

40. The Council has recently emphasized the importance of strengthening fiscal governance in the Member States . Both the Treaty and the Stability and Growth Pact stress the importance of national rules and institutions for budgetary discipline. In its report of 20 March 2005 on the reform of the Stability and Growth Pact, the Council stated that "national budgetary rules should be complementary to the Member States’ commitments under the Stability and Growth Pact". The Council further underlined that domestic governance arrangements should complement the EU framework, and that national institutions could play a more prominent role in budgetary surveillance.

41. Various institutional elements can reduce spending and deficit biases . First, procedural rules laid down in law or in the constitution govern the implementation of the annual budget law and fix the respective powers of the various actors. Second, numerical fiscal rules, which fix targets and ceilings for fiscal aggregates or set benchmarks for the conduct of fiscal policy, can limit the discretion of fiscal authorities that are prone to deficit bias. Third, independent fiscal institutions (e.g. fiscal councils) can play a valuable role by providing inputs or recommendations on fiscal policy issues.

42. Numerical fiscal rules can play a useful role . Such rules can be defined in many different ways. For instance, they can introduce limits on the deficit or debt of different government entities ( budget balance and debt rules ). The limits can be set on a yearly basis or on average over a given period. Alternatively, they can set benchmarks for the evolution of some categories of government expenditure ( expenditure rules ) or predefine the allocation of certain categories of tax revenue ( revenue rules ). Numerical fiscal rules can be more or less strong. Fiscal rules enshrined in the constitution or in other forms of law and subject to strict monitoring and enforcement mechanisms, can impose binding limits on the conduct of fiscal policy. While still allowing some room for discretion in policy-making, they can directly contribute to fiscal discipline. Numerical fiscal rules based on political commitments or informal agreements between different tiers of general government can also have a positive impact on the conduct of fiscal policy. Such rules provide benchmarks against which fiscal policy can be assessed by the public, and can effectively contribute to policy coordination between different levels of government.

Graph 1.13: Number of numerical fiscal rules in force in the euro-area Member States

[pic]

Source: Commission services.

43. Euro-area Member States increasingly rely on numerical fiscal rules . According to a survey conducted by the European Commission in 2005, the number of fiscal rules in force in the euro-area Member States has increased continuously over the last fifteen years (Graph 1.13). There has been an interesting evolution in the government sub-sectors covered by numerical fiscal rules. While the existence of numerical fiscal rules at local and regional level was already frequent in the early nineties, an increasing number of numerical fiscal rules has since been introduced at central government level. A relatively recent feature is the introduction of numerical fiscal rules in the social security sector and rules covering the whole of the general government sector. Such developments may be a response to the introduction of the EU fiscal rules, which impose requirements for the general government deficit and debt, and to the increasing spending pressures in the social security sector.

Graph 1.14: Statutory base of fiscal rules at different levels of general government

[pic]

Source: Commission services.

44. The characteristics of the rules vary with the level of government . According to the same survey by the European Commission, rules applied to regional and local governments generally rely on annual schemes. In contrast, rules concerning the general government and central government sectors have a longer time horizon. These rules generally play a key role in those Member States where the annual budget process is embedded in a comprehensive medium-term budgetary framework. The statutory basis of numerical fiscal rules also seems to depend on the level of government. The large majority of numerical fiscal rules applied to local and regional levels of governments are enshrined in law or the constitution. Rules concerning central government and the whole of the general government sector are, on the other hand, generally based on forms of political agreement – e.g. internal stability pacts or other forms of political agreement or commitment (Graph 1.14)

45. Rules applied at local levels of government generally have stronger monitoring and enforcement procedures . A crucial characteristic of fiscal rules is the nature of the monitoring and enforcement mechanisms. Automatic correction or sanction procedures in the event or risk of non-compliance tend to favour respect of rules. Regular monitoring of compliance by an independent authority is also important. Such monitoring and enforcement procedures are, on average, applied more often at local and regional government levels than at higher levels of government (Graph 1.15). However, the apparent weaker status of the latter may be compensated by more public attention and media interest. High media visibility of a fiscal rule can be expected to contribute to its enforcement, through higher reputation costs in the event of non-compliance.

Graph 1.15: Enforcement mechanisms of numerical fiscal rules in force in 2005

[pic]

Source: Commission services.

46. Empirical evidence suggests that a larger reliance on numerical rules can help to reduce deficits . The European Commission's report 'Public Finances in EMU – 2006' shows that there is a relation between the size of government deficits and the reliance on numerical fiscal rules. Over the last fifteen years, the cyclically-adjusted primary balance has on average improved in the years following the introduction of numerical fiscal rules. Another key result is that an increase in the share of government finances covered by numerical fiscal rules seems to lead, ceteris paribus , to lower deficits or higher surpluses (Graph 1.16). The analysis in the above-mentioned report also confirms the effectiveness of expenditure rules in addressing a possible spending bias. In particular, the decline in the ratio of primary government expenditure adjusted for the cycle was significantly larger after the introduction or strengthening of expenditure rules. In addition, the introduction of an expenditure rule helped to secure a primary balance large enough to stabilise the debt-to-GDP ratio. As for revenue rules, rules on how to use extra revenues stemming from windfall gains under cyclically favourable conditions (which could involve the setting-up of stabilisation funds) can be instrumental in achieving fiscal consolidation.

