COMMISSION OF THE EUROPEAN COMMUNITIES 
Brussels, 06.03.1996 
COM(96) 86 final 
1996 Annual Economic Report 
(presented by the Commission) 

1996 ANNUAL ECONOMIC REPORT 
PART A: COMMUNITY-WIDE TRENDS 
SUMMARY AND CONCLUSIONS i 
CHAPTER 1: RECOVERY LOOKING FOR A SECOND BREATH 1 
1.1. MARKED GROWTH SLOWDOWN DURING 1995 1 
1.1.1. Main trends 1 
1.1.2. Factors behind the slowdown 2 
1.2. REBOUND IN ACTIVITY EXPECTED DURING 1996 7 
1.2.1. Underlying economic fundamentals are favourable 7 
1.2.2. Important short-term risks and uncertainties 13 
1.3. CONTINUED PROGRESS TOWARDS NOMINAL CONVERGENCE 14 
1.3.1. Historically low and converging price increases 15 
1.3.2. Insufficient progress in reducing budget deficits. 16 
1.4. FALTERING IMPROVEMENT IN LABOUR MARKET CONDITIONS 19 
1.4.1. Recent developments. 19 
1.4.2. Longer-term trends in employment creation in the Community 20 
1.4.3. Incidence of unemployment in the EC 22 
1.5. WHITE PAPER MEDIUM-TERM OBJECTIVES PUT AT RISK 25 
BOXl: THE GROWTH IMPACT OF THE 1995 EXCHANGE RATE TURMOIL 5 
BOX 2: CURRENT OUTLOOK IN A HISTORICAL PERSPECTIVE 12 
BOX 3: THE ECONOMIC COMPOSITION OF UNEMPLOYMENT 24 
CHAPTER 2: ECONOMIC POLICIES FOR GROWTH AND EMPLOYMENT 28 
2.1. DESIRED POLICY MIX 28 
2.2. MONETARY POLICY 29 
2.2.1. Inflation and monetary policies in the medium term 29 
2.2.2. Monetary stability affected by internal and external factors in 1995 33 
2.2.3. Room for further easing of monetary policies. 36 
2.3. BUDGETARY POLICY 39 
2.3.1. Recent developments and short-term prospects 39 
2.3.2. Medium-term benefits of continuing and enhanced consolidation 42 
2.3.3. Fiscal consolidation and short-term growth prospects 48 
2.3.4. Priority areas for consolidation 49 
2.4. WAGE DEVELOPMENTS 53 
2.4.1. The appropriate wage trends. 53 
2.4.2. Wage adjustment in the EC since 1980 56 
2.4.3. Expected wage developments 58 
2.5. STRUCTURAL POLICIES 59 
2.5.1. Vital complement to macroeconomic policy-mix 59 
2.5.2. Initiatives taken in 1995 to improve the functioning of product markets 67 
2.5.3. Labour market reform: More needs to be done 69 
BOX4: THE DOLLAR AND THE ERM 35 
BOX 5: EXAMPLES OF SUCCESSFUL FISCAL CONSOLIDATION EFFORTS 51 
BOX 6: PRODUCTIVITY AND EMPLOYMENT GROWTH 61 
Box 7: THE COMMUNITY IN THE WORLD ECONOMY 63 
/ta 
6.3.96 
PART B: ECONOMIC SITUATION AND POLICY ISSUES IN THE INDIVIDUAL MEMBER 
STATES 
BELGIUM 73 
DENMARK 77 
GERMANY 80 
GREECE 85 
SPAIN 89 
FRANCE 94 
IRELAND 98 
ITALY 102 
LUXEMBOURG 107 
THE NETHERLANDS 110 
AUSTRIA 113 
PORTUGAL 117 
FINLAND 121 
SWEDEN : 125 
UNITED KINGDOM 129 
6.3.96 
PART A 
COMMUNITY-WIDE TRENDS 
6.3.96 
Summary and conclusions 
In presenting the Commission's views on the current economic situation and main policy issues in 
the Community, the 1996 Annual Economic Report is intended to initiate a debate on the policy 
options to be considered in the forthcoming 1996 Broad Guidelines exercise. Job creation is the 
principal social, economic and political objective of the Union and its pursuit requires a whole 
variety of measures. This report concentrates on macroeconomic policies and also deals with 
structural policies, in particularly those initiated and agreed at the Community level. These 
policies have been set out in detail in a number of reports, including in particular the joint 
employment report approved by the December 1995 Madrid European Council. 
The Community needs to stay on course 
Creating jobs and reducing unemployment is the single greatest challenge facing the 
Community at the present time. Policy-makers in the Community are faced with a 
situation in which decisions taken in the short term will fundamentally affect the evolution 
of the Community's growth, employment and convergence performance in the coming 
years. However, the juxtaposition of cyclical difficulties and slow progress with structural 
reforms has raised uncertainties about the short-term economic prospects and pointed to 
the need for affirmation about the effectiveness and soundness of the policies followed by 
Community governments. In this situation, there is a clear need to articulate policy 
intentions more effectively in order to stabilise expectations and to mobilise political 
supportibr stated objectives. This is all the more essential in order to avoid a weakening in 
the determination to implement the appropriate policy framework in the face of the current, 
less than ideal, economic conditions. 
This situation has certain parallels to the conditions prevailing in the first half of the 1980s 
but decisive and concerted action provided the key to a turnaround in economic sentiment 
and performance. The challenge facing policy makers is therefore: 
• to revive the recovery by introducing national and Community co-ordinated 
measures aimed at restoring confidence; and 
• to achieve the latter whilst simultaneously supporting the medium-term orientation 
of Community policy aimed at transforming the upswing into a strong and sustained 
growth process supported by capacity and employment-creating investment coupled 
with the necessary progress towards nominal convergence. 
The maintenance of this medium-term orientation is crucial to the realisation of the two 
complementary objectives of Community policy, namely: 
• a substantial reduction in the level of unemployment; and 
• successful transition to Economic and Monetary Union on 1 January 1999. 
6.3.96 
11-
Disappointing growth trend during 1995... 
The Community economy is experiencing a marked slowdown. Contrary to expectations 
prevailing at the begmning of 1995 of output growth of around 3 percent per year in 1995 
and 1996, the economic expansion lost considerable steam throughout 1995 and came to a 
virtual standstill in the closing months of the year. Overall, the performance was 
disappointing not just in terms of the average growth rate achieved (available evidence 
suggests GDP growth of the order of 2Vi per cent) but especially because the momentum 
was insufficient to prevent unemployment from rising in some Member States at the end 
of last year and since progress with fiscal consolidation was modest. Better results on 
these two fronts are crucial to the credibility of the Community's medium-term ambitions. 
The slowdown was initially induced by "inherent cyclical forces", including an end to the 
early-cycle boost from stockbuilding. These forces were exacerbated by the rise in long-
term interest rates during 1994, the currency turmoil in the spring of 1995 and the ensuing 
decline in private sector confidence. The abrupt and sizeable movements in exchange 
rates — reflecting a combination of dollar weakness and doubts in the financial markets 
concerning the credibility of fiscal and structural policies in a number of countries — 
heightened financial uncertainties and created perceptions of risks to the proper 
functioning of the internal market. These developments in combination with inadequate 
progress in combatting unemployment have contributed to a decline in confidence and a 
scaling back of spending and hiring decisions. 
... threatens confidence in the Community 
Consequently, the Community enters 1996 in a less confident mood. Although the 
balance of probability is still pointing towards a renewed strengthening in activity, the 
ongoing deterioration in business and consumer sentiment suggests that confidence-
enhancing action remains essential to prevent a prolongation of the current pause in 
economic activity. Increasing levels of uncertainty among economic agents stem from a 
variety of sources. Externally, the global technological revolution, increasing competition 
from low cost producers and an accelerated pace of structural change in all areas of the 
economy are having an impact. Internally, insufficient reduction of high unemployment 
and uncertainty surrounding the implementation of measures needed to realise key 
economic and political objectives are negatively affecting the medium-term expectations 
of investors and consumers alike. 
Av 
6.3.96 
Ill 
Such pessimism is exaggerated given favourable economic fundamentals... 
While the fears generated by global and Community-wide phenomena may be 
understandable, much of the anxiety should prove short-term in nature. The Community is 
presently enjoying quite favourable underlying economic conditions. Extra-Community 
import demand continues to expand at a healthy pace, the profitability of investment is 
improving and, in overall terms, is noticeably higher than during the second half of the 
1980s, inflation is at a historical low, interest rates have been substantially reduced and a 
partial reversal of previous exchange rate overshooting has taken place. Furthermore, 
progress is being made towards greater nominal convergence. The Community finds itself, 
therefore, in a paradoxical situation. The prevailing sentiment of caution and indecision is 
at odds with the fundamentals and with the broad degree of convergence amongst 
governments regarding their objectives and the means for achieving them. 
... but confidence building measures are necessary. 
Consequently, within the overall economic policy framework established in the 
Commission's 1993 White Paper on Growth, Competitiveness and Employment and 
embodied in successive Broad Economic Policy Guidelines adopted by the Council since 
1993, confidence building measures are called for to overcome the current short-term fears 
and anxieties. Measures which can be organised at the national and/or Community level 
should help provide the reassurance necessary to re-ignite the recovery process and thereby 
exploit the favourable underlying conditions. This is the essential rationale underlying the 
Commission President's recent proposal for a European confidence pact for employment. 
In this context, the Commission has suggested making supplementary resources available 
for the successful realisation of the trans-European networks (TEN's) as well as for 
research and development efforts. In addition, following the conclusions of the Madrid 
European Council, the Commission is proposing an action plan in favour of SMEs. Display 
of common action in these fields will foster confidence in the ability of the Member States 
and the Community to achieve shared objectives. Furthermore, cooperation between the 
social partners, in concertation with governments, on a comprehensive programme for 
stability and employment could spur confidence and improve the investment climate. Such 
pacts should be examined not only in the light of short-term considerations but also as a 
part of an overall medium-term package of measures. To ensure the chances of overall 
success, such policy packages must be credible, provide clear signs regarding the policy 
course, be compatible with the agreed macroeconomic strategy, contain detailed initiatives 
on ways to pursue structural reform and aim to receive broad acceptance among different 
strands of opinion in society. 
I A 
6.3.96 
IV 
Realising the desired "détente" of the macroeconomic policy mix.... 
The objective of policy must be to re-ignite the recovery process whilst at the same time 
maintaining the credibility of the stability-oriented medium-term policy framework. With 
respect to budgetary policy, there appears to be virtually no room for manoeuvre in the 
vast majority of Member States in the current situation. Given the risk of adverse reactions 
on forward-looking financial and foreign exchange markets, any slippage in fiscal 
consolidation efforts would be counterproductive. On the contrary, the most important 
contribution that macroeconomic policies can make at the present time is to bring about a 
continued "détente" in the policy mix. The primary objective of monetary policy is to 
achieve and maintain low inflation. But, if budgetary consolidation efforts are pursued 
resolutely and wage developments remain adequate, the conditions will be created for 
realising a further, durable, easing in monetary conditions. The attached report highlights 
the fact that such a "détente" was hampered last year by the incomplete application of 
policy intentions in some Member States. Consequently, the key to avoiding a more 
prolonged economic slowdown is linked essentially to the enthusiasm and commitment of 
all Member States to put their overall policy framework on a credible footing. 
...will depend on a credible budgetary consolidation process... 
Despite the generally promising trends towards more fiscal rectitude in recent years, 
excessive budget deficits continue to exert downward pressures on current and prospective 
living standards in the Community. In a number of Member States, high budgetary 
imbalances fuel inflationary expectations and contribute to high interest rate premiums. 
More generally, high budget deficits depress national saving, lead to higher expected tax 
rates, impair additional actions to combat unemployment, hamper efforts to raise 
production and employment potential, and reduce the ability of budgetary policy to respond 
to economic downturns. The urgency of fiscal consolidation efforts in the Community is 
recognised by all Member States. 
Despite the positive medium-term effects, governments may be reluctant at present to 
continue budgetary reforms due to concern about their short-term impact. However, 
depending on the particular circumstances that a country finds itself in, this impact may 
well be limited, or indeed positive in countries with high interest rate premia and 
insufficient fiscal credibility. The right fundamentals are in place to induce a significant 
crowding-in of private sector demand. The impact also depends on the overall package of 
measures decided and the manner in which implementation is achieved. The most critical 
requirement is that budgetary consolidation must form part of an overall economic 
approach which is credible. 
6.3.96 
.... and on continuing appropriate wage developments. 
Within the macroeconomic framework, the Social Partners carry a vital responsibility in 
maintaining appropriate wage trends. The Broad Economic Policy Guidelines emphasise 
the necessity of nominal wage increases which are compatible with the inflation objective of 
the monetary authorities. Furthermore, real wage developments should ensure a continuing 
recovery in investment profitability, whilst also providing for increases in standards of 
living. 
From a macroeconomic point of view, recent and prospective aggregate wage 
developments do not constitute a serious constraint on growth in most Member States. In 
some, however, wage trends have not been fully compatible with the stability objective of 
the monetary authorities and/or with the need to improve and safeguard the economy's 
growth potential. On the micro side, labour cost levels are often not in line with 
productivity levels. Consequently, a greater degree of skill-related, regional and sectoral 
wage cost differentiation will be necessary in order to ensure a more employment-
generating growth process. 
Macroeconomic policies must be accompanied by structural reforms. 
Re-igniting the recovery process should go hand-in-hand with progress towards the 
realisation of the Community's key medium-term objectives in terms of unemployment and 
the move to a single currency. In order to achieve these objectives, macroeconomic 
policies must be accompanied by action on the structural side with essentially three aims: (i) 
to ensure a tension-free macroeconomic growth process by measures aimed at a better 
functioning of goods and services markets allied to a greater flexibility of the labour 
market; (ii) to enhance the endogenous growth forces by actions geared towards promoting 
innovation, competition and improving human capital and (iii) to increase the employment-
intensity of growth through a widening of the wage cost scale, especially by reducing 
indirect labour costs at the lower end, and reorganising working conditions. 
Structural policies are largely the responsibility of national authorities, but in order to 
increase their potency and effectiveness, national actions should be co-ordinated and 
complemented by specific actions at the Community level when appropriate. At present, 
Community actions comprise a series of competitiveness and labour market initiatives with 
particular attention being devoted to the internal market, the trans-European networks 
(TENs) and the monitoring of the implementation of the Community's employment strategy 
adopted at the Madrid European Council in December of last year. This strategy is focused 
on action in the five key areas defined by the European Council in Essen: (i) improving 
k 4 + 
6.3.96 
- VI 
employment opportunities for the labour force by promoting investment in vocational 
training; (ii) increasing the employment intensity of growth (flexible work organisation, 
appropriate wage agreements, environmental and social services activities); (iii) reducing 
non-wage labour costs extensively enough to ensure a noticable effect on decisions 
concerning the hiring of employees and in particular of less qualified workers; (iv) 
improving the effectiveness of labour-market policy by avoiding practices which are 
detrimental to the readiness to work and by moving from a passive to an active labour 
market policy; and (v) improving measures to help groups which are particularly hard hit by 
unemployment. 
A complete application of the Broad Economic Policy Guidelines is the key 
In overall terms, therefore, the key to solving the Community's present short-run difficulties 
and achieving its medium-term ambitions lies in the credible application of the Broad 
Economic Policy Guidelines framework and the employment strategy agreed by the 
European Council in Essen and subsequent European Councils. These respective 
frameworks embrace macroeconomic, labour market and structural elements which will 
produce mutually reinforcing effects crucial to the simultaneous promotion of growth and 
employment creation and to the realisation of EMU on 1 January 1999. 
6.3.96 
Chapter 1: Recovery looking for a second breath 
1.1. Marked growth slowdown during 1995 
1.1.1. Main trends 
Chart 1 
Quarterly rates of GDP growth, EUR 9' 
Real % p.a. 
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 
| 92 | 93 | 94 | 95 
' EUR 9=D,F,I,UK,E,NL1S,A,FIN The surprisingly strong recovery 
of the Community economy in 
1994 gave way to a marked 
slowing of the rate of expansion 
during 1995. Output growth 
progressively decelerated from a 
pace of 3î4 to 4 per cent 
(annualized rate) throughout most 
of 1994 to around 2 per cent in the 
second and third quarters of 1995 
(chart 1). On the basis of the latest available indicators, the Community economy may have 
seen virtual stagnation in the final quarter of the year. Output may even have contracted 
slightly in some countries, notably Grermany and France. If these expectations are borne 
out, output growth in the Community for 1995 as a whole would turn out to be slightly 
below the 2.7 per cent anticipated in the Commission's November 1995 Economic 
Forecasts, but likely remain of the order of 2*/2 per cent. 
While economic activity in 
1995 continued to be 
supported by healthy extra-
EC exports, domestic demand 
within Community countries 
slowed down. In the first half 
of the year, there was a sharp 
reduction in the contribution 
from stockbuilding and 
construction investment slow­
ed unexpectedly. Investment 
in equipment kept expanding 
solidly while private 
consumption continued 
growing at a modest pace. In Table 1: 
The Community economy : 
use and supply of goods and services 
(real annual percentage change) 
Private consumption 
Government consumption 
Gross fixed capital formation 
- of which: equipment 
- of which: construction 
Stocks (contribution % GDP) 
Domestic demand (incl. stocks) 
Exports of goods and services b) 
Imports of goods and services b) 
Gross domestic product 1986-
90 
3.7 
2.0 
5.7 
7.1 
4.8 
0.1 
3.9 
VA 
6 
3.3 1991-
92 
1.8 
1.9 
-1.3 
-2.3 
-0.5 
-0.2 
1.0 
31/* 
4 
1.2 1993 
-0.3 
1.1 
-6.6 
-10.7 
-3.3 
-0.7 
-2.0 
8 
-3 
-0.6 1994 
1.6 
1.0 
2.5 
2.6 
2.4 
0.9 
2.5 
10 
41/* 
" 2.8 1995 
a) 
1.9 
1.0 
4.5 
8.0 
1.9 
0.1 
2.3 
814 
5% 
2.7 
a) November 1995 Forecasts. Growth rates are likely to be revised down. 
b) Extra-Community trade only (estimates) 
A 
6.3.96 
-2 
the latter half of the year both investment and private consumption slowed down markedly. 
The loss of growth dynamism was particularly marked in countries whose currencies 
appreciated significantly in the spring of 1995, but the pace of expansion moderated in 
virtually all Member countries. In the former group of countries, exports generally levelled 
off and investment grew less rapidly than previously expected. While private consumption 
initially held up well, the worsening labour market prospects led to a moderation in 
consumer expenditures in the second half of the year. In countries whose currencies 
depreciated markedly, the boost to export market shares was to some extent off-set by 
slowing growth on their export markets, and domestic demand was restrained by high real 
interest rates and adverse terms-of-trade effects. 
1.1.2. Factors behind the slowdown 
The faltering of the recovery process essentially appears to have been caused by two types 
of forces. First, the initial moderation of output growth was induced by what may be 
termed "inherent cyclical forces", comprising an end to the early-cycle boost from stock-
building and a gradual switch in the forces driving the recovery. Such factors have also 
caused a short-lived pause during previous upturns. Secondly, this cyclical pause has been 
exacerbated by a number of interrelated forces: the lagged effects of the rise in long-term 
interest jates during 1994, the currency turmoil in the spring of 1995 and, partly as a result 
of these factors, a steady decline in private sector confidence. 
Growth pause not in itself unusual 
The importance of the "inherent cyclical 
forces" is highlighted by a comparison of the 
growth profile as well as the role of stocks in 
the recent recovery with previous 
experiences. During 1994, the swing in 
stockbuilding gave a powerful boost to the 
recovery in activity, accounting for almost a 
full percentage point of the 2.7 per cent GDP 
growth rate, but the 1994 recovery did not 
rely more heavily on stock-building than 
previous upswings. Also in the two previous 
cyclical upturns there was subsequently a 
temporary negative contribution from stocks 
which led to a short-lived growth pause 
(chart 2). Thus, such an "inherent cyclical Chart 2 
Role of stocks during recovery, EUR 4* 
% 1975 Q3 - 1977 Q4 
l^wjjii^ilii^^^^.i 
Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 09 Q10 
,fGDP 1993 Q2 - 1995 Q3 
Q1 Q2 Q3 04 Q5 06 Q7 08 Q9 Q10 
EUR 4 : D, F, I, UK 
6.3.96 
3 -
Table 2 
Long-term interest rates 
D 
E 
F 
1 
S 
UK 
EUR Dec. 
1993 
5.5 
8.1 
5.8 
9.2 
7.6 
6.3 
6.8 Dec. 
1994 
7.3 
11.1 
8.3 
11.8 
10.9 
8.6 
9.0 April 
1995 
6.8 
11.8 
7.7 
12.8 
11.4 
8.4 
8.8 Jan. 
1996 
5.3 
9.1 
6.3 
10:0 
8.3 
7.8 
7.4 pause" principally related to the stock cycle is not unusual, and therefore not necessarily 
worrying. However, the present slowdown may prove to be more intense and more 
protracted than previous growth pauses as a result of adverse developments in financial 
markets. 
Long-term interest rates increased markedly during 1994 
First came the marked increase in long-term interest 
rates on world and Community financial markets 
during 1994. Between December 1993 and 
December 1994, long-term bond yields increased by 
some 225 basis points in the Community on average 
while inflation in general remained on a declining 
trend. This increase was partly related to a 
"contagion effect" from a similar rise in US yields, 
and partly reflected the surprising strength of the European economic upturn which seemed 
to raise the prospects either of early monetary tightening or an eventual build-up of 
inflationary pressures. However, the rise in yields varied considerably across EC Member 
States, reflecting inter alia their economic performance, policy stance and credibility. In 
particular, long-term interest rates rose significantly more in countries where uncertainty 
about future fiscal policies was rife and whose public finances were not yet perceived by 
the markets as having been put on a clearly sustainable path. 
The rise in long-term interest rates was expected to hold back economic activity in 1995 
through its demand-dampening effects, particularly on investment in construction, but 
within the context of an ongoing recovery the impact was thought to be modest. However, 
it appears in retrospect that the higher long-term interest rates in conjunction with other 
factors may have placed a stronger-than-anticipated brake on companies' and households' 
spending decisions in 1995. 
Exchange rate turmoil and faltering confidence 
Chief among these additional factors was the exchange rate turmoil which erupted in spring 
1995. The abrupt and sizeable shifts in exchange rates heightened financial uncertainties 
and undermined confidence in the perspectives for an orderly recovery. The currency 
turmoil appears to have been caused essentially by two developments. First, the US-dollar 
weakened significantly in the wake of the Mexican peso crisis and shifting market sentiment 
about the relative strength of the major international currencies. Secondly, the pressure 
already exerted on intra-European exchange rates by the weak dollar was reinforced by 
6.3.96 
uncertainties concerning the future course of budgetary consolidation in some Member 
States and/or perceived risks of renewed inflationary tensions. The resulting currency 
movements, which in many cases came on top of previous shifts, were bound to have a 
significant impact on the economies of appreciating as well as depreciating countries and 
played a key role in the slowdown of the Community economy as a whole (see box 1). 
Chart 3 
Currency turmoil and confidence 
EUR 
2 4 6 8 1012 2 4 6 8 10 12 2 4 6 8 1012 2 4 6 6 1012 
| 92 | 93 | 94 | 95 
Germany 
20 
10 
0 
-10 
-20 
-30 pS 
-40 tt*S:-:-:re>-»:-:+^^ 100 
2 4 6 8 10 12 2 4 6 8 1012 2 4 6 8 1012 2 4 6 8 1012 
92 I 93 I 94 I 95 
Italy 
100 While industrial confidence had 
declined slightly before March 1995, 
the exchange rate turmoil set in train 
a sustained decline in production 
expectations in industry and caused a 
weakening in consumer confidence 
(chart 3). The drop in industrial 
confidence was generally more 
pronounced in appreciating countries 
(exemplified in the chart by 
Germany) reflecting anxiety about 
the loss in competitiveness, while 
consumer confidence tended to 
decline in depreciating countries 
(particularly Italy) where consumers 
anticipated an erosion of their 
purchasing power while having to 
face higher interest rates. Much the 
same pattern was discernible during 
the exchange rate crisis of September 
1992 when the British pound and the 
Italian lira left the ERM. Also then, economic sentiment had started deteriorating before 
the currency crisis, but the latter greatly accelerated the erosion of confidence, particularly 
for businesses in appreciating countries and for consumers in depreciating countries. 
Developments in early 1995, including in Germany inappropriate wage agreements together 
with the appreciation of the DM, undermined the competitiveness and profitability of 
industry. They also caused companies to scale back their expectations of future sales, to 
revise down their desired stock levels and to postpone spending decisions. This initial drop 
in purchases led to a further weakening of business confidence which again had 
repercussions on spending and hiring decisions. The decline in business confidence 2 4 6 8 10 12 2 4 6 8 1012 2 4 6 8 10 12 2 4 6 8 1012 
| 92 | 93 | 94 | 95 
* Index: 1987Q1=100 
6.3.96 
5-
continued throughout the year, but seems to have come to a halt more recently. As 
confidence in the continuation of economic recovery was slipping and as the improvement 
in the labour market faltered, consumer confidence declined gradually during the second 
half of the year. 
In sum, the progressive weakening of economic activity during the year owes much to a 
"vicious circle" of declining confidence and increased caution in spending and hiring 
decisions. This was in large part a result of financial turmoil, while the underlying 
economic forces had in fact not deteriorated to an extent which would necessitate or justify 
such a marked slowdown in the Community. This points to the need both for increased 
policy credibility within the EC and for increased efforts at the international level to prevent 
large and sudden movements in the major international currencies. 
Sox 1: The growth Impact of the 1995 exchange rate turmoil 
Between December 1994 and April 1995, the US dollar fell by 12 per cent vis-à-vis the Deutsche 
Mark, adding to a 10 per cent slide during 1994, The tali of the dollar, combined with 
uncertainties surrounding budgetary/inflation prospects in 
some Member States, triggered significant intra-European 
currency movements. Between December 1994 and April 
1995 the Italian lira felt by around 13 per cent in nominal 
effective terms, and the pound sterling and the Swedish 
krona weakened considerably. Within the ERM, the central 
rates of the Spanish peseta and the Portuguese escudo 
were devalued in March. The Deutsche Mark and the 
currencies which are closely tied to the DM strengthened 
significantly in trade-weighted terms, by up to 6 per cent 
between December and April. Table B1.1 
Nominal effective exchange rates 
Index, August 1992=10X3 
B 
D 
F 
I 
Esp 
Sw 
UK Dec. 
1993 
99.9 
100.8 
100.9 
75.1 
78.4 
74.6 
88.7 Dec. 
1994 
103.3 
103.1 
102.4 
72.7 
78.2 
77.5 
87.1 April 
1995 
107.9 
109.3 
106.3 
63.2 
77.1 
73.0 
83.1 Jan. 
1996 
105.9 
106.7 
106.7 
71.7 
80.6 
83.2 
82.1 
Export volumes in the four major EC countries 
Mex 1H2Q3 « 100 The large shifts in exchange rates 
led to substantial changes in 
relative price and cost 
competitiveness. As was also the 
case following the exchange rate 
movements in September 1992f 
this had a marked, if not 
unequivocal, impact on the relative 
export performances of the Member 
States. Following September 1992, 
the exports of Italy and the UK 
improved relative to those of 
Germany and France by almost 10 
per cent within two to three quarters 
(see chart). Export growth was then broadly similar until late 1994, when the stronger DM caused 
German exports to grow at a stower pace and the weaker lira helped Italian exports leap forward. 
The less pronounced changes in the nominal effective exchange rates of France and the UK 
6.3.96 
6-
meant that currency movements had a less dominant, but still visible, influence on export growth 
in those countries. 
Exchange rate movements in early 1995 affected macroeconomic developments in the 
Community in a number of ways. Firstly, on average the European currencies appreciated 
relative to the Community's international competitors, implying a loss of price competitiveness on 
world markets. Secondly, in countries whose currencies depreciated significantly, the short-term 
boost to export market shares was to some extent off-set by lower growth on export markets, and 
by rising interest rates and the erosion of consumer purchasing power from higher inflation on the 
home market. Thirdly, in countries whose currencies appreciated significantly, the negative 
impact on exports and squeezed profit margins had knock-on effects on investment which 
expanded by less than it might otherwise have done. Fourthly, for all these reasons, the 
exchange rate turbulence had a negative impact on industrial as well as consumer confidence, 
which precipitated a decline in the willingness to spend. 
A quantitative assessment of the overall impact on economic activity is possible only under 
specific assumptions. An indication of the magnitude may be given by simulations using the 
Commission services' Quest model. These simulations assume unchanged real interest rates 
(disregarding any tightening of monetary policy in depreciating countries over and above the 
increase in inflation) and do not take into account any autonomous blow to confidence which the 
turbulence may have caused. Table B1.2 shows 
the simulated impact on growth in 1995 and 
1996 of, first, the exchange rate changes 
between December 1994 and April 1995, and 
second, the partial reversal between April and 
December 1995. The simulated impact on 
growth in Germany of the initial appreciation 
(and in general in countries whose currencies 
closely followed the DM) is of the order of 1 
percentage point in the first year and about half 
as much in the second year. Conversely, Italian 
output would be boosted by about Vi per cent 
with most of it taking place in the first year. 
For the EC as a whole, the model simulations indicate that the currency turmoil may have led to a 
reduction in output by almost Vz percentage points in 1995. However, it is likely that the knock-on 
effects which the turmoil had on confidence and on interest rate differentials relative to the DM 
did in fact lead to a larger negative impact on growth. The partial reversal of the exchange rate 
overshooting which took place during the remainder of 1995 is likely to have positive effects on 
growth in 1996 in appreciating countries as well as for the Community as a whole, thus off-setting 
the second-year effects of the spring turmoil. Again, through confidence effects and reduced 
interest rate premia, the positive impact is likely to be larger than indicated by the model 
simulation. Table B1.2 
Simulated impact on GDP growth 
(Percentage points) 
D 
F 
I 
UK 
EUR Spring currency 
turmojl 
(Dec. 94 - April 95) 
1995 
-1.1 
-0.3 
0.4 
0.1 
-DA 1996 
-0.4 
-0.1 
0.2 
0.0 
-0.2 Subsequent 
partial reversal 
(April - Dec.95) 
1995 
0.1 
0.0 
-0.1 
0.0 
0.0 1996 
0.3 
0.1 
-0.3 
0.0 
0.2 
6.3.96 
-7 
1.2. Rebound in activity expected during 1996 
Due to the deterioration in economic conditions since the finalisation of the Commission 
services' November 1995 forecasts, the growth outlook for 1996 has become less 
favourable than previously anticipated. Whereas output in the Community as a whole had 
been forecast to expand by 2.6 per cent in 1996, it now seems likely that growth will be 
below 2 per cent. This downward adjustment of expectations essentially reflects the impact 
of the weaker starting point and the anticipated continuation of weakness in activity into 
the first months of 1996. 
In qualitative terms, however, the reasoning behind the November 1995 forecasts remains 
valid. Provided that the credibility of economic policies is not weakened, the main forces 
determining the growth outlook for the European economy are favourable to a renewed 
pick-up in the rate of expansion in economic activity during the year. In these 
circumstances, output growth is likely to accelerate from a subdued pace in the beginning 
of the year to an annualized rate of around 3 per cent in the latter half of the year. 
Although the average figure for the year is likely to be lower than that of 1995, the 
underlying tendency would, in contrast, be positive. 
The expansion of economic activity would likely be led by rising investment in equipment, 
underpinned by sustained growth in Community exports and a gradual revival in 
consumption, enhanced by positive, albeit moderate increases in real wages and 
employment. Residential and non-residential construction should see a renewed pick-up, 
and the drag from destocking will come to an end as inventory overhangs are brought 
down, after which the stock cycle might again provide a boost to growth. 
1.2.1. Underlying economic fundamentals are favourable 
The main positive growth forces include: 
i. The world economy outside the EC is set to continue to expand at a healthy pace; 
ii. The fundamentals of the European economy in terms of low inflation, moderate wage 
pressures and sound investment profitability are favourable; 
iii. Monetary policies have been eased, long-term interest rates have fallen back, and the 
spring 1995 exchange rate misalignment.has been partially reversed. 
6.3.96 
Chart 4 World economy continues to expand at a healthy pace 
Economic activity outside the 
Community has expanded at a strong 
pace since 1992 and world trade has 
been growing at a rate well above the 
average of the last two decades (chart 
4). The growth in non-EC countries' 
imports in 1993-95 was even faster than 
might have been expected on the basis 
of the observed output growth. This is 
partly explained by the composition of 
world demand growth in recent years, 
not least in the US, which has been 
skewed towards investment and stocks 
both of which typically have a large 
import content. In addition, the 
renewed dynamism of world trade owes 
to the rapid integration of emerging World* GDP growth excluding the EC 
Real % pa. 
•i-KYKvM-i-KliYi-ifv 
70 72 74 76 78 80 82 84 86 90 92 94 
World imports* growth excluding the EC 
Real % p.a. 
70 72 74 76 78 80 82 84 86 
excluding CEEC 90 92 94 
markets in Asia and Central and Eastern Europe into the world economy, as well as to the 
trade-liberalising measures agreed in the GATT Uruguay round. 
Table 3 
International economic environment 
(real annual percentage change) 
-
World excl. EC 
USA 
Japan 
DAEa) 
CEEC and FSU b) 
World excl. EC 
USA 
Japan 
DAEa) 
CEEC and FSU b) 
Extra-EC markets 
Extra-EC exports 1993 1994 1995 1996 
Real GDP 
3.0 
3.4 
-0.2 
6.8 
-8.4 3.8 
4.1 
0.5 
7.9 
-7.4 3.6 
2.1 
0.4 
7.9 
-4.3 4.4 
2.3 
2.3 
7.4 
4.0 
Imports 
10.1 
11.9 
7.0 
13.4 
4.6 
6.8 
972 11.4 
15.0 
13.3 
15.8 
7.0 
10.2 
10% 10.8 
12.3 
11.4 
14.4 
7.3 
9.2 
9 9.2 
7.7 
10.5 
12.4 
9.0 
8.5 
61/2 
a' Dynamic Asian Economies. 
' Central and Eastern Europe and former Soviet Union 
Source: Commission services estimates and forecasts In addition to strong export market growth, the 
Community has benefitted from a large 
improvement in its competitive position 
between 1992 and 1994 due to subdued unit 
labour cost increases and a substantial fall in the 
EC's trade-weighted exchange rate. As a 
consequence of these factors, extra-EC exports 
expanded strongly in 1993-95 at an average 
annual rate of 9Vz percent (table 3). Community 
exports grew rapidly on most major markets, 
including the US, Japan, South-East Asia and 
countries in Central and Eastern Europe. 