Graph 1.16: Relation between numerical fiscal rules and budgetary outcomes

[pic]

Source: Commission services.

47. The impact of numerical fiscal rules on budgetary outcomes depends on their design . On average, rules enshrined in law or the constitution, and provided with well-defined enforcement mechanisms that can be activated by independent authorities seem to have a greater influence on budgetary outcomes. However, other, less formal, rules can also positively influence budgetary outcomes. There are several examples of rules which are not enshrined in law or in the constitution, but are based on strong political commitments (e.g. coalition agreements), that have had a clear influence on budgetary developments and played a key role in fiscal consolidation strategies.

Graph 1.17: Cyclical behaviour of primary government expenditure

[pic]

Note: OG – output gap.

Source: Commission services.

48. The nature and design of numerical fiscal rules is also important for the cyclical behaviour of fiscal policy . Some economists have argued that overly strict numerical rules may hamper the stabilisation function of fiscal policy. Therefore, it is crucial how rules are defined. Rules that exclude cyclically-sensitive items or that are applied "over the cycle" may actually reduce the risk of pro-cyclicality in fiscal policy. Moreover, multi-year expenditure rules or frameworks can effectively curb the tendency for expenditure to grow faster during economic good times. In the same way, "rainy-day funds" or numerical fiscal rules that pre-define the allocation of possible revenue windfalls are valuable. They can help governments to credibly commit not to spend or give away via tax cuts better-than-expected tax revenue during good times. Such rules therefore can be instrumental in avoiding pro-cyclical policies as can be seen from the empirical evidence. Countries in which numerical fiscal rules are properly designed in order not to hamper the stabilisation function of fiscal policy tend to have a more counter-cyclical fiscal stance. Empirical analysis also confirms the positive properties of expenditure rules. Pro-cyclical behaviour of expenditure in good times is less frequent in countries with strong expenditure rules (Graph 1.17).

49. Overall, national fiscal rules can play an important role in supporting fiscal consolidation while helping avoid pro-cyclical policies . The desirable characteristics of fiscal rules depend on domestic circumstances. There is no "one-size-fits-all" design. However, it appears that a number of features support the effectiveness of national fiscal rules. As highlighted by the Ecofin Council in its conclusions adopted on 10 October 2006, fiscal rules, to be effective, should benefit from strong national ownership as well as from a clear political commitment by all levels of government and parliament.

1.4. CONCLUSIONS

50. The euro-area economy is benefiting from a strong recovery. The upturn is now well established and broadly based among sectors. Domestic demand picked up strongly in 2006, as private consumption was boosted by the solid performance of the labour market. Risks to the outlook are mainly on the upside.

51. The robust recovery has made an adjustment of the policy mix appropriate. Accordingly, the ECB has been increasing interest rates in 2006 and in the early months of 2007. Although monetary conditions have become somewhat tighter in the light of these interest rate increases and the appreciation of the euro exchange rate, monetary and financial conditions have remained favourable. Fiscal policy has been only marginally adjusted so far, with more remaining to be done in view of the still-high debt levels and the budgetary challenges of ageing. Better-than-expected revenue led to a slight fall in the euro-area's fiscal deficit and the fiscal stance became somewhat tighter. However, several Member States failed to make full use of the improved economic situation. Some countries that have achieved their medium-term objectives run the risk of procyclical policies. Moreover, some Member States that have not yet achieved their MTO failed to achieve the required structural adjustment of 0.5% of GDP. On the positive side, it is noteworthy that the largest part of fiscal adjustment in the euro area comes from Member States with excessive deficits.

52. Measures to reduce services inflation would enhance the scope for an accommodative monetary policy. Inflation rates came down in the last months of 2006 and are expected to remain moderate over 2007 and 2008. Services inflation continues to be the largest and the most persistent component of core inflation. This is due to low overall labour productivity growth – combined with the often high labour intensity and insufficient wage differentiation between sectors – and the barriers to competition in many services sectors. Addressing these deficiencies would contribute to lower inflation.

53. Best practices from Member States show how successful fiscal consolidation is best achieved. Expenditure-based consolidations appear to be more successful than revenue-based consolidation. To succeed with consolidation, it also helps to create national ownership for the process and to show strong political leadership. Institutional settings can significantly contribute to sound fiscal policies. Many euro-area Member States are successfully making use of numerical rules in their fiscal policies. When designing these rules, it is important to keep in mind: (i) how these rules can best contribute to favourable budgetary outcomes, (ii) which level of government they apply to, and (iii) how pro-cyclical outcomes can be avoided.

2. A DYNAMIC, SMOOTHLY FUNCTIONING EMU

54. While a smooth adjustment to economic disturbances is of central importance to EMU, more progress is needed. The benign economic environment provides a good opportunity to make further progress. Section 2.1 examines divergences in growth, inflation and current accounts. First lessons from adjustment in the euro area are presented in section 2.2. Section 2.3 highlights recent positive developments in structural reform under the Lisbon Strategy for growth and jobs and in productivity growth. Finally, sections 2.4, 2.5 and 2.6 look at the role of financial markets, product markets and labour markets respectively, within the adjustment process. Section 2.7 concludes.

2.1 ECONOMIC ADJUSTMENT IN THE EURO AREA REMAINS SLUGGISH

55. Growth differences exhibit some persistence in the euro area. Growth differences between euro-area Member States already existed before 1999 and have tended to persist, though not to any markedly different extent. Since 1999, annual growth in Germany, Italy, the Netherlands and Portugal has nearly always been below the euro-area growth average, while Greece, Spain, Ireland, Luxembourg and Finland consistently recorded above-average growth rates (Graph 2.1). The remaining euro-area countries grew by close to the average. These growth differences have persisted during the whole period, but narrowed somewhat in 2006 due to the strengthening of the German economy and improvements in the Italian economy. Overall, what is noticeable is that these growth differences persist, even though the euro-area countries have become much more integrated and business cycles have become more closely aligned.

Graph 2.1: Annual GDP growth in the euro area

(in %)

[pic]

Fast-growing economies (unweighted): GR, ES, IE, LU and FI

Slow-growing economies (unweighted): DE, IT, NL, PT

Source: Commission services.

56. Inflation differentials in the euro area are low but also tend to be persistent. From a historical perspective, inflation dispersion clearly dropped in the run-up to EMU, from around 5-6 percentage points at the beginning of the nineties to less than 2 percentage points in 1999. In EMU's first two years dispersion increased somewhat, but it returned to low levels afterwards (see graph 2.2). However, inflation differences among euro-area Member States have tended to persist. Six Member States, namely Greece, Spain, Ireland, Italy, Portugal and Slovenia, were found to be persistently above the average, while the other three –Germany, France and Austria– were persistently below. Only four Member States, i.e. Belgium, Luxembourg, Finland and the Netherlands, recorded periods of both positive and negative differentials vis-à-vis the euro-area average over the period 1999-2006.

57. Persistent differences in growth and inflation originate in a number of factors. Differences in growth and inflation should not be a source for concern per se if they reflect different positions in the cycle or if the main reason for such a divergence was a one-off event. However, there were other factors behind the persistence phenomenon in this case, the three main ones being as follows. First, initial conditions matter. The strong decline in interest rates in the run-up to EMU in some countries inflated consumption and investment such as in real estate. These developments were fuelled to a certain extent by financial exuberance and the credit cycle. Second, prices and wages were too slow to adjust to national cyclical conditions, with wage flexibility, which is conducive to the reallocation of factors of production, remaining particularly insufficient. Third, some budgetary policies were pro-cyclical and failed to achieve the necessary fiscal consolidation (see Chapter 1). As a result of these three elements, national business cycles were amplified.

Graph 2.2: Inflation dispersion for euro-area Member States HICPs

(year-on-year growth in %)

[pic]

Range: distance between highest and lowest inflation performance

Source: Commission services.

58. Persistent current account differences suggest that competitiveness adjustments are slow. The dispersion of current account balances within the euro area has widened significantly since the late nineties. This is a result of the sharp deterioration of current account deficits in Greece, Portugal, and Spain and – to a lesser degree – of the markedly rising surpluses in Finland, Germany, Austria and the Netherlands (which have seen improvements in their current account position of respectively 5.5, 4 and 3.4 percentage points, see Graph 2.3). At the same time, the external balance of countries already in deficit at the start of EMU did not rebound. Portugal saw no improvement in the period 1999-2006 and still records a deficit of close to 9% of GDP, and the current account position of Spain and Greece deteriorated between 1999 and 2006 by 6 and 2.8 percentage points respectively.

Graph 2.3: Current account balances for selected euro-area Member States

(in % of GDP)

[pic]

CAB = Current account balance

Source: Commission services.

The widening dispersion of current account positions within the euro area is due to a combination of causes. Differences in cyclical positions had some impact, albeit rather modest. Deeper financial integration, mostly related to the European integration and the euro, played a stronger role. It allowed a cut in the risk premium and a loosening of credit constraints. This enlarged the borrowing capacity of the private sector in Greece, Portugal and Spain. As these three countries have lower per capita income than the euro-area average, financial deepening has made it possible to meet their potentially higher financing needs through additional foreign capital flows. A third explanation for the dispersion of current accounts stresses competitiveness changes. Although changes in competitiveness and therefore in the current account balance are needed to adjust to a shock, the extent and duration of these changes reveal some structural inefficiencies. In particular in Spain and Portugal, losses in competitiveness have been compounded by the sluggish response of wages in the face of a sharp productivity slowdown. Overall, whereas current account differences can still be reabsorbed without significant consequences in the longer term, the rebalancing process will need to be followed carefully in the coming years from both an analytical and a policy perspective.

59. Slow adjustment is compounded by low productivity growth. Slower productivity growth lowers the economy's potential growth and means that the correction of an accumulated competitiveness gap takes longer. Restoring competitiveness means a downward adjustment of unit labour costs, which are determined by the evolution of nominal wages and productivity. A failure to achieve higher productivity growth thus means that nominal wages will have to bear the brunt of the adjustment.