The rapid pace of export market growth 
appears to have slowed down somewhat and the 
gain in export market shares is likely to have 
6.3.96 
come to an end following the strengthening of the Community's currencies on a trade-
weighted basis during 1995. Nevertheless, the outlook for the external environment 
remains relatively favourable. The expansion of economic activity in the United States 
moderated to less than 3 per cent during 1995. In the absence of inflationary tensions, 
output is expected to expand at close to its potential rate in 1996 (table 3). In Japan, the 
depreciation of the yen in combination with substantial monetary and fiscal policy stimulus 
is expected to produce the long-awaited recovery during this year. The rate of expansion 
in non-OECD countries is also expected to firm slightly in 1996-97 as continued high 
output growth in Asia, Latin America and Eastern Europe combines with an end to recent 
years' severe output drop in the former Soviet Union. Notwithstanding the firming of 
economic activity outside the Community, world import growth is assumed to moderate 
slightly in 1996 as recent years' high import elasticity is not expected to continue unabated. 
The growth of extra-EC export markets (i.e. the weighted import growth of the 
Community's trading partners) is expected to remain high by historical standards in 1996. 
Therefore, although Community exporters have on average lost price competitiveness as a 
result of exchange rate changes, Community exports to third countries are expected to 
continue expanding at a rather healthy pace. 
Healthy supply-side fundamentals 
Favourable conditions on the supply-
side of the Community economy, in 
terms of subdued inflation, available 
resources and strong and increasing 
profitability levels, are in place to 
accommodate a sustained renewed 
strengthening of demand. Inflation 
in the Community, as measured by the 
private consumption deflator, 
subsided further to a level of around 3 
per cent in 1995. Currently, inflation Charts 
% p.a Inflation and wages in the EC 
90 92 94 
is either below 3 per cent or on a downward trend in all Member States. Overall, the 
Community's inflation performance matches even the best results of the 1960's (chart 5). 
Furthermore, although wage settlements in some countries were concluded at 
disappointingly high levels in early 1995, recent developments indicate that wage increases 
will remain relatively moderate in the near future. It thus seems that the price stability 
gains in the Community are being safeguarded and continue to provide a positive 
background for the conduct of monetary policies. 
6.3.96 
10-
Chart6 
Investment profitability in the EC 
(Net returns on net capital stock) 
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 Capital profitability in the 
Community remains strong on 
average and is almost back at 
the level prevailing in the 
1960's, after having suffered a 
severe and prolonged 
deterioration during the 1970's 
and the early 1980's. If 
profitability in the 1961-73 
period is set to an index of 
100, investment profitability now stands at an index of 96 (for EUR15 in 1995) after having 
touched a minimum of index 65 in 1981. Return on capital is higher today than during the 
strong economic upturn in 1986-90, when investment in equipment expanded at rates about 
twice as high as the rate of GDP growth. The sound profitabiUty levels are likely to sustain 
increased investment, not only by raising expected returns on capital but also by exerting a 
beneficial impact on the balance sheet position and thus the financing means of companies. 
Improved monetary and financial conditions 
Following the exchange rate turmoil in spring 1995, many governments have taken steps to 
sustain and in some cases reinforce the pace of fiscal consolidation in 1996. This has 
carried with it important benefits. 
First, helped by a moderate recovery of the US-dollar, there has been à partial reversal of 
the exchange rate overshooting which occurred in spring 1995. The D-Mark and 
currencies closely linked to the DM have receded somewhat in trade-weighted terms and 
the currencies of several countries which achieved an improvement in the credibility of their 
budgetary policies, notably Italy and Sweden, strengthened significantly relative to their 
most undervalued levels in April 1995. Second, long-term interest rates in the 
Community have fallen back considerably during 1995, assisted by a coincident decrease 
in US long-term yields. Just as higher long-term interest rates during 1994 played a 
significant role in restraining economic activity in the Community in 1995, the subsequent 
fall in rates should be an important stimulus to economic activity in 1996. 
In addition to these factors, the conduct of monetary policy in the Community in the 
second half of 1995 is likely to have a positive influence on economic activity in 1996. 
As described in detail in chapter 2, short-term interest rates were reduced in Germany and 
6.3.96 
-11 
countries whose currencies are closely linked to the DM (in France, this only took place 
following the introduction of consolidation measures in November 1995) as well as in 
countries which had been forced to raise interest rates during the spring currency turmoil to 
defend their exchange rate and to head off inflationary consequences of currency 
depreciations. 
Chart 7 
Monetary conditions and output, EUR4 
15 
io m 
5 « ~$^~rttentnfifërê£r 
rates 
70 72 74 76 78 80 82 84 86 88 90 92 94 
15 
Yield curw 
JYwircKtywrj 
70 72 74 76 78 80 82 84 86 88 90 92 94 96 Although monetary policy is far from 
the only factor affecting economic 
activity, there has been a close 
relationship between short-term 
interest rates and subsequent growth 
in output (over the following 4 
quarters) in the Community over the 
last two decades (chart 7, top half). 
The level of nominal interest rates is 
only one indicator of the stance of 
monetary policies. In a detailed 
assessment, other indicators such as 
real short-term interest rates, the term 
structure, the growth of money supply 
and credits etc. should also be taken 
into account (see chapter 2). The 
lower half of chart 7 illustrates the 
relationship between the yield slope 
(the difference between long-term and 
short-term interest rates) for the 
Community and subsequent output growth. The yield slope is partly a reflection of the 
current monetary stance and partly of the financial markets' expectations concerning 
growth, inflation and the future stance of economic policies. 
In view of recent interest rate reductions, the current monetary policy stance seems geared 
towards a renewed, but moderate strengthening of growth for the Community as a whole in 
1996. In addition, provided that the credibility of the overall policy framework is 
reinforced, subdued inflationary pressures and intensified fiscal consolidation efforts in a 
number of countries imply that the conditions are increasingly in place under which central 
banks are likely to find themselves in a position to be able to lower interest rates further 
and/or keep them low without jeopardizing the stability objective. 
6.3.96 
12 
Box 2: Current outlook in a historical perspective 
This box reviews three episodes which have specific features in common with the current 
situation and which may help to shed light on the forecast of renewed strengthening in 1996. 
Recovery in early 1980's - A comparison of the current situation with the recovery in the early 
1980's reveals a number of similarities as well as important differences. Also then there was, a 
clear pause in the recovery when the initiât stock-building effect faded. Output growth even 
turned temporarily negative in the third quarter of 1982. Furthermore, the recovery in the early 
1980's also took place against a background of high budget deficits and fiscal policy was 
tightened almost to the same degree as nowt as measured by the annual reductions in the 
cyclically-adjusted budget deficit. Nevertheless, there are three fundamental differences which 
bode well for the present economic outlook. First while world trade growth was very subdued in 
1980-83, the external environment has been favourable in 1993-95 and is expected to continue to 
be so in 1996. Second, investment profitability suffered less during the recent recession and 
starts improving from a relatively high level. Third, inflation is running at a much slower pace now 
(3 per cent) than it did in the early 1980's (still above 10 percent in 1982). This provides a much 
more favourable background for the setting of monetary and financial conditions. 
US-dollar fall in 1985-86 - The plunge of the dollar from its severely overvalued level of 3.3 DM 
in February 1985 initially had little impact on industrial confidence in the Community since it was 
not wholly unexpected and the dollar level remained relatively favourable. But the continued 
decline of the dollar into 1986 led to a noticeable drop in industrial confidence in the first half of 
that year and had an immediate and significant adverse impact on investment. However, the 
impact of this deterioration on the real economy was short-lived, and recovery in investment was 
rapid thanks partly to an easing of monetary conditions. At the time, the economy also benefitted 
importantly from the sharp fall in oil prices and stronger consumer confidence. Nevertheless, 
most of ihe factors making for a rapid revival then would appear also to be in place in the current 
situation. 
Stock market crash in 1987 -• Stock prices tumbled on world financial markets by roughly one 
third within the span of a few days in September 1987, and business confidence suffered a severe 
blow. Partly due to the initial caution of economic operators, output growth in the. Community 
faltered in late 1987. However, the monetary authorities took fast and significant action in 
reducing interest rates in the wake of the stock market crash. This easing of monetary policy was 
instrumental in overcoming the shock of the financial turbulence and to turn around the economy 
one or two quarters later. With hindsight, however, the combination of this monetary easing with 
an excessively lax fiscal stance proved too expansionary. As growth rebounded quickly and 
strongly, output in the Community expanded by 4*2 percent in 1988 after 2.9 per cent per year in 
1986-87. The subsequent overheating of the Community economy, exacerbated by the effects 
of German unification, led to a build-up of inflationary pressures which in turn forced a prolonged 
and painful economic downturn to re-establish price stability. 
6.3.96 
- 13 
1.2.2. Important short-term risks and uncertainties 
While expectations centre on a renewed strengthening of activity no later than the second 
half of 1996, the worsening economic climate over the latest months has raised the risks of 
a more extended period of subdued growth. 
The most pertinent risk in the period immediately ahead is that the self-reinforcing 
downward spiral in confidence and spending intensifies. In the near future, output is likely 
to grow at a slower rate than final demand (until the inventory adjustment has come to an 
end) raising the risk that job creation will come to a virtual halt or, in certain countries or 
industries, even be reversed. Particularly in an environment where companies are faced 
with fierce global competition as well as rapid technological and structural changes, they 
are likely to want to see more solid demand prospects before they again become willing to 
hire additional labour. Consumers have to gauge uncertain employment and income 
prospects in the short run as well as the effects of necessary social and pension reforms in 
some countries in the longer run. This might prompt households to raise their saving ratio 
out of precautionary motives, thus leading to a further moderation in the pace of consumer 
spending. If this risk materializes, the slowdown could ~ in spite of improved monetary 
and financial conditions ~ be more severe and possibly more protracted than currently 
anticipated. 
The growth slowdown has cast doubts among some observers as to whether a suffcienr 
number of Member States would be ready to participate in EMU at the starting date of 1 
January 1999 laid down in the Maastricht Treaty given that weaker economic activity 
hampers the necessary progress towards sounder budgetary positions. An extended period 
of subdued growth would likely intensify these uncertainties. This might in turn lead to 
renewed instability on financial markets, dimming further the growth prospects in the 
Community. 
A different but related set of risks applies to the conduct of economic policies. Impatience 
with the pace of recovery along with fears of social unrest might weaken or even paralyze 
governments' efforts to carry out the necessary budgetary and structural reforms. 
However, any hoped-for short-term benefits of reduced fiscal rigour would most likely 
prove illusory. If uncertainties were to arise about the resolve and ability of governments 
to implement fiscal consolidation plans, this would be reflected in higher long-term interest 
rate risk premia in the countries concerned, and would presumably force central banks to 
raise short-term interest rates in order to underpin the currency on foreign exchange 
markets, and in an attempt to preserve overall policy credibility. Indeed, a relaxation of the 
6.3.96 
- 14 
fiscal consolidation efforts within the Community would risk leading to renewed and 
possibly wide-spread tensions in foreign exchange markets. The combined impact of such 
unfavourable interest and exchange rate developments would have severe, detrimental 
effects on private sector confidence and thus on the chances of renewed and sustained 
recovery. 
It is equally important to maintain the current policy consensus within the Community 
concerning the desirability of moderate wage developments. Any attempt to stimulate 
consumer demand by encouraging higher wages would most likely backfire. Such a policy 
would serve only to add to Europe's long-standing problems of insufficient international 
competitiveness, underinvestment and excessive labour costs relative to the costs of other 
production factors. Even in the short run, the negative effects of these factors would assert 
themselves. Reduced competitiveness, diminished attractiveness as a production location 
and lower capital profitability would have a negative impact on exports and investment. 
For consumers, higher wage income per worker would be partly off-set by higher prices, by 
companies' reduced ability to profitably employ labour, by reduced income for self-
employed and by reduced capital income. Perhaps most importantly, if wages were 
increased at a rate incompatible with the stability objectives of the monetary authorities, the 
ensuing tightening of monetary and financial conditions would ensure a negative overall 
impact on demand and employment. 
However, some of the uncertainties surrounding the outlook may also point in a positive 
direction. As the Community is enjoying the most favourable underlying economic 
conditions since the 1960s, the revival in economic activity could surprise in a positive 
manner once confidence is restored. This requires inter alia that governments take all 
possible steps to persuade economic agents of their determination to realise their stated 
objectives. 
1.3. Continued progress towards nominal convergence 
Further progress towards meeting the convergence criteria was achieved in 1995, although 
not in all cases at a sufficient pace. Convergence on the inflation and interest rate fronts 
made largely satisfactory advances; progress was also made in relation to the consolidation 
of public budgets although the fiscal outcome was less than satisfactory in several Member 
6.3.96 
15-
states; and the situation on the foreign exchange markets stabilised after being marred by 
marked fluctuations in the spring of the year1. 
1.3.1. Historically low and converging price increases 
In 1995, the average rate of inflation in the 
Community, as measured by the private 
consumption deflator, eased marginally to 3.1 
percent. Price convergence strengthened and 
eleven Member countries had rates of inflation at 
or below the reference value for compliance with 
the Maastricht inflation criterion. Inflation 
convergence was maintained among the Member 
States which have long participated in the ERM 
and were in the narrow band prior to the widening 
of the fluctuation margins in August 1993 
(Belgium, Denmark, Germany, France, Ireland and 
the Netherlands). In addition, the United Kingdom 
and the three new Member States (Austria, Finland 
and Sweden) all had inflation rates below the 
reference value. Austria has long maintained a 
stable exchange rate vis-à-vis the German mark, 
and in the UK, Sweden and Finland, central bank 
policy is conducted with respect to an inflation 
target. Of the remaining countries, Italy witnessed 
an acceleration in its inflation rate to 5 Vz percent, 
mainly as a result of the depreciation of the lira. 
Spanish inflation remained at around 5 percent, 
Portugal showed a strong deceleration to 
4 VA percent and Greece experienced a significant 
deceleration of over 1 Vz percentage points, 
although the rate of inflation remained above the 
Community average. Table 4 
Inflation developments 
(percentage change, private consumption deflator 
B 
DK 
D 
GR 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR15 
Reference 
Value 1992 
2.0 
1.8 
4.8 
15.1 
6.4 
2.4 
2.5 
5.4 
0.1 
3.1 
3.9 
11.1 
4.1 
2.2 
4.7 
4.6 
2.8 1993 
3.1 
1.0 
3.9 
13.6 
5.5 
2.2 
1.7 
5.1 
4.4 
2.3 
3.4 
7.1 
4.2 
5.8 
3.5 
4.0 
3.1 1994 
3.0 
1.0 
2.7 
10.8 
4.9 
1.8 
2.7 
4.8 
2.6 
2.4 
3.0 
5.5 
1.3 
3.0 
2.4 
3.2 
2.9 1995 
1.5 
2.0 
2.0a 
9.2 
4.9 
1.9 
2.5 
5.6 
1.9 
1.6 
2.4 
4.1a 
1.1a 
2.8 
3.0 
3.1 
3.0 
Source: Commission's November 1995 forecasts 
"Reference value" is calculated as the average of the 3 
best performers plus VA percentage point. 
a) Taking into account latest information. 
Chart 8 
Inflation convergence in Greece, 
Spain and Italy* 
* Private consumption delator, r eference value is average of 3 best 
performers • 1.5 % 
1 For a detailed analysis, see the European Commission's "Report on Convergence in the European Union 
in 1995", November 1995. The present report only reviews convergence with respect to price stability 
and sound public finances. 
6.3.96 
16-
The generally favourable inflation performance had its origins in a number of factors: 
the establishment of central bank independence in several countries has raised the 
credibility of price stability objectives, and low inflation is increasingly built into 
expectations; 
central bank actions, particularly in countries whose currencies had depreciated 
significantly or where wage settlements had been concluded at relatively high levels, 
reinforced the firmness and credibility of the anti-inflationary stance; 
moderating GDP growth meant that output remained below its full capacity level; 
notwithstanding higher-than-expected wage settlements in some countries at the 
beginning of the year, nominal compensation per employee increased by a relatively 
moderate 3 VA percent last year in the Community as a whole; together with 
productivity growth of 2 percent this led to a relatively modest 1 VA percent increase in 
nominal unit labour costs; 
raw material prices decelerated in the first half of 1995 and remained subdued 
thereafter. 
Given the expected continuation of these factors, and in particular the strengthened 
credibility of the anti-inflation objective throughout the Community, the outlook for price 
convergence in 1996 is relatively benign. The recent strengthening of the currencies of 
some of the countries with comparatively high inflation rates should further help this 
process. Nevertheless, continuing vigilance will have to be exercised if inflationary 
pressures should reemerge. This is particularly the case for countries which have 
experienced significant currency depreciations in the not-too-distant past because of the 
variable lags which exist in the pass-through from such currency movements to domestic 
inflation. 
1.3.2. Insufficient progress in reducing budget deficits 
The budgetary position of the Member States in general improved in 1995. Government 
deficits were reduced in the large majority of Member States, but there were important 
exceptions to this rule. Government debt continued to increase as a share of GDP in a 
majority of Member states, but with few exceptions the deterioration occurred at a 
significantly slower pace than in previous years. 
The latest available Commission services estimates of budgetary developments in the 
Community date from the economic forecasts of Autumn 1995 (table 5). The unexpectedly 
6.3.96 
17-
sharp cyclical slowdown in some countries towards the end of 1995, in conjunction with 
budgetary slippages in at least a couple of Member States, imply that the budget deficits in 
several countries are likely to be somewhat higher than indicated in these forecasts. It is 
particularly disappointing that the government deficit turned out to be significantly higher 
than anticipated in Germany (3.6 per cent of GDP against a forecast of 2.9 per cent) thus 
overshooting the Maastricht reference value. 
Consequently, the general government deficit in 
the Community as a whole in 1995 will almost 
certainly turn out to be above the 4.7 percent of 
GDP estimated in the latest forecasts, but most 
likely remain at about 5 per cent of GDP. 
Compared to 1993, when the recession had 
strongly deteriorated the public finance positions 
of most countries, the overall public deficit has 
nevertheless been cut by around 1 Vz percentage 
points of GDP. Discretionary policy actions 
contributed to more than half of this improvement 
with the remainder owing to the positive effects of 
recovery in 1994 and early 1995. 
Notwithstanding the worse-than-expected 
budgetary outcome in some countries, most 
Member States succeeded in reducing their budget 
deficit in 1995. The strongest improvement is 
expected in Sweden (more than 3 percent of GDP) while Denmark, Greece, France, Italy 
and the United Kingdom are expected to reduce their deficits by 1-2 percentage points. 
Other countries see declines of less than 1 percent of GDP. However, in Germany, Ireland 
and Austria, the deficit-to-GDP ratio has deteriorated, partly as a result of lower-than-
expected economic growth (Germany and Austria), and partly due to a relaxation of 
budgetary stringency. Table 5 
General government deficit 
(per cent of GDP) 
B 
DK 
D 
GR 
E 
F 
IRL 
1 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1992 
-7.1 
-2.9 
-2.8 
-11.7 
-4.2 
-4.0 
-2.4 
-9.5 
0.8 
-3.9 
-2.1 
-3.3 
-5.9 
-7.8 
-6.3 
-5.2 1993 
-6.7 
-4.5 
-3.5 
-12.1 
-7.5 
-6.1 
-2.4 
-9.6 
1.8 
-3.2 
-4.3 
-7.1 
-8.0 
-13.4 
-7.8 
-6.3 1994 
-5.3 
-3.8 
-2.6 
-11.4 
-6.6 
-6.0 
-2.1 
-9.0 
2.2 
-3.2 
-4.4 
-5.7* 
-5.8 
-10.4 
-6.8 
-5.5 1995 
-4.5 
-2.0 
-3.6b 
-9.3 
-5.9 
-5.0 
-2.5a 
-7.2b 
0.4 
-3.1 
-5.5 
-5.2* 
-5.6*» 
-7.0 
-5.1 
-4.7 
Source: Commission's Nov. 1995 forecasts 
a) This figure includes the payment of arrears of 
social welfare payments due under the Equal 
Treatment Directive and incorporates the 
more recent information presented in the Irish 
budget. 
b) Taking into account most recent information. 
The average debt-to-GDP ratio for the Community increased in 1995 by about three 
percentage points to 71 percent. This was largely due to the unification-related debt 
assumptions by the German federal government (especially the Treuhandanstalt) but even 
in the absence of this factor the debt ratio would have increased. In fact, the debt-to-GDP 
ratio deteriorated in 11 of the Member States. On a more positive note, the fall in the ratio 
in the other Member States ranged from a Vz of a percentage point in the case of Italy to 
6.3.96 
- 1! 
Table 6 
General government gross debt 
(percent of GDP) 
B 
DK1 
D 
GR 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR Level 
1993 
137.5 
80.3 
48.2 
114.5 
60.4 
45.3 
97.4 
119.4 
6.3 
81.3 
62.8 
67.2 
57.3 
76.2 
48.5 
66.2 1994 
136.0a 
75.6 
50.2 
113.0 
63.0 
48.4 
91.1 
125.4 
5.9 
78.0 
65.2 
69.4 
59.8 
79.3 
50.3 
68.1 1995 
133.8a 
73.6 
58.8 
114.4 
64.8 
51.5 
85.9 
124.9 
6.3 
78.4 
68.0 
70.5 
60.3a 
81.4 
52.5 
71.1 Change 
95/94 
-2.2a 
-2.0 
8.6 
1.4 
1.8 
3.1 
-5.2 
-0.5 
0.4 
0.4 
2.8 
1.1 
0.5a 
2.1 
2.2 
3.0 95/93 
-3.7a 
-6.7 
10.6 
-0.1 
4.4 
6.2 
-11.5 
5.5 
0.0 
-2.9 
5.2 
3.3 
3.0a 
5.2 
4.0 
4.9 
Source: Commission's Novermber 1995 forecasts 
1) Government deposits with the central bank, government 
holdings of non-governmental bonds and public enterprises 
related debt amounted to 20 % of GDP in 1995. 
a) Taking into account latest information. over 5 percentage points in Ireland. The 
continued increase in the debt ratios in a 
majority of the Member States during the 
recovery demonstrates the urgent need for 
fiscal retrenchment in many countries. 
With regard to the short-term outlook, the 
less favourable output growth in 1996 will, in 
itself, render more difficult progress towards 
lower budget deficits. On the other hand, a 
number of governments have recently taken 
significant, and sometimes courageous, steps 
to place public finances on a more sound 
footing. Irrespective of the current 
slowdown, the progress which is being made 
in reducing structural deficits will remain 
intact and thus reinforce the basis for meeting 
EMU objectives independent of cyclical 
conditions. 
It is essential that governments do not allow cyclical weakness to become an excuse for 
relaxing structural fiscal consolidation efforts. Only a strict fiscal discipline can provide the 
restoration of confidence and the lower interest rates which are necessary for a renewed 
strengthening of economic activity. While it is evident that a number of countries have yet 
to achieve considerable reductions in their deficits in order to respect EMU commitments, 
the degree of progress to be achieved is not so great as to be regarded as unrealistic. 
Several Member States are expected to introduce additional retrenchment measures 
between now and 1997, which would further improve convergence in the budgetary field. 
6.3.96 
- 19-
1.4. Faltering improvement in labour market conditions 
1.4.1. Recent developments 
Employment 
Chart 9 
Employment and unemployment in the EC* 
%tfcMfemtabourforu 
ViUlrtHrtft.tlt3HMtJUtt>>fattM>feltttt{rfoy!iMfe: 
{right &eate} 
_t t i 1 L^-t » •••<• •»• • < + ' •• < > 
78 79 80 81 82 83 84 85 86 87 88 89 90 91 
* Including the 5 new German Ldnder since 1991 91 92 93 94 95 The initial strength of the current recovery 
led to some improvement in labour market 
conditions and employment started rising 
gently during 1994, for the first time since 
1991. During the first three quarters of 
1995, total employment increased slightly 
further but under the impact of slowing 
economic activity the positive trend was 
reversed in the latter part of the year. 
Consequently, employment is likely to have risen by considerably less than the VA per cent 
anticipated in the November 1995 forecasts and, correspondingly, net job creation did not 
attain the 1.1 million jobs hoped for earlier. 
Notwithstanding fast productivity gains, employment 
growth for 1995 as a whole was strongest in Ireland 
(previously forecast at 3Vi per cent), driven by a 
buoyant expansion of economic activity of around 7 
per cent. The growth of employment was strong also 
in Denmark, Luxembourg, Sweden and Finland (in 
the likely -range of 1 Vz to 3 per cent) due to above-
average economic growth as well as a catching-up of 
hiring following the increase in the number of hours 
worked per person during the economic upturn in 
1994. In Spain, measures aiming at a more flexible 
organisation of work may have helped to lower the 
employment threshold of growth. The number of 
employed people increased by 2V* per cent against a 
background of output growth of around 3 per cent. 
In contrast, employment continued falling or, at best, remained stagnant in 1995 in 
Belgium, Germany, Italy, Austria and Portugal. In several of these countries the most 
recent trends have continued to point downward. In the remaining Member States, the rate 
of improvement slowed down towards the end of the year. Table 7 
Employment growth 
(%pa.) 
B 
DK 
D 
GR 
E 
F 
IRL 
1 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1992 
-0.4 
0.1 
-1.9 
1.5 
-2.1 
-0.7 
0.4 
-0.6 
2.5 
2.0 
1.8 
-1.8 
-7.1 
-4.3 
-2.0 
-1.3 1993 
-1.4 
-2.3 
-1.8 
0.9 
-4.4 
-1.0 
0.6 
-6.8 
1.8 
-0.1 
0.6 
-1.9 
-6.1 
-5.5 
-1.5 
-2.5 1994 
-0.7 
-0.2 
-0.7 
1.9 
-0.9 
0.1 
2.6 
-1.6 
1.3 
0.1 
0.3 
-0.2 
-1.3 
-1.0 
0.7 
-0.4 1995 
0.4a 
2.1 
-0.2a 
1.0 
2.7a 
1.1 
3.5 
0.1 
2.5 
1.2 
0.2 
-0.6 
2.2a 
1.7 
0.8 
0.7 
a) Taking into account latest information. 
Source/Commission's November 1995 forecasts 
6.3.96 
-20 
Unemployment 
The resumption in job creation in 1994 originally led 
to a fall in the unemployment rate from its peak of 
11.3 percent of the labour force in the spring of that 
year to 10.6 per cent in September 1995. But due to 
the slowing of employment growth in the course of 
1995, the improvement subsequently reversed course 
and the unemployment rate rose to 10.9 per cent in 
December 1995. The rate of joblessness continued 
falling in Denmark, Spain, Finland and the United 
Kingdom. In Ireland and Greece significant 
employment gains were not translated into substantial 
progress in reducing the jobless rate due to high 
labour force growth. In the closing months of 1995, 
the unemployment rate edged up in Germany, France, 
Italy and Sweden. Table 8 
Unemployment rate 
(% of civilian labour force) 
B 
DK 
D 
GR 
E 
F 
IRL 
1 
L 
NL 
A 
P 
FIN 
s 
UK 
EUR 1992 
7.3 
9.2 
6.6 
7.9 
18.5 
10.4 
15.4 
9.0 
2.1 
5.6 
3.6 
4.2 
13.1 
5.8 
10.1 
9.3 1993 
8.9 
10.1 
7.9 
8.6 
22.8 
11.7 
15.7 
10.3 
2.7 
6.6 
4.2 
5.7 
17.9 
9.5 
10.4 
10.9 1994 
10.0 
8.2 
8.4 
8.9 
24.1 
12.3 
15.1 
11.4 
3.5 
7.0 
4.4 
7.0 
18.4 
9.8 
9.6 
11.3 1995 
10.2 
6.9 
8.3 
8.9 
22.5 
11.5 
14.9 
11.7 
3.8 
6.7 
4.5 
7.2 
17.2 
9.1 
8.5 
10.7 
Source: Commission's November 1995 forecasts 
If the latest assessment of weaker economic activity in early 1996 is borne out, the short-
term outlook for the labour market is less favourable than previously expected. With 
practically no further gains in employment for the Community as a whole, unemployment 
would rise further over the very short term. However, provided that the economy picks up 
again, unemployment should resume its downward trends in the latter part of the year. 
1.4.2. Longer-term trends in employment creation in the Community 
The Community suffered large job 
losses during the economic 
downturn of the early 1980's. 
However, the subsequent 
strengthening of economic growth 
to an average rate of 2.8 per cent 
per year during the period 1984-91 
led to the net creation of IOV2 
million jobs in the Community. 
Whereas private sector employment 
had stagnated and then declined markedly during the period 1975-83, coinciding with 
rising employment in the public sector, the net creation of jobs in the 1984-91 period took 
place predominantly in the private sector. In this regard, the contribution of SMEs was Table 9 
Job creation in the EC 
(ESA basis; million jobs) 
Total economy, EUR15-
Total economy, EUR13-a> 
- of which: private 
- of which: public 1976-
1980 
2,9 
2,8 
0,0 
2,8 1981 
1983 
-3.0 
-3,1 
-4,1 
1,0 1984-
1991 
10.4 
10,0 
7.4 
2.6 1992-
1994 
-4.4 
-4.4 
-3.4 
-1.0 1995 
Ub> 
l.lb> 
1.2b> 
-0.1b> 
a) EUR15 except Portugal and Greece. 
' November 1995 forecasts; including the new German Lander. 
Source: National accounts and Commission services estimates. 
6.3.96 
21 
significant. In 1988-90, employment in SMEs grew by 2Vi per cent per year whereas 
employment in larger companies grew by VA per cent per year. The 1984-91 period clearly 
demonstrated the capacity of the European economy to create new employment as long as 
robust, non-inflationary growth could be maintained. However, during the subsequent 
economic downturn 4Vz million jobs were lost in 1992-942. While the downturn affected 
both SMEs and large entreprises, the employment decline was less pronounced in SMEs. 
The performance of employment in the 
current recovery does not appear to 
confirm often-stated fears of "jobless 
growth". Despite the intensely 
competitive environment in the industrial 
sector and consequent efforts to cut 
costs, the EC economy was able to 
sustain a positive net creation of jobs in 
the first three quarters of 1995, and the 
employment threshold of growth ~ i.e. 
the level of output growth above which 
total employment-will expand — was the 
same as^ the average over the last two 
decades for the Community as a whole. 
However, the employment threshold has 
tended to vary between Member States 
as well as fluctuate over time in 
individual countries. 
Slow job creation or even job losses in 
certain sectors with fast productivity 
growth may indirectly help generate 
employment in other sectors of the 
economy via a reduction in the relative 
price of the products of the former, 
which helps raising the purchasing power 
of all consumers and boosting the overall 
demand for products and services, 
including those produced in employment-chart 10 GDP growth in the EC 
mm. 
75 77 79 81 83 85 87 89 91 93 95 
Employment growth in the EC 
•wXj^ftHflSMfcBw^cJ 
75 77 79 81 83 85 87 89 91 93 95 
Labour productivity growth in the EC 
75 77 79 81 83 85 87 91 93 95 
Chart 11 
Sectoral employment trends 
Index 1970=100 
70 72 74 76 78 80 82 84 86 
Source : OECO (1994 data based upon Eurostat Estimate) 
2 In addition, around 1 million jobs were lost in the new German Lander as a result of restructuring. 
6.3.96 
22 
intensive sectors with low productivity growth. SMEs, which tend to make a relatively 
greater contribution to employment in less capital-intensive sectors, play a key role in 
generating employment opportunities. Over the last 25 years, employment has been on a 
downward trend in the sectors of the economy with high productivity growth, namely 
agriculture and manufacturing industries (chart 11). However, in the manufacturing sector, 
where cyclical movements of employment are more pronounced, there have been periods of 
strong employment creation, notably during the high-growth period in the late 1980's. The 
long-term downward trend in manufacturing and agriculture, however, is a structural 
phenomenon which has been compensated by increased employment in the services sector 
of the economy. This upward trend was temporarily interrupted during the latest recession, 
when employment in the service sector began to shrink, partly under the impact of a more 
competitive environment, for instance in financial services, and due to the vulnerability of 
many small and medium sized service entreprises which had been founded during the 
preceding period of high growth. 
The Community's record during the 1980s and again the improvement in employment from 
mid-1994 to mid-1995 suggest that the failure to reduce unemployment significantly has 
not primarily been due to an incapacity to create jobs under the right conditions, but rather 
to an inability to~ sustain job-creating growth for sufficiently long without encountering 
macroeconomic hindrances or structural barriers on the labour market. 
1.4.3. Incidence of unemployment in the EC 
The gravity of the structural unemployment problems in Europe is underlined by the extent 
to which unemployment affects certain groups of labour, in particular low-skilled and 
inexperienced workers, and often turns into long-term unemployment. 
With respect to skills, the rapid transformation which the European economy is undergoing 
under the impact of technological developments, new organisational structures, increased 
competition and globalisation, have tended to reduce the demand for unskilled labour in 
Europe. However, these rapid changes on the demand side have not been met with equally 
rapid progress on the supply side of the labour market in terms of new skills, competences 
and occupational and geographical mobility. 
In addition, low-skilled and inexperienced labour is often priced out of the market since the 
productivity of such labour is not considered to correspond to the total labour costs 
including taxes. Non-wage labour costs represent, in many European countries, a 
substantial share of total wage costs, and generally weigh most heavily on the lower paid. 
6.3.96 
-23 
Furthermore, the degree of protection 
provided through income support schemes 
in some cases generate very small 
differences in net disposable incomes 
between being in and out of work. In this 
way, the functioning of the social benefits 
system may, despite its overall merits, put a 
floor under the wages for unskilled and 
inexperienced labour which contributes to 
pricing such labour out of work. 
These mechanisms reinforce the difficulties 
which young, inexperienced people and 
long-term unemployed whose skill levels 
have deteriorated, have in finding and 
retaining a foothold on the active labour 
market. Table 10 
Unemployment features, 1994 
B 
DK 
D 
GR 
E 
F 
IRL 
I 
L 
NL 
P 
UK 
A 
S 
FIN 
EUR Unem­
ploy­
ment rate Youth 
unem­
ployment 
rate 
Percent 
10.0 
8.2 
8.4 
8.9 
24.3 
12.3 
14.7 
11.4 
3.5 
7.0 
7.0 
9.6 
9.8 
18.4 
11.2 24.1 
10.7 
8.6 
27.7 
45.3 
29.1 
23.3 
32.3 
7.7 
10.7 
15.1 
17.0 
22.6 
33.6 
21.8 Long-term 
unem­
ployed 2) Low-
skilled 
unem­
ployed 3) 
Share of total 
unemployment 
58 
32 
44 
51 
53 
38 
591) 
62 
30 
49 
43 
45 
10D 
21 
48 52 
31 
22 
40 
68 
46 
64 
59 
63 
32 
79 
58 
50 
1) 1993 2) Unemployed for more than 12 months 3) Edu­
cational level lower than upper secondary; share calculated 
for the persons aged 15 to 59 years. 