Graph 2.4: Labour productivity in the euro area Member States

(Average annual growth in %)

[pic]

Source : Commission services and EU KLEMS database.

60. Historical data from the new EU KLEMS database confirm weak productivity growth . The EU KLEMS project builds a system of analysis at the industry level for the EU Member States (as well as the US and Japan) which encompasses internationally harmonised statistics, as well as a growth accounting analytical framework.[8] The comparison of average growth figures from the period 1970-1995 to the period 1995-2004 indicates that labour productivity growth decelerated for all euro-area Member States except Ireland and Greece.[9] While annual productivity growth decelerated from 2.4% to 1.3% in the euro area between the two periods, it accelerated from 1.3% to 2.4% in the United States (Graph 2.4).

Graph 2.5: Labour productivity in the euro area

7-sector breakdown

(Average annual growth in %)

[pic]

Note: ELECOM= Electrical machinery, post and communication; MexElec= Manufacturing excluding electrical; OtherG= Other goods producing industries; DISTR= Distribution services; FINBU= Finance and business services; PERS= Personal and social services; NONMAR= Non-market services.

Source : Commission services and EU KLEMS database.

61. Wider positive spillovers from the acceleration of productivity in the high-tech sector have not been visible. Evidence suggests that information and communication technologies (ICT) play a significant role in the revival of productivity in advanced countries. But although productivity accelerated markedly in the ICT-producing sector[10] of the euro area in the 1995-2004 period, its contribution to aggregate euro-area productivity figures remained small (Graph 2.5). This is due to its low share in total output and the absence of discernable productivity spillovers to other sectors (Table 2.1). In fact, productivity decelerated in manufacturing and all services sub-sectors.

62. Trends in total factor productivity (TFP) confirm this picture. TFP can be defined as the capability to combine efficiently labour and capital in the productive process[11]. In all euro-area countries except Finland and the Netherlands, the contribution of TFP to output growth has decreased (Graph 2.6). In Italy, Spain and Luxembourg TFP-growth even turned negative. Beyond these lacklustre developments, there are grounds for hope. First, some euro-area countries, such as Finland and the Netherlands, owed their better performance to a significant acceleration of TFP in the ICT-producing sector and in distribution services. Thus in these countries some form of spillover, albeit limited to one sector, may have materialised. Second, the recent rebound in productivity growth could be more than just cyclical in nature (see Section 2.3).

Table 2.1: Contribution to labour productivity growth (in percentage points) |

Euro area | United States |

1980-1995 | 1995-2004 | 1980-1995 | 1995-2004 |

Total industries | 2.4 | 1.3 | 1.3 | 2.4 |

ELECOM | 0.2 | 0.2 | 0.3 | 0.4 |

MexElec | 0.8 | 0.4 | 0.4 | 0.4 |

OtherG | 0.5 | 0.3 | 0.0 | 0.0 |

DISTR | 0.5 | 0.3 | 0.6 | 0.9 |

FINBU | 0.0 | 0.0 | 0.0 | 0.4 |

PERS | 0.0 | 0.0 | 0.0 | 0.1 |

NONMAR | 0.2 | 0.2 | 0.1 | 0.2 |

Note: In the period 1980-1995, reallocation of labour contributes to 0.1 percentage point in the euro area and to -0.1 point in the US. Source: Commission services and EU KLEMS database. |

Graph 2.6: Total factor productivity in the euro area Member States, market economy

(Average annual growth in %)

[pic]

Note: The first period covers 1987-1995 for Belgium and 1982-1995 for France. Only the data for 1995-2004 are available for Slovenia.

Source: Commission services and EU KLEMS database.

2.2 FIRST LESSONS FROM THE EURO AREA'S ADJUSTMENT PROCESS

63. The euro area has an even greater stake in successful structural reform than the EU. Whereas the European Union as a whole needs reforms to boost its growth potential and stimulate job creation, the euro-area, being a monetary union, should pay even more attention to such reforms as they enhance internal adjustment through market flexibility. The first years of EMU provide a number of country-specific experiences that are especially useful in this regard. Since 1999, the euro area has had to face several episodes of economic turbulences (bursting of the dot-com bubble, 9/11 terrorist attacks, high volatility of oil prices). In addition, the economic impact of the run-up to EMU had differentiated effects among euro-area Member States before 1999, and these effects persisted after 1999. All these elements enable policy-makers to better understand how the adjustment process has worked in practice and to draw tentative conclusions.

64. Competitiveness is the main channel for adjustment. Theoretically, above-average demand in a given country should push costs and prices upwards. The deterioration in the relative cost situation should then worsen that country's cost and price competitiveness and slow the pace of economic activity towards the euro-area average. The experience of the Netherlands during 1997 to 2005 illustrates that this adjustment process has worked in practice (see Box 3 for country examples). At times of country-specific weakness the reverse would occur if real prices and wages are flexible downwards.

65. However, the real-interest rate channel can complicate adjustment. Real interest rates in euro-area Member States tend to fall as inflation accelerates in a boom, and to increase during a slowdown. This may amplify swings in output and inflation in the short and medium term. Such effects are inherent to some degree in all monetary unions. As shifts in competitiveness get underway, real interest rates at the national level can affect the adjustment path in a perverse (i.e. pro-cyclical) direction.

66. Evidence shows that adjustment in the euro area is working but could be slow. According to a Commission model[12], the adjustment process in the euro area is dynamically stable, because the balancing effects of the competitiveness channel are stronger than the unbalancing impact of the real interest rate channel. However, the adjustment can be quick or slow. It could even led to overshooting, when corrective action is pursued beyond what is needed (Graph 2.7).

Graph 2.7: Potential patterns of adjustment in a monetary union

[pic]

Source : Commission services.

67. In some cases sluggish price and wage responsiveness have impaired adjustment. Wage behaviour, taken together with underlying trends in productivity, has an important influence on the efficiency of adjustment process. Significant divergences exist in the extent to which wages and prices have responded to changes in national output gaps. Some countries have experienced sluggish wage adjustment, compounded by low downward real price flexibility. Thus adjustment through changes in competitiveness may be slow, resulting in a less efficient adjustment process and larger swings in output and employment (see section 2.6 for further analysis.)

68. Financial markets have played an important role in the adjustment process . Financial markets encourage risk-sharing and can help to smooth the effect of an economic shock. The decline in risk premia and the easing of credit constraints have opened up new economic opportunities, including higher scope for household borrowing. But financial markets have not always made a positive contribution to the adjustment process. Asset markets have tended to boom as real short- and long-term interest rates declined, so that wealth effects have amplified the real interest rate channel (see section 2.4.)

69. Fiscal policy has sometimes been pro-cyclical . During upswings, budgetary authorities have sometimes overestimated the underlying strength of revenues, which have been boosted temporarily by a consumption-rich composition of GDP and, in some cases, asset market booms. In addition, there is a tendency to revise potential growth up too sharply, and to factor it into public sector wage agreements and budgetary projections. Therefore, some countries have failed to accelerate fiscal consolidation in "good times". As a corollary, there has been sometimes insufficient fiscal flexibility to support economic activity during the downswing.

70. Fiscal policies and financial and labour market developments interact and jointly influence adjustment . Individual countries' experiences show that it is important to pay attention to the potential interactions between policies and sectors in order to smooth the adjustment process. Otherwise there is a risk of pro-cyclicality, which amplifies swings in output and inflation. The experiences of Spain and the Netherlands illustrate this risk. In Spain, a fall in risk premia, a relaxation of credit constraints on households, strong migration flows and demographics heavily strained the housing market. In the Netherlands, pro-cyclical developments in financial markets, wages and the fiscal stance proved mutually reinforcing.

71. Finally, there can be sizeable spillover effects in the euro area . For instance, strong housing investment in large euro-area countries affects other Member States through demand effects. Inflationary pressures in one country could raise aggregate euro-area inflation and lead to a tightening of monetary conditions for the euro area as a whole. Hence, it is important for Member States to promote reforms to facilitate adjustment in the euro area in the context of the Growth and Jobs Strategy.

Box 3: Country-specific experiences with adjustment in EMU

Germany had a poor growth performance in the first years after the creation of the euro area. However, growth was already slow since the mid-nineties. After unification, wages increased well in excess of productivity, large overcapacities were created in the construction sector and public finances became unsustainable. As productivity growth remained low, adjustment took place through wage moderation. As strong constraints were also set on public spending, domestic demand remained muted for a decade. Competitiveness improved markedly, through lower wage increases than in the rest of the euro area. Rising current account surpluses have demonstrated the renewed strength of the German economy, while the recent revival of construction and consumer spending points to a more balanced growth mix. As a result, growth in Germany is now close to the euro-area average for the first time since 1994.

Spain has consistently recorded higher growth rates than the rest of the euro area. As a result, Spanish real GDP per capita rose from around 80% of the euro-area average in the mid-nineties to 90% in 2005. In the early years of monetary union, declining interest rates boosted investment, especially in the housing sector. This trend was fuelled by financial innovation and a rapid population growth. As a result, inflation increased steadily and the decline in real interest rates added to demand pressures. The current account deficit widened significantly to reach 6% of GDP. Labour market reforms, a relatively cautious budgetary policy and increased trade openness have mitigated somewhat inflationary pressures and positively influence the ongoing adjustment process.

The Netherlands outpaced the euro-area average growth by 1 % point in the period 1996-2000. High growth rates were fed by strong consumption and investment growth, in particular in housing. The sharp increase in housing prices and consequent wealth effects together with expansionary fiscal policy at the end of the economic boom induced some overheating. The tightening labour market exerted upward pressures on wages from 2000 to 2002, while inflation peaked at 5.1% in 2001, the highest rate among euro-area countries at the time. The cumulative increase in nominal unit labour costs between 1998 and 2003 resulted in an accumulated loss in competitiveness and a fall in corporate investment. Significant wage restraint, together with fiscal consolidation, dampened domestic demand and restored competitiveness. After three years of slower growth, GDP moved back to the euro-area average from 2004 on.