Source : EUROSTAT Labour Force Survey 1994 and 
National Statistical Institutes for S, FIN 
Young people continue to be particularly 
affected by joblessness, and they appear to 
have borne a disproportionately large part 
of the increased unemployment risk during 
the recent economic downturn. 
Furthermore, unemployment remains 
significantly higher among women than 
among men, even if the incidence of 
unemployment has become less imbalanced 
in recent years. During the economic 
downturn, the rate of unemployment 
increased more among men than among 
women, in part reflecting the larger share of 
the male working force employed in 
cyclically sensitive sectors. Chart 12 
Unemployment Rate in the EC* 
(by age) 
iiiiHiiiii 
83 84 85 86 e7 88 a9 90 91 92 93 94 
(by sex) 
90 91 92 93 94 83 84 85 86 87 88 
•EUR 12 
Source : Eurostat Harmonized Unemployment Rates 
6.3.96 
-24 
Box 3: The economic composition of unemployment 
From an economic perspective, unemployment may be disaggregated into a cyclical and a non-
cyclical component3. The cyclical component results from a lack of total demand relative to the 
available productive capacity. Since a part of the unemployed labour force is directly 
"employable", cyclical unemployment can be absorbed by an increase in demand during the first 
stages of a recovery corresponding to the return to normal use of the existing capacity. However, 
since the cyclical component of unemployment has been estimated to represent little more than 2 
percent of the labour force in 1994, eliminating it will not be enough to bring unemployment down 
to acceptable levels. 
Economic composition of unemployment in the EC 
(% of civilian labour force) 
12 
:pj^t3^ 
Sttbèm^tirtèiYp6yrtie«t 
:K-.::C:::< :::>::::<:::+:::O:::-:J :•:•:•>:•:•:•:!•: :•:< :•:•:•». : :•:<•• : .*:•• ••>••:•:•:€•:•:•:+:•:•• J:-: :••<•:•• :>::::c ::H :•:•:•>:. 
7273747576777879808182838485868788899091929394 
*EUR 12 Thé non-cyclical component is linked in 
the first instance to the lack of employment 
posts at given real labour costs, i.e. 
ultimately to a lack of capacity which can 
be profitably employed at given wage and 
price levels» In such circumstances, higher 
demand would lead to inflation rather than 
a durable expansion of employment. Part 
of the non-cyclical unemployment can be 
absorbed by a strong, investment-based 
growth process Involving an expansion of 
the productive capacity facilitated by an 
increase in investment profitability. The 
working posts thus made available could be 
filled by those who continue to be in the 
turnover on the labour market and who are quickly "employable" with limited retraining. 
Howevetv part of the non-cyclical unemployment corresponds to a part of the labour force which is 
not easily able to fill the kind of jobs that will become available through the growth process. This 
overlap represents structural unemployment stricto sensu. The size of this overlap is difficult 
to assess but according to estimates of the Commission services, ft amounts to at least 4 per cent 
of the labour force3. The proportion of long term unemployment (about SVz per cent of the active 
population) may also be used as a rough indicator. This structural unemployment stricto sensu 
must be reduced by active labour market policies especially geared to problem groups and long-
term unemployed. Such policies have an important social objective and contribute to reduce 
social exclusion. But without the creation of adequate working posts, the full return of these 
policies would not be reaped and such measures would risk becoming a source of disillusion for 
the intended beneficiaries if, as before, they were unable to find a job. 
In a different perspective, tensions in the labour market may appear even before the level of 
structural unemployment stricto sensu is reached. A marked rise in employment might be 
constrained by the appearance of a NAIRU (Non Accelerating Inflation Rate of Unemployment) 
limit in the form of an acceleration of wage inflation before unemployment has been sufficiently 
brought down. When unemployment falls, the increasing bargaining power of "insiders" or 
regional and occupational bottlenecks in combination with rigid wage structures may lead to an 
acceleration of wages. However, the empirical estimation of the NAIRU is fragile, partly because 
the NAIRU is not a universal constant but a structural, endogenous parameter of the economic 
and the wage formation system. One recent estimate5 put the NAIRU in the EC as a whole at just 
above 6 per cent in 1994, but the uncertainty is very considerable. The risk of renewed wage 
inflation putting a brake on employment creation can be reduced by carrying out structural 
reforms of the labour market as proposed in the priorities of the European Councils in Essen and 
Madrid. 
"The composition of unemployment from an economic perspective" European economy no. 59, 1995. 
6.3.96 
-25 
1.5. White Paper medium-term objectives put at risk 
Since the publication of the Commission's 1993 White Paper on growth, competitiveness 
and employment, there has been widespread consensus in the Community on the need for 
solid medium-term growth as a prerequisite for a significant reduction in the level of 
unemployment. The current economic slowdown has raised doubts about the possibility of 
achieving such strong growth and employment creation in the Community in the coming 
four to five years and, in particular, about the feasibility of cutting unemployment by half 
between 1994 and the year 2000. 
The White Paper was accompagnied by medium-term projections for a number of scenarios 
for the period 1994-2000. The "reference scenario" illustrated the possible outcome if the 
Member States maintained, as soon as their economies had recovered, budgetary policies in 
line with the desired convergence path and if wage trends would be kept appropriate. 
These conditions would allow monetary policies to be less restrictive than otherwise, and 
exchange rate stability would be restored. 
The growth profile in this scenario 
implied a rather slow recovery in 1994-
95 followed by a further acceleration in 
1996-97 and a stabilisation of the 
average growth rate in the Community at 
around 3Vz per cent per year in the 
following years. The average growth 
rate in the years 1994-2000 would be 2.9 
per cent, just below the 3 per cent per 
year observed in 1984-1990. In this 
scenario, the expansion would be led by 
a strong expansion of investment thanks 
to a satisfactory evolution of final 
demand combined with high and rising 
levels of profitability. Thus, the 
expansion of productive capacity would 
keep in step with output, and the 
scenario would not imply a repetition of 
the overheating problems of the 1988-90 
period (chart 13). Chart 13 
Actual and potential output in the EC, 
1983-2000 (WP scenario) 
GDP and Production Capacity 
1983 
% pa 1986 1989 1992 1995 1998 
GOP and Production Capacity 
ÏI11 llïl I Mill 111 l.l it 11111 l.l.l.l 1111 l.l 1111111111 ill 11Al ill 1.1.11.I.I.I.I.I.1.1 MM III 11 ill 11111111.111111 
1983 1986 1989 1992 1995 
Output gap (*) 1998 a -1 
.1983 1986 1989 1992 
(*) Ratio of actual to potential GDP 1995 1998 
6.3.96 
26 
Chart 14 
November 1995 Forecasts versus 
White Paper reference scenario 
(Average annual rate of growth, in percent) 
a. Real GOP growth 
il'l/l'/!:l:l:l:l:l:!'i.:l:!v!il:l:l:l:l:l:!:l 
1993 1994 1995 1996 1997 1998 1999 2000 
b. Private investment 10 
forecast 
5 t „,.,.„.„ ;v 
1993 1994 1995 1996 1997 1998 1999 2000 
c. Employment 
1993 1994 1995 1996 1997 1998 1999 2000 In actual fact, however, the 
recovery was much stronger in 1994 
and, despite the intensifying 
slowdown during the year, also 
better than expected for 1995 on 
average (chart 14). Thus, at the 
time of elaboration of the 
Commission's November 1995 
forecasts, the achievement of the 
White Paper growth scenario still 
appeared feasible. However, the 
subsequent deterioration in the 
outlook for 1996 will render the 
achievement of the White Paper 
scenario more difficult, even if it is 
not yet excluded. 
If, andjonly if, confidence is restored quickly there may be a strong rebound in the 
Community as a whole on the basis of healthy growth fundamentals. Indeed, growth in the 
second half of 1996 and in 1997 could well be as strong as 3 per cent or more. This would 
provide the basis for a strong, investment-led and sustainable growth pattern in 1998-2000. 
However, too buoyant growth from 1997 onwards would imply a renewed risk of tensions 
on the use of productive capacities. Policy-makers would have to remain vigilant in order 
to avoid a repetition of the overheating phenomenon which occurred in not so dissimilar 
circumstances in 1988/89. 
6.3.96 
-27 
White Paper scenario and 
growth assumptions for 1997 
1993 1994 1995 1996 1997 1998 1999 2000 If growth were to revive strongly by 
1997, a return to the White Paper growth 
scenario would become possible (chart 
15) and this could lead to a substantial 
reduction of unemployment. A stronger 
growth path would hardly appear feasible 
without tensions arising. But a return to 
the White Paper growth scenario, 
combined with structural policies aimed at 
securing a tension-free growth process, 
increasing the employability of the labour force and making economic growth more 
employment-creating, are necessary in order to make progress towards the White Paper 
ambition in terms of unemployment. 
The Report of the Commission to the Madrid European Council on the mutually 
reinforcing effects of increased co-ordination of macroeconomic and structural policies 
concluded that: " no process of strong growth and no substantial reduction in 
unemployment is possible in the European Union unless the Broad Economic Policy 
Guidelines are applied in a determined and properly co-ordinated fashion. The most 
important risk - which was felt through the monetary turbulence of Spring 1995 - is a lack 
of credibility in the application of the common strategy by a number of Member States, 
which has negative consequences for everybody. In that case, the result would be sub-
optimal for all. This is why the Broad Economic Policy Guidelines should be 
implemented with determination by policy makers and social partners in all countries ". 
This should be done along the lines set out in the remainder of this report. 
6.3.96 
28 
Chapter 2: Economic policies for growth and employment 
2.1. Desired policy mix 
The macroeconomic policy-mix is largely determined by a triangle of forces ~ namely 
monetary policy, budgetary policy and wage trends --, responsibility for which is assumed 
by three different groups of actors. The conduct of monetary policy is exercised by 
increasingly independent central banks whose primary objective is to achieve and maintain 
price stability. The responsibility for budgetary policy resides with sovereign governments 
and parliaments, but whose freedom of action is constrained by Treaty provisions and by 
the pressing need for fiscal consolidation. The conduct of wage negotiations is generally 
under the responsibility of the social partners with the wage formation process varying 
importantly across Member States. Wage developments should respect the conditions for 
price stability and contribute to the required profitability of employment-creating 
investment. Efficient co-ordination between the various policy actors is essential to ensure 
the avoidance of policy conflicts of the type seen during the late 1980s/early 1990s which 
was one of the key factors behind the 1992/93 recession. 
The most important contribution that this triangle of forces can make to relaunch the 
recovery process, to achieve a high degree of sustainable convergence and to significantly 
and durably reduce an alarming unemployment total consists in bringing about a further 
détente in the macroeconomic policy mix. In the Community there exists a potential for a 
further easing of monetary conditions. A healthy and efficient use of this potential requires, 
however, that the other two forces are consistent with the objective of price stability. 
Indeed, more decisive and credible fiscal adjustments efforts in a number of Member States 
and continuing adequate wage developments will enable further, soundly-based reductions 
in short and long-term interest rates. 
In order to overcome the current growth pause and to place the Community's economy on 
a strong, non-inflationary and employment-creating medium-term growth path, a 
rebalancing of the macroeconomic policy, thus generated, must be reinforced and co­
ordinated by a broad range of structural policies. The latter contribute to the overall 
strategy through essentially three channels : (i) to ensure a tension-free macroeconomic 
growth process by measures aimed at a better functioning of goods and services markets 
and a greater, positive flexibility of the labour market; (ii) to enhance the endogenous 
growth factors by actions geared towards promoting innovation, competition and 
6.3.96 
-29-
improving human capital and (iii) to increase the employment-intensity of growth through a 
widening of the wage cost scale, especially by reducing indirect labour costs at the lower 
end, reorganising working conditions, etc. 
2.2. Monetary policy 
2.2.1. Inflation and monetary policies in the medium term 
Since the early 1980s monetary policy in the Community has been increasingly geared 
towards the objective of price stability. This strategic reorientation of monetary policies 
was driven by disappointment with the macro-economic performance of the Community in 
the 1970s which made it clear that low unemployment could not simply be achieved at the 
cost of accepting higher inflation and that, in fact, there was no lasting trade-off between 
low unemployment and low inflation. In addition, governments and economic operators 
were becoming more and more convinced of the drawbacks of high inflation and adapted 
their behaviour accordingly. 
High inflation is typically accompanied by a greater degree of price uncertainty. This tends 
to be reflected in higher real long-term interest rates than otherwise (through the 
incorporation of a risk premium) and makes long-term investment and savings decisions 
more uncertain since the real value of income and wealth is more difficult to maintain when 
the future price level is uncertain. These factors lead to a sub-optimal level of investment 
and savings and thus to a lower production potential than otherwise. High and variable 
inflation also distorts price signals and may contribute to a misallocation of resources. 
Moreover, high inflation has negative distributional effects since households in the lower 
income brackets have less access to durable consumption goods or financial investments 
with good real value characteristics. Finally, unanticipated inflation represents a shift in 
resources from creditors to debtors. In the 1970s, the government sector became an 
important borrower, spending too often on present consumption rather than on investment. 
An easy monetary policy facilitated this channelling of funds to the government. In the 
1980s, disinflation and high real interest rates added to the governments' debt burden which 
increased drastically as a share of GDP. 
The realisation that a sustainable growth path is better served with price stability led to the 
formulation, with increasing success, of monetary policy in terms of that objective. The 
rate of inflation in the Member States decelerated markedly during the first half of the 
1980s and since then have remained markedly lower than during the 1970s. The average 
6.3.96 
30-
Inflation and unit labour costs in the EC inflation in the Community (based on the 
consumption price deflator) declined from 
over 12 per cent in the early eighties to 3.6 
per cent in 1987 (chart 16). While the 
endeavour to improve price stability in the 
wake of the second oil price shock in 
conjunction with the recession among the 
Community's trading partners was a main 
factor behind the economic downturn in the 
early 1980's, the further reduction in inflation from 1983-87 was achieved alongside 
renewed employment-creation and accelerating economic growth. The credibility of the 
ERM based on a stable nominal anchor contributed strongly to this favourable evolution. 
The disinflation process was temporarily interrupted in the late 1980s when a too 
expansionary monetary-fiscal policy mix engendered an overheating of the Community 
economy. The accompanying acceleration in inflation and inflationary expectations was 
compounded by German unification and the hike in oil prices resulting from the Gulf war. 
Monetary policy returned to a firm anti-inflationary stance in late 1990 and inflation, after 
having peaked atpver 5!/2 per cent in 1991, fell gradually back to just over 3 per cent in 
1995. Meanwhile, the severe tightening of monetary policy in Germany and the rest of the 
Community in the aftermath of German unification contributed to the exchange rate 
turbulence in the ERM because in a number of Member States the deterioration of the 
economic situation called, in the opinion of markets, for a differentiated policy response. 
The recession in 1993, when real GDP in the Community declined by 0.6 per cent, was 
then also particularly severe. 
The considerable progress towards price stability can be attributed to a combination of 
factors. 
Chart 17 Demand pressures and inflation in the EC 
1980 1982 1984 1986 1988 1990 1992 1994 First, as the monetary authorities became 
increasingly conscious of the importance 
of low inflation they took action 
accordingly. While nominal short-term 
interest rates declined regularly 
throughout the 1980's on average in the 
Community, compatible with the trend 
decline in the Community-wide money 
supply growth, real short rates followed 
6.3.96 
-31 -
an upward course until 1986-87. In late 1987, interest rates were lowered in the wake of 
the world-wide drastic fall in stock market prices, which created fears of an impending 
slowdown. Instead, the economy overheated and from 1989 to 1992, interest rates were 
increased considerably. Both nominal and real rates peaked in August/September 1992 at 
12.4 per cent and around TA per cent, respectively. Already by 1989, money supply 
growth was decelerating more rapidly and, by 1991, also inflation. In a number of Member 
States, however, money supply targets in the early nineties were overshot, so it was only 
from 1993 onwards, in the context of subdued economic growth, that central banks were 
able to ease monetary conditions significantly. In late 1995, the average nominal short rate 
in the Community, at 6.4 per cent, was lower than at any time in the 1980's and the real 
rate, at V/z per cent, was down to levels last prevailing in 1983. Despite the lowering of 
interest rates, money supply growth plunged in 1994-95 and targets were undershot (table 
11), suggesting that monetary policy could have eased earlier without jeopardising price 
stability. The overshooting of money supply targets in some Member States and exchange 
rate unrest in others prevented this from happening. 
Secondly, and related to the first factor, the rate of wage increases declined markedly. Unit 
labour costs — which are a prime determinant of inflation together with profit margins, 
import prices and indirect taxes — decelerated strongly in the first half of the 1980's and 
rose at_a rate generally below inflation. Following a sharp upturn in 1989-90, unit labour 
costs decelerated again between 1991 and 1994 (chart 16). The evolution of unit labour 
costs can be compared with the evolution of the ratio of M2 over real GDP. This ratio ~ 
with an appropriate assumption on the velocity of money ~ gives an indication of the 
increase in. the money supply in excess of what is needed to finance real transactions. The 
decline in the M2/real GDP-ratio over the 1980's reflects the lower availability of liquidity 
to finance nominal developments. A widening in the difference between the change in the 
M2/real GDP ratio and the change in unit labour costs suggests that monetary policy 
accommodates wages pressures, while a narrowing suggests that monetary policy is 
relatively tight as in the late eighties/beginning of the nineties. The difference narrowed 
again in 1994-95. This may suggest either an increase in the velocity of money or that 
monetary policy was relatively strict in 1995 with respect to the moderate wage pressures. 
Finally, from the mid-1980's onwards, the creation of the single market (including the 
liberalisation of capital movements) in combination with a generalised move towards 
market deregulation, led to a strengthening.of competition and an improvement in the 
allocation of resources. These effects contributed to the moderation of price rises. 
6.3.96 
32 
Whilst all Member 
States pursue the 
objective of price 
stability, the monetary 
policy frameworks in 
individual Member 
States target different 
variables. These 
frameworks have 
become more diverse 
in the Community 
over recent years 
(table 11) in an 
attempt to formulate 
the most appropriate 
and credible response 
to the changing 
economic and 
financial circumstan­
ces. Inside the ERM 
the focus is on the exchange rate, but to a variable degree. Hitherto, the exchange rate 
target has been most narrowly binding in Belgium, the Netherlands and Austria while, on 
the other hand, in Spain and Portugal, exchange rate fixity has been less pronounced. 
Furthermore, in Spain and France the exchange rate target is complemented by an inflation 
and money supply target, respectively. Germany is the only country which continues to 
give considerable weight to the control of the money supply. Outside the ERM, an 
inflation target represents the focus of attention of the policy makers in Finland, Sweden 
and the United Kingdom. iTable 11 I 
Money, credit and inflation targets and outcomes 
(per cent per year) 
II 1994 I 1995 
Target Target Outcome Target Outcome 
variable3 (medium (medium 
term) term) 
Germany M3 4-6 4.9 4-6 2.5 (Dec) 
France M3 (around 5) 1.1 (around 5) 3.9 (Nov) 
EITa 4.2 4.8 (Oct) 
Spain M3 - 8.2 10.7 (Nov) 
ALP+CP - 7.6 9.2 (Nov) 
ALP 4.5-7.5 8.2 9.7 (Nov) 
CPIb 4.7 (<3) 4.3 (Dec) 
Italy M2 5-7 1.6 5 2.2 (Dec) 
UK M4 3-9 4.5 9.3 (Dec) 
MO 0-4 6.7 5.6 (Dec) 
RPIX*5 1-4 2.4 1-4 3.0 (Dec) 
(<2.5) 
Finland CPIYb - 1.3 2 -0.6 (Nov) 
b ' <*> 
Sweden CPIb -(2) 2.4 2±1 2.6 (Dec) 
I 1 (2±D 
a Money supply targets: MO, M2, M3, M4; ALP; credit targets: EIT 
b Inflation targets: CPI, CPIY (CPI minus indirect taxes, subsidies and 
capital expenditure on housing, RPIX (retail price index minus mortgage 
interest payments) 
6.3.96 
-33 
2.2.2. Monetary stability affected by internal and external factors in 1995 
After the exchange rate turbulence of 1992 and 1993, exchange rates in the EU countries 
went through a period of calm that lasted until the end of 1994. Subsequently, the 
currencies of the Member States once more displayed pronounced volatility, particularly in 
March and April 1995. Despite interruptions, calm had returned to the markets by the end 
of 1995 (chart 18). Similarly, short- and long-term interest rates displayed considerable 
volatility in 1995 with diverging trends (chart 19) reflecting, to some extent, the tensions in 
the exchange markets but also responding to developments and prospects for inflation and 
economic activity. Internal and external factors prevented monetary policy from being 
more balanced at the beginning of 1995 and delayed the necessary easing of monetary 
conditions. 
Chart 18 
The evolution of some EU currencies 
against the DM 
Index primo January 1994 =100 
JAN MAR JUN SEP DEC FEB MAY AUG NOV 
1994 | 1995 j 
110 JAN 
1996 Exchange rate tensions at the international 
level, related to the financial crisis in Mexico 
affecting especially the dollar exchange 
markets, were at the origin of pressures on 
several European currencies at the beginning 
of the year (see box 4). The Italian lira 
suffered most during the currency turbulence, 
losing over 16 % of its DM value between the 
end of 1994 and April 1995. Political 
uncertainty and doubts about the commitment 
to budgetary consolidation played a major 
role in the currency's weakness. Similar 
problems affected the Swedish krona, and 
inside the ERM, the Spanish peseta, which 
devalued on 6 March by 7 % and with it the 
Portuguese escudo by 3.5 %. The strong 
appreciation of some Community currencies 
and the simultaneous increase in interest rates in countries whose currencies had come 
under pressure amounted to a significant tightening of the monetary stance in Europe. 75 ^V 
JAN MAR JUN SEP DEC FEB MAY AUG NOV JAN 
1994 I 1995 11996 
Slow money supply growth in Germany and better inflation prospects led the Bundesbank 
to reduce official rates at the end of March; two more cuts were to follow (in August and 
December). This provided the other Member States with the necessary room to ease 
monetary policy as well. This was done in a differentiated way and at a different pace, 
determined by recent inflationary developments and the situation in the exchange markets, 
6.3.96 
34-
reflecting inter alia the credibility of governments to stick to a stability oriented economic 
policy. 
Chart 19 
Short-term interest rate differentials 
against the DM 
JAN MAR JUN SEP DEC FEB MAY AUG NOV JAN 
1994 | 1995 | 1996 Almost all ERM participants were in a 
position to lower rates substantially. Dutch 
and Austrian money market rates followed 
closely developments in Germany, although 
the short-term differential in the latter 
widened. In Belgium, the differential with 
DM rates widened temporarily to close to 
2% in March, but it subsequently 
disappeared and Belgian rates were able to 
track short-term interest rate developments 
in Germany. In Denmark, France and 
Ireland; considerable progress was likewise 
made in the second half of the year when 
exchange rate tensions subsided. There 
was a brief interruption for France in the 
Autumn, but following the introduction of 
credible fiscal consohdation efforts, the 
differential narrowed significantly. 
However, short differentials with Germany 
remained higher compared to the beginning of the year in France and Ireland. Spain was 
not in a position to lower rates substantially because of doubts in the markets on the 
political stability and the budgetary situation, while in Portugal interest rates continue to be 
more than 5 % higher than in Germany. 
Outside the ERM, where central bank action is geared more directly to developments in 
domestic inflation, monetary policy was progressively tightened in Sweden and Italy 
because the inflation outlook deteriorated. Money market rates remained relatively stable 
in the United Kingdom, fluctuating between 6.50 per cent and 6.75 per cent. In Greece 
better inflation prospects allowed interest rates to be reduced considerably, while in 
Finland, after an initial hike in March, interest rates were cut in several steps from the 
Autumn onwards and short-term differentials narrowed again to 70 basis points. 
At the end of 1995 the monetary situation compares favourably to the Broad Economic 
Policy Guidelines. Exchange rate stability was returning (chart 18) and 11 Member States 
realised the objective of an inflation rate between 2 and 3 per cent as a step towards JAN MAR JUN SEP DEC FEB MAY AUG NOV JAN 
1994 "I 1995 | 1996 
6.3.96 
35 
stability. These developments are encouraging for keeping the inflation rate low in a 
durable way. Progress was strongest in the Member States already experiencing a low 
degree of inflation as well as in Greece and Portugal. In Italy, the rate of inflation 
accelerated by 2 percentage points to 6.0 per cent while in Spain inflation remained 
broadly unchanged. Monetary policy made an important contribution to the overall 
positive developments, but occasionally led to tensions when there was a perceived lack of 
fiscal discipline or when inflationary expectations were fuelled by excessive wage claims. 
Box 4: The dollar and the ERM 
Although domestic reasons, related to political uncertainty or to the commitment to 
budgetary consolidation, explain part of the exchange rate volatility in the ERM, external 
factors had an important influence. The sensitivity of the ERM to external developments 
is illustrated in the graph below, showing the influence of the USD/DM exchange rate on 
tensions in the ERM, represented by the spread between the strongest and weakest 
currency in the grid. One observes that an appreciation of the German mark vis-à-vîs the 
dollar tends to widen the spread. A clear shift in the relation after the realignment on 6 
March is also visible. 
The transmission mechanism explaining this phenomenon is as follows. When the US 
dollar weakens, capital flows into the German mark more than into other European 
currencies because the markets think that certain countries have relatively more 
difficulties to accept a higher dollar. This puts upward pressure on the German mark in 
the ERM and the spread widens. This sort of intra-European volatility will naturally vanish 
among members of EMU. While the US dollar appears to be an important trigger at 
certain moments for ERM turbulence, it can not be considered as its only cause; in fact, 
for several other currencies, the bilateral exchange rate spread does not widen after a 
dollar fall against the DM. 
The evolution of the USD and the spread between the! 
strongest and the weakest ERM currency in 1995 
OWUSD (left-hand scale) T14 
J'F'M'A'M'J'J" A1 S" O " N " D The inpact cf the IJEDcn the SWin 1939 
»_ srœ6Mïch 
H 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 
1.36 1.40 1.44 1.48 1.52 1.33 
ExchEnaeiateDVmSD 
6.3.96 
36 
2.2.3. Room for further easing of monetary conditions 
In early 1995, Member States in the ERM took a cautious approach to the easing of 
monetary conditions in order to preserve stability. This policy was successful in terms of 
the chosen objective (low inflation, low growth of money supply or stable exchange rate) 
but against the background of the more restrictive fiscal stance and the low level of the 
dollar it appears to have been relatively tight in the first half of 1995. Later in the year, 
when it became clear that the economy was hit by a marked slowdown, Member States 
were, to varying degrees, able to relax monetary policy. This led to a more balanced 
policy mix. After the sharp rise of long rates in 1994 ~ because of better growth 
prospects, international arbitrage flows and a less certain inflation outlook, but also 
because monetary policy was prevented to be sufficiently loose due to the budgetary 
situation — long rates almost completely reversed the evolution in 1995. As long-term 
interest rates declined more rapidly during the year than short-term interest rates, the term 
structure of interest rates became flatter (chart 20). While the difference between the 3-
month interest rate and the 10-year bond yield was 2.5 per cent in January for the 
Community average, it decreased to 1.2 per cent in December 1995. As the slope of the 
yield curve partly reflects market expectations about future inflationary pressures, this 
flattening suggests that inflationary expectations were abating. It also implies that the 
official interest rate reductions have, on average, been credible. However, these cuts in 
interest rates have yet not been fully transmitted to the economy as bank lending rates 
remain high (chart 20), suggesting that credit institutions did not fully pass the advantage 
to their customers but also increased their profit margins. This is of particular importance 
for small and medium-sized entreprises which have less easily access to capital and money 
markets — where interest rates declined markedly — but rely more on bank credit. The 
same applies to the household sector and this may restrain consumer spending. A smooth 
and competitive transmission mechanism forms an essential element in reaping the full 
benefits of lower interest rates. 
Outside the ERM monetary policy generally remained tight, on the whole, in response to 
emerging inflationary pressures. In Italy, short rates rose by about 1.5 per cent in the first 
quarter of 1995 and stayed high. Measured by the reaction of the exchange rate, this 
policy enjoyed particularly high credibility in Sweden and Finland. In the latter country 
short-term differentials against the DM could already be reduced substantially (chart 19). 
Inflation seems to be currently firmly under control in the majority of the Member States 
while the appropriate action was taken where this was less the case, mainly in countries 
with a weaker exchange rate. The risks for an interruption of the favourable trend also 
appear small. Such risks could be linked to the future emergence of a-positive output gap 
6.3.96 
37 
and/or a stronger growth of unit labour costs. Long-term interest rates adjusted for 
(current) inflation remained substantial in 1995. This could reflect a general increase of 
real rates of return on investment which would be a positive development. The 
liberalisation of capital movements and financial deregulation from administered interest 
rates towards market behaviour contributed to the emergence of higher real interest rates 
already during the 1980s. On the other hand, the current high real long rates may to some 
extent also reflect a risk premium for a higher level, and/or higher volatility, of inflation in 
the future. This kind of price uncertainty appears to stem more from occasional doubts in 
the markets on the commitment for budgetary consolidation and, linked to that, the 
commitment to meeting the EMU objectives, rather than to excessive wage demands. 
These risks make the monetary stance more restrictive than it would otherwise need to be 
to preserve stability. 
Chart 20 
INTEREST RATES AND EXPECTED INTEREST RATES IN THE EU 
The evolution of the average interest rates in EU 15 In this context market analysts often refer to the existence of a risk premium on German 
long-term bonds because they presume that monetary policy in EMU would be less 
rigorous than current German 
monetary policy. This is an 
interpretation based on the 
steep slope of the yield curve 
compared to the relatively flat 
slope in the USA and a higher 
long-term interest rate in 
Germany than in the US. 
However, another interpretation 
is equally valid. Indeed, the 
present constellation of interest 
rates is consistent with an 
expectation of a strengthening 
of the US dollar against the 
German mark relative to its 
currently low level. 1 • * 
Feb Apr Jun Aug Oct Doc Feb Apr Jun Aug Oct Dec 
94 | 95 
Three-month futures contracts in Dec 95 and Jan 96 
p*q Given the current growth 
outlook, and in the light of the 
successful easing of monetary 
policy and the gradual reversal 
of exchange rate misalignments 
since March 1995, the objective 
6.3.96 
38-
of low inflation would appear to be compatible with an additional easing of monetary 
conditions. This presupposes that wage pressures and exchange rate tensions can be 
avoided and budgetary consolidation remains credible. The potential for easing remains 
intact even though short-term interest rates in Germany and some other countries are 
approaching low levels. Even lower interest rates have been observed in the past. In 
Germany, the level of the discount rate was lower in 1959 and at the end of 
1987/beginning of 1988, the period following the October 1987 stock exchange crash 
(2.75 per cent and 2.50 per cent respectively). Futures contracts provide an indicator of 
the general orientation of market expectations about future interest rates (chart 20). 
Interest rate expectations have been adjusted downward as illustrated by the decline in the 
interest rates implied by futures contracts, suggesting that market expectations are 
consistent with a further easing of monetary policy. In France and Italy the expected drop 
in short-term interest rates is larger than in Germany, so that the short-term interest rate 
differentials could narrow, which is an indication of stability in the exchange markets. In 
Germany and the UK the implied interest rate by the December-96 contract is higher than 
on some previous contracts, suggesting that short-term interest rates could be bottoming-
out in the course of 1996. The expected interest rate at the end of 1996 remains, however, 
lower than the one observed on average in January. 
Continued wage moderation and enhanced credibility for fiscal consolidation should create 
the conditions for a durable relaxation of monetary policy in Europe. 
6.3.96 
39-
2.3. Budgetary policy 
2.3.1. Recent developments and short-term prospects 
Recent origins of budgetary imbalances 
In general terms, the worrying budgetary positions confronting the Community as a whole 
and the majority of member countries result from the combined influence of three main 
factors: first, the failure of Member States in general to exploit the strong economic 
expansion of the second half of the 1980s to curb existing large structural imbalances; 
second, the exacerbation of these imbalances in the early 1990s by underlying 
deteriorations in Germany (related to unification) and also in a large number of the other 
Member States; and finally, the sharp cyclical deterioration linked to the recession of 
1992/93. 
At the trough of the downturn in the early 1980s, the Community's overall budget deficit 
widened to a hitherto unseen high of around 5 per cent of GDP. Despite a growing 
consensus among policy-makers that budgetary policies needed to be oriented towards the 
objective of medium-term consolidation, efforts made to reduce structural imbalances in the 
course of the 198.0s proved insufficient. The Community's overall budget deficit declined 
to a low of 2V2 percent of GDP at the end of the decade but the improvement was mainly 
due to better cyclical conditions. Indeed, the structural deficit remained unchanged at the 
high level of some 3!/2 per cent of GDP during the prolonged and healthy economic 
expansion of the 1980s (chart 21). 
Chart 21 
Output gap and trends in budget deficit, EUR 
% ofCOP The early 1990s witnessed a 
substantial and rapid deterioration 
in the budgetary performance due to 
both discretionary policies and 
cyclical factors. In the space of 
only 4 years, the Community's 
budget deficit increased by nearly 4 
percentage points to a record high 
of 6.3 percent of GDP in 1993. 
Initially, there was a strong 
deterioration in the cyclically-
adjusted budget deficit for the Community as a whole. This stemmed to a large extent 
from the impact of unification on German public finances. But it also reflected a move 
towards an expansionary fiscal stance in some Member States (table 12), in part reflecting 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 
6.3.96 
40 
endeavours to offset the growth impact of the coinciding tightening of monetary 
conditions. 
Following the onset of recession in the second half 
of 1992, the further sharp deterioration in the 
Community's overall budgetary position entirely 
reflected the consequences of the cyclical downturn. 
This was partly offset by a small, but in the 
circumstances necessary, attempt at redressing the 
structural imbalances. 