Portugal went through a boom in the run up to euro-area membership. Annual GDP growth exceeded 4% until 1999, driven by strong investment as interest rates fell. Because of the rising demand pressures, wage and price inflation exceeded the euro-area average in the 1990s by more than 5 and 2% points respectively. Private debt rose gradually to high levels, representing eventually 120% of households' disposable income in 2005. Competitiveness was hurt, which resulted in rising current accounts deficits. Fiscal policy in the last decade was initially pro-cyclical and thereby reinforced domestic demand pressures, whereas the subsequent fiscal consolidation limited the country's capability to smoothen adjustment. Between 2000 and 2003, a sharp downward adjustment occurred as consumption and investment slowed down considerably. Against the background of weaker productivity and increased competition in export markets from emerging countries, the external sector only provided limited support. Adjustment challenges remain.

2.3 RECENT IMPROVEMENTS IN ADJUSTMENT CAPACITY

Progress with the Lisbon Strategy

72. The Lisbon Strategy for growth and jobs coordinates structural reform in the European Union. It aims to foster employment and raise potential growth in the whole Community through reforms in product markets, budgetary institutions, financial and labour markets.

Moreover, as emphasised by the European Parliament in its resolution on the situation of the European economy, the Lisbon Strategy is also essential for "strengthening innovation, technological advances and human capital accumulation, removing remaining barriers hampering the operation of the Internal Market, and creating a more conducive environment for business activities".[13] The fact that integrated reforms strengthen Members States' capacity to adjust to economic shocks in an economic and monetary union is an additional incentive to undertake them.

73. Euro-area Member States have addressed many reform areas that are important to stimulate growth and jobs. This is shown in the Annual Progress Report of December 2006 in which the Commission assesses the National Reform Programmes and Implementation Reports of the Member States. Promising reforms have been undertaken, or have been planned, to increase labour participation rates, boost R&D and innovation, develop human capital and create a more attractive business environment, notably through policies improving the quality of regulation. There have also been important steps to reinforce fiscal sustainability, with governments generally setting out measures to improve their budgetary positions and tackling projected increases in pension and health care costs.

Graph 2.8: Structural indicators earmarked for the Growth and Jobs Strategy, euro area

(change in percentage points from 2000 to 2005)

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Note: data and methodology could be accessed on the Eurostat website (http://europa.eu.int/comm/eurostat/structuralindicators)

(*) change in relation to the EU25 average; (**) 2000-2004 change

Source: 2006 Commission assessment of National Reform Programmes, euro-area fiche.

74. Structural indicators point to progress in several areas. In particular, the employment rate in the euro area rose by 2 percentage points between 2000 and 2005 to reach 63.5% (Graph 2.8). The employment of women contributed most to this increase and reached 55.2%. However, this performance was skewed, with Spain (+7 points) and Italy (+3.9 points) accounting for the bulk of the improvement. In contrast, progress was broad-based for older workers, whose area-wide employment rate grew by 6 percentage points to reach 40.4% in 2005. The dispersion of regional unemployment rates followed the same downward trend and decreased from 12.9% in 2000 to 10.5% in 2005, mainly due to positive developments in Spain, Italy, Greece and Finland.

75. Further progress is needed with the structural reforms most relevant to increase the adjustment capacity of the euro area. Therefore, the Commission has included a fiche dedicated to the euro area in its Annual Progress Report on the state of implementation of the Lisbon Strategy. The euro-area fiche focuses on reforms that are deemed especially relevant for the smooth functioning of EMU and, on the basis of a thorough dialogue with euro-area Member States, issues four recommendations to them:

( Firstly, to make use of the favourable cyclical conditions to aim at or pursue ambitious budgetary consolidation towards their medium-term objectives in line with the Stability and Growth Pact, hence striving to achieve an annual structural adjustment of at least 0.5% of GDP as a benchmark;

( Secondly, to improve the quality of public finance by reviewing public expenditures and taxation with a view to enhancing productivity and innovation, thereby contributing to economic growth and fiscal sustainability;

( Thirdly, to effectively implement measures that improve competition, especially in services, and step up measures that promote the full integration of financial markets and competition in retail financial services;

( Fourthly and finally, to improve flexibility and security on labour markets inter alia by better aligning wage and productivity developments, balancing employment protection and security in the market and enacting measures to promote labour mobility across borders and between occupations.

Box 4: The euro-area fiche: assessment of reforms in euro-area Member States This box presents a summary of the Commission assessment on reforms undertaken by euro-area Member States. Macro-economic dimension: Progress has been made towards achieving sound budgetary positions. Sound public finances will create the necessary room to cope with fluctuations over the economic cycle and reinforce fiscal sustainability in perspective of ageing populations. The combined euro-area budgetary position should improve and the public deficit is expected to be lowered to 1.5% of GDP in 2007. The euro-area Member States with the highest budget deficits are expected to record relatively strong improvements in their structural balances in 2006 and/or 2007. During 2006, measures in the area of pension and health reform have been adopted or announced in a number of euro-area countries, including in countries considered to face a medium or high risk to the sustainability of their public finances. While progress has been made to reduce deficits, some countries need to accelerate the pace of budgetary consolidation and continue reforming pension and health care systems. Microeconomic dimension: The assessment of reform efforts in the field of goods and services markets in the euro area shows signs of progress. While all euro-area countries took policy actions to promote better regulation, encourage R&D and the diffusion of innovation, the measures proposed or taken could be more ambitious in order to effectively address the challenge of low productivity growth in the services sector. In order to improve the functioning of the euro-area services markets, the adoption of the Directive on Services in 2006 represented notable progress (see below for a discussion of the Services Directive). In this respect, quick implementation is essential to enhance competition in sheltered services. Many Member States addressed competition issues in network industries (notably in the gas and electricity sector but also in electronic communications). Nevertheless, greater efforts are needed in many countries in respect of issues such as the separation of network management and supply as well as the resources and independence of the regulator. Many Member States are taking positive steps towards reform in the key area of professional services, whereas others yet need to undertake major efforts. The 2007 Internal Market Review will propose essential actions that Member States, especially euro-area countries, must take. The single currency crucially enhanced the integration of financial markets among the euro-area Member States, but more needs to be done to exploit untapped potential. At the EU level, some initiatives of particular importance for the euro area are advancing, namely the Directive on payment services, the results of the Commission's inquiry into competition in financial services and the application of a code of conduct on clearing and settlement of securities. Some progress in the transposition of the Market in Financial Instruments Directive has been achieved in some euro-area Member States. Employment dimension: The general assessment of labour market reforms is fairly positive. A number of policies were initiated in order to increase labour supply and make work pay. A number of countries have adopted further measures to increase labour supply through interventions targeted towards particular groups (women, older workers, the young, migrants, and disabled people). To make work pay, a number of countries have adopted measures to reduce income taxes. These cuts either benefited all employees or were targeted at vulnerable groups (long-term unemployed, low-wage workers, young and older workers). There is still insufficient action to enhance incentives for older workers to stay longer in the labour force. Reforms of unemployment benefit systems to promote activation measures are also insufficient. Only limited action has been taken in the area of employment protection. Most Member States made progress with the implementation of programmes to foster human capital formation. However, they mostly focused on education for the young at the expense of training for adults already in the workforce. Finally, a review of the functioning of wage setting and measures to enhance labour mobility in euro-area countries is warranted. Monitoring Implementation of the Lisbon Strategy - Key dates and procedures Autumn 2005 Each Member State produces its National Reform Programme (NRP), which defines the main national challenges in view of the Lisbon objectives, as well as the policies addressing them. Autumn 2006 The NRPs are followed by annual Member State Implementation Reports (IR) that show where progress is made in meeting Member States' own reform strategies. The Commission submits a Technical Implementation Report on the progress with policy measures at the Community level. Winter 2005 and 2006 The NRPs and subsequent annual IRs are then subject to a thorough assessment, first by the European Commission, and then by the Member States themselves. In its 2006 assessments, the Commission highlights what it considers to be the strengths and weaknesses of each Member State. A separate assessment is produced for the euro area, the so-called euro-area fiche. Winter 2006 Spring 2007 The concluding section of the Commission's assessment includes specific policy recommendations covering those areas where weaknesses need to be urgently tackled. These were addressed to each Member State and to the euro area as a whole. They are discussed by the Council in view of adopting a Council Recommendation on the 2007 Broad Economic Policy Guidelines (Art. 99(2)) and on the Employment Guidelines (Art 128(4)) addressed at each Member State and, concerning the euro-area fiche, at the euro-area Member States. |

Rebound in productivity growth: more than just cyclical?

76. Higher labour productivity growth is important for the euro area . For many years, the euro area has been lagging behind the US in terms of productivity growth (see Section 2.1). This has led to lower potential growth in the euro area. However, higher potential growth alleviates the economic consequences of ageing. Higher productivity and economic growth also facilitate the adjustment to economic shocks. In particular, high productivity growth could reduce the need for wage restraint in adjusting to a negative competitiveness shock.

77. Labour productivity in the euro area surprised on the upside in 2006. Boosted by the acceleration of economic activity, labour productivity growth in the euro area averaged 1% last year, compared with an annual average rate of 0.7% during the previous decade. The acceleration in labour productivity in 2006 was broad-based. Within the private business sector, labour productivity growth strengthened in manufacturing industry, largely thanks to capital deepening. Labour productivity increased markedly in the private services sector. It grew by 1% in 2006 (see Graph 2.9), which constitutes a significant improvement from the previous decade (0.2%). Given the higher weight of services in GDP, the services sector contributes now as much to overall labour productivity growth as the industry sector.

78. Cross-country divergence of labour productivity growth was marked in 2006. Among the larger euro-area Member States, productivity gains in Germany have doubled (3.7%) in comparison with the average over the 1995-2005 period. Labour productivity growth in France also accelerated to 2.5%, from 1.4% on average over the previous ten years. In Spain, productivity grew by 1.1%, compared to -0.7% in the earlier period. Italy presented a less favourable picture, with labour productivity only slightly accelerating from 0.3% to 0.7% in 2006. However the Spanish and Italian figures might have been subject to temporary downward pressures due to the effect of the regularisation of immigrants on employment statistics in 2006.