Countries reacted very differently to the deepening 
downturn. In Germany, the process of correcting 
the unification-induced build-up in imbalances firmly 
commenced in 1992-93. Likewise, budgetary policy 
was tightened significantly in Belgium, Ireland, Italy 
and the Netherlands, broadly off-setting the negative 
budgetary impact of the recession. All of these 
countries were confronted with high budgetary 
imbalances at the beginning of the 1990s. In 
contrast, several countries (Denmark, France, 
Finland, Sweden and the UK) attempted to alleviate the economic slowdown through a 
fiscal stimulus. In these countries, structural deficits widened by at least 1 percentage point 
during 1992/93. Table 12 
Cyclically-adjusted deficits 1985-95 
(per cent of GDP) 
B 
DK 
D 
GR 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 1985 
-7.6 
-3.4 
-0.3 
-13.7 
-4.8 
-1.8 
-10.3 
-11.9 
7.7 
-2.4 
-1.9 
-4.8 
2.9 
-3.7 
-1.7 
-3.5 1989 
-7.2 
-0.5 
0.5 
-15.5 
-4.9 
-2.4 
-1.4 
-10.9 
-5.2 
-2.9 
-3.6 
1.2 
2.2 
-3.3 
-3.7 1991 
-8.2 
-1.4 
-5.2 
-12.0 
-7.3 
-3.1 
-2.3 
-10.9 
-4.5 
-3.4 
-8.3 
-0.7 
-2.4 
-2.6 
-5.4 1993 
-5.9 
-2.4 
-3.3 
-11.7 
-6.4 
-5.0 
-1.1 
-8.3 
2.8 
-2.7 
-3.6 
-6.7 
-2.4 
-9.3 
-5.8 
-5.1 1995a 
-4.0 
-2.2 
-3.2 
-8.9 
-4.9 
-4.5 
-3.3 
-6.8 
0.6 
-3.0 
-5.4 
-4.6 
-3.5 
-5.4 
-4.5 
-4.2 
a) November 1995 Forecasts; EUR including five 
new German Lander from1991 onwards 
Note: Commission services' estimates. The metho­
dology is explained in European Economy, n" 60, 
1995. p. 35-90. 
In retrospect, the attempt to use budgetary policy to counteract monetary tightening 
proved neither viable nor successful in most Member States. In addition, as the 
Community had failed to cure its fiscal imbalances during the previous boom period, it had 
lost control over a potentially important policy instrument during the recession in 1992-93. 
Insufficient consolidation efforts In 1994-95 
Consequently, most Member States committed themselves to ambitious medium-term fiscal 
consolidation plans once the recovery took hold. In overall terms, the net borrowing of the 
general government was estimated in the November 1995 forecasts to have fallen to 4.7 per 
cent of GDP in 1995 from its peak of 6.3 per cent of GDP in 1993, as a result of better 
cyclical conditions as well as retrenchment efforts. Despite this improvement, the 
government debt/GDP ratio in the Community as a whole posted a marked rise of nearly 
6.3.96 
41 
five percentage points in the years 1994-95. Although partly due to exceptional factors, 
this development underscores the insufficient adjustment in the primary balance. 
The estimated discretionary tightening in the Community over the two years 1994-95 
amounts to just below 1 percent of GDP. During the last two years, considerable 
consolidation measures — leading to reductions in structural deficits of one percentage 
point of GDP or more — were undertaken in about half of the Member States, including 
those where budgetary situations were most preoccupying. Nevertheless, the structural 
deficits in the vast majority of Member States are still in excess of 3 per cent of GDP going 
into 1996. 
Two countries (Ireland and Austria) are estimated to have shown a noticeable structural 
deterioration over the period under review. In Ireland, the budgetary relaxation (over 2 
percentage points of GDP during 1994-954), albeit from a low level, give some cause for 
concern. With regard to Austria, the underlying budgetary position worsened markedly 
(WA percentage points), with the additional costs of EU membership in 1995 accounting for 
only a limited part of this deterioration. 
Evidently, many countries did not exploit to the full the possibilities of implementing fiscal 
consolidation measures in the context of the relatively good economic conditions pertaining 
in 1994 and early 1995. Consequently, the differentiated increase in long-term interest 
rates during 1994, the currency turmoil in the early part of 1995 and the associated 
tightening of monetary conditions in several countries, were in part related to a belief in 
financial markets that consolidation efforts had been smaller, and less rapid, than hoped for. 
In this way, insufficient credibility of fiscal policies played a significant catalysing role in the 
slowdown of the Community economy in the course of 1995. 
1996: Reinforced fiscal consolidation efforts 
Several Member States have taken substantial, and sometimes courageous, efforts to 
reduce budget deficits in 1996. According to the Commission services' estimates of 
cyclically-adjusted deficits, the discretionary consolidation measures to be implemented in 
the Community in 1996 will result in a reduction in the overall structural deficit from 4.2 
per cent of GDP in 1995 to 3.4 per cent in 1996. The size of this discretionary tightening 
is roughly twice as large as the efforts undertaken in 1995. All fifteen Member States are 
4 Around V% percentage point of GDP is due to exceptional factors (see note to table 5 in chapter 1). 
6.3.96 
42 
expected to reduce their structural deficits this year. Particularly important efforts are 
being taken in countries with currently high deficits or debt problems. 
Whilst the improvement in structural budget balances will in se not be affected by the 
worsening growth outlook in 1996, actual budget deficits risk widening under the influence 
of adverse cyclical conditions. However, it would be unwise to allow slippage from 
announced targets. Any market doubts about the resolve of governments to stick to fiscal 
adjustment programmes would risk resulting in an instant reversal of the favourable trends 
in short- and long-term interest rates currently being experienced in many Member States. 
Furthermore, in these countries the negative effects on budgetary positions emanating from 
a lower-than-expected level of economic activity in 1996 will be compensated by 
diminishing debt service costs resulting from lower interest rates. This impact depends 
inter alia on the size of the outstanding debt and its maturity structure. For instance in 
Belgium and Italy, countries with a high public debt, the effect is important: a 1 percentage 
point decrease in the interest rate is estimated to lower the budget deficit by 0.3 to 0.4 per 
cent of GDP in the first year and by 0.5 and 0.8 per cent of GDP (cumulative), respectively, 
in the second year. 
Encouragingly, there is a general recognition in the Community of the need to prevent any 
slippagfiL from the announced consolidation paths. While continuing fiscal consolidation 
efforts are clearly needed, the stated targets remain within reach, provided that there is a 
relatively strong growth revival in the course of 1996, strengthening into 1997. 
2.3.2. Medium-term benefits of continuing and enhanced consolidation 
Bringing order to the Community's public finances can be expected to yield a high medium 
and long-term dividend. Indeed, in most Member States credible fiscal consolidation 
efforts are a prerequisite: 
i. to place public finances on a sustainable footing, increase economic efficiency and 
contribute to the achievement of a sustained medium-term growth process; 
ii. to unburden monetary policy and restore the potential for counter-cyclical fiscal 
action; 
iii. to participate in EMU. 
Placing public finances on a sound footing 
The persistence of sizeable budget deficits (exceeding 3 per cent of GDP for most of the 
period since the first oil shock) has resulted in a steep upward trend in the government debt 
6.3.96 
43 
Chart 22 
General government consolidated gross debt, EUR* 
% 01 GUP 
" 73 75 77 79 81 83 85 87 89 91 93 95 
• 1970-1977: EUR11 (OK, F, NL and P excluded). 
General government net borrowing, EUR* 
% of COP 
'1 73 75 77 79 61 83 85 87 89 91 93 95 
'1970-1978: EUR11 (CR, L, P and 8 excluded). to GDP ratio, reaching over 70 percent of GDP in 
1995 in the Community (chart 22). The steady 
ascent in the government debt ratio has been 
accompanied by a sharp increase in the debt 
servicing cost, with interest payments on the existing 
debt climbing from 1.8 per cent of GDP in 1973 to a 
daunting 5XA percent of GDP now. This evolution 
carries the risk of keeping the government finances 
on an unsustainable track and leads to the crowding-
out of more productive government expenditure. 
While a secular rise in public debt is a common 
feature in most Member countries, the increase was 
particularly spectacular in Belgium (in the 1980s), in 
Greece, Spain and Italy (in the 1980s and 1990s) and 
Finland and Sweden (in the 1990s). These developments have been accompanied by a 
rapid rise in interest payments on debt, approximating or exceeding 10 per cent of GDP in 
the three most indebted member countries (Belgium, Greece and Italy). 
The primary deficit is the key policy-
variable determining the change in the debt 
ratio. The improvement in the primary 
balance over the period 1982 to 1989 (from 
a deficit of 1.3 per cent of GDP to a surplus 
of 2.2 percent of GDP) was too slow to halt 
the increase in the debt ratio because real 
interest rates in excess of real output 
growth added to an adverse "snowball 
effect" (chart 23). In the early 1990s, a 
sharp increase in the debt ratio (the ratio 
grew from 55 percent of GDP in 1990 to 68 
percent in 1994) occurred essentially 
because of a relaxation of budgetary 
stringency which led to a deterioration in 
the primary balance. Given that a primary 
surplus of 3A per cent of GDP in 1995 was 
insufficient to stabilise the debt ratio in the Chart 23 
Government gross debt dynamics, EUR* 
% of GDP A " Annual change in gross debt ratio 
Contributions to the change in the gross debt ratio 
% of GDP B " Primary deficit 
70 72 74 76 78 80 82 84 86 88 90 92 94 
*1970-1978:EUR11 (DK, F, NL and P «xchided). 
6.3.96 
44 
Community on average, there is an urgent need to pursue with determination the 
achievement of larger surpluses on primary balances. 
Increasing economic efficiency 
The development of budgetary imbalances has generally taken place in conjunction with an 
increase in the governments' share in overall GDP. General government receipts and 
expenditure, which represented 34 per cent of Community GDP in 1961, rose to 46 per 
cent and 51 per cent of GDP, respectively, in 1995. Asymmetric policy behaviour over the 
course of the business cycle is at the root of the trend increase in the ratio of government 
spending to GDP. Whereas expenditures climbed markedly in every economic downturn, 
only limited corrections took place in subsequent periods of recovery. The revenue ratio 
typically adjusted to the new expenditure situation albeit partially and with a certain time 
lag. 
Table 13 
Receipts and expenditures of general government - EURa 
(in % of GDP) 
Levels Changes 
1961 1973 1985 1989 1993 1995 1961-73 1973-85 1985-89 1989-93 1993-95 
Current receipts 
of which 
1. Indirect taxes 
2. Direct taxes 
3. Social security contributions 
4. Other current receipts 
Total expenditure 
of which 
5. Current transfers 
5bis. of which to households 
6. Actual interest payments 
7. Public consumption 
8. Net capital transfers 
9. Gross capital formation 
Pro memory 
10. Gross saving 
11. Net lending(+) / borrowing(-) 
12. Gross public debtb 34.3 
13.9 
8.7 
10.2 
1.5 
33.6 
11.5 
3.1 
13.7 
0.8 
4.5 
6.0 
0.7 
65.2 37.6 
12.7 
10.2 
12.0 
2.7 
38.5 
16.1 
13.1 
1.8 
16.1 
0.9 
3.6 
3.7 
-0.9 
36.8 45.2 
13.5 
12.9 
14.9 
4.1 
49.4 
21.8 
17.9 
5.0 
19.2 
1.0 
2.9 
-0.6 
-4.5 
53.9 44.8 
13.4 
13.3 
14.6 
3.4 
46.8 
20.7 
17.1 
4.6 
18.2 
0.9 
2.8 
1.2 
-2.4 
54.1 46.2 
13.6 
12.9 
15.9 
3.7 
52.5 
23.7 
20.0 
5.5 
19.5 
1.0 
2.8 
-2.5 
-6.3 
66.2 46.2 
13.9 
12.8 
16.0 
3.4 
50.9 
23.4 
19.8 
5.4 
18.9 
0.6 
2.6 
-1.6 
-4.7 
71.0 3.3 
-1.2 
1.5 
1.8 
1.2 
4.9 
4.6 
-1.3 
2.4 
0.1 
-0.9 
-2.3 
-1.6 
-28.4 7.6 
0.8 
2.7 
2.9 
1.4 
10.9 
5.7 
4.8 
3.2 
3.1 
0.1 
-0.7 
-4.3 
-3.6 
17.1 -0.4 
-0.1 
0.4 
-0.3 
-0.7 
-2.6 
-1.1 
-0.8 
-0.4 
-1.0 
-0.1 
-0.1 
1.8 
2.1 
0.2 1.4 
0.2 
-0.4 
1.3 
0.3 
5.7 
3.0 
2.9 
0.9 
1.3 
0.1 
0.0 
-3.7 
-3.9 
12.1 0.0 
0.3 
-0.1 
0.1 
-0.3 
-1.6 
-0.3 
-0.2 
-0.1 
-0.6 
-0.4 
-0.2 
0.9 
1.6 
4.8 
1961 and 1973 : EUR 15 excluding Greece, Portugal, Austria, Sweden and Finland. 
1961 and 1973 : EUR 15 excluding France, Netherlands, Greece, Portugal, Austria, Sweden and Finland 
On the expenditure side the main contribution to the progression in the government's share 
of GDP has stemmed from rising transfers to households, which has risen from 12 percent 
of GDP in 1973 to 20 percent in 1995, linked essentially to growing rates of unemployment 
and increased old age pension provisions, and greater levels of interest payments on 
government debt {3Vz percentage points increase). The strong growth in transfers to 
households was only partly matched by an increase in social security contributions, 
implying that a growing proportion of these transfers (about 3 per cent of GDP at present) 
has to be financed through fiscal resources. Whilst the share pf indirect taxes remained 
6.3.96 
45 
broadly unchanged over the last two decades, the direct tax pressure increased by 4 
percentage points in the Community on average. 
There are growing signs that the present 
share and structure of government revenues 
and expenditures is impairing the efficiency 
and flexibility of the Community economy in 
terms of crowding-out of private sector 
activities, higher tax burdens, an increasing 
wedge between labour costs and take-home 
pay, and reduced labour market flexibility. 
Greater awareness of these detrimental 
effects has contributed to make a downsizing 
of the government's share in the economy an 
important goal for budgetary policy in the 
Community. Chart 24 
Transfers to households and 
unemployment rate, EUR 
71 73 75 77 79 81 83 85 87 89 91 93 95 
Contributing to the achievement of a sustained, strong medium-term growth path 
In the context of the need to move to a sustainable, healthy medium-term growth path, 
action towards sounder public finances is crucial to excite a rise in national saving, a 
reduction in real interest rates and a crowding-in of private investment. Although a high 
investment level may be realised by drawing upon foreign savings, such a situation is not 
sustainable over a longer period of time, and would be inappropriate for the Community as 
a whole given its size in the world economy and its degree of economic development. 
Recent empirical analyses concur that persistent fiscal imbalances and declining national 
saving (in the Community and elsewhere) have contributed importantly to the high level of 
real long-term interest rates experienced in the Community and world-wide since the 1980s 
and to the declining trend in investment. 
A high level of national savings must 
therefore go hand in hand with the 
Community's ambitions to generate the 
higher investment levels which are vital to 
underpin a satisfactory medium-term 
growth performance. Given the observed 
long-term stability in private savings, 
there is widespread agreement that the National, private and government saving, EUR 
% of GDP 
PftetMSawng 
I , 1 r<,l > . > • t . I- • • • •! • -I • < • < . < 
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 
6.3.96 
46 
most direct and desirable way to increase national savings is through an increase in 
government saving. Restoration of positive government savings must consequently form 
an integral part of the budgetary strategy. 
Unburdening monetary policy 
By fostering low and stable inflationary expectations, a low budget deficit and government 
debt facilitate the primary task of monetary policy to achieve and maintain nominal stability. 
Especially in countries where short-term interest rates are to a large extent determined by 
exchange rate considerations, the credibility of fiscal policy plays a decisive role in the 
degree of restrictiveness of a stability-oriented monetary policy. This was amply 
demonstrated by recurrent currency turbulences during recent years. Financial market 
concern about the firmness of the commitment of some governments to achieve a sustained 
reduction of budget deficits led to pressures on currencies, forcing bouts of interest rate 
tightening in the countries concerned. In addition, risk premiums on long-term interest 
rates are substantial in several countries, despite marked progress towards low inflation and 
relatively large margins of slack. Whilst to some degree this reflects perceived risks to 
stability associated with the considerable depreciation of these currencies in recent years, 
large fiscal imbalances also appear to have affected expectations about future inflation in 
some member countries. Finally, sound public finances will also reduce the likelihood of, 
or the economic costs of, a possible market testing of the anti-inflationary credibility of the 
newly independent central banks. 
As a consequence, the combination of sound fiscal policy with less restrictive monetary 
policy is likely to result in a composition of growth which provides stronger investment and 
thus a faster and sustained expansion of potential output, than a combination of lax fiscal 
policies with higher real interest rates. 
Restoring the margin of manoeuvre for counter-cyclical fiscal action 
Large budgetary imbalances reduce the scope for counter-cyclical fiscal action. When the 
underlying budgetary position is sound, the free play of the automatic stabilisers tends to 
cushion cyclical variations in economic activity and the potential availability of fiscal action 
may be an important insurance in case of severe adverse shocks. In the case of severely 
unbalanced budgetary positions, however, the counter-cyclical use of budgetary policy may 
well de-stabilise rather than stabilise the economy if financial markets fear sustainability 
problems, leading to a rise in long-term interest rates or currency instability. Consequently, 
the stabilisation function cannot be considered in isolation. 
6.3.96 
47-
Chart 26 
Cyclical component of general government deficit 
70 72 74 76 78 80 82 84 86 88 90 92 94 
* For each year, the Maximum (Minimum) relates to the Member state with the 
highest (lowest) rate among the 15. In the Community, the size of the 
cyclical component of the budget 
deficit is quite important but it 
varies in a substantial manner over 
time and across Member States. 
The adverse impact of the 
automatic stabilisers was equal to 
or exceeded 2 per cent of GDP in 
at least one Member States during 
about half of the time over the last 
two decades (chart 26). 
Furthermore, there appears to be a quite clear relationship between the magnitude of the 
cyclical component and the size of the country: small, open economies, which are relatively 
more vulnerable to external developments and usually less diversified, tend to need more 
room for manoeuvre. Other factors which influence the size of the automatic stabilisers are 
the overall size of the government sector, the progressivity of the tax system, the 
generosity of unemployment benefit schemes and the sensitivity of unemployment to 
fluctuations in output. 
In the Community on average, the cyclical component of the budget deficit fluctuated 
within a margin of slightly less than ± 2 per cent of GDP during the last two decades. 
Consequently, in order to keep the actual budget deficit below 3 per cent of GDP in the 
Community as a whole during economic downturns, it is essential to bring the structural 
deficit down to close to balance (compared to an estimated level of above 4 per cent of 
GDP in 1995). 
Participating in EMU 
The budgetary convergence criteria of the Maastricht Treaty provide an effective support 
framework for Member State efforts by exerting a useful disciplinary role in terms of the 
correction of existing excessive deficit and debt ratios. The correction of these imbalances 
will ensure the necessary degree of fiscal discipline in Stage 3 and support the anti-
inflationary commitment of the future European Central Bank which is essential for 
ensuring an optimal policy mix in the third stage. 
The Community's budgetary policies must therefore encompass the convergence 
requirements of the Maastricht Treaty within the overall medium-term budgetary goal of 
close to balance, as stated in the Broad Policy Guidelines approved by the Council in July 
6.3.96 
48-
1995. The appropriate reference benchmark in this perspective should be broad 
equilibrium in the "structural" budget balance while at the same time allowing the actual 
balance to fluctuate around this value in accordance with the economic cycle. Thus, 
budgetary policy would be in a position to play a symmetric stabilisation role in periods of 
economic expansion and downturn, without endangering the restored sustainability. This 
shock-absorbing role for budgetary policy will be particularly important once the single 
currency is in place in terms of its role in helping to accommodate country-specific 
economic disturbances. 
2. 3.3. Fiscal consolidation and short-term growth prospects 
Governments acknowledge that the medium-term benefits of fiscal consolidation efforts are 
potentially large. That is why all Member States are committed to the objective of sound 
public finances. Nevertheless, governments often hesitate to implement planned 
retrenchment measures because of the perception that in the short run these will restrict 
economic activity and worsen the labour market situation. Clearly, the direct impact of 
fiscal consolidation tends to restrain demand and growth via a reduction in government 
purchases or in private sector disposable incomes. It is thus understandable, given the 
present pause in the growth process, that some Member States may be anxious about any 
negative growth impact from adhering to their existing consohdation plans. 
However, this demand-restraining impact may be offset by a number of indirect effects. 
Budget deficit reductions are likely to make it easier for a stability-oriented monetary 
policy to contribute to a better policy mix. Furthermore, fiscal consolidation may limit the 
adverse demand impact via a reduction in long-term interest rates. In an environment of 
forward-looking financial markets which increasingly focus on the sustainability of 
budgetary policies, high and rising public debt ratios are contributing to high risk premiums 
on interest rates. Provided that the announced adjustment measures are judged credible by 
financial markets ~ i. e. they dispel fears of future monétisation of the public debt and, 
thus, rising inflation --, fiscal consolidation, especially in highly indebted countries saddled 
with high risk premiums, may entail a sizeable fall in long-term interest rates, which in turn 
stimulate investment and alleviate the debt service burden. Less restricitive monetary 
conditions and lower long-term interest rates will have a beneficial impact on investment 
and attenuate the impact on private consumption. This may well offset the direct impact of 
withdrawing the fiscal stimulus, even in the short run. 
6.3.96 
49-
The "crowding-in" of investment is more likely to be encouraged, as is the case at present, 
by high levels of profitability and a progressive return to positive public savings contributes 
soundly to its financing. A rapid and substantial crowding-in of investment is essential not 
only in terms of expanding future productive capacities but also in terms of anchoring non-
inflationary expectations. 
Furthermore, through expectational effects, credible fiscal restraint may also exert a 
favourable impact on consumer behaviour. There is ample theoretical and empirical 
evidence that if budget retrenchment signals a permanent cut in government spending and 
taxes over the medium term, consumers tend to respond rapidly by decreasing their 
savings. 
In broad terms therefore a credible package of consolidation measures may not have 
significant adverse short-term effects provided a number of factors are adequately taken 
into consideration. The consolidation process must be correctly timed, be non-piecemeal in 
its implementation with the order of priorities firmly oriented towards the expenditure side. 
In addition to these basic requirements, it is important that budgetary consolidation is 
perceived to constitute an element in an overall economic approach which is balanced and 
consistent. Under these circumstances the application of the overall economic approach 
would represent a type of "regime" change (see box 5). 
2.3.4. Priority areas for consolidation 
It is clear that trenchant medium-term fiscal consolidation efforts will require fundamental 
budgetary reforms which may provoke adverse political reactions. It is therefore crucial 
that the distribution of the necessary efforts is even-handed to ensure the required degree of 
social acceptability which is vital to the success of the overall adjustment exercise. 
Although specific measures to be taken need to be tailored to situations in individual 
member countries, the primary task in virtually all member countries is, as stated in the 
1995 Broad Economic Policy Guidelines, to promote fiscal consolidation by reducing 
structural deficits. Whilst in terms of actual budget deficits, the less favourable economic 
environment may hide the extent of the fiscal adjustment being undertaken, significant 
consolidation results should become apparent over the medium term as cyclical conditions 
improve. 
6.3.96 
-50 
It is widely recognised that controlling the growth of government expenditure is the 
preferred approach. The overall tax burden in the Community is already high, especially 
relative to its major partner countries, and tax increases would imply raising their 
distortionary effects. Furthermore, there is widespread and strong political resistance to 
higher taxation. Conversely, actions aimed at containing the increase in government 
expenditure, and also at restructuring the latter, could be accompanied by increased 
efficiency of the public sector. In a medium-term perspective, they would open the door 
for new and more productive initiatives, such as additional expenditure to combat long-
term unemployment, to improve education or to reverse the downward trend in public 
investment. It will also increase the degree of preparedness to meet longer-term challenges 
linked to the ageing of the population which will inevitably put additional strains on an 
already stretched social spending budget. Finally, curtailing the share of government 
expenditure would create scope for a reduction in the overall tax burden once budget 
deficits are on a firmly declining path and close to balance. 
Following several years of attempts at controlling government spending, but whose impact 
was offset by continuing 'snowball effects' and high and rising unemployment, little if any 
scope exists for easy and painless actions in most Member States. These countries face the 
more daunting task of fundamental reform of basic government expenditure programmes. 
Amongjhe issues which need to be addressed are the need to place pension provisions on a 
sustainable footing, to curb the rise in health care costs, to reduce distortionary and costly 
subsidies, to increase the effectiveness of social transfers and to improve the functioning 
and efficiency of public services. 
Finally, in countries with high budgetary imbalances, a drastic reduction in budget deficits 
without a certain rise in the tax burden appears unachievable. In this context, increasing 
indirect taxes may be preferable to direct taxes, as the distortionary effects are likely to be 
lower. Furthermore, member countries would also stand to gain from a broadening of the 
tax base, a reduction of excessively high marginal tax rates, modification of tax structures 
in ways which are likely to be conducive to growth and employment and introduction of 
measures designed to improve tax administration. Member countries should give particular 
attention to a reduction in employers' social contributions at the lower end of the wage 
scale and provide for alternative financing means or increased expenditure restraint in order 
not to endanger the overall goal of greater budgetary discipline. 
6.3.96 
51 -
Box 5: Examples of successful fiscal consolidation efforts 
There is broad consensus within the Community on the need for fiscal consolidation and all 
governments have committed themselves to policies of medium-term fiscal consolidation. While 
subscribing to the unambiguously positive, medium-term macroeconomic effects of credible 
efforts to reduce excessive budget deficits, many policy-makers fear that far-reaching fiscal 
retrenchment efforts will, in the short run, adversely impact on aggregate demand and thus 
jeopardise output growth and add to unemployment 
Recent economic analysis and historical evidence shows that this concern is not always justified, 
especially not tn countries with excessively high budget deficits, indeed, experience in a number 
of Member Countries during the 1980s suggests that major fiscal contraction can go hand in hand 
with high growth and strong job creation. The 1933 Danish fiscal adjustment program and the 
1957 Irish deficit reduction program are two Illustrative cases. Against a backdrop of poor 
economic performance, both countries implemented very demanding measures which proved to 
be very successful in reversing a steady trend of rapidly worsening budgetary positions while 
enjoying a substantial improvement in economic performance in the short run. 
Denmark 
Budget balance (% GDP) 
Primary balance (% of GDP) 
Government debt (% of GDP) 
GDP (real % p.a.) 
Domestic demand (real % p.a.) 
-of which Investment (% p.a.) 
Long term interest rate (% ) 
Inflation (% p.a.) 
Employment(% p.a.) 
Unemployment (%) 1982 
-9.1 
-3.1 
63.9 
3.0 
3.5 
7.1 
20.5 
10.2 
0.2 
89 1983 
-7.2 
0.9 
73.4 
2.5 
1.4 
1.9 
14.4 
6.8 
0.7 
9.0 1984 
-4.1 
5.5 
75.1 
4.4 
5.1 
12.9 
14.0 
6.4 
2.9 
8.5 1985 
-2.0 
7.8 
72.0 
4.3 
5.4 
12.6 
11.6 
4.3 
2.6 
7.1 1986 
3.4 
12.2 
63.7 
3.6 
6.1 
17.1 
10.6 
2.9 
4.3 
5.4 Over the period 1982-1986 Denmark 
transformed a deficit of 9.1 per cent of 
GDP into a surplus of 3.4 per cent of 
GDPT i.e. &n improvement of 12.5 per 
cent of GDP, The credibility of the 
policy shift was reflected in a halving 
of the léyej of long-term interest rates 
and a marked fall in inflation. Rather 
than plunging the economy into 
recession, the fiscal adjustment was 
accompanied by a strong economic 
expansion, „ despite an unfavourable 
international environment in the initial 
phase. Over the period, real GDP 
growth averaged 3% per cent, almost 
double the Community average. Growth 
was predominantly driven by the 
crowding-in of private spending; private 
consumption and, especially, investment 
expanded vigorously. As a result of 
buoyant economic activity, the rate of 
unemployment fell from 8.9 per cent in 
1982 to 5.4 per cent in 1986. This 
prosperous episode came to a sudden 
end in the second half of the 1980s. 
Overheating and high pay rises, 
reflecting strained labour market 
conditions, led to a tightening of monetary policy and a relapse of expectations. This, in turn, 
resulted in a prolonged period of subdued growth, deteriorating public finances and rising 
unemployment Public debt (% of GDP) Denmark 
0 12 3 4 5 6 
Cyclically-adjusted budget deficit (% of GDP) 
6.3.96 
52 
Ireland 
Budget balance (% GDP) 
Primary balance (% of GDP) 
Government debt (% of GDP) 
GDP (real % p.a.) 
Domestic demand (real % p.a.) 
-of which Investment (% p.a.) 
Long term interest rate (% ) 
Inflation (% p.a.) 
Employments p.a.) 
Unemployment (%) 1986 
-10.6 
-1.4 
114.9 
0.3 
2.1 
0.0 
11.1 
3.7 
0.2 
16.8 1987 
-8.5 
0.8 
116.0 
4.7 
0.3 
-2.3 
11.3 
2.4 
0.8 
16.6 1988 
-4.4 
4.2 
111.6 
4.3 
1.3 
-1.6 
9.4 
4.0 
0.0 
16.1 1989 
-1.8 
6.0 
101.7 
6.1 
7.6 
13.8 
89 
40 
-0.2 
14.7 1990 
-2.3 
5.5 
96.5 
7-8. 
5.7 
11.1 
10.1 
2.0 
4.2 
13.4 In Ireland, the 1987 budgetary 
adjustment plan led to a marked 
reduction in general government net 
borrowing from 1034 per cent of GDP 
in 1987 to 1.8 per cent of GDP in 
1989, reflected In a 15 points large 
drop in the public debt-to-GDP ratio 
over the same period. The fiscal 
consolidatiori did net hamper high 
economic growth, as real GDP growth 
accelerated from virtual stagnation \n 
1986 to growth of 6 per cent in 1989. 
While improved competitiveness and 
positive external developments proved 
instrumental in spurring the marked 
turnaround both in terms of output and 
budgetary performance» the domestic 
economy also responded favourably to 
the policy shift with the preceding phase 
of deeply depressed domestic demand 
giving way to a substantial pick-up in 
investment and consumption. Further­
more, unemployment fell, albeit less 
significantly, from 16*6 per cent in 1987 
to 14.7 per cent in* 1989, A key feature 
of the Irish approach was thai fiscal 
consolidation was assisted by an agreement with the social partners on a comprehensive 
adjustment plan in which the adherence to moderate wage Increases was a crucial element, in 
contrast to the Danish experience, output growth remained buoyant lit the subsequent period dn^ 
the public debt ratio declined steadily, despite slowing fiscal consolidation efforts. Pubic debt (% of OOP) Ireland 
3 4 5 6 7 8 S 10 11 12 13 14 15 16 
CycMcaJly-adJustad budget dele* (% of OOP) 
However, success of fiscal consolidation efforts in Denmark m6 Ireland contrast with the 
experience of many other countries. Important features of both the Danish and Irish experiences, 
differentiating them from less successful ones, are: 
- In both countries, fiscal retrenchment was part of a credible-change In the economic policy 
regime* The regime change implied a renewed commitment to stable exchange rates and 
low inflation supported by budget consolidation and appropriate wage behaviour. Other 
factors were also at work {improved competitiveness position; liberalisation of capital 
movements) but undoubtedly the positive expectations effect of the policy shift enabled the 
economy to reap the benefits of these developments. 
Although the direct impact of slower public expenditure growth was clearly negative, 
important indirect effects, linked to the improvement In expectations, were evident in the 
substantial falls In long-term interest rates and a surge In private sector confidence. 
- The distinction between the Danish and Irish experiences and other less successful 
retrenchment efforts is not simply the scale of adjustment undertaken but also the positive 
effects on private sector expectations attributable to a credible commitment to sustaining the 
budgetary adjustment into the medium-term. While there was some rise in the tax burden, 
the bulk of the adjustment was on controlling growth of public expending, which yielded 
positive expectations about a permanent decline in the share of government in the economy. 
6.3.96 
53 -
2.4. Wage developments 
2.4.1. The appropriate wage trends 
Whereas monetary policy is conducted by increasingly independent central banks and 
budgetary policy is determined by sovereign governments, the development of wages 
generally represents the outcome of negotiations between social partners. Nevertheless, 
wage trends are a key ingredient of macroeconomic and structural policies. The 
macroeconomic wage bill (including all social security contributions) is equivalent to about 
50 per cent of Community GDP, broadly equalling the share of total government spending 
in the economy. Consequently, the evolution of aggregate wages and wage differentials 
has substantial implications for inflation, growth, employment and the employment-content 
of growth. In view of their economic importance, it is warranted that policy-makers, whilst 
fully respecting the autonomy of the social partners in this area, closely monitor wage 
developments and set the stage by concluding appropriate wage agreements in the public 
sector. 
To help assess the appropriateness of wage developments, some broad signposts have been 
developed at the Community level in the framework of the surveillance of economic 
performance and policy. At the macroeconomic level, two issues are of particular concern. 
Firstly, it is of crucial importance that the perception of the expected rate of inflation which 
is embodied in wage settlements is, as much as possible, compatible with the price-stability 
objective of the central bank. If this is the case, wage developments de facto do not place 
an undue burden on the conduct of monetary policy. Conversely, if wages increase in a 
manner which is inconsistent with achieving and/or maintaining low inflation, a stability 
conflict arises of the type experienced during the early 1990s. 
Secondly, as regards real wages, it is important that their evolution at the macroeconomic 
level takes into account the need for safeguarding, and if necessary improving, the 
profitability of investment. In this respect, the Commission, in its 1993 White Paper, put 
forward a rule of thumb: over the next few years, real wages should increase by about one 
percentage point less than overall labour productivity. The validity of such a rule is now 
widely accepted. It was embodied in the Council's Broad Guidelines of 1994 and the 
conclusions of the Essen European Council. This rule is based on both past experience and 
the realisation of the significance of enhanced investment profitability to the Community's 
medium-term conditions to foster a strong expansion of productive capacity and 
employment-creating growth. During the period 1982-89, which saw a steady restoration 
6.3.96 
54-
in investment profitability, real wages increased on average by 1 percentage point per year 
less than productivity growth. This marked improvement in profitability contributed to the 
brisk expansion of investment, especially in equipment, and to the acceleration of actual 
and potential rates of growth during the second half of the 1980s. 
Respecting this rule, in combination with employment growth, also allows for a sufficient 
increase in consumption and overall demand which is necessary for investment and to 
favour an appropriate balance between capital-widening and capital-deepening investment. 
Furthermore, adequate wage trends will contribute to the external cost competitiveness of 
the economy and positively affect entrepreneurial location decisions. 
In this context, it is noteworthy that in the Community on average, the profit share already 
exceeds the level registered in the 1960s. However, this is necessary in order to 
compensate for the comparatively higher capital/output ratio. In the next few years, 
profitability may approximate the level reached during the quasi-full-employment period. 
But in view of huge capital needs and to offset the relatively higher level of real interest 
rates (compared to the levels prevailing during the 1960s), a further improvement in 
profitability is called for. Since average labour productivity is enhanced by the employment 
of a larger capital- stock, the standard of living of workers will be positively affected over 
the medium term. 
Obviously, for the development of employment, an adequate degree of wage differentiation 
is also highly relevant. However, policies should aim at lowering total wage costs at the 
lower end of the scale without reducing the disposable income of low-wage earners. In the 
pursuit of a higher level of employment, the results of wage settlements should provide for 
an appropriate differentiation across qualifications as well as geographical areas and sectors 
and firms. Market forces are pushing into this direction. But the interaction between tax 
and social benefit systems in many countries create an 'implicit wage floor', preventing a 
substantial downward adjustment of wages relative to productivity. A widening of the 
distribution at the lower end of the wage scale would increase the employment-content of 
growth but the scope for such action is limited by the social/political exigency to preserve 
the foundations of the European social model. The closer the link between wage and 
productivity levels of the particular working post, the more activities with below-average 
productivity could be (re-)introduced in the production process. It would make low-
productivity activities profitable that were formerly either priced out of the official market 
or "transferred" to foreign low-wage producers. Similarly, it would help limit the process 
of substitution of parts of the workforce by capital investment. 
6.3.96 
55-
Such a downward widening can be obtained in two manners. Market forces can be allowed 
to substantially lower the wages of low-skilled workers as has happened in the US. Taken 
to extremes, this option entails serious economic and social consequences ("working poor 
syndrome"). There are, however, possibilities for some widening in keeping with a reform 
of the European social model. Gross labour costs can be reduced by lowering employers' 
social contributions or by simultaneously lowering wages and taxes on low incomes 
without affecting net income. The first approach is currently being pursued in several 
Member Countries (including France, Belgium, Netherlands, Ireland and the UK). While 
some positive results are emerging at the national level, their size appears yet to be 
insufficient to perceive a noticeable macroeconomic influence at the Community level. To 
neutralize the impact on budget deficits and to avoid adverse economic side-effects, it is 
essential to carefully design such measures and to target them at the low end of the wage 
scale. 
The requirement for an appropriate degree of wage flexibility has also significant regional 
aspects. In the Community, intense intra-regional trade links have been accompanied by a 
narrowing of regional divergences in wage and productivity levels. Nevertheless, wide 
discrepancies remain between Member States and regions in the levels of overall 
compensation per employee and disparities of broadly identical magnitudes exist in the 
levels of overall labour productivity. As a result, the levels of unit labour costs are similar 
across Member States. For the less-favoured regions in the Community to exploit fully 
their competitive advantage in terms of wages and non-wage labour costs, it is essential 
that increases in real wages relative to changes in productivity remain adequate. This 
should enable these regions to post a relatively more dynamic growth, productivity and 
employment path and would eventually enable relatively stronger increases in real wages, 
thereby advancing the catching-up process. 
In the wage-profitability-investment-employment nexus, there is also a role for wages 
having a larger flexible and profit-related component. Such a flexibility is especially 
desirable at the sector/firm level in order to respond adequately to sectoral/firm specific 
changes in economic conditions. In this context, experience has indicated that in the 
absence of such flexibility, the adjustment to adverse shocks occurs through 
disproportionate losses in working posts. 
These considerations stressing the need for appropriate wage behaviour are all the more 
pertinent in view of the ongoing deepening of European economic integration. Following 
6.3.96 
56 
the full liberalisation of capital movements, investments are taking place in those 
geographical areas where the expected rate of return is highest. Although the latter is 
determined by several structural and microeconomic factors, wage developments are an 
important element. In EMU, with single monetary and exchange rate policies and overall 
reduced freedom in budgetary policy, the role of wages in response to changed economic 
situations will gain prominence. As a result, it will be essential that the social partners 
exhibit the necessary degree of flexibility in wage negotiations. All these issues constitute 
important topics for the dialogue between the social partners. 
2.4.2. Wage adjustment in the EC since 1980 
Over the past 15 years, the evolution of 
nominal wages in the Community has 
generally not only accompanied but also 
facilitated the remarkable disinflation 
process. As shown in chart 27, 
significant wage adjustments contributed 
quite strongly to the noticeable fall in 
inflation achieved during the protracted 
expansion phase of the 1980s. The rate 
of increase in nominal unit labour costs Chart 27 
Nominal wages and inflation - EUR 
% change p.a. 
decelerated strongly from the beginning of the decade and was actually faster than the rate 
of inflation. The success in adjusting wage trends during the period 1980-89 was all the 
more spectacular in the initial years as it occurred against an unfavourable background of 
strongly rising import prices. 
It is only towards the end of the 1980s that the promising trend of moderating wage 
increases came to a halt and wage behaviour became clearly incompatible with the 
monetary authorities' stability objective in the period 1990-92. The policy-induced 
overheating of the Community economy in 1988-89 led to a marked pick-up in inflation 
and inflation expectations. Wage trends reacted to the accelerating rate of inflation, albeit 
with a certain lag: nominal wages per head accelerated to 7.4 per cent in 1990 against 5.4 
per cent in 1987. In the light of these developments, monetary policy was tightened as 
from late 1988 and became very tight in 1991-92. The stability conflict was exacerbated by 
the post-unification boom in West Germany which generated bottlenecks in the labour 
market and entailed steep wage increases. The period since 1993 has generally seen a 
substantial improvement in wage behaviour. Nominal wage increases decelerated 
6.3.96 
57-
considerably and assisted the resumption of the trend towards price stability in the 
Community. 
Chart 28 
•7^Ubfmff9ikffMfy0fMi9h-Real wages and labour productivity - EUR 
annual % changes 
3 
2 
1 
o i 
-1 
1 
o 
-1 
-2 
-3 
80 81 82 83 84 85 86 87 89 90 81 92 93 94 95 The long-term macroeconomic 
evolution of real wages in relation 
to labour productivity and 
investment profitability shows a 
similar pattern as the nominal 
indicators. During the 1980s, 
increases in real wages, while 
remaining positive, fell clearly short 
of labour productivity growth, 
resulting in a substantial decline in 
real unit labour costs. This 
conspicuous wage development was a key factor behind the boost in investment 
profitability which rose steadily from the low point reached in 1980 of about 65 per cent of 
the average over the period 1961-73 to close to 90 per cent in 1989 (see chart 6 in chapter 
1). This improvement was interrupted during the slowdown of the early 1990s as real 
wages reacted with a certain time-lag to the cyclical deceleration in labour productivity 
growth^ Nevertheless, due to the greater responsiveness of employment to economic 
trends, the deterioration was markedly smaller than in previous recessions. Noteworthy in 
this respect were developments in 1992 when growth in labour productivity exceeded its 
long-term trend because of strong labour shedding. Productivity gains thus obtained 
should not be distributed to those who keep their employment. Over the last two years, 
wage trends were again generally in line with the Council's recommendation in the Broad 
Economic Policy Guidelines. The rapid expansion of output and the impact of 
restructuring measures have resulted in labour productivity growth in excess of real wages, 
albeit also accelerating. This laid the grounds for a renewed recovery in investment 
profitability from 1994 onwards. 
With respect to an increased flexibility of the labour market in relation to unemployment, 
empirical evidence seems to suggest that in the first half of the 1980s wage flexibility in the 
Community deteriorated, but stabilised thereafter. In terms of the differentiation of wages, 
there is no clear picture for the Community. While in France and the UK there is a clear 
trend towards an increased earnings dispersion in the 1980s, the latter stayed almost 
unchanged in Italy and decreased somewhat in Germany5. 
Based on figures published in "The OECD jobs study, Implementing the strategy", 1995, p. 14 
6.3.96 
58 
2.4.3. Expected wage developments 
Following a slight acceleration last year from the low rate registered in 1994, nominal 
wages are assumed, according to the Commission's November 1995 forecast, to increase 
by about 3% per cent this year and next in the Community on average. Real wages might 
pick up to 1 per cent following two years of virtual stagnation whereas labour productivity 
growth is expected to return to its long-term trend of around 2 per cent. These recent and 
prospective developments suggest that from a macroeconomic perspective wage behaviour 
in the Community on average is appropriate and set to contribute positively to the 
achievement and maintenance of price stability, to the generation of a high, employment-
creating growth path and to the improvement in the Community's external competitive 
position. Given a long-term trend in annual productivity growth of 2 per cent in the 
Commumty on average, the Broad Guidelines in effect suggest that growth in nominal 
compensation of employees per head of the order of 3/4 per cent in the Community on 
average may be considered compatible with the intermediate price inflation target of 2-3 
per cent, as a step towards stability, with the need for a continuing improvement in 
investment profitability and with the necessity to ensure an adequate expansion of domestic 
demand. 
Although in most Member Countries wage developments are in keeping with the objectives 
of price stability and a further restoration of investment profitabiUty, some important, 
country-specific, trends are discernible. In some countries where inflation is already low, 
relatively subdued demand and, more importantly, the competitiveness losses associated 
with currency appreciation, have limited the extent to which wage and unit labour costs can 
be passed on to prices. This is particularly the case in Germany where the relatively high 
pay settlements at the beginning of last year and the strong effective appreciation of the 
DM led to a significant squeeze of profit margins in export sectors. Obviously, wage 
trends cannot adjust instantaneously to movements in exchange rates and in case of a clear 
overshooting, a market-mduced correction of exchange rates is certainly the most desirable 
option. Still, in order to safeguard the country's competitive position and its attractiveness 
for private sector investment decisions, it is essential in Germany, but also in some other 
countries, to contain pay settlements whilst at the same time implementing measures to 
enhance productivity and employment. Proposals of this type are currently being discussed 
in some countries by the social partners, sometimes in concertation with the government. 
Conversely, in some depreciating countries, like Spain and Italy, the actual rate of inflation 
turned out to be higher than the targeted rate of inflation incorporated in the pay 
6.3.96 
-59-
settlements last year. This resulted in a fall in real wages for the second consecutive year. 
According to the forecasts, nominal wage increases might accelerate somewhat to the 4V£ 
to 5 per cent range. In both countries, it is essential that workers do not seek to catch up 
on previous years' losses in purchasing power through higher pay claims as this would risk 
fuelling a price/wage spiral. Instead, continuing adequate wage behaviour in combination 
with credible fiscal rectitude should engender an appreciation of these currencies, thereby 
lessening (imported) inflationary pressures. Such an evolution seems to take place in Spain 
and Italy and such a policy mix was successfully implemented in Sweden last year. In the 
latter country, however, forecasted wage settlements for this year seem to embody a 
marked acceleration in the rate of increase of nominal wages which risks being in conflict 
with the stability objective and which allied with the considerable appreciation of the Krona 
may threaten its external competitive position. Finally, in a few other Member Countries, 
for instance Greece, the disinflation process is far from being completed. 
2.5. Structural policies 
2.5.1. Vital complement to macroeconomic policy-mix 
The objective of setting in place the desired macroeconomic policy mix, described in 
previous sections, is essentially twofold: firstly, to overcome the present pause in the 
recovery and secondly to firmly re-establish the Community's economy on a robust 
medium-term growth path. With regard to the latter objective, macroeconomic policies 
provide the essential framework within which such a strong traditional growth process 
underpinned by capacity and employment-creating investment can develop. This is needed 
to ensure a significant increase in both the effective and potential rates of growth in the 
Community. Assuming the maintenance of trend productivity growth of the order of 2 per 
cent, this would allow for strong employment creation. However, for such a growth 
process to be sustained and thus to allow for strong employment creation, macroeconomic 
policies must be accompanied and supported by structural measures in both the goods and 
services markets and in the area of labour market reform. 
Structural policies are crucial to the success of the Community's growth and employment 
strategy for essentially three reasons. Firstly, structural policies create the conditions 
necessary for a higher rate of economic expansion without the early appearance of adverse 
inflationary pressures. Secondly, they help to increase the endogenous growth forces by 
ameliorating the efficiency and overall competitiveness of the economy. Thirdly, they play 
a crucial role in improving the employment content of growth and reducing structural 
6.3.96 
60 
unemployment. Furthermore, structural policies must also take into account the need to 
preserve a healthy environment. 
(i) To ensure a tension-free macroeconomic growth process ~ Well functioning 
product and service markets contribute to achieving higher growth and employment by 
allowing relative prices to adjust swiftly to changing economic conditions. 
Furthermore, the economic merit of actions geared towards increasing the flexibility of 
labour markets is related to their contribution to avoiding labour market bottlenecks 
and a resumption of wage inflation as unemployment comes down. As such, they are 
crucial to help reduce the NAIRU. Indeed, measures aimed at improving the 
transparency of labour markets, at enhancing flexibility in the areas of professional and 
geographical mobility or at retraining target groups hit by exclusion or industrial 
restructuring facilitate the re-absorption of unemployed workers when the demand for 
labour resumes. Some measures have already been introduced in these areas at the 
national level, backed up by Community programmes in the context of the Structural 
Funds. Such measures, however, do not in themselves engender new jobs. 
(ii) To reinforce the Community's endogenous growth forces — Specific measures 
directed towards enhancing competitiveness and innovation will underpin strong 
advancements in terms of productivity and consequently real standards of living and 
wealth. Indeed, policies aimed at fully exploiting the potential of the internal market, 
reinforcing competition, fostering investment in new technologies, accelerating the 
realisation of trans-European infrastructure networks, stimulating SMEs, raising the 
quality of human capital, and furthering investment in weaker regions, all have in 
common the objective of reinforcing the endogenous growth forces of the 
Community's economy via increases in overall productivity. Taken as a whole, these 
policies could, according to the new growth theories, lead to an acceleration in the 
Community's rate of growth through an enhancement of the overall productivity of its 
economic structure. 
The net employment effects of these policies will ultimately depend on the smoothness 
of the inter-sectoral redistribution of productivity gains and developments in terms of 
labour demand (see box 6). For this process to operate effectively, relative price 
movements must be permitted to operate flexibly, the sectoral changes implied by this 
process must command a large degree of economic and social acceptability and finally 
growth must be sufficiently high as to ensure a positive net balance in terms of job 
creation across the sectors. Therefore, to bear fruit in terms of net employment, the 
6.3.96 
-61 -
Box 6: Productivity and employment growth 
As stressed in the White Paper on "Growth, competitiveness and employment" and by the Social 
Partners, there is no contradiction between initiatives to enhance productivity growth and net 
employment creation provided that the wealth created by the sectors with high-productivity 
increases is adequately redistributed within the economy, enabling sectors with low productivity 
growth to create new jobs. One important channel of redistribution of productivity gains is 
decreasing relative prices in sectors with high productivity growth, increasing the purchasing 
power for all consumers, and thus demand for products and services in general, and especially in 
employment-intensive sectors with low productivity growth and increasing relative prices. As is 
shown in the table below, such a mechanism has worked well during the 1960s and in 1986-90 in 
the Community. 
Employment, productivity and relative prices in main sectors 
(EUR5, in % per year)3 
Indicator 
Value added 
Employment 
Productivity 
Relative price Period 
1961-73 
1974-85 
1986-90 
1961-73 
1974-85 
1986-90 
1961-73 
1974-85 
1986-90 
1961-73 
1974-85 
1986-90 Total 
4.9 
2.1 
3.1 
0.3 
0.2 
1.0 
4.6 
1.9 
2.1 
-Agriculture 
1.8 
1.7 
1.7 
-4.6 
-2.9 
-3.1 
6.5 
4.7 
4.9 
-0.4 
-2.5 
-2.0 Industry 
5.5 
1.0 
2.4 
0.5 
-1.4 
0.3 
5.0 
2.4 
2.1 
-1.0 
-0.4 
-0.4 Market 
services 
5.6 
3.5 
4.0 
1.6 
1.7 
2.4 
4.0 
1.5 
1.6 
0.7 
0.5 
0.4 Non-market 
services 
3.7 
2.3 
1.4 
2.2 
2.0 
1.0 
1.5 
0.3 
0.4 
3.4 
3.5 
2.9 
a) Comparable data over the whole period are only available for B, D, F, I and NL. 
Source: Eurostat and Commission services. 
For such a process to work effectively, three essential conditions must be met simultaneously: 
• relative product prices between sector must be allowed to change in the right direction without 
artificial rigidities. The full working of the internal market and the achievement of convergence 
together with the pressure of international competition in a more open world economy are 
ensuring that the required flexibility of markets is maintained and strengthened throughout the 
Union. There is statistical evidence that this process has been and continues to be at work; 
• sectoral changes need to be economically justified and socially acceptable. Also concerning 
the process of sectoral change there is clear evidence that it is going on strongly. Progress in 
the five key areas identified by the Essen European Council, especially the re-direction of 
labour market policies from passive income support to more active measures, such as reforms 
and strengthening of education and training systems, are underway and will be instrumental in 
supporting such processes of change, while cushioning the possible adverse social costs; 
• and, above all, the rare of growth must be high enough to maintain a positive balance between 
job creation and job destruction across sectors. If this is the case, this process will give an 
important contribution to the achievement of the employment targets of the Union. At present 
the growth condition is not fulfilled, underlining the need for a firm and credible implementation 
of the policies agreed upon in the Broad Economic Policy Guidelines. 
6.3.96 
62 
newly created competitive and productivity potential must be exploited by effective 
high rates of growth. If the latter is not the case, efforts targeted at the labour market 
will lead to frustration amongst the higher skilled groups while human capital 
continues to be destroyed by long-term unemployment. 
(iii) To increase the employment-content of growth — The achievement of a higher 
labour content of growth essentially means that more jobs will be created for a given 
growth rate of GDP. Such an outcome implies, in statistical terms, that the growth of 
the overall apparent productivity of labour will become slower. It is self-evident, of 
course, that this outcome should not be achieved by negatively influencing productivity 
at the firm or sector level. Theoretically, the employment-content of growth may be 
increased by a macroeconomic evolution of relative factor prices which favours the 
use of labour with respect to capital. Such a development of relative factor prices 
stimulates in the first place, via increased profitability, the traditional growth process 
driven by capacity-enhancing and employment-creating investment. Yet, this is likely 
to take a considerable time to have a noticeable impact on the employment-content of 
growth. 
Apart from this macroeconomic substitution process, increasing the employment-
content of growth rests essentially on a widening of the wage scale and changes in the 
field of working time and work organisation. In the European social model the first 
option can only be realised to a limited extent by reducing net wage income at the 
lower end of the wage scale (see above). A more promising way is by lowering non-
wage labour costs for this category. The second approach of a higher flexibility in 
working time arrangements — which can be combined in- some cases with a reduction 
in working time ~ if tailored to the specific needs of enterprises and individuals, will 
achieve a better utilisation of fixed capital and stimulate both new jobs and higher 
participation in the labour market. In addition to these two approaches, the promotion 
of local and regional initiatives, for example in the fields of social services could 
contribute considerably to an increase in the labour-content of growth. This also 
applies to environmental protection industries and services, where job creation has 
been much higher than in the rest of the economy. 
There are thus ways to achieve a higher labour content of growth without calling into 
question fundamental social values. In implementing these measures, caution must be 
exercised to ensure that they are neutral in terms of costs and government budgets. 
Under these assumptions, it is clear that the introduction of these measures has 
substantial employment potential. They are used to varying degrees in the Member 
States. However, the scale of the measures currently taken is still too small to ensure 
significant results at the Community level. 
6.3.96 
-63 
Table B7.1 
Growth of trade and GDP 
(annual percentage change) 
World Trade3) 
World GDP 
EC GDP 1970-79 
7 
4 
3.4 1980-89 
41/2 
31/2 
2.2 1990-95 
6 
TA 
1.7 
a) Average of exports and imports of goods Box 7 : The Community in the world economy 
The world economy is becoming increasingly "globalised". Trade integration among industrialised 
countries continues to rise and emerging economies in Asia and in Central and Eastern Europe 
are becoming increasingly important trading partners. In addition, international capital flows have 
become more mobile and both financial and foreign direct investment flows have risen markedly 
(although gross flows have risen strongly, this does not in general apply to net capital flows, as 
mirrored in current account balances). The globalisation of markets has been driven by progress 
in transportation and communication technology, libéralisation of trade and investment, and by 
changes in enterprise organization and strategy6. 
These developments play an important 
role for the Community economy. 
Currently, extra-EC exports of goods and 
services account for about 10 per cent of 
Community output (EUR15). The share in 
GDP has increased only modestly over 
the last two decades, but since prices on 
internationally traded products bave risen 
slower than the overall price level, this 
masks the fact that international trade has expanded at a considerably higher pace in volume 
terms than overall output growth. 
The Community is a major participant in world trade. Table B7.2 shows that the Community's 
share in world merchandise exports (excluding intra-EC trade) remains high at 23 per cent, but 
since the early 1970s, this share has 
declined somewhat. This fall is to some 
extent explained by a comparatively low 
share of Community exports in strong-
demand, high-technology sectors relative 
to the US and Japan (26 per cent of total 
exports in the EC versus 30 per cent in the 
US and 35 per cent in Japan7 ). In 
addition, the Community has a 
comparatively low share of exports 
directed towards markets which have been 
growing fast, partly due to geographical 
factors. For example, exports to Japan, the NICs and China, where import growth rates would 
appear to be particularly promising over the medium term, represent only 14 per cent of extra-EC 
exports, against 23 per cent in the US and 27 per cent in Japan7. However, the Community is 
well placed to benefit from the expected strong growth of trade with Central and Eastern 
European countries (CEEC) in coming years. In 1994, around 9 per cent of extra-EC exports 
(EUR12) were directed towards CEEC and the former Soviet Union, and such exports expanded 
by around 15 to 20 per cent per year in 1994-95 {in value terms). Table B7.2 
Shares in world trade (goods)3) 
(per cent) 
EUR12 
US 
Japan 
DAEb) 
World 1972-74 
25.3 
19.0 
10.6 
5.6 
100.0 1982-84 
23.2 
17.6 
12.5 
10.9 
100.0 1992-94 
23.5 
18.4 
14.2 
15.1 
100.0 
a) Exports; world and EC trade excludes intra-. EC trade 
b) Dynamic Asian Economies 
6 It is worth recalling that internationalisation of the economies, as measured by the share of trade in overall 
GDP, for many countries is no greater today than before 1914 during the period of liberal trade and fixed 
exchange rates under the gold standard. In a similar vein, capital mobility, in terms of net flows, do not 
appear to be higher today than it was at that time. 
7 "European Competitiveness in the Triad", Note for the attention of the EPC, Commission services 1995. 
6.3.96 
64-
Table B6.3 
Foreign direct investment flows, EUR12 
(billion ECU) 
Inward FDl 
- from OECD 
- from US 
- from Japan 
Outward FDl 
- to OECD 
-to US 
- to Japan 
-to rest of Asia 
- to CEEC 
Net inflow 1984 
6.2 
5.0 
3.0 
0.4 
17.4 
13.0 
11.5 
0.3 
n.a. 
n.a. 
-11.2 1989 
27.9 
23.0 
9.8 
4.4 
33.3 
26.8 
24.1 
0.7 
n.a. 
n.a. 
-5.4 1993 
21.0 
16.0 
9.0 
1.7 
21.9 
13.4 
10.2 
-1.2 
1.8 
2.4 
-0.8 
Source: Eurostat. FDl excluding reinvested earnings. Increased trade has been paralleled by 
increased foreign direct investment, in the 
second half of the 1980's there was a 
marked rise in both inward and outgoing 
FDl for the Community. Foreign 
investment in the EC rose vigorously as 
foreign investors sought to prepare for the 
internal market, and the Community's net 
outflow of FDl was substantially reduced. 
From 1989 to 1993, the latest year for 
which data are available, both inward and 
outgoing FDl flows fell back somewhat 
under the impact of the economic 
slowdown, but the level remained 
relatively high in a historical perspective. 
FDl flows were largely m balance for the 
Community (EUR12) as a whole in 1993. 
At least until recently, most outward investment flows have been directed towards other 
industrialised countries with a secondary role played by investment in low-wage countries. In most 
sectors outward FDl takes place mainly to gain access to local markets for goods and services. 
Services sectors - in many of which firms are required to have a physical presence in the local 
market — account for a share of outward FDl almost as large as the manufacturing sector. 
Outward FDl in low-wage countries represent only a marginal, though growing fraction of 
domestic investment in the EC. 
While there is broad agreement that the Community economy, as well as its partners, stand to 
gain in overall terms from increased international integration, there remains a concern that 
particular groups within the Community may loose out (unless they are, in one way or another 
being compensated). In particular, the downward pressure on low-skilled wages and/or the rising 
unemployment among low-skilled labour in most European countries has been attributed to the 
increased competition from low-wage countries. However, it is very difficult to separate the 
effects of increased international trade from the effects of technological changes which also 
appears to have reduced demand for unskilled labour. Recent studies have not been able to offer 
conclusive evidence on the magnitude of these effects. One recent review of the available 
evidence has concluded that competition from low-wage economies has had a negative impact on 
EC employment in some sectors, but that it is not particularly large. It may well be off-set by 
rising employment in other sectors. Trade with developed economies has in general had larger 
positive and/or negative effects. In the EU, with the exception of the UK, rising import penetration 
from low-wage competitors has resulted in falling employment among low-skilled labour, whereas 
in the US and the UK, it has resulted in lower wages for manual labour. 
For the Community, active participation in the globalisation process is an essential means of 
achieving a continued improvement in living standards as well as better overall job opportunities. 
However, in order to reap the full benefits of such international integration, rigorous and extensive 
action is called for in the Community to facilitate structural adjustments as well as retraining 
efforts. 
6.3.96 
-65 
(iv) To generate environmentally sustainable economic growth ~ It is, by now, 
increasingly recognized that there is no simple linear relationship between economic 
growth and pressures on the environment. Although an increase in the production of 
goods and services would a priori lead to an increase in resource use and pollution, 
countervailing forces - like technical progress, structural change and increasing 
preferences for a clean environment - frequently tend to compensate for this increase. 
One can therefore say, provided that an appropriate policy framework is put in place, 
that there is no inherent conflict between economic development and the environment. 
In fact, in the long run, economic prosperity is likely to depend on a healthy 
environment. 
One of the main conditions for a harmonious development of economic activity and the 
environment is, in line with the polluter pays principle, that market participants receive 
the right price signals. Only if market prices reflect not only private but also 
environmental costs will it be possible to reach a path of environmentally sustainable 
economic growth. 
Although it has to be stressed that environmental policies should be pursued in their 
own right, environmental policies can make a positive contribution to employment 
creation. The main channel for employment gains to occur from environmental 
policies involves the use of revenues from taxes, which are introduced for 
environmental purposes, to* compensate for reductions in social charges levied on 
essentially low-paid labour. Caution has to be applied both with respect to the size of 
these potential employment gains from such tax reform and with respect to the specific 
conditions that have to be fulfilled for reaping any such benefits. Overall, most of the 
available evidence suggests that well devised environmental policies could have 
positive employment effects, but that these are likely to be very moderate and will 
certainly not offer a complete solution to the present European unemployment 
problem. The energy sector can also assist economic growth and employment by 
becoming more competitive. The achievement of a single energy market through the 
integration of the gas and electricity sectors is the primary requirement in this respect. 
Active labour market and education policies can improve the efficiency of the labour 
market by matching demand with supply of labour. In addition, by concentrating efforts in 
terms of enhancing the employability of workers, in particular for those groups trapped in 
the hard core of structural unemployment, structural reforms act to address some of the 
key factors contributing to social exclusion. These policies have therefore an important 
social dimension as they contribute to maintaining and reinforcing cohesion and social 
consensus in the Union. 
6.3.96 
66 
An unprecedented pace of technological change, the emergence of new producers of 
traditional products and an acceleration in the process of globalisation are leading to fiercer 
competition in world-wide as well as domestic markets. This is, in turn, provoking 
fundamental sectoral, enterprise and skills-based changes in economies. The latter are 
moving swiftly towards a diversified, knowledge-based, pattern of production of goods and 
services with companies being organised in a less hierarchical and more decentralised 
manner leading to the generation of increasing opportunities for high-skilled jobs linked to 
the greater complexity of operations. While new opportunities are undoubtedly flowing 
from this process of structural change, the side-effect is that it also demands deep-seated 
changes not only in the work organisation but also in the skill levels needed. 
This process of globalisation should not, however, be seen as a negative phenomenon since 
it ultimately generates a more efficient, world-wide, allocation of resources. It should also 
be stressed that the increased competition that globalisation inevitably brings should not be 
met by inappropriate calls for protectionist measures or for drastic cuts in wage levels. It 
should however be confronted by policies aimed at enhancing the Community's natural 
comparative advantages particularly in terms of having a highly skilled, highly educated, 
workforce. There is a clear link extending from multilateral trade liberalisation and 
increased market access for Community producers in third countries to better growth and 
employment opportunities in the Community. The Commission has recently set out a 
strategy for ensuring improved market access8, using to the full the WTO trade disciplines 
and rights while pursuing additional liberalisation efforts. 
In conclusion therefore, it is clear that macroeconomic and structural policies should be 
applied in parallel in a climate of enhanced confidence and increased social consensus. This 
view is shared by the European Social Partners9. Without growth, structural policies are 
more difficult to implement and may even have undesired effects. Thus the policies 
designed to improve the operation of the markets in goods and services could result in 
increases in overall productivity without net job creation. Similarly, labour market policies 
can, for the most part, reach their objectives only if growth ensures that a sufficient number 
of actual jobs is created and provides the necessary financing capacity. At the same time, 
improvements in competitiveness and in the operation of the labour market are necessary to 
8"The Global Challenge of International Trade: A Market Access Strategy for the European Union", 
Communication from the Commission 1996, COM(96) 53. 
9 "The Social Partners guidelines for turning recovery into a sustained and job-creating growth process". 
Joint Opinion elaborated by the Macroeconomic Group of the Social Dialogue, 16 May 1995. 
6.3.96 
67-
maintain sustained growth in the medium term by limiting the risks of inflationary strains in 
producer prices and wages. 
2.5.2. Initiatives taken in 1995 to improve the functioning of product 
markets 
Implementing reforms aimed at strengthening the forces contributing to endogenous 
growth and at enhancing the dynamism and competitiveness of the Community economies 
has been reiterated with good reason in Community documents over the years. In this 
regard, the importance of fully exploiting the opportunities provided by the internal 
market has been particularly stressed. The Madrid European Council of December 1995, 
reaffirmed the importance it attaches to the completion of this, already highly successful, 
initiative by highlighting the need to introduce greater competition in many sectors in order 
to improve competitiveness with a view to job creation. With regard to Member States' 
implementation of Internal Market directives in this area, the global rate of transposition of 
such directives, as of 21 November 1995, was 93.2 percent with national performances 
ranging from rates of transposition of 87.8 percent to 99.1 percent. Problems in relation 
to transposition (i.e. delays in transposition, partial transposition, non-conformity) are 
being experienced in the following sectors: public procurement, insurance, free movement 
of people, new technologies and services/audio-visual, and intellectual and industrial 
property rights. 
Efforts to ensure better conditions for the effective operation and competitiveness of 
European ^enterprises continued in 1995. In July 1995 the independent expert group on 
legislative and administrative simplification submitted its final report and the Commission 
agreed to present concrete measures to ensure that such a simplification process occurs. In 
this regard, the Madrid European Council referred to the Commission report on the 
independent experts group study and called upon the Commission to table its new 
proposals for the consolidation of Community law and asked the Council to act as soon as 
possible in this area. The Commission's action programme for industrial competitiveness 
was given Council support and the Commission nominated the Competitiveness Advisory 
Group, presided over by Mr. Ciampi, and consisting of high-level experts and industrialists. 
This latter group presented its report on competitiveness to the Madrid European Council 
with the latter instructing the Council to examine its recommendations. 
As regards the Information Society, the Commission presented important initiatives in the 
area of telecommunications in 1995. The objective of these initiatives, which essentially 
6.3.96 
68-
concerned infrastructures and the provision of universal services, was to ensure a greater 
liberalisation of the regulatory framework. 
In relation to the key area of SMEs, the Madrid European Council took note of the 
Commission report on the role played by the latter as a source of jobs, growth and 
competitiveness. The Commission report stressed the need to simplify the administrative 
formalities impacting on SMEs, to remove obstacles affecting their operation in the internal 
market, to improve their financial environment and to ensure better access for SMEs to 
information, training and research. The European Council urged the Commission to act on 
their report as quickly as possible in order to put into practice its recommendations. In 
response to this request, the Commission expects to approve a new multi-annual 
programme for SMEs in March and submit it to the Council. Also the next integrated 
programme for SMEs is under preparation. 
With regard to the Trans-European networks (TENs) some progress was made in 1995. 
In all areas ~ transport, telecommunications and energy ~ examination of the various 
proposals progressed. As regards the energy sector, a common position on the guidelines 
was adopted by the Council in June. The aim was twofold: to advance the development of 
the networks in general and to facilitate the realisation of the priority projects identified by 
the Essen European Council in December 1994. In the autumn, the Council formally 
adopted the Financial Regulation in relation to the financing of the TENs and under its 
provisions the Commission was able to decide, in December, on the co-financing of a 
number of feasibility studies in the area of energy. The Madrid European Council 
confirmed, the essential role of TENs in enhancing competitiveness, job creation and the 
cohesion of the Union. It welcomed the progress recently achieved in this area and called 
upon the Council and the Parliament to complete the legislative framework rapidly. It 
urged Member States to give top priority to the effective implementation of projects and 
especially those identified as being of special importance. Lastly, the European Council 
requested the EcoFin Council to adopt, on a proposal from the Commission, the necessary 
decisions to complement the financial resources currently available for these networks. 
This proposal is expected to be submitted to the Council soon. 
The Structural and Cohesion Funds continued to make an important contribution to the 
balanced development of the EU. In fact, ECU 22 billion was spent in the weaker regions 
under the Structural Funds, which concentrated on investment in productive capacity, 
physical infrastructure and human capital. Over ECU 2 billion was spent in the poorer 
6.3.96 
-69 
countries under the Cohesion Funds, divided between transport and environmental 
measures. 
Finally, on the subject of the environment, the clear and decisive role which the 
Community is playing on the international stage in terms of environmental protection was 
welcomed by the Madrid European Council. With a view to putting economically efficient 
measures in place to help the Community fulfil its international commitments to stabilise 
emissions of greenhouse gases, the Commission presented a revised C02/energy tax draft 
Directive in May 1995. This draft Directive contained guidelines that will enable Member 
States to introduce C02/energy taxes at the national level which are compatible with 
Community legislation. Fair and efficient pricing approaches, also in other areas, are 
necessary to bring the Community on a sustaninable development path. In December 1995, 
the Commission published a Green Paper aimed at launching a broad discussion on policy 
options for internalising the external costs of transport. In addition, financial incentives for 
demonstration projects promoting sustainable production techniques, land use development 
and other measures will be made available once the Council Regulation for LIFE II is 
adopted. Furthermore, the Commission announced in 1995 a pilot project on "Growth and 
Environment" to offer financial support, in the form of loan guarantees, to small firms 
carrying out investments that either contribute to energy savings or otherwise bring 
environmental improvements. Finally, the Commission issued, in December 1995, a White 
Paper on an Energy Policy for the European Union, highlighting market integration as the 
central, determining factor in the Community energy policy. The contribution that the 
energy sector can make towards enhancing the competitiveness of the European economy 
is to seek, greater efficiency in the organisation of energy systems and more effective 
delivery of energy services. The White Paper proposes the building up of a cooperative 
approach by establishing a framework which supports dialogue, transparency and shared 
analysis of energy policy issues leading to the identification of common energy policy 
objectives. 