79. Productivity usually picks up strongly in the early stages of an economic upturn and tends to decelerate in a downturn. This pro-cyclical behaviour reflects the lagged response of employment to output changes. But labour productivity growth is also subject to long-run dynamics typically captured by trend patterns. As a key determinant of long-run economic growth, trend productivity growth (i.e. productivity growth without its cyclical component) constitutes a core economic indicator. Hence, trend labour productivity is of significant policy relevance, as it is a key variable for competitiveness, potential output and ultimately economic welfare.

80. A number of factors suggest that the productivity revival is not solely due to a cyclical recovery. The recent rise in productivity growth appears to be broad-based and also comprises sectors that are less sensitive to the business cycle such as services. Other supportive factors for a more than cyclical improvement in productivity include: the strong rise in the investment ratio in recent years, a reversal of the trend decline in total factor productivity growth, an increase in the share of productivity-enhancing ICT investment and use, and, last but not least, recent reforms in product and labour markets in the framework of the Lisbon Strategy for Growth and Jobs (see Box 4). Therefore, whilst a clear-cut decomposition of the recent acceleration in productivity growth into cyclical and structural components is difficult, the above-mentioned factors suggest that the recent rebound in labour productivity could be more than just cyclical in nature.

Graph 2.9: Actual and trend labour productivity growth in the euro area

(Private business sector, in %)

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Source: Commission services.

2.4 COMPLETING FINANCIAL MARKET INTEGRATION

81. Financial integration creates an efficient financial system and boosts economic potential. The financial sector fulfils key functions that are necessary for an efficient allocation of financial resources in time and space and allows real sector activity to expand optimally. These functions include: (i ) executing financial transactions safely and economically thanks to appropriate mechanisms for trading, clearing and settlement; (ii ) pooling investor resources and subdividing investment opportunities, thereby overcoming mismatches of scale; (iii ) effectively pricing and managing the risks related to financial transactions through providing liquidity; (iv ) reflecting available information efficiently in prices; and (v ) addressing possible information asymmetries and conflicts of interest in the financial intermediation process. To the extent that the financial sector is constrained in the performance of these various functions, there is a consequent cost in terms of sub-optimal economic performance and welfare loss.

82. Financial integration also raises a region's capacity to cope with economic shocks. With well-integrated financial markets, the euro area would be less vulnerable to external shocks, while a regional shock – originating within the euro area – would be diffused and thereby diluted more easily. Moreover, financial integration creates new opportunities for cross-border diversification of portfolios. Such reallocation reduces home bias, promotes risk-sharing and increases the overall capacity of the financial system to bear risks. On the other hand, integration increases contagion risk so that a local financial disturbance can propagate rapidly across the entire financial system. This could be a risk for financial stability if the procedures for crisis prevention, management and resolution remain segmented on a national basis, making area-wide responses more difficult. In this context, improved co-operation among the relevant national authorities is essential to ensure that the financial-stability arrangements keep pace with financial-market innovations. Finally, empirical evidence for the United States reveals that financial markets play a non-negligible role in smoothing the macro-economic cycles. Better-integrated financial markets within the euro area could do the same.

83. The euro has provided a major impetus to financial integration in the EU. The process of EU financial integration has accelerated markedly since the introduction of the euro. The euro has created large and liquid financial markets in which financial intermediaries can reap the benefits of larger economies of scale and scope. Before the introduction of the euro, the need for market participants to operate in national currencies was a major obstacle to an integrated financial system. The presence of currency risk limited the attractiveness of cross-border financial activity, thereby restricting competition between the domestic markets of the Member States. However, the elimination of currency risk has also shifted attention to the need to remove remaining obstacles to financial integration, linked to differences in national regulation, supervisory practices, laws and taxation (see below).

84. The global trend in financial innovation also helps financial integration. In particular, credit derivatives make it easier for financial institutions to rebalance their exposure to national or sectoral credit risk. This is done by issuing synthetic credit risk transfer such as collateralised debt obligations that are backed by diversified assets. This market has grown considerably over the last few years. Although precise data for the euro area are not available, such innovative products promote market completeness and have the potential to spread risk more evenly over the euro area.

85. The Financial Services Action Plan (FSAP) removed many remaining obstacles to an integrated financial market. The FSAP, which was launched in parallel with the introduction of the euro, comprises 42 legislative and non-legislative measures, of which 40 have been adopted, relating to both wholesale and retail financial markets. For example, the FSAP facilitates EU-wide capital-raising (through the Prospectus Directive), sets common standards for financial reporting (e.g. the Regulation on International Accounting Standards) and promotes investor confidence and market integrity (e.g. through the Market Abuse Directive). Recent measures include action to improve the inter-operability of national clearing and settlement systems (through a code of conduct on clearing and settlement) and establishing common rules for securities and derivatives markets (through the Market in Financial Instruments Directive, also known as M