2.5.3. Labour market reforms: More needs to be done 
The creation of jobs and the fight against unemployment constitutes the primary economic 
and social goal of the European Community. In this regard, it is encouraging that, for the 
first time, the Community has a common employment strategy, based on a combination of a 
stability oriented macroeconomic policy, aimed at engendering higher rates of economic 
growth, and structural adjustment. Structural adjustment initiatives involve both 
continuing improvements in the functioning of product and service markets, along the lines 
6.3.96 
-70 
covered in 2.5.2., and labour market policies aimed at improving skills and competencies as 
well as promoting a higher degree of overall flexibility which is crucial for strengthening the 
economy's growth capacity. 
While ascertaining the nature of the problem and outlining the correct policy approach to 
be adopted is an important element in terms of the overall solution, the greatest challenge is 
at the implementation phase. Following the broad employment strategy agreed by the 
European Council in Essen in December 1994, Member States have started to renew and 
enhance their existing employment policies along the lines of the five broad objectives 
agreed at the latter summit and fleshed out at Cannes in June 1995. 
Since the launching of the Essen strategy a wide range of measures aimed at upgrading the 
skills of low-skilled workers, at reducing the overall costs of labour, at improving the 
efficiency of active labour market policies and at facilitating higher labour mobility have 
been introduced, to varying degrees, in a large number of Member States. A first 
assessment of the efforts undertaken was made by the Commission, the EcoFin Council, 
the Labour and Social Affairs Council and the Social Partners in preparation for the Madrid 
European Council in December 1995. These various reports highlighted that efforts made 
so far needed to be commended and recognised. Nevertheless, they stressed that labour 
market ^reforms would have to be pushed forward if a decisive improvement in the 
Community's employment situation was to be realised. With this in mind a number of areas 
for reform were singled out as needing to be pursued or strengthened at national level. 
These recommendations were taken on board in the joint report submitted by the Council 
(EcoFin and Labour and Social Affairs) and the Commission to the Madrid European 
Council which approved the report and reaffirmed its determination to give the objective 
of job creation maximum priority in the European Union in the coming years. It expressed 
its pleasure with the way in which the Essen-strategy, based on close co-operation between 
all the interested parties, had been implemented in practice in 1995 and emphasised that this 
strategy would continue to provide the framework for Member States' multiannual 
programmes and for the development of their employment policy. Concretely, Member 
States were urged to prioritise the following areas of action in their multiannual 
employment programmes, applying the latter particularly to certain disadvantaged 
categories such as first time job-seekers, the long-term unemployed and unemployed 
women: 
• additional training programmes, especially for the unemployed; 
6.3.96 
71 
• making business strategies more flexible in areas such as the organisation of work 
and of working time; 
• ensuring a pattern of non-wage labour costs which are appropriate to unemployment-
reducing objectives; 
• continuing the current wage restraint by linking it to productivity, as an essential 
element in promoting the intensive use of the factor of production labour; 
• obtaining the maximum level of efficiency in social protection systems so that, while 
maintaining where possible the level attained, they never act as a disincentive to 
seeking work; 
• pressing for adaptation of passive labour market policies, which act to protect the 
unemployed, into active job-creation measures; 
• substantially improving the machinery for information-sharing between those 
providing and those seeking employment; 
• promoting local employment initiatives. 
Finally, the Madrid Council, requested the Council (EcoFin and Labour and Social Affairs) 
and the Commission to continuously monitor and assess Member States' progress in 
relation to the application of their multiannual employment programmes and to submit a 
second joint annual report for its December 1996 meeting. In this way the European 
Council reaffirmed its determination to ensure the continued success of its job creation 
strategy centred on the need to ensure a more employment-creating growth pattern backed 
up by structural reforms aimed at eliminating existing rigidities and achieving a more 
efficient operation of national and Community labour markets. 
6.3.96 
-72-
PART B 
ECONOMIC SITUATION AND POLICY ISSUES 
IN THE INDIVIDUAL MEMBER STATES 
6.3.1996 
73 
BELGIUM 
Weak consumer expenditure slows down growth 
In 1995, economic growth in Belgium is estimated at 1.9%, approximately VA of a 
percentage point lower than in 1994. After strong growth in economic activity in the last 
quarter of 1994 and the first of 1995, the level of economic activity decreased in the 
second and third quarters of 1995. The unemployment rate (Eurostat definition) rose in 
the whole year of 1995, from 10.0% in 1994 to 10.2%. In 1995, Belgium made 
significant progress towards nominal convergence: ©inflation fell to 114%, remaining 
amongst the lowest in the Union, and; (ii) the general government budget deficit declined 
from 5.3% of GDP in 1994 to an estimated 4,/2%. 
TaUel 
Belgium: Macroeconomic performance 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 1586-90 1991-93 1994 1995 
3J0 
3^ 
1.1 
8.7 
23 
14 0.8 
0.8 
-0.6 
7J6 
25 
2J6 22 
14 
-0.7 
10.0 
3J0 
43 1.9 * 
15 * 
04 
102 
1.5 
5J0 
JL 
For definitions, see Table 2 
Source: Commission's November J 995 forecasts 
* Taking into account latest information •A In 1995 real GDP decelerated 
from 2.2% in 1994 to 1.9%. Key 
factors in this have been the 
weakness in private consumption, 
which grew by just 1.4% in real 
terms in 1995 (virtually the same 
rate as in the previous year), and 
an estimated neutral contribution 
of stocks to economic growth (in 
1994 changes in stocks had given 
a positive net contribution of 
0.3%). Although the household 
saving rate fell in both 1994 and 
1995, it remains at about 19% of disposable income, which is a relatively high level by 
European standards. The lack of dynamism of private consumption mainly reflects three 
factors: (i) slow growth in disposable income; (ii) unfavourable prospects for the labour 
market, and; (iii) the uncertainty surrounding additional fiscal tightening measures, 
together with the impact of the planned reform of the Social Security system. 
Investment expenditure, particularly in the manufacturing sector, played a significant role 
in fostering economic growth in 1995. Investment of enterprises grew by about 5% in 
1995, reflecting high capacity utilisation rates in the manufacturing industry since 1994, 
together with improved profitability. Residential construction is estimated to have 
increased by about 1% in 1995. The growth rate of exports in 1995 remained at around 
6.3.1996 
-74-
the same level as in the previous year, notwithstanding the slowdown in foreign demand 
and the effective real appreciation of the Belgian franc. Wage moderation resulting from 
the real wage freeze in the private sector and the adoption of the so-called "health index" 
to adjust wages should improve competitiveness. 
Nominal convergence is progressing 
Tabid 
Belgium: Economic policy indicators 
1986-90 1991-93 1994 1995 
-72 
131.4 
3.8 
15 9.1 
-6.8 -4.8 
-53 -45 The excellent monetary stability record of Belgium in recent years continued in 1995. 
The inflation rate (measured by the CPI) declined from 2.4% in 1994 to about 114% in 
1995, which is amongst the lowest rates in the Union. In 1996, inflation is projected to 
remain at a low level. 
In 1995, significant progress 
was registered in reducing fiscal 
imbalances. The budget deficit 
fell from 5.3% of GDP in 1994 
to an estimated 4Î4%, mainly 
reflecting the reduction in real 
primary spending of around 
VA%, together with lower 
interest charges due both to 
lower interest rates and 
improved debt management 
techniques. The general 
government gross debt ratio 
declined for a second 
consecutive year, attaining 
133.8% of GDP in 1995 
(137.9% in 1993). Money growth 
(% change) 
Gove rnme nt budge t balance 
(% of GDP) 
Gross gove rnme nt debt 
(% of GDP) 
Noniruri"wages per head 
(% change) 
Real wage s per head 
(% change) 133 D 136.0* 133.8 * 
5.7 
3.1 49 
IX 2.7 
1.1 
Source: Commission's November 1995 forecasts 
* Taking into account latest information 
Definitions 
Unemployment rate: harmonized Eurostat de finition, excluding Austria, for whic 
OECD data is used. 
Inflation rate : private consumption deflator. 
Money growth:broad money (M2/M3). 
Gove m me nt budge t balance : net lending/borrowing of general gove rnme nt. 
Nominal wage s: compensation of employees per head. 
Real wages: nominal wages per head deflated by private consumption prices. 
These two measures were adopted in the framework of the "Global Plan" in November 1993. The 
"health-index" is the official CPI excluding tobacco, and alcohol products, petrol and diesel. 
Effectively, the "health-index" excludes from the CPI those products which are more directly affected 
by (increases in) excise taxation, thereby in practice partly severing the link between price increases 
and automatic wage indexation. 
6.3.1996 
-75-
Since the introduction of the convergence programme in 1992, the government has 
adopted several fiscal packages. The 1996 Federal budget is the most recent set of 
measures, aiming to reduce the public deficit to 3% of GDP in 1996, with total savings 
amounting to BFR118 billion (or 1.4% of GDP), of which about a third are 
non-recurrent measures. The general government deficit is projected to decrease from 
4.5% in 1995 to nearly 3% in 1996. 
Since the end of 1993, the Belgian franc has been amongst the strongest currencies of the 
EMS. In the course of 1995, the short-term interest rate differential against the DM has 
been progressively reduced and disappeared since the end of 1995. The long-term 
interest rate differential against the DM has also narrowed substantially. Interest rate 
developments reflect to a large extent an improved assessment of Belgium's economic 
fundamentals, and the enhanced credibility attached to the process of fiscal consohdation. 
Labour market imbalances remain 
Since 1993, Belgium has registered a significant surplus on the current account of the 
balance payments of over 4% of GDP. However, Belgium has lost price-competitiveness 
since 1990; between 1990 and 1995, relative unit labour costs expressed in a common 
currency deteriorated by nearly 13% against a group of 19 competitor countries. Given 
the appreciation trend of the nominal effective exchange rate associated with the 'franc 
fort" policy, Belgium needs to keep the rise in its production costs below the average of 
its trading partners. This can be achieved either: (i) by having relatively lower increases 
in labour costs expressed in local currency, and/or, (ii) by achieving higher productivity 
gains. 
Given the insufficient degree of wage moderation in the first half of the 1990s, Belgian 
enterprises are forced to increase labour productivity in order to remain competitive, 
adopting capital intensive techniques of production which are not conducive to job 
creation. 
Between 1985 and 1995, output increased by about 25%, whereas employment rose by 
just 314%. There is a window of opportunity to reassess labour market policies in 1996, 
given that the current real wage freeze comes to an end at the beginning of 1997, and 
6.3.1996 
-76 
there seems to exist a wide social and political consensus on the need to revise the law 
on the "safeguard of competitiveness" . 
Chart 1 - Belgium 
Participation rates in Belgium and EUR3 (D*, F, NL) 
labour force as % of population 1S-64 years Difference in percentage points 
Difference between EUR3 and B 
(right-hand «ale) 
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 
* Unified Germany from 1991 onwards 
Source: Commission services Labour market 
participation is 
relatively low in 
Belgium, and the 
average duration of 
unemployment spells 
high. This suggests 
that there might be a 
correlation between 
the relatively generous 
eUgibility rules 
governing the various unemployment and career interruption schemes and the low degree 
of labour market participation. Measures aiming to reduce the attractiveness of 
non-participation could pay out a substantial reward in the medium to long term, 
reducing the imbalances in the labour market and easing the financing of Social Security . 
The 1"996 budget included a number of measures to stimulate employment creation, 
namely measures favouring work-sharing, temporary reductions in Social Security 
contributions for low-paid jobs, and measures targeted to some problem groups (e.g. 
young unemployed, long-term unemployed, etc.). 
Belgium has achieved significant progress in recent years as regards nominal 
convergence. However, over the same period, important labour market imbalances have 
been building up, which require additional corrective measures to improve the 
functioning of the labour market and allow for a substantial reduction of unemployment 
in the medium-term. 
The law to "safeguard competitiveness" (31.1.1989) established a number of objective criteria to 
assess competitiveness developments and take appropriate corrective.measures. 
6.3.1996 
77-
DENMARK 
Strong growth, supported by a balanced economic policy 
The recovery in Denmark started already in 1993, somewhat ahead of the other 
continental Member States, and strengthened in the following year in which output 
recorded a strong 4.4% rate of growth. 1995 was altogether again a year of good growth 
and continued decline of unemployment. During the year, however, the cyclical pattern 
became more similar to other European countries: growth was strong in the first months 
of 1995, but has weakened since then. 
As in the majority of the other Member States, Danish fundamentals are sound and there 
is reason to believe that the current growth slowdown is a temporary one. Profitability is 
good, long and short-term interest rates are low and consumer confidence remains at a 
high level, all of which would point to renewed growth momentum. 
Private consumption remained subdued in the second half of 1995. However, this should 
be seen on the background of very strong growth in 1994, and of relatively high real 
long-term interest rates which have stimulated savings. 
Tahlel 
Denmark: Macroeconomic performance 
1986-90 1991-93 1994 1995 Investment in equipment 
picked up strongly in 1995, 
mainly due to the high degree 
of capacity utilisation in 
industry and the good 
profitability in manufacturing. 
Construction, on the other 
hand, increased only modestly, 
given the high level of interest 
rates earlier in the year. 
Indicators for construction in 
late 1995 suggest a moderate 
pick-up. As previous investment has increased production capacity, and as incoming 
orders appear to have been stagnating, new investment in equipment may not have 
increased further in the second half of 1995. GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 1.4 
0.4 
0.9 
6.4 
3.7 
-2.1 1.2 
0.0 
-1.1 
9.2 
1.8 
2.2 4.4 
5.2 
-0.2 
8.2 
1.0 
2.0 4.5 
2.1 
6.7 
2.0 
1.5 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
6.3.1996 
78 
Table 2 
Denmark: Economic policy indicators 
| 1986-90 1991-93 
Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt: 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 1994 
6.3 
0.9 
60.7 
5.1 
1.4 6.8 
-3.2 
71.3 
3.4 
1.6 -5.6 
-3.8 
75.6 
3.2 
2.2 -2.0 
73.6 The weakened growth in major 
export markets has influenced 
Danish exports negatively and 
the Danish krone appreciation 
in the first half of 1995 may 
have depressed exports further. 
Imports moderated, compared 
with the double digit growth 
rate of 1994, and the current 
account surplus remained solid. 
Reduced interest payments on 
foreign debt due to declining 
foreign debt and lower interest 
rates contributed to this. The 
prospects for Danish exports 
next year could be positively influenced by greater exchange rate stability while on the 
other hand growth prospects for export markets have worsened recently. 3.3 
1 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
'Government deposits with the central bank, government holdings of 
non-government bonds and public enterprise related debt amounted to 
some 23% of GDP in 1994 
Chart 1 - Denmark 
Discount and repo rates in 1994 and 1995 
—Discount rate 
—Repo rate Despite strong growth and a sharp decrease in registered unemployment Danish inflation 
remains subdued. For 1995, consumer prices increased by 2%. The favourable inflation 
performance may in part 
be explained by the 
appreciation of the 
Danish krone. Also, it 
seems that Danish wage 
settlements are adjusting 
to low Danish consumer 
price increases, thus 
reducing the risks of 
unfavourable wage/price 
developments. J i i i i i i ' ' ' ' » ' i i ' i i i i i i i i 
J F M A M J J 
1994 
Source: Commission services ONDJFMA.MJ JASONDJ 
1995 1996 
While fiscal policy is being tightened, short and long-term interest rates have been 
decreasing, in line with those of most other countries (Chart 1). Key interest rates were 
increased in the Spring of 1995, as the Danish krone came under pressure. Since then, 
the krone along with the other core currencies has been appreciating against most other 
currencies and the monetary authorities, following international developments, decreased 
6.3.1996 
-79 
the discount rate and other key interest rates. Long-term rates have also been decreasing 
in 1995. 
Registered unemployment in Denmark had been increasing from 1987 onwards. The 
situation changed in 1994, when unemployment started decreasing. The favourable 
development in unemployment continued in 1995, as employment increased faster than 
the labour force and as active labour market measures (leave schemes, early retirement 
schemes and special job training or education) brought down registered unemployment 
further. The improved employment situation has not led to any sharp wage increases 
although the registered unemployment rate is now approaching the level which could 
lead to some inflationary pressures. 
Continued fiscal tightening and structural reform 
After having fought the 1992/93 recession with a temporary fiscal expansion, the Danish 
government has been tightening fiscal policy since 1995. This followed i.a. from the 1993 
tax reform which is implemented over the period 19.94-98, personal income taxes being 
to some extent replaced by environmental taxes. Discretionary budgetary measures 
together with strong automatic stabihsers have markedly improved public finances. In 
1995, general government net borrowing of about 2% of GDP is estimated and the gross 
public debt ratio is likely to have continued its downward trend. The near-term outlook 
is for a continued reduction of the deficit and debt. 
Structural policies, not least in view of the persisting high unemployment, remain very 
important. Throughout 1995, increased efforts were made to improve education and 
increase labour mobility in order to prevent labour market tensions. Further structural 
improvements are laid down in the 1996 budget, aiming at preventing youth 
unemployment, tightening unemployment benefit eligibility rules, improving state 
supported jobs and vocational training and creating jobs for elderly or handicapped 
persons. Also, the maximum period for which unemployment benefits can be received is 
reduced from 7 to 5 years. These highly needed structural measures will have full effect 
in the coming years. 
The fiscal tightening and the continued structural reforms constitute important policy 
measures which go in the right direction. However, an increased effort is needed to 
ensure a positive macroeconomic development over the medium term, particularly 
through increased labour market flexibility and education. 
6.3.1996 
80 
GERMANY 
Slow-down in the pace of the recovery during 1995 
In 1994, Germany came out of recession with a fairly strong recovery: GDP increased by 
2.9%. The upswing was led mainly by buoyant growth in exports and investment, 
particularly in construction. The pace of the recovery slowed somewhat in the second 
half of 1994 and in a more pronounced way in 1995, so that economic growth reached 
about 2% in the latter year, significantly below initial expectations. 
One of the main factors behind the deceleration was a gradual loss of drive in investment: 
while in the last quarter of 1994 fixed capital formation was still growing by almost 7% 
on the year, by the third quarter of 1995 it had fallen below the previous year's levels. 
Not only construction, but also equipment investment slowed, despite relatively high 
capacity utilisation. Exports, too, gradually decelerated, partly because of a weaker 
growth in export markets than had been the case in 1994. By contrast, domestic 
consumption, while not particularly dynamic, was on a slow upward path, after having 
been rather weak throughout 1994. 
Chart 1 - Germany 
Confidence indicators slide and investment weakens 
Index 1985 = 100 
130 Manufacturing 
no 
80 % annual change Index 1985 = 100 
10 130 Construction 
w 
Three month moving average 
—confidence indicator s.a. (left-hand scale) 
Oequipment investment (right-hand scale) 
| 1994 | 1995 | 
Source : Statistisches Bundesamt, Commission services % annual change 
10 
Three month 
moving average 
—confidence indicator s.a. (left-hand scale) 
E3construction investment (right-hand scale) 
80 u I_J i i i i i i i i i i_ 
The cooling down of investment was preceded, at the beginning of the year, by a 
worsening of economic sentiment. Confidence in industry, which had reached high levels 
6.3.1996 
-81 
in the preceding recovery, fell off dramatically after January 1995. In the construction 
sector, a slowdown had been widely anticipated, mainly owing to the phasing out of 
fiscal incentives (Chart 1). 
Table 1 
Germany: Macroeconomic performance 
1986-90 1991-93 1994 1995 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 6.7 
^1.0 2.9 
2.8 
-0.7 
8.4 
2.7 
-1.3 1.9 * 
1.8 * 
-0.2 * 
8.3 
2.0 * 
-0.8 * 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information The loss of confidence went 
together with renewed 
concern over German 
industrial competitiveness, 
already negatively affected by 
the preceding combination of 
a strong DM and high wage 
increases (Chart 2). Tough 
cost control, restructuring, 
extensive payroll cuts and 
wage moderation were 
starting to redress the trend in 
1994; but then a revaluation of the DM in the summer of that year, relatively high wage 
increases at the beginning of 1995, and finally a further considerable DM appreciation in 
March 1995 significantly worsened the situation. By then, the DM's nominal effective 
exchange rate had risen 8.3% in twelve months3. On the domestic side, tax increases 
negatively affected sales prospects. 
Chart 2 - Germany 
Indicators of international price competitiveness 
(Germany compared to 20 industrialised countries) 
Index 1987 = 100 
—nominal effective exchange rate 
—real effective exchange rate (deflator of toul exports) The deteriorating mood 
induced enterprises to 
be very cautious in 
hiring personnel. In 
west Germany, 
employment continued 
to slide longer after the 
beginning of the 
upswing than in the 
previous recovery. 
Overall, employment in 
the year 1995 did not show any improvement over 1994: job creation in East Germany, 
due to rapid economic convergence, could not fully compensate for the losses in the J i i i i i ' • 
1991 | 
Source: Commission services 
3 Effective rate vis-à-vis 18 industrial countries. 
6.3.1996 
82 
West. Unemployment gradually increased during the year. Despite weakening consumer 
confidence, the saving rate remained more or less unchanged. 
By the end of the year, there were few signs of improvement, even if some sectors did 
show some indications of a more positive trend in the offing. Nevertheless, the 
deceleration observed during 1995 need not continue in the course of 1996. Several 
negative factors are set to fall away, or to diminish in importance, so that growth 
prospects should gradually improve during the year. 
TaUe 2 
Germany: Economic policy indicators 
| 1986-90 1991-93 1994 1995 
8.3 
-3.2 
44.6 In particular, the strong decline in interest rates which occurred in the course of 1995 
will stimulate the economy, 
just as the increase during 
1994 was a factor behind the 
slow-down. Nominal short-
term interest rates fell by more 
than 200 basis points during 
1995 and real short-term rates 
are currently just above 2%. 
There are chances for a further 
easing in short-term rates. The 
appreciation of the DM seems 
to have come to an end, so 
that pressure from foreign 
competitors should also 
subside somewhat. Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 1.6 
-2.6 
50.2 
3.2 
0.5 2.3 
-3.6 
58.8 
3.7 
1.7 * 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information 
1 Unification Felated debt assumptions by the federal government in 1995 
(Treuhand and eastern housing companies), equal to DM235 bn (6.75% 
of GDP), are not included. 
The Federal Government has acknowledged the current growth pause in its annual 
economic report and has reduced its growth expectations for 1996 to Wz%. The outlook 
assumes that activity will regain momentum in the course of 1996. Nevertheless, since 
the weak start to the year renders a higher annual growth performance unlikely, the 
government expects total employment to continue to fall and unemployment to rise 
further in 1996, to about 10% of the German workforce or almost 4 million. 
The labour market situation has prompted the social partners, including the Federal 
government, to agree on a pact for employment. The ambitious goal to halve registered 
unemployment by the end of the decade was commonly agreed upon. To achieve this 
goal, decisive action is necessary to improve the supply-side conditions of the German 
6.3.1996 
83 
economy in the medium term and in its annual economic report the government 
presented a 50 point programme for this purpose. 
East Germany: convergence advances, but deep-rooted problems persist 
After having grown markedly in the years before, east German GDP advanced again 
strongly by 6% in 1995. Manufacturing output continued to rise even faster, as new or 
modernised plants began production, while the boom in construction, where activity had 
increased by 21% in 1994, petered out. In 1995, employment increased for the second 
consecutive year and unemployment fell again. Yet the latter has been edging higher 
since last summer, reflecting decelerating growth and less relief from labour market 
policy. 
With eastern (nominal) unit labour costs still exceeding the west German level by about 
one third, little progress was achieved in 1995 with respect to cost competitivenes. Wage 
increases slowed, but productivity gains decelerated also. Factories are more diverse than 
elsewhere: some are technologically very advanced, able to cope with western wage 
rates, many are less productive, and have difficulties surviving even with lower eastern 
wages. One way to tackle this would be relatively low collectively agreed wages, leaving 
room Tor wage differentiation by means of a positive wage drift where circumstances 
permit. 
The very weak eastern competitive position is still evident in various aspects. Although 
there is arising number of modern plants, and east German exports to the EU increased 
by some 30% in 1995, eastern exports still account for only 2% of the German total, 
compared with a share of 11% of GDP. With the current average level of profitability it 
will take considerable time to converge to western patterns of distribution. Profits are 
still low and enterprises vulnerable to shocks. The region will continue to rely heavily on 
western transfers, which currently represent some 4V£% of German GDP. 
Public finances: no further consolidation in 1995 
The general government net borrowing requirement amounted to 3.5% of GDP in 1993 
and fell to 2.6% in 1994. In early 1995, the deficit was expected to decline further. Since 
6.3.1996 
84 
then, however, the deficit perspectives have deteriorated and the preliminary official 
borrowing figure for 1995 was 3.6%4. 
This reversal was mainly due to disappointing revenues. Over and above the 
consequences of slower than expected growth in 1995, there were larger than previously 
estimated shortfalls in direct taxation linked to several special, mainly temporary factors, 
e.g. the impact of the 1993 recession on final tax bills settled last year. Nonetheless, the 
total tax to GDP ratio remained at an all time high of 43%% of GDP, reflecting the re-
introduction of the 7.5% solidarity surcharge on income taxes. 
General government spending accelerated, particularly in social security. Health 
expenditures turned out more dynamic than expected and a new long-term care insurance 
was introduced. Yet outlays by territorial authorities fell short of initial plans. At the 
outset, the execution of the federal budget was delayed, owing to the October 1994 
elections, and later, when revenue shortfalls became obvious, spending was handled 
restrictively on an ad hoc basis at all government levels. Given quickly rising interest 
charges due to debt assumptions, primary non social security spending barely rose in real 
terms. 
Government debt rose to some 59%» of GDP by the end of 1995. The assumption of 
Treuhand and eastern housing companies debts alone accounted for a 6% percentage 
points jump in the debt ratio. By now, unification-related liabilities which have partly 
been accruing off budget have by and large already been taken over by the federal 
government. They have contributed heavily to the rise in the debt ratio from just 41.5% 
back in 1991. 
4 Figure released early in 1996 by the German authorities. It excludes debt assumptions from 
Treuhand and eastern housing companies amounting to 6.75% of GDP. 
6.3.1996 
85 
GREECE 
Progress in macroeconomic adjustment in 1995 
Macroeconomic trends in 1995 were marked by two key developments: progress in 
disinflation and, continued efforts to redress the fiscal imbalances. At the same time, real 
interest rates, while continuing to remain high, have shown some easing tendency and 
actual exchange-rate depreciation has been broadly consistent with the monetary policy 
objective of the Bank of Greece. In 1996, economic growth is expected to accelerate 
underpinned principally by strengthening domestic demand. 
Economic activity in Greece started to recover in 1994, reflecting principally the 
contribution of an improving external economic environment, while domestic demand 
remained weak. Growth accelerated further in 1995. Domestic demand, and particularly 
gross fixed investment, began to strengthen, while private consumption remained flat. 
Public investment performed quite well, largely supported by Community Structural 
Funds. The recovery of domestic activity has also been accompanied by a modest 
widening of the deficit in the external accounts. 
Tafclel 
GreecM-Macroeconomic performance 
GDP growth rate 
(% change) 
Total dorrestic demand 
| (% change) Growth of private 
consumption spending, at 
1.4% in volume terms in 
1995, continued to remain 
weak, reflecting principally 
the modest growth in real 
incomes. Real wages grew 
by 0.5% in 1995, after 
growing at 1.3% in 1994. 
However, real disposable 
income remained virtually 
stagnant in 1995. Important 
factors in this development have been the implementation of the 1994 tax bills, which led 
to a rise in direct tax revenues, and the decline in interest rates, which limited the growth 
of non-labour income. However, private consumption was supported by a fall in the 
saving rate, from 18.9% of gross disposable income in 1994 to 17.9%» in 1995. This fall 
in the saving rate likely reflects the combined impact of the reduction in real interest rates 
and the partial resolution of tax uncertainty. Moreover, the situation in the labour market Employment (% change) 
Unemployment rate (%) 
Inflation {% change) 
Balance of current account 
(% of GDP) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
6.3.1996 
-86 
has started to improve; unemployment, which peaked during the recession, has stabilised 
at 9.5% of the labour force. 
Greece's relatively high inflation has been on a downward trend since mid-1993, and for 
the first time in over twenty-two years the rate of consumer price inflation was in single 
digits through most of 1995. On the basis of the private consumption deflator, inflation 
averaged 9.2%) in 1995, compared with an average of close to 16% in the first three 
years of the 1990s. The improving inflation performance has been supported by several 
factors: first, fiscal policy over the past two years has become gradually more restrictive 
than in previous years; secondly, the stance of monetary and exchange rate policy has 
been restrictive since 1991; consequently, imported inflation has been limited through 
successive reductions in the rate of depreciation of the drachma and the under-indexing 
of the inflation differential against Greece's Community partners has led to an 
appreciation of the real exchange rate; as a result, while this has contributed to shifting 
relative prices in favour of imports, it has also contributed to anchoring inflation 
expectations and, together with the progress in budgetary consolidation, it has imparted 
a disciplining effect on domestic price-setting behaviour; and, finally, the success in 
reducing actual inflation has likely restrained inflation expectations in the product and 
labour markets (in recent years, nominal wage agreements now extend over a two-year 
horizon and, together with clauses protecting against surprise inflation, have generally 
contributed to easing cost-push pressures on prices). 
TaUe2 
Greece: Economic policy indicators 
Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 
For definitions, see Table 2for Belgium 
Source: Commission's November 1995 forecasts With a disinflation strategy 
largely based on fiscal adjustment 
and on underindexing the 
depreciation of the drachma 
exchange rate to Greece's 
inflation differential vis-à-vis the 
ECU, the exchange rate objective 
has been supported by a positive 
sentiment about stabilisation and 
depreciation prospects. 
Following the successful 
response to averting an exchange 
rate crisis in mid-1994, which 
was unleashed by the liberalisation of the remaining capital account restrictions, Greece's 
foreign currency reserves have risen to unprecedentedly high levels and large net 
autonomous capital inflows are supporting the external value of the drachma. At the end 
6.3.1996 
87 
of September 1995 Greece's reserves stood at USD 16.1 billion. The capital inflows have 
been largely sterilised to prevent the swelling of domestic liquidity above the objectives 
set by the Bank of Greece's monetary programme for 1995. 
Real interest rates, which have displayed some easing tendency in 1995, continue to 
remain high. The continuing high level of inflation, as well as uncertainty about the 
durability of both the gains made on inflation and those made in budgetary consolidation, 
continue to underpin risk premia in interest rate determination. 
Policies to address imbalances and promote convergence 
Greece's budgetary imbalances have started to improve since 1994 when the central 
government budget targets were broadly realised. In 1995, the progress in reducing fiscal 
imbalances and in containing the growth of indebtedness continued. The deficit of the 
general government has been reduced from the peak so far this decade of 12.1% of GDP, 
recorded in 1993, to 9.3% of GDP in 1995 5. Correspondingly, the primary balance has 
recorded surpluses since 1992; the deficit is expected to decline further in 1996, and the 
primary surplus to increase, compared to last year. However, budgetary policy continues 
to be circumscribed by large interest payments which in 1995 amounted to 13.4% of 
GDP and constituted almost 35% of total receipts of the general government. 
The size of the interest bill reflects Greece's heavy indebtedness and the persistence of 
high interest rate on government debt. In spite of stubbornly high inflation, the debt ratio 
reached 114.4% of 1995 GDP, up from 82.6% in 1990. This large increase reflects 
principally the takeover of debt outside the general government into its accounts. It is 
clear that the primary surpluses recorded in recent years are not yet adequate to stabilise 
the debt ratio but only to contribute to a slowdown in the growth of the debt ratio. 
Budgetary adjustment has relied on raising revenues through combating tax evasion, 
widening the tax base, and improving the efficiency of the tax mechanism, and also on 
restraining the growth of primary expenditure. Total current revenues of the general 
government have risen from 32% of GDP in 1990 to 36.4%) of GDP in 1995, and much 
of this progress has taken place following the implementation of the April 1994 tax bills. 
-> In the summer of 1995, the Greek authorities included the general government accounts items 
previously omitted or not fully accounted for; the revised data, which are used presently, have 
resulted in a lowering of the general government deficit dating back to 1992. The revision has not 
affected the pace of fiscal adjustment between 1993 and 1995 measured by the change in the deficit 
ratio, even though the level of the ratio is now lower by more than one percentage points in terms of 
GDP in 1993. 
6.3.1996 
88-
There has been less progress in restraining primary expenditure growth; primary 
spending represented almost 31% of GDP in 1995, up from 29.4% in 1992. 
Chart 1 - Greece 
Fiscal adjustment (general government) 
Cyclically adjusted variables as % of trend GDP Cyclically adjusted variables as % of trend GDP 
—Primary expenditure (left-hand 
scale) 
•Deficit (right-hand scale) —Revenues (left-hand scale) 
ea Primary balance (right-hand 
scale) 
1988 1989 
Source: Commission services Chart 1 presents the 
composition of fiscal 
adjustment since the 
end of the past decade 
by comparing data on 
revenues and primary 
spending adjusted for 
cyclical fluctuations 
and reported as ratios 
of trend GDP; thus, 
the data may be 
thought of as representing discretionary policy. The reduction in the primary deficit has 
been taking place since 1992 and it has been achieved principally through discretionary 
increases in the ratio of revenues to GDP which has risen from 32.3%) of trend GDP in 
1990 to 38.0%) in 1995; on the other hand, cyclically adjusted primary spending has 
remained broadly stable at close to 34% of GDP. 
The key policy issue is to secure and further the gains on inflation and on budgetary 
consolidation; these are key conditions for reductions in real interest rates and for 
fostering and sustaining economic growth. While progress has been made in relation to 
the Treaty convergence criteria in the past two years, the distance that needs to be 
covered requires that the adjustment policies must be pursued without fail. 
6.3.1996 
-89 
SPAIN 
Healthier economic recovery but surrounded by a number of uncertainties 
Despite the deceleration in economic activity since the Spring, Spanish GDP rose in 1995 
by 3%. Employment rose sharply in 1995 (2.7%) as a result of the economic growth, 
wage moderation and a more flexible labour market. Nevertheless, the unemployment 
rate fell only moderately because of an increase in the participation rate. Inflation 
resumed its downward trend in May 1995 whereas the general government deficit was in 
line with the convergence programme target in 1995. Although imports resumed faster 
growth than exports in 1995 the external accounts remained close to balance, partly as a 
result of the improvement in the terms of trade. 
Economic activity in Spain, which has been growing continuously since mid-1993 began 
to decelerate in the second quarter of 1995. Despite this, after having risen 2% in 1994, 
GDP is estimated to have grown by 3.0% in 1995. 
After two years of growth led by net exports, partly due to the peseta depreciation, in 
1995 the engine of growth was domestic demand, whereas the external sector 
contributed negatively to GDP growth. The marked recovery in domestic demand in 
1995 was based on a strong growth of investment, both in construction and equipment, 
while private consumption remained sluggish. 
TaUel 
Spain: Macroeconomic performance 
1986-90 1991-93 1994 1995 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 4.5 
6.6 
3.2 
18.9 
6.6 
-1.3 0.6 
-0.2 
-2.1 
19.2 
6.1 
-2.7 2.1 
1.1 
-0.9 
24.3 
4.9 
-1.2 3.0 
3.3 
2.7 
22.7 
4.9 
-1.3 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information After a cumulative fall of 14% in 
1992 and 1993, investment 
began to recover in 1994 as a 
result of the pick-up in final 
demand, led at first by strong 
export growth, the improvement 
in business profitability, lower 
indebtedness of the non-financial 
enterprise sector and a higher 
capacity utilisation rate. 
However, given subdued private 
consumption and some 
deceleration in external demand 
growth, investment began to decelerate in mid-1995. 
6.3.1996 
-90-
Chart 1 - Spain 
Private consumption, employment and the saving rate 
Annual % change ^ 
•Total employment 
—Private consumption 
—Households' raving rate (right-hand scale) 
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 
Source Commission services Private consumption is 
assessed to have grown by 
1.6% in 1995, a relatively 
low rate taking into 
account the sharp rise in 
employment (Chart 1) and 
in real gross disposable 
income (3.1%). The 
household saving ratio is 
estimated to have picked up 
to 12.8% in 1995, as a 
result of growing 
uncertainty as to future income developments. This could be explained by lower job 
security, as a result of the 1994 labour market reform, memories of the sharp 1992-93 
recession, tougher conditions for access to unemployment benefits and uncertainty as to 
the future of the pension system, also reflected in a boost of private pension systems. 
Hence, a major question mark as to the development of economic activity in Spain, as in 
other Member States, is associated with households' readiness to spend. 
Exports and imports have been slowing down after the very sharp rises recorded in 1994. 
However exports have been decelerating more markedly than imports as a result of the 
fading effects of the earlier 
peseta depreciation and the 
J recovery in domestic demand. TaMe 2 
Spain: Economic policy indicators 
1 1986-90 1991-93 1994 
Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 14.5 7.5 
The Spanish external accounts 
improved significantly in the last 
few years as a consequence of 
the peseta depreciation in 
1992-94 and the deeper recession 
in Spain than in the EU as a 
whole. The balance of goods and 
services shifted from a deficit of 
3.2% of GDP in 1991 into 
balance in 1994. Although in 
1995 real import growth once again outpaced the growth of real exports, an -3.8 
44.1 
7.7 
1.0 -5.5 
51.5 
8.2 
2.0 -6.6 
63.0 
3.1 
-1.7 -5.9 
64.8 
3.9 
-0.9 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
6.3.1996 
-91 
improvement in the terms of trade allowed the balance of goods and services to remain in 
balance. 
Employment rose substantially in 1995, as a consequence of the steady economic 
growth, wage moderation and a more flexible labour market, the two last factors having 
led to a lowering in the threshold of employment creation and the apparent productivity 
growth. However, the unemployment rate has fallen relatively moderately and has 
remained clearly above 20% in 1995 given the continuous rise in the activity rate, linked 
to a steady increase in women's participation in the labour market. 
The general government deficit-to-GDP ratio is estimated to have been cut further to 
5.9% in 1995 after 6.6% in 1994 and 7.5% in 1993. However, despite this reduction, the 
general government debt ratio still increased, though at a decelerating pace, to some 
64% of GDP by the end of 1995. 
There has been a deceleration in the CPI inflation rate (year-on-year) since May 1995. 
However, on average the inflation rate remained flat in 1995 as compared to 1994, 
mainly as a result of the impact of the January 1995 indirect tax rises which pushed up 
inflation in the first months of 1995. The downward trend in inflation is supported by 
moderate wage increases, a stable currency, a slowdown in import price growth and the 
anti-inflationary stance of the Bank of Spain. 
At the end of 1994, the Bank of Spain adopted a new monetary policy strategy 
incorporating a basic medium-term objective set in terms of the inflation rate, with 
exchange rate stability viewed as having especial relevance for the attainment of this 
objective. Indications of strong inflationary pressure led the Bank of Spain to raise 
interest rates by a total of 190 basis points during the first half of 1995. Improved 
inflation prospects in the second half of the year, together with the strength of the peseta, 
paved the way for a 25-basis-point reduction in interest rates in December. Long-term 
interest rate differentials with Germany narrowed somewhat during the year but 
remained at 390 basis points in December. Currency turbulence early in 1995 led to a 
sharp depreciation of the peseta culminating in a 7% devaluation of the peseta's ERM 
central parity on 6 March. The currency subsequently recovered against the DM, 
appreciating quickly towards its new central parity. In the last quarter of the year, the 
peseta strengthened further, moving progressively upwards in the ERM grid to finish the 
year as the second strongest currency in the grid. 
6.3.1996 
-92-
The economic fundamentals now appear to provide a sounder base for steadier economic 
growth in Spain than in previous upturns, in particular that of the late 1980s. The 
recovery has been led by exports and investment and some room exists for stronger 
private consumption without major tensions showing up in the external accounts. A more 
flexible labour market which has also contributed to wage moderation has laid a better 
ground for more balanced economic growth. 
The main uncertainties as to the strength of the recovery now have to do with the 
developments in external markets and the behaviour of consumers as reflected through 
the household saving ratio. 
High public deficit and unemployment still the two main challenges 
Economic policy in Spain has been guided by the 1994 revised convergence programme 
which aimed at complying with the EMU criteria through structural reform and a more 
balanced policy mix. Of key importance is the process of fiscal adjustment which should 
lead to a 3% general government deficit-to-GDP ratio in 1997. 
Chart 2 - Spain 
General government budgetary variables (as % of GDP) 
QGross debt (right-hand scale) 
— Primary deficit 
•Interest payments 
—Tntal rififkit 
1990 1991 
Source Commission services The Spanish 
authorities have 
gained credibility by 
meeting their 
convergence 
programme/budget 
deficit targets in 
1994 and in 1995. 
This has been mainly 
achieved through a 
cut in the primary 
deficit (which 
excludes interest 
payments) as shown in Chart 2. Reversing the previous trend, current expenditure 
excluding interest payments was reduced from 39.1% of GDP in 1993 to 37.2%) in 1995, 
more than compensating the fall in current receipts from 41.8% of GDP in 1993 to 
40.7% in 1995. 
6.3.1996 
-93-
However, fiscal adjustment was largely back-loaded to 1996 and 1997 along with the 
convergence programme. The draft budget law for 1996 targeted the deficit ratio 
included in the convergence programme: 4.4% of GDP, but it was voted against by 
Parliament. Hence, the 1995 budget law has been carried forward into 1996 with some 
fiscal adjustments, which should have a similar impact on the deficit as the draft budget 
law. In 1996 the budgetary savings are expected to lead to a primary surplus for the first 
time this decade. A strict compliance with the budgetary targets is essential to make it 
easier for interest rates to come down further and so, while boosting the economy, to 
curb the growing weight of interest payments, which already account for more than 5% 
of GDP. 
Employment has been evolving very favourably since early 1994. Although its growth 
decelerated in 1995-Q4, total employment still rose in that quarter by 3.2%) 
(year-on-year) and by 2.7% on average in the whole year. This has allowed an increase in 
the traditionally very low activity and employment rates. However, despite the 
improvements, the unemployment rate was still 22.8%) in 1995-Q4 and the share of 
temporary jobs in total employment was 34.5%. In order to redress the large Spanish 
labour market imbalances, further reforms in product and services markets are called for, 
especially in sectors sheltered from competition, which can help reduce inflation and 
improve efficiency, output and employment. 
6.3.1996 
94 
FRANCE 
Economie growth slows as domestic demand weakens 
The French economy began to slow down early in 1995 before decelerating sharply, with 
GDP growth (year-on-year) falling from more than 4% in the first quarter to less than 
1% in the last quarter. The very significant contribution of stocks to economic growth in 
1994 had somewhat masked the lack of dynamism in the other components of domestic 
demand, which failed sufficiently to take up the running in 1995. 
TaUel 
France: Microeconomic performance Consumption has not regained 
momentum and the support 
jj 1986-90 1991-93 1994 I^S^ measures taken in 1994 have 
been prolonged in 1995. The 
distinct increase in the 
purchasing power of personal 
disposable income, resulting 
from higher employment and 
the more favourable trend of 
wages per head, gave rise to a 
modest upturn in consumption 
in 1995 since the savings ratio 
rose significantly. Households' expectations regarding unemployment and incomes fell 
after the" summer, which has adversely affected consumption and overall economic 
activity. GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) -
Balance of current account 
(% of GDP) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
The revival of productive investment, which started in the spring of 1994, is likely to 
continue beyond 1995. Although the capacity utilization rate has decreased since 
mid-1995 and the outlook for demand is less rosy, the low level of investment in 
previous years means there is a hefty investment backlog. Profitability has also risen over 
the last two years. Substantial financing capacity have been generated during the last 
years and the constraint of high real interest rates has been partly removed at the 
beginning of 1996. 
Exports were exceptionally buoyant and made a major contribution to growth in 1994 
and the first quarter of 1995, but a lull has been discernible since the spring. Although 
firms have benefited from lower unit labour costs, an increase in the effective exchange 
6.3.1996 
-95-
I TaUe 2 
1 France: Economic policy indicators 
Money growth 
(% change) 
Government budget balance 
(56 of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head _ 
(% change) 1986-90 
8.9 
-1.8 
33.7 
4.2 
1.3 1991-93 
1.4 
-4.1 
40.2 
3.6 
0.9 1994 
1.9 
-6.0 
48.4 
2.1 
0.3 rate has been detrimental to price competitiveness and forced them to cut margins. 
France now has a healthy current account position; following a deficit equivalent to 0.5% 
of GDP in 1991, a surplus of 0.6% of GDP was recorded in 1994 and a surplus of some 
1.0% of GDP is expected in 1995. 
Inflation firmly under control but labour market situation worrying 
The rise in consumer prices remained below 2% in 1995. In spite of the hike of two 
percentage points in the 
standard VAT rate on 1 August 
1995, retail prices rose in 1995 
at the same pace as in 1994. 
Sales prices in manufacturing 
have decelerated since the 
beginning of 1995 and consumer 
caution is likely to keep retailers' 
margins under pressure. 
Unit labour costs are estimated 
to have increased by about 1% 
in 1995 as a result of lower 
growth in productivity and 
rising wages. Bringing these costs under control has formed a key part in combatting 
inflation. "Expressed in national currency, unit labour costs fell by some 10% in relation 
to the other industrialized countries between 1987 and 1995, whereas for the Community 
as a whole they increased by about 5%. -5.0 
51.5 
3.0 
1.1 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
Chart 1 - France 
Value added, salaried employment and productivity in the non-agricultural 
market sectors (seasonally adjusted) 
Value added and employment (quarterly % change) Productivity (1988 Ql =100) 
| 1988 | 1989 | 1990 
Source: Commission services, INSEE 1991 | 1992 | 1993 | 1994 | 1995 | Changes in 
employment have been 
consistent with the 
standard productivity 
cycle. Growth in 
employment, which 
was limited in the early 
part of the recovery 
and thus led to a sharp 
increase in productivity 
6.3.1996 
-96 
in the first half of 1994, subsequently grew at a quarterly rate of 0.4% in the non-
agricultural market sectors. New jobs were created largely in the business service sector, 
which includes the activities of temporary employment agencies, and in the household 
service sector. Employment continued to expand up to the middle of 1995, whereas GDP 
stagnated, producing a dip in productivity. However, after falling steadily since the 
summer of 1994, unemployment began to rise again as from the autumn of 1995. In 
1996, as in 1995, productivity gains could be slightly below their trend rate since the 
employment support policy should result in a disproportionately large increase in jobs 
relative to growth. 
Cutting public deficits, a priority for jobs and growth 
Fiscal consolidation is a necessary condition for a stable macroeconomic environment 
conducive to growth and employment. It should enable an easing of monetary policy, 
compatible with the monetary stability objective, which should offset the adverse effect 
on economic activity of budgetary restraint. The Government has also launched 
structural initiatives to make the labour market function more effectively. 
General government net borrowing rose sharply after 1991, reaching 6% of GDP in 
1994. The public deficit will probably amount to 5% of GDP in 1995 and will therefore 
be in line with the Government's objective. Moves to bring public finances under control 
in 1995 focused largely on the central government deficit, which was to be trimmed from 
4.9%) to 4.2%» of GDP. Tax increases and spending cuts contained in the supplementary 
Finance Law of August 1995 enabled new spending on employment to be funded while 
adhering to the deficit target specified in the initial Finance Law. However, additional 
measures were taken at the year-end to offset the shortfall in taxation. 
O Chart 2 - France 
The components of general government net borrowing 
•/.of GDP ' 
1987 1988 1989 
Source: Commission services, INSEE The consolidation of 
central government 
finances will continue 
in 1996 and efforts 
will be made to 
remedy the recurrent 
social security deficit, 
which constitutes a 
major obstacle to 
compliance with the 
6.3.1996 
97 
convergence criteria. The ongoing reform of the social security system aims at reducing 
the deficit from 0.8%o of GDP in 1995 to 0.2% in 1996 and to achieve a surplus in 1997. 
The consolidation will stem from health spending control and increases in taxes and 
social security contributions. 
The Government's objective is to reduce net borrowing by 1% of GDP each year so as 
to bring it down to, or below, the 3% mark by 1997. However, if growth would not 
increase again, additional measures could be necessary in order to achieve the 
Government's fiscal policy objectives. 
The twin objectives of monetary policy are to ensure domestic price stability and 
maintain the franc's parity within the EMS. They were achieved in 1995. Nevertheless, 
interest rates and the differential with Germany were still high in France in the course of 
1995. The large public deficits and high unemployment are two of the factors 
undermining the franc's credibility, with the result that interest rates still carry a risk 
premium. Whereas long-term rates were headed downwards throughout the year, short-
term rates rose sharply in March as the German mark gained ground against the other 
European currencies. After June, as political and budgetary uncertainties were gradually 
dispelled, the Bank of France was able to ease monetary policy. 
Structural measures are necessary to improve the functioning of the labour market. This 
year, for instance, France adopted a multiannual employment plan in response to the 
request of the Essen European Council. Measures have recently been taken in the 
priority areas identified by the Council. Policy in 1995 focused on reducing the cost of 
unskilled labour and placing young people and the long-term unemployed in 
employment. The Government decided to intensify moves -begun in July 1993 - to 
reduce security contributions for the low-paid. Overall, budget efforts to reduce the cost 
of unskilled labour should amount to 0.6% of GDP in 1996 and account for 9% of the 
total cost of wages below 1.3 times the minimum wage level (SMIC). 
A rebound in growth in the course of 1996 could be fostered by renewed household 
confidence, due to a reduction in uncertainties concerning budgetary policy. Moreover 
fiscal consolidation and the lack of inflationary pressures should constitute an 
environment favourable to a further reduction in interest rates. 
6.3.1996 
98-
IRELAND 
Continuation of broad-based growth in 1995 
The current dynamism of the Irish economy is based on a variety of factors which 
encourage both stability and growth. Consumer and business confidence remain high, 
having recovered from the setback of temporarily higher interest rates in the first quarter 
of 1995. The subsequent decline in nominal interest rates to relatively low levels and the 
generally buoyant domestic demand provide a favourable climate for investment. The 
background of nominal stability has also been encouraged by continued strict budgetary 
policy and the corresponding decline in the debt burden. Price stability is also helped by 
the continued adherence to the wage agreement between the social partners which allows 
for cumulative pay increases in line with expected inflation, but lower than the expected 
growth in productivity. The resulting improvements in competitiveness combined with 
the favourable development of outlook for international trade have seen a continued 
positive contribution of net exports to overall GDP growth. 
The Irish economy grew 
strongly in 1995, continuing 
the broad-based growth that 
emerged in 1994. As in 1994, 
GDP is expected to increase by 
over 6% in 1995, but unlike 
the trend of earlier years, when 
growth was fuelled mainly by 
net exports, domestic demand 
is expected to make the most 
important contribution to 
growth. The buoyancy of TaHel 
Ireland: IVfacroeconomic performance 
| 1986-90 1991-93 1994 1995 
GDP growth rate 4.6 3.1 6.7 6.7 
(% change) 
Total domestic demand 3.3 -0.2 4.2 5.9 
(% change) 
Employment (% change) 1.0 0.4 2.6 3.5 I 
Unemploy ment rate (%) 15.5 15.3 14.7 14.4 I 
Inflation (% change) 3.2 2.4 2.7 2.5 
Balance of current account -1.2 3.4 5.1 6.0 
(% of GDP) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
domestic demand has had a beneficial impact on the more labour-intensive indigenous 
sectors of the economy, resulting in strong employment growth of 49 000 in the year to 
mid-April 1995 (+4.1%). However, this strong rise in employment has not been matched 
by the decline in unemployment. The rising trend in labour force participation from a 
relatively low level, particularly the substantial rise in female participation, is the main 
explanation for this difference. With the expectation that this trend will continue into the 
medium term combined with the projected increase in the population of working age, the 
implication is that, in the absence of increased emigration, employment growth needs to 
6.3.1996 
99 
be sustained at a high level for a number of years if unemployment is to show a more 
significant decline. Nevertheless, the rising numbers in employment, along with continued 
moderate increases in real wages, contributed to the growth in private consumption. In 
addition, unanticipated post-budgetary contingency payments in the latter half of 1995 
raised household incomes, while a confidence-induced decline in household saving is 
thought to have further boosted private consumption with growth expected to have been 
over 4% in 1995. The low level of interest rates, the continuing confidence of the 
industrial sector, rising output, and a healthy saving ratio allowed investment growth to 
improve on the recovery which began in 1994, when it rose by 7.3%. The recovery in 
investment is expected to have reached about 8% in 1995, driven partly by increased 
private sector activity but also reflecting some upturn in public investment. The recovery 
in public investment reflects some catching up from the relatively low level of 1994 when 
delays in disbursements from the Structural Funds constrained the capital programme. 
The steadily improving competitiveness of the Irish economy helped export volumes rise 
by about 10% in 1995, thereby continuing to make a significant contribution to growth, 
albeit lower than in previous years. The state of the public finances remains healthy and 
although there was some upward pressure in 1995 the deficit is expected to remain 
comfortably within 3% of GDP. The recovery has thus far not been accompanied by any 
significant increase in price pressures, with the consumer price index showing only a 
2.4%) increase in the final quarter of 1995 compared with the previous year. 
Foreign exchange market developments during the first quarter of 1995 were 
dominated by à weakening US dollar, a strengthening DM and a re-emergence of 
tensions in the ERM. Amid these tensions, the Irish pound depreciated sharply early 
in the year. The Irish central bank responded to exchange market tensions by 
engaging in forex intervention to stabilize the currency. A 1 percentage point rise in 
the official short-term facility rate in early March, also helped to support the 
currency. In March, the Minister of Finance expressed a preference for the Irish unit 
to move higher in the ERM even if it meant trading above par with sterling. The IRL 
promptly broke through par, moving quickly to a range of UKL 1.02-1.03. Against 
the DM, the Irish unit also entered an appreciating trend from April onwards, 
although it has been subject to short-term reversals during periods of sterling 
weakness. In the second half of the year, with inflation pressures remaining under 
control, the Irish Central Bank followed Bundesbank official rate cuts in August and 
December, reducing Irish official interest rates by a total of 75 basis points. By the 
end of the year, the Irish unit had strengthened further against sterling, as well as 
reducing its gap against the strongest in the ERM grid. 
6.3.1996 
100 
2.7 2.8 0.4 0.2 \ Favourable prospects over the 
medium term 
The prospects for continued 
non-inflationary growth remain 
favourable, although some 
moderation from the very high 
rates of 1994 and 1995 is 
expected. The general outlook 
is one of growth slowing 
toward its trend rate following 
the rapid surge of 1994 and 
1995. The growth in 
consumption in particular 
should moderate, following the 
exceptionally strong growth in 
1995. This is anticipated partly 
because of the absence of the substantial budgetary transfers that occurred in 1995 and 
also due to the expected attenuation of employment growth. Investment has particularly 
benefited from the emergence of more balanced growth in the economy and the generally 
favourable business G overnment budget balance 
(% of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 
For definitions, see Table 2 for Belgium • 
Source: Commission's November 1995 forecasts 
* Taking into account latest information 
1 The 1995 figure includes the payment of arrears of social welfare payments 
due under the Equal Treatment Directive and incorporates the more recent 
information presented in the Irish Budget 
Chart 1 - Ireland 
annual % change Contributions to GDP growth 
• Domestic demand 
ED Net exports 
— GDP climate suggests that 
investment will remain 
buoyant. However, 
investment growth is 
expected to fall from its 
1995 rate to about 6% 
to 7% in the following 
two years. Public 
consumption is 
expected to show the 
lowest growth of the components of domestic demand as the authorities seek to restrain 
the growth in public expenditure. On the external side, further improvements in 
competitiveness should see export volumes continue the strong growth of 1995 resulting 
in continued substantial trade surpluses. 1991 
Source: Commission services 
6.3.1996 
101 -
The favourable outlook for growth and interest rates should, along with stricter control 
of general government expenditure, see a renewed decline in the general government 
deficit. The favourable cyclical conditions and the need to further reduce the debt ratio 
warrant greater efforts to reduce the budget deficit. The continued absence of 
inflationary pressure is encouraging, especially considering the shift from export-led 
growth (where prices tend to be moderated by international factors), towards internally 
driven growth. The success of the social partners in moderating wage increases and the 
stability of the exchange rate provide the cornerstones of the anti-inflation policy. 
Continued adherence to these policies should see the private consumption deflator 
remaining at about 2V/2%. 
6.3.1996 
102 
ITALY 
An economic recovery with poor employment content and high inflation 
After the depreciation of the Lira, Italy enjoyed an export-led economic recovery earlier 
than other countries. The economic upswing continued to gather momentum in 1995 
despite the strains in financial and exchange rate markets and the unsettled political 
situation. Inflation accelerated 
TaUel 
Italy: IVfacroeconomic performance 
"H 1986-90 1991-93 1994 1995 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts during the year but peaked in 
November 1995, whereas 
employment creation was 
lagging. Italy's economic cycle, 
however, might have reached its 
peak in 1995. 
The path of the economic 
recovery initiated in the last 
months of 1993 has been, until 
now, the traditional one with the 
~ initial irripulse coming from a 
buoyant export performance followed by a steady increase of investment in equipment. 
The latter surged in 1995 fuelled by a still robust external demand, strong profits and 
capacity utilisation rates approaching historically high levels, while investment in 
construction remained weak reflecting both the uncertainties affecting public works and 
the high level of interest rates. Private consumption, unlike in previous recoveries, 
experienced a continuous deceleration on a year-on-year basis. Tight fiscal conditions 
and moderation in wages induced some squeeze on household real gross disposable 
income. Moreover, throughout most of 1995 the consumer confidence indicator 
deteriorated in spite of some positive signs in employment creation. Uncertainties over 
the pace of the budgetary consolidation process, the reform of public pensions' schemes 
and the lack of security of the new jobs appear to have made households more cautious. 
Net foreign trade made a positive contribution to the growth of GDP and the surpluses 
of both the trade and the current accounts widened compared to 1994. A specific 
characteristic of the current cyclical phase as compared to previous consumption-led 
upturns was that, late in 1995, private consumption was not taking the lead and emerging 
as the main contributor to growth at a time when exports were running out of steam and 
investment in equipment was probably approaching its peak. 
6.3.1996 
- 103 -
Chart 1 - Italy 
10 Thousands Employment by sector 
(Absolute changes on end-period data, seasonally adjusted) 
50 
-200 -50 
-100 
-150 h 
1991 1992 1993 1994 1995 
Note: Expressed as man-years according to national accounts definitions. 
Source Commission services, ISTAT 
Employment creation in 1995 was disappointing (Chart 1) and had little impact on the 
reduction in the unemployment rate which reached a peak of 12.2% in January 1995. 
Without the significant reduction in the labour force due to the discouragement effect 
this figure would have been even higher. 
Chart. 2 - Italy 
annual % change Inflation indicators 
10 
—Producer prices 
—Consumer prices 
J I I 1_ i ' I I l I I I l , I 
1995 
Source: Commission services, ISTAT In 1995, the net 
increase in employment 
was very marginal 
(81 000 units) and only 
the labour force 
surveys of April and 
July showed positive 
employment creation 
figures. On average, 
employment fell by 
J 0.5% compared to the 
average employment level prevailing in 1994. In October, the labour force survey 
showed a trend reversal for the first time since October 1993 and total employment 
increased by 0.4% year-on-year (confirming the positive signals already emerged in the 
6.3.1996 
- 104-
previous surveys of April and July). Most of this increase took place among independent 
workers. Employment in the services sectors, in particular, increased by 2% 
year-on-year, whereas in the agriculture and industry sectors it declined by 5.4% and 
1.1%, respectively. In the early stages of the recovery Italian companies made a more 
intensive use of labour before recruiting new employees as they preferred to re-engage 
workers who were previously laid off and put temporarily aside in the Wage 
Supplementary Fund and to increase overtime working. However, as the scope for more 
intensive use of labour progressively narrowed, firms started to hire new workers. The 
effects of the economic upswing on employment were smaller than in previous 
expansionary phases. Moreover, the poor impact of the current economic recovery on 
employment and the correspondingly high level of unemployment could be an indication 
of the need to continue with the removal of the still existing structural constraints on the 
labour market. 
Inflation, as measured by the CPI, increased substantially in 1995 (5.4%) as compared to 
the previous year (3.9%). A number of factors contributed to an upsurge in consumer 
prices (Chart 2) since February 1995. Apart from the mechanical increase in the price 
level induced by the February mini-budget, the weakness of the lira during most of the 
year allowed for a widening in profit margins and fuelled import and producer output 
prices-Moreover, the capacity utilisation rate in the manufacturing industry was 
increasing at a rapid pace and business and consumer expectations on prices worsened. 
Inflation, however, might have reached its peak in November 1995: producer and 
wholesale prices peaked in June, the impact of the February 1995 increase in indirect 
taxes is "over and the currency appreciated by the year end. In addition, wage 
developments are not putting a 
pressure on inflation, given that 
wage setting did not seem to be 
affected by the upwards trend 
during 1995. TaUe2 
Italy: Economic policy indicators 
I 1986-90 1991-93 1994 1995 
Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 8.7 7.3 1.9 2.1 
-10.1 -9.8 -9.0 -7.2 
92.6 109.7 125.4 124.9 
S.8 5.9 3.4 4.7 
2.7 0.1 -1.3 -0.9 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information Monetary policy is playing a 
major role in combatting 
inflation. The central bank has 
placed a tight rein on monetary 
and credit aggregates. Official 
rates were hiked twice in the 
first part of 1995 and the Bank 
6.3.1996 
105 
of Italy did not follow the Europe-wide cut in official rates that occurred later in the 
year. Real short-term interest rates remained at very high levels (above 5%) for most of 
1995. The lira, which had fallen to a low of LIT 1 275 per DM in March, recovered 
substantially from May onwards. After a brief emergence of tensions in October, it 
remained on a clear upward trend in the last part of 1995, closing the year just above LIT 
1 100 per DM. The recent reappreciation of the lira bodes well for combating inflation. 
Budgetary consolidation made significant progress but still represents the main 
challenge ahead 
In 1995 the state sector borrowing requirement declined to 7.4%» of GDP from 9.5% in 
the previous year. The primary balance reached a surplus of 3.5%» of GDP, considerably 
higher than the 1.1% surplus recorded in 1994. The public debt is likely to have fallen, 
albeit marginally, in terms of GDP for the first time since 1980. 
The budgetary consohdation effort was carried out in two steps. The Budget Law for 
1995 enacted a fiscal package with measures amounting to 2.7% of GDP. This package, 
however, became insufficient to achieve the intended objectives due to the unfavourable 
evolution of interest rates. Therefore, the authorities decided to adopt, in March 1995, 
an additional package of measures, worth 1.2% of GDP, mainly consisting of an increase 
in indirect taxes. The additional measures did contribute to the rise in prices, but had the 
advantage of having an immediate and certain impact on the budget. The deficit - also 
owing to the strong nominal GDP growth - was finally reduced below its original target. 
The economic policy objectives for 1995 also included the reform of the pension system 
and the advancing of the privatisation of the state-owned companies. A comprehensive 
pension reform was approved in August modifying the former earnings-based system into 
a contribution-based one. The new system has gained in transparency and equity 
although its financial equilibrium might still not be secured. The new rules, however, 
should facilitate a solution to the issue in the future. The privatisation process has made 
significant progress: the legal framework for the sell-off of the public utilities was 
established and the first phase in the privatisation of ENI, the energy conglomerate, has 
begun with the quotation on the stock market and the placement of 15% of its shares. In 
1995, LIT 8.3 trillion revenues from privatisation accrued to the Treasury, an outcome 
not too far from the declared LIT 10 trillion target. 
As for the future, in July 1995 the Italian Parliament approved a three year economic and 
financial plan aiming at a general government deficit of 5.9% of GDP in 1996, 4.4% in 
6.3.1996 
106 
1997 and 2.6% in 1998. In order to meet these objectives, the Budget Law for 1996 
introduces a budgetary package (1.7% of GDP) quantitatively lower than those enacted 
in the last four years. 
The budgetary measures introduced in the past few years have reduced the room for 
manoeuvre for further intervention with respect to increases in tax rates or cuts in the 
spending of public institutions. Nevertheless, transfers, subsidies and tax breaks granted 
to private enterprises and institutions should be scaled down in the present phase of 
economic recovery. More important, a reform effort should be aimed at increasing the 
efficiency of the public administration, at abating tax evasion and at enhancing the 
budgetary discipline of local authorities. The measures defined by this year's Budget Law 
appear to target these issues. They involve structural changes and often depend on 
modifying the behaviour of public administrators and/or tax-payers, which makes it 
difficult to either predict their degree of success or to quantify their effect on the budget. 
6.3.1996 
- 107 
LUXEMBOURG 
Luxembourg economy still enjoying sustained growth 
The Luxembourg economy was largely unaffected by the 1992-93 recession and has 
recovered from the world steel crisis which marked that same period. From 1994 
onwards it benefited from the recovery in neighbouring countries, recording real GDP 
growth of some 3% in 1995. Economic activity in 1995 was stimulated by both domestic 
demand and exports. Private consumption, underpinned by fairly substantial wage rises, 
grew by more than 2%. Investments recovered after dipping in 1994. Exports made a 
positive contribution to growth in spite of an increase in the effective exchange rate. The 
upward trend in employment continued, climbing by more than 2.5% in 1995, while the 
downturn in manufacturing was more than offset by growth in the service sector. 
After a short-lived inflationary 
burst in 1993 which saw price 
rises of 3.6%, largely as a result 
of the mechanical effects of the 
rise in excise duties, the 
increase in consumer prices fell 
back to 2.2%) in 1994 and will 
probably remain more or less 
unchanged in 1995. 
This favourable trend is set to 
continue in 1996 even if the TaUe 1 
Luxembourg : Macroeconomic performance 
j \ 1986-90 1991-93 1994 1995 
GDP growth rate 4.6 1.6 3.3 3.1 
(% change) 
Total domestic demand 5.5 2.7 2.3 2.5 
(% crmfige) 
Employment (% change) 3.1 2.8 , 2.5 2.5 
Unemployment rate (%) 2.1 2.2 3.5 3.9 
Inflation (% change) ' 3.5 3.7 2.4 1.9 
Balance of current account 28.1 21.6 15.9 29.6 
(% of GDP) 
For definitions, see Table 2 for Belgium 
Source: Commission's November J 995 forecasts 
buoyancy of exports is curbed 
by the appreciation of the Luxembourg franc and by the cyclical downturn in 
Luxembourg's main trading partners, because growth should still be buoyed up by 
domestic demand, particularly private consumption and investment. Employment should 
therefore continue to rise steadily. 
General government as a whole recorded a surplus equivalent to some 0.4% of GDP in 
1995; the small central and local government deficit was more than offset by the social 
security surplus. Gross public debt, running at around 6.3% of GDP, has increased 
slightly in recent years, whereas net public debt has fallen as social security has built up 
6.3.1996 
Table 2' 
Luxembourg: Economie policy indicators 
Money growth 
(% change) 
Government budget balance 
(% ofGDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 1986-90 1991-93 1994 108 
substantial financial assets. In view of the favourable outlook for growth, the public 
finance situation is unlikely to worsen in the foreseeable future. 
However, this overall positive 
trend conceals marked 
differences between sectors. 
Whereas the growth in 
financial activity continued, 
confirming its role as the 
motor of the Luxembourg 
economy, the steel industry 
had to undergo further 
restructuring. Employing 
almost 18 000 people, the 
financial sector now accounts 
for about 10% of domestic i** 
8.8 
5.2 
1.7 1.5 
5.2 
5.7 
1.9 2.2 
5.9 
3.4 
1.0 0.4 
6.3 
3.7 
1.7 
For definitions, see 'fable 2 for Belgium 
Source: Commission's November 1995 forecasts 
employment, but a period of consolidation is now anticipated following the very rapid 
expansion of recent years. 
Unemployment, although the lowest in the European Union, has risen sharply since 
1990. 
The expansion in domestic employment was very rapid between 1980 and 1994, 
averaging 1.8% a year as against 0.2% for the European Union as a whole. The bulk of 
this expansion was essentially met by an increase in the number of foreign workers, 
__ whether resident in the 
Chart 1 Luxembourg 
Employment, unemployment and non-resident workers, 
•rv. , j ( absolute annual change) 
C3 Total employment 
• Non-resident workers 
Q Unemployment 
% Ê I il Hf JlftllLlfl M 
78 80 82 84 86 
Source Commission services and Statec country or, as was 
primarily the case, 
frontier workers. In 
1994 resident foreign 
workers and frontier 
workers accounted for 
28% and 25% 
respectively of total 
domestic employment, 
with Luxembourg 
citizens accounting for 
6.3.1996 
109 -
only about 47%. The most spectacular increase was in the number of frontier workers, 
which rose more than threefold between 1985 and 1994 in response to the high wages 
paid in Luxembourg. 
In spite of this very favourable labour market trend, unemployment has increased sharply 
in recent years, from 1.7% in 1990 to 3.8% in 1995 (as defined by Eurostat). Although 
this figure is the lowest for the European Union and would be considered very 
satisfactory in most Member States, it is historically high for the Grand Duchy. Since this 
albeit limited rise in unemployment can scarcely be attributed to unduly sluggish growth 
or to an insufficient increase in the number of jobs available, it would seem to suggest 
that the available pool of labour is no longer adapted to the quite specific structure of the 
Luxembourg economy. 
6.3.1996 
110 
THE NETHERLANDS 
Steady growth maintained in 1995 
Following a relatively mild recession in which gross domestic product never fell in 
volume terms from one year to the next, the upturn began sooner than expected, i.e. at 
the end of 1993. Growth was relatively strong in 1994, at approximately 2.5%», and was 
slightly below 3% in 1995. 
The upturn in activity was initially driven mainly by exports; in 1995 export growth 
accelerated, while domestic investment, especially by firms, showed renewed buoyancy. 
Domestic demand was also bolstered, by the increase in private consumption which 
continued to grow at the moderate pace recorded in 1994, i.e. approximately 2%. A 
slightly more marked increase in real disposable income and the improvement in the 
labour market situation underpinned spending by households and improved their 
expectations. With domestic demand expanding, a high rate of import growth was 
maintained. In 1996 activity is likely to slacken in particular as a result of the cyclical 
slowdown in the Netherlands' main trading partners. 
Employment, which had 
practically marked time in 1993 
and 1994, showed a fairly sharp 
upturn in 1995; total 
employment increased by 1.2%, 
paving the way for a reduction 
in the unemployment rate 
- measured as a proportion of 
the labour force - from 7% in 
1994 to 6.7% in 1995. 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts Inflation remained low as a 
result of continuing wage 
restraint and the strengthening of the exchange rate; consumer prices rose by no more 
than approximately 1.9% in 1995. The external trade and current account surpluses again 
increased, with the latter reaching 4.8% of GDP in 1995, as compared with 4.4% in 
1994. 
The main target of monetary policy is to maintain a stable parity between the guilder and 
the German Mark due to the strength of the guilder in the exchange rate mechanism of 
the EMS, the Dutch central Bank has been able to reduce secured loans rate to 2.75% at 
6.3.1996 
Ill 
the end of 1995. Long-term rates have closely followed the German rates while short 
term rates have been consistently lower than in Germnay, with the differential reaching -
0.25% at the end of 1995. 
The priority economic-policy objectives: public finances and employment 
The two main problems currently facing the Dutch economy, which constitute the 
principal priorities of the last convergence programme adopted in December 1994 and of 
the current government's programme, are the fight against unemployment and the public 
finance situation. 
Table 2 
Netherlands: Economic policy indicators 
1991-93 1994 1995 
Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt 
(% of GDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) -5.1 
77.3 
1.7 
0.8 6.4 
-3.3 
79.9 
4.1 
1.2 -0.5 
-3.2 
78.0 
2.3 
0.0 -3.1 
78.4 
3.2 
1.5 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts Unlike most other 
Member States, the 
Netherlands was successful, 
during the recession of the 
early 1990s, in limiting the 
growth in the general 
government deficit, which 
reached a maximum of 3.9% of 
GDP 'in 1992. However, the 
deficit decreased only slowly, 
since it is still at 3.1% in 1995 
and should be reduced to 2.8%» 
in 1996, below the 3% 
reference value in the Treaty. 
Taking into account the improvement of the economic situation since the beginning of 
1994, this means that the structural deficit has only marginally decreased. The reduction 
of the public deficit has not been sufficient to bring about a significant decrease of the 
ratio of gross government debt to GDP, which has fluctuated around 80% since 1988 
and still stood at 78.4% in 1995. The current fiscal policy in the Netherlands aims 
simultaneously to reduce the ratio of government debt and deficit to GDP and to support 
growth and employment by reducing taxes and social security contributions, aiming 
especially at cutting non-wage labour costs. 
Since the second oil shock, the Netherlands has succeeded in reducing unemployment 
more rapidly and more sharply than most other Member States despite an increase in the 
labour force of almost twice the Community average. Similarly, unemployment increased 
only fairly moderately during the last recession and remained far below the level recorded 
in the early 80s, whereas it reached record levels in many other Member States. This 
good performance by the Netherlands is due in part to the very low participation rate, 
6.3.1996 
112 
Chart 1 - Netherlands 
Labour market trends 
Unemployment rate (%) Employment ( 1970 =100) 
(Right-hand scale) (Left-hand scale) 
—Unemployment rate NL 
—Unemployment rate EUR 15 
E3 Employment - NL 
• Employment - EUR 15 
70 72 74 76 78 80 82 84 86 88 90 92 94 
Note: Unified Germany from 1991 onwards 
Nominal compensation per employee 
relative to EUR15 (EUR15=100), 1980=100 
130 
80 
70 h -Eur4inECU 
-NL, in ECU 
•NL, in Dutch guilder 
70 72 74 76 
Eur4=B DKWDF 
iSowrce.Commission services 
nominal or in real terms or in national or in common currency. which is a consequence of 
the systematic recourse to 
an early retirement system 
and of an exceptionally 
high number of persons 
deemed unable to work 
for medical reasons. 
However, the favourable 
evolution in Dutch 
unemployment is also due 
to the strong growth in 
employment since the 
second oil shock, which 
resulted in particular in a 
substantial increase in 
part-time working, 
especially with women 
working in the service 
sector. This growth in 
employment reflects the 
fact that, for almost 15 
years, wage growth in the 
Netherlands has been less 
than in the Community as 
a whole and the main 
trading partners in 
particular, either in 
The economic performance of the Netherlands in recent years and its successful 
emergence from recession, compares favourably with other countries, clearly placing it 
among the Member States achieving the most satisfactory degree of nominal 
convergence. However, further efforts need to be made in order to bring a fundamental 
solution both to the problems of employment and of public finance. 
6.3.1996 
113-
AUSTRIA 
Although decelerating, growth was solid in 1995 
As a small, open economy Austria is strongly affected by international developments. 
Nevertheless, with the help of a specific policy mix it has managed in the past to partly 
compensate negative external effects. Among others, a combination of a hard-currency 
exchange rate policy and a productivity oriented incomes policy helped to keep both 
inflation and unemployment low, while in general GDP growth rates were above the EU-
average. 
TaUe 1 
Austria: Macroeconomic performance 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 1986-90 1991-93 1994 1995 
3.0 
3.4 
1.1 
3.4 
2.1 
0.2 1.7 
1.6 
1.5 
3.8 
3.6 
-0.1 3.0 
4.5 
0.3 
4.4 
3.0 
-0.9 2.4 
in 
0.2 
4.5 
2.2 
-1.8 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information In recent years, the Austrian 
economy benefited from 
significant productivity gains 
and its exports to the European 
car industry. Tourism is another 
traditional field of Austrian 
specialisation. That sector's 
surplus has offset the large 
merchandise trade deficits, 
especially with Germany. The 
opening of Eastern Europe 
increased competition, but also 
brought new opportunities: 
Austria's eastern neighbours 
showed a strong interest in Austrian consumer and investment goods and the process of 
structural adjustment in Austria was to some extent speeded up by transferring 
labour-intensive processes to neighbouring countries with considerably lower wage 
costs. 
In 1995, real GDP may have grown by about 21/2%, somewhat less than in the previous 
year (3%). The slowdown mainly resulted from adverse effects of the Schilling's 
appreciation and a predominantly cyclical decline in construction demand. Nevertheless, 
a favourable export performance and a strong demand for investment equipment 
supported a solid real GDP growth. Private consumption developed well in 1995, 
stimulated especially by the real disposable income but also by facilitated possibilities of 
shopping abroad. Investment in equipment grew strongly, mainly reflecting the increased 
6.3.1996 
114 
need to restructure and improve productivity in order to maintain competitiveness within 
the European Union. Public consumption increased only moderately. At the same time, 
investment in construction decreased, mainly due to the normal pattern of the 
construction business cycle. Unlike in recent years, the budgetary strains limit the public 
sector's possibilities for additional investment in infrastructure. 
The external balance worsened significantly, mainly due to a sharp decrease of the 
traditional surplus in tourism for the second year in a row. Despite the effective 
appreciation of the Austrian Schilling, commodity exports performed very well, partly as 
a result of improved market access due to EU-membership, but also benefitting from the 
strong international demand for equipment investment, not just in the European Union 
but also in Central and Eastern Europe. Exports outperformed imports, thus contributing 
to a slight improvement in the trade balance. But the Schilling's appreciation stimulated 
imports too, not least through travelling and shopping abroad. Low air-fares contributed 
to this trend. At the same time, Austria's tourism exports were confronted with 
decreasing demand. Especially tourists from Germany, which account for about 60% of 
Austria's foreign guests, shifted towards other destinations. While the relatively price 
inelastic winter tourism developed well, summer tourism experienced lower revenues as 
a result of exchange rate related losses in price competitiveness and occasional 
deficiencies in the quality supply. Tourism in Austria is not only highly specialised on 
visitors from Germany and the Netherlands, but it is also confronted with significant 
overcapacities, while low capital reserves increase the vulnerability with respect to 
demand fluctuations. The stagnation in tourism revenues underlines the need for 
structuraT adjustment. 
These developments led to a marked deterioration of the current account. In addition, for 
the first time Austria contributed to the EU-budget, which further weakened the current 
account balance by some 0.7% of GDP. However, despite the breakdown of the 
coalition government during the set up of the 1996 budget, the credibility of the 
exchange-rate peg to the DM was not affected. 
Price inflation moderated significantly in 1995. Agricultural producer prices dropped due 
to the shift to the CAP; the Schilling's appreciation further relieved import costs. 
Nevertheless, despite higher competitive pressure it took some time for prices and cost 
advantages to be passed on to consumers. The effect of EU-membership is estimated to 
have lowered consumer prices by VA percentage points by the end of 1995. 
6.3.1996 
115 
Labour market performance worsens and the budget deficit widenes 
Table 2 
Austria: Economic policy indicators 
1986-90 1991-93 1994 1995 Recent output growth has not 
sufficiently translated into 
employment growth. On the 
contrary, especially in manu­
facturing increased investment 
in equipment reduced the need 
to hire additional labour in 
order to meet increased output. 
In contrast with past 
experience, reduced job 
opportunities in manufacturing 
are not being compensated by 
new employment in the service 
sector. The tourism industry itself faces a crisis, while the construction sector suffers from 
decreasing demand, especially with respect to infrastructural investment. This 
development is partly compensated by a stronger outflow from the labour force, 
especially into early retirement, which, however, aggravates the financial problems due to 
the strong increase in the number of pensioners and the decreasing labour force 
participation raté of the Austrian pension system. Money growth 
(% change) 
Government budget balance 
(% of GDP) 
Gross government debt 
(%ofGDP) 
Nominal wages per head 
(% change) 
Real wages per head 
(% change) 7.2 
-3.2 
58.1 
4.4 
2.3 5.4 
-3.0 
59.9 
5.6 
2.0 5.3 
-4.4 
65.2 
3.1 
0.1 -5.5 
68.0 
4.0 
1.5 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
Chart 1 - Austria 
%ofGDP General government net borrowing 
—A H3EUR4 HEUR15 
ii 
80 81 82 83 84 85 86 87 89 90 91 92 93 94 95 
* EUR4: Four Member States with lowest deficits in 1993 and 1994 (Germany, Ireland, Luxembourg and Netherlands); 
Unified Germany from 1991 onwards. 
Source Commission services 
6.3.1996 
116-
After having been for a long time among those EU-countries with the lowest public 
deficits, Austria's public finances deteriorated quickly from 1993 onwards, leading to a 
more than doubling of general government net borrowing from 2.1% of GDP in 1992 to 
4.4%o in 1994. This was partly caused by the effects of automatic stabilisers and the 
second stage of a tax reform, both cushioning the negative effects of the 1993 recession. 
Another important factor was a systematic underestimation of social policy related 
expenditures. In 1995, Austria's EU accession increased total public spending by a further 
2% of GDP. About half of those costs were internal payments to mitigate transition costs 
for the agricultural and other hard hit sectors. These transition supporting payments will 
fade out within the next four years, reducing the burden to the budget to less than lx/2% 
of GDP. In order to bring public deficits back to a manageable, pre-1993 level, decisive 
consolidation steps will have to be taken. 
6.3.1996 
117 
PORTUGAL 
Domestic demand continued to strengthen in the first part of the year 
The upturn of economic activity in Portugal, which had started in 1994 primarily driven 
by exports, was furthered in 1995 by the dynamism of investment and the recovery of 
private consumption. Still subdued in the beginning of the year, private consumption has 
gradually gained strength, as real income and consumer confidence improved. The late 
recovery of private consumption reflected the consecutive fall of household real 
disposable income in the two previous years as well as prolonged pessimism in consumer 
confidence. In 1995, lower inflation and slower deceleration of nominal wages than in 
the previous years allowed real income to increase, providing room for the recovery of 
private consumption. Investment accelerated in the year, significantly induced by public 
projects partly financed by the EU funds, but private investment has also picked up as 
business confidence and economic activity improved. By the second half of the year, 
however, this component of demand lost steam in line with the deterioration of the 
external environment. Construction and machinery equipment were the most dynamic 
components of investment in 1995, while transport equipment fell markedly, after the 
exceptional increase in the latter part of 1994. 
Table 1 
Portugal: Macroeconomic performance 
1986-90 1991-93 1994 1995 Exports continued to lead the 
economic upswing in 1995, and 
market share gains are likely to 
have occurred in some external 
markets. The trend of both 
export prices and estimated 
production costs suggests that 
exporters' profit margins 
increased as well. However, 
exports started to decelerate in 
the second half of the year but 
the completion of a large 
automobile factory project 
helped total exports to maintain 
a significant growth rate in the year as a whole. Imports also grew at a marked pace, in 
line with the expansion of total demand; as a consequence, the trade balance deteriorated 
considerably in 1995. GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% ofGDP) 5.1 
7.6 
1.8 
6.1 
11.7 
-0.5 J 0.7 
2.6 
-0.3 
4.6 
10.2 
-2.0 1.1 
1.7 
-02 
7.0 
5.5 
-1.4 2.5 
3.3 
-0.6 
7.2 
4.1 
-1.4 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information 
6.3.1996 
118 
[Table 2 
Portugal: Economic policy indicators 
[ 1986-90 1991-93 1994 1995 | 
| Money growth 17.0 12.5 9.4 
| (% change) 
| Government budget balance -4.7 -5.6 -5.7* -5.2* 
I (% of GDP) 
R Gross government debt 64.4 66.6 69.4 70.5 
| (% of GDP) 
I Nominal wages per head 16.4 11.0 4.8 6.0 
I (% change) 
Real wages per head 4.2 0.7 -0.7 1.7 
(% change) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information Due to the delay in the 
recovery of domestic demand, 
the labour market situation 
continued to deteriorate in 
1995. Total employment fell 
by 0.6%o on average, more 
than in the year before. 
However, this is due to a 
slower expansion of the 
number of self-employed. In 
fact, self-employment, which 
represented about 30% of total 
employment in 1995, increased 
only marginally (by 0.3%), 
after having grown by more 
than 5% in the previous year. The significant expansion partly reflects a growing 
preference on the part of enterprises to switch from permanent employment contracts to 
"out-sourcing", with a view to reducing payroll costs. The number of wage-earners, in 
turn, decreased by 1%, in 1995, after a 2% fall in the year before (-2.8% in 1993). Total 
hours worked declined less, by 0.3% (in 1994 and 1993, they had fallen by, respectively, 
0.4% and 2.2%). The unemployment rate (which has followed the economic cycle with a 
lag of one year) rose to 7.2% on average, after 6.8% in 1994 and 5.5% in 1993; 
nevertheless, it remained clearly below most EU countries, reflecting the more flexible 
labour market in Portugal. But long-term unemployment increased significantly, 
amounting to roughly 40% of total unemployment (34.2% in 1994); youth 
unemployment grew faster than the total as well; both these facts suggest an increase in 
structural unemployment. In line with labour market developments and helped by the 
declining path of inflation, nominal wage growth continued slowing in 1995, albeit less 
than in the years before. Excluding general government, wages implicit in collective 
agreements increased by 4.8% in 1995, after 5.1% and 7.3% respectively in 1994 and 
1993. 
Inflation continued decelerating 
Foreign exchange stability, wage moderation and the sluggish recovery of consumer 
demand allowed inflation to continue on a downward trend in 1995. This trend has been 
6.3.1996 
119 
steadily maintained since the end of 1990, when exchange rate policy was geared 
towards escudo stabihty. In 1995, the consumer price index (excluding rents) rose by 
4.1% on average, down from 5.2% in the previous year, and the differential vis-à-vis the 
three besf performing EU economies narrowed, to 2.7 percentage points from 
3.6 percentage point in 1994. The VAT rate increase in January 1995 from 16%» to 17% 
affected price performance in the first quarter of the year; but the 0.75% reduction in 
employers' Social Security contributions, declining labour costs, and some narrowing of 
Chart 1 - Portugal 
•Tradeables 
Non tradeables 
Differential (percentage points Inflation developments 
(12 month moving average, % change) 
20 
I M >.« >.t< >x< ».< ».< m-».t ».<+>.« >.« >.« >.« m >.« >.« n.t n.t ».i »•< n < » « >,« 15 
10 —Portugal 
^EUR average 
itt Differential vis-à-vis 3 best countries (percentage points) 
KatKCWttWttrev+ttX^^ 
1990 I 1991 I 1992 | 1993 | 1994 | 1995 
Source: Commission services 1990 | 1991 | 1992 1993 1994 1995 
profit margins in retailing may have partly offset the impact of that measure on inflation. 
However,- the pattern has not been the same as regards inflation for tradeables and 
non-tradeables: the first remained on a downward course over the year, assisted by the 
relative stabihty of the escudo and the moderate increase of import prices; the latter, 
which had particularly contributed to the deceleration of overall inflation in 1993 and 
1994, showed a more moderate improvement, reflecting slower progress in wage 
moderation and the revival in consumer demand. 
The Spring 1995 exchange rate turmoil affected particularly the volatility of the Spanish 
peseta and, to a lesser extent, the Portuguese escudo. Strong market strains led the 
Spanish peseta to be realigned within the ERM, on 6 March 1995; the escudo followed 
and its central parity was devalued by 3.5%. Nevertheless, in effective terms, the escudo 
appreciated by about 2%, on average, in the year. Despite the relative stability of the 
escudo after the currency turmoil and steady progress in nominal convergence, the 
interest rate differentials vis-à-vis the German mark remained wide. 
6.3.1996 
120 
Government deficit below the budget target but faster progress is required 
The general government deficit was reduced in 1995 to 5.2% of GDP6, after 5.7% in the 
previous year. This development was mainly due to the growth of direct tax revenues, 
reflecting further progress in efficiency in tax collection. The primary balance improved 
slightly and just moved into surplus; but, after having fallen since 1992, interest payments 
increased albeit at a lower rate than the other current expenditures. Public investment 
grew significantly, by 20%, in line with the allocation of the EU structural funds. The 
government debt ratio increased marginally, to 70.5% of GDP from 69.4% of GDP in 
1994. 
The general government deficit needs to be further reduced in line with the objectives of 
the convergence programme. A strict budgetary policy must be followed, namely 
because investment expenditures should be allowed to grow, in line with the availability 
of EU structural funds. A rigorous budgetary policy should contribute to consolidate the 
credibility of the policy pursued by the authorities, therefore allowing domestic interest 
rates to come down and so reducing the still wide differentials vis-à-vis the best 
performing EU economies. 
6 This figure corresponds to the latest estimate of the Portuguese authorities included in the proposal of 
the 1996 budget, submitted to the Parliament in February 1996. At the time of the Autumn forecasts, 
the official estimate for the general government deficit in 1995 was 5.4% of GDP. 
6.3.1996 
121 
FINLAND 
From deep recession to well-founded recovery 
Finland has been recovering from the very deep recession of the early 1990's, but the 
high unemployment and public sector indebtedness will take time to be tackled. In the 
second half of the 1980's, financial liberalisation and favourable terms-of-trade 
developments led to a rapid credit expansion which, in turn, resulted in an unsustainable 
soaring of asset prices, an overheated investment activity and an excessive rise in the 
indebtedness of .the private sector in the late 1980's. The subsequent weakening of 
domestic demand owed much to a sharp reversal of asset prices and the ensuing debt 
problems. The severity of the recession was magnified by the falling apart of the Eastern 
export markets and terms-of-trade losses, which all together led to high interest rates in 
the wake of weakening confidence on the markka. 
r Chart 1 - Finland 
1990 Ql = 100, seasonally adjusted 
150 From recession to recovery 
-fsfCGDP ' 
Domestic demand 
Exports 
—Imports 
125 
100 
75 I I fM^K 
1990 I 1991 | 1992 
Source: Commission services, Statistics Finland 1993 1994 1995 
Despite some deceleration of growth, Finland's GDP growth reached an estimated 4.4% 
in 1995. The recovery was initially driven by rapidly expanding exports since the second 
half of 1991; the turnaround in domestic demand, however, came later and has been 
much weaker (Chart 1). Export growth decelerated in the second half of 1995 and, due 
to increasing imports, the contribution of net exports to GDP growth is turning negative. 
However, due to a marked improvement in the terms of trade, the current account 
showed a record surplus in 1995. 
6.3.1996 
122 
Private consumption picked up in the second-half of 1993 as households reduced their 
saving, but the recovery remained modest until mid-1994, when the pent-up demand for 
consumer durables, accumulated during the recession years, started to turn into effective 
demand. Private confidence has recovered in line with rising employment and increasing 
real incomes, and households indebtedness is already back to the pre credit-boom level, 
though households still remain cautious as to their borrowing decisions. In 1995, private 
consumption increased by a figure close to 5%. 
Investment provided the main impetus to economic growth in 1995. Investment in 
equipment, which declined by more than 60% during the recession, picked up in the 
course of 1994 and grew strongly during 1995. Export industry investments expanded 
particularly fast: they had started from a low level, capacity utilisation rates were high, 
profitability was Table 1 
Finland: Macroeconomic performance 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 1986-90 1991-93 1994 1995 
3.4 
4.0 
0.2 
4.7 
4.5 
-32 -4.0 
-7.3 
-6.0 
12.9 
4.6 
-3.8 4.4 
3.6 
-1.1 
18.4 
1.3 
1.3 4.4 
4.9 
2.2 
172 
1.1 
3.5 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information companies 
good and their balance sheets 
were relatively sound. By 
contrast, construction activity 
remained subdued throughout 
1995: public investment 
continued to decline and 
private building activity was 
depressed by an over-supply of 
old business premises and 
dwellings. 
Employment fell strongly 
during 1991-94 (by 19%) and started to pick up only in the second half of 1994, 
accelerating to a 3% annualised growth in the first half of 1995, despite further job 
losses in some home market services. This job increase did not, however, translate 
into an equivalent fall in unemployment, because of a rebound of the activity rate 
from its recession-induced low levels. Finland's traditionally low unemployment rate 
rose sharply in the early nineties, having reached 19% in early 1994 before dropping 
to 17.2% in 1995. 
In the past, Finland had in general healthier public finances than most EU countries, with 
general government balances showing surpluses. The level of public gross debt was low 
and, due to large surpluses in the pension funds, there was even a strong net asset 
6.3.1996 
-123-
Table2 
Finland: Economic policy Indicators 
j """" 1986-90 1991-93 1994 1995 
Money growth 135 35 6.1 : 
(% change) 
Governmentbudgetbalance 40 -5.1 -63 * -5J6 * 
(% of GDP) 
Gross government debt 165 40.6 59.8 603 * 
(% of GDP) 
Nominal wages per head 8.8 22 IS 53 * 
(% change) 
IReal wages per head I 4.1 -1.7 12 42 * 
(% change) I For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information position. The recession, however, led to a sharp rise in the general government deficit, 
which was attributable to state 
finances, as local government 
and social security funds 
showed surpluses. The recovery 
has already contributed to put 
the deficit onto a declining 
trend, although in 1995 a 
number of temporary and 
exceptional factors affecting 
both revenues and expenditures 
(e.g. timing of tax refunds, and 
transitory effects of the change 
from sales tax to value added 
tax as well as of joining the EU) 
masked this trend; however, the central government deficit remained large in 1995 (10% 
of GDP). 
So far the upswing has shown no signs of emerging inflationary pressures. In 1995, 
consumer prices rose only by 1.1%; in December 1995, the increase in the CPI from 
the previous year was only 0.3%. Import prices remained stable throughout 1995 due 
to the strengthening of the markka, and food prices declined by a tenth as a result of 
Finland's accession to the EU. The centralized two-year wage agreement signed in 
September 1995 has further contributed to moderate inflation expectations. The 
agreement will constrain wage increases to about 2 % in both years. 
Monetary policy remains targeted at low inflation. The development of monetary 
aggregates has been very moderate. In response to inflationary pressures, the Bank of 
Finland one month tender rate was first raised in February and then in June 1995, when it 
reached 6%. After September 1995, however, the tender rate was cut four times 
altogether by VA percentage point to 4Vi% by the end of 1995. Low inflation, favourable 
inflation outlook and, later, lower economic growth motivated these interest rate cuts. 
By the end of 1995, interest rate differentials with Germany had narrowed to one 
percentage point in the long end and half a percentage point in the short end. 
6.3.1996 
124-
High unemployment and central government indebtedness are the main challenges 
Whereas the economic recovery seems to be on sound ground, high unemployment 
and heavy central government indebtedness remain the main challenges ahead for 
economic policy. Fiscal policy up to 1999 is due to be conducted in the framework of 
the convergence programme of September 1995 and the multi-annual employment 
programme of October 1995. Hence, the two main priorities will be the reduction of 
the government net borrowing and the increase in the flexibility of the economy. 
The stated goal of economic policy is to meet in time all the convergence criteria of 
the Economic and Monetary Union. The government is committed to maintaining 
permanently the former temporary austerity measures, amounting to approximately 6:5% 
of GDP, and to new expenditure cuts amounting to 3.5% of GDP, most of which are to 
be implemented by 1997. The austerity measures concern grants from central 
government to local government, subsidies to industry and agriculture, child benefits, 
student grants, national pensions and other social assistance grants. 
Government finances will be consolidated without raising the overall tax burden, but 
the structure of taxation will be reformed to encourage working and employment. The 
taxation of earned income will be eased, while the tax rate on capital income and the 
corporate tax rate have been raised from 25 to 28%. Also environmental taxes and 
indirect taxes will be increased. 
Unemployment remains the biggest problem for the Finnish economy. The multi-
annual employment programme aims at the very ambitious target of bringing the 
unemployment rate down to 8-9% by 1999. However, structural problems, as 
reflected in the increasing share of long-term unemployed, make it hard to achieve 
such a target. Even if the labour market is to be made somewhat more flexible, the 
fiscal consolidation process limits the scope for tax incentives such as those leading to 
significant tax wedge reductions. 
6.3.1996 
125 
SWEDEN 
Improved economic situation 
After the severest recession since the 1930s, during which GDP fell by about 5% of 
GDP, the Swedish economy is recovering. GDP grew by 2.6% in 1994 and in the first 
half of 1995 the growth rate accelerated further. The recovery is led by exports which 
have induced a strong increase in manufacturing production and investment. This has 
resulted in a relative increase of the industrial sector in the Swedish economy offsetting a 
trend relative decline in recent decades. In 1995 it is expected that GDP growth averaged 
3.7%. 
TaUel 
Sweden: Macroeconomic performance 
1986-90 1991-93 1994 1995 
GDP growth rate 
(% change) 
Total domestic demand 
(% change) 
Employment (% change) 
Unemployment rate (%) 
Inflation (% change) 
Balance of current account 
(% of GDP) 2.3 
2.9 
0.8 
2.1 
6.6 
-0.9 -1.6 
-2.9 
-3.9 
6.2 
6.1 
-2.6 2.6 
1.8 
-0.9 
9.8 
3.1 
0.3 3.7 
1.5 
1.7 
9.2 
2.8 
1.6 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts During 1995, the situation of 
the public finances was the 
focal point of Swedish 
economic policy. In the 
beginning of the year, despite 
announced measures to reduce 
the fiscal deficit, lack of 
confidence resulted in a further 
depreciation of the krona and 
an increase in the interest rate 
differential against Germany. 
A supplementary budget bill 
with some further measures was presented in April 1995, but this could not prevent the 
krona falling to an all time low against the DM and the long-term interest rate differential 
against Germany increased to around 4.5 percentage points. Since then, however, the 
strong growth, a marked improvement in public finances and falling inflation 
expectations has increased the credibility for the Swedish economy and economic policy. 
The krona has gradually strengthened and interest rates have fallen. From its low point in 
April, the krona had appreciated by more than 15% against the DM by the end of 1995 
and the long-term interest rate differential against Germany had diminished to some 
2.5 percentage points. 
The economic recovery has been led by exports induced by the strong competitive 
position of industry. In volume, exports of goods increased nearly 16% in 1994 and are 
expected to expand by a further 13% in 1995. At the same time, world market prices for 
6.3.1996 
126-
important Swedish export products, such as paper and pulp, increased sharply during 
1995 implying strong gains in the terms of trade. As a result net exports have given a 
major boost to GDP growth both in 1994 and 1995. The strong growth in exports has 
led to a rapid increase in industrial production. This resulted in a sharp increase in 
capacity utilisation early in the upturn, that raised fears of an upsurge in inflation. A 
strong increase in investment particularly in manufacturing has, however, led to a rapid 
expansion of production capacity and despite a continued increase in industrial 
production during 1995, the rate of capacity utilisation remained broadly unchanged 
through the year. 
Chart 1 - Sweden 
Exports of goods and industrial production 
Volume indices. 1990 = 100, seasonally adjusted 
' ' ' ' 
1985 | 1986 | 1987 | 1988 | 1989 | 1990 
Source: Commission services During the latter part 
of 1995, a slowdown in 
export growth and 
industrial production 
was registered due to 
recent economic 
indicators. This may 
partly stem from the 
weaker demand in 
other European 
countries. It may also 
be partly due to the appreciation of the krona which to some extent has eroded the 
previously extremely strong competitive position. 
Table 2 
Sweden: Economic policy indicators 
1986-90 1991-93 
Money growth H 7.4 6.1 
(% change) 
Government budget balance I 3.2 -7.1 
(% ofGDP) 
Gross government debt 51.8 65.4 
(% ofGDP) 
Nominal wages per head 8.3 4.3 
(% change) 
Real wages per head 1.6 -1.2 
(% change) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information 1994 
-10.8 
79.3 In 1995, household disposable 
incomes have been affected by 
the tight stance of fiscal 
policy. The result of various 
fiscal consolidation measures 
in 1995 is a reduction in 
disposable income of more 
than 5 percentage points. 
Together with rather modest 
wage increases in 1995 and 
employment growth, this 
resulted in a decrease in 
disposable income of 1.5%. 
6.3.1996 
127 
Nevertheless private consumption increased modestly and the household saving ratio 
decreased somewhat compared to 1994. 
In 1996, growth is expected to slow. Domestic demand is expected to remain rather 
subdued partly because of a continuously strict stance of fiscal policy in coming years 
that will restrict the growth of household disposable income. In such a situation, a strong 
growth in exports is needed to keep up the growth rate in the economy. In this respect, 
the tendency toward a slowdown of external demand during the second half of 1995 may 
be cause for concern. 
Producer prices increased at a rapid pace in the beginning of 1995 partly as a 
consequence of the weak krona. Another factor was price increases for pulp and paper. 
These price increases raised fears of a pick-up in inflation which has been the case in 
previous episodes of depreciation induced recoveries in Sweden. There was also an 
acceleration in the consumer price index in the beginning of 1995 and the year-on-year 
increase exceeded the upper tolerance margin of the Swedish central bank's inflation 
target. This upturn was, however, only temporary and in line with the appreciation of the 
krona the rate of inflation has since gradually dampened and was at the end of 1995 
again well inside the tolerance band. 
Major challenges for economic policies in coming years 
To bring down the rate of unemployment is one of the major challenges facing the 
Swedish'authorities at present. Despite some employment gains during 1995, 
unemployment has remained at an historically very high level. In this respect, the 
outcome of the wage agreements in 1995, which will result in wage increases above 
competitor countries in coming years, is not an encouraging sign. This is particularly 
worrying given the fact that wage increases in the sheltered part of the economy 
exceeded those in industry. This indicates a need to increase the efforts to improve the 
functioning of the labour market. Otherwise there is a risk that the result will be an 
erosion in competitiveness and an upsurge of inflation, which would be damaging for 
employment prospects. 
Another major challenge is to put the public finances on a sound footing after the severe 
deterioration during the recession in the beginning of the 1990s. In this respect, 
economic policies have so far been successful and public finances have improved 
considerably since the budget deficit peaked at 13.4%» ofGDP in 1993. The deficit is 
6.3.1996 
128-
expected to amount to some 7% of GDP in 1995 and is forecast to continue to improve 
in coming years. At the same time, the rapid build-up of the public sector debt has almost 
come to an end. This would be in advance of the path laid down in the convergence 
programme presented in June, which forecast a considerably higher budget deficit in 
1995 and also a stabilisation in the consolidated public debt at a later date than now 
foreseen. 
The improvement in public finances stems from the government's consolidation 
programme of 118 billion kronor corresponding to some 7.5% of GDP, which is the 
cornerstone in the convergence programme. The stronger economic activity has also 
played an important role in the improvement. As a result of the high level of public sector 
revenues and expenditures the Swedish budget is very sensitive to cyclical swings. The 
improvement is due both to increased revenues and lower expenditures in roughly equal 
parts. A marked slowdown in the economy in the coming years might therefore raise 
fears concerning prospects for employment and public finances. 
As regard monetary policy, the explicit inflation target that was announced after the 
krona was left to float is for an annual increase in the consumer price index of 2% with a 
tolerance limit of 1 percentage point on either side. From August 1994, monetary policy 
was gradually tightened in response to indications of higher inflation expectations and 
pressure. The main inflationary impulse came from the weak krona, although the 
appreciation of the krona that took place in the latter part of 1995 and subdued domestic 
demand helped to keep inflation within the tolerance band. Inflation expectations also fell 
gradually'in the course of 1995. In January 1996 the official repo rate was reduced twice 
with in total 0.46 percentage points. 
6.3.1996 
- 129 
UNITED KINGDOM 
The recovery continues though growth slows down 
The recovery is now well into its fourth year and is of longer duration than that in the 
rest of the EU where recovery started later. The expectation for 1995 was that growth 
would slow down to more sustainable rates than the 3.9% of 1994 but, in the event, 
growth was less than generally expected. While GDP in 1995 as a whole rose by 2.6%, 
growth in the second, third and fourth quarters of the year averaged just under 2% at an 
annual rate. 
In 1994, the output of 
production industries grew by 
5.1%, partly as a result of an 
upsurge in oil production as 
output from newly developed 
fields came onstream. 
Manufacturing and 
construction output also grew 
strongly - by 4.3% and 4.0% 
respectively. Service output 
rose by 3.6%. However, in 
1995 industrial production 
was subdued as oil production peaked; in addition manufacturing output was broadly flat 
throughout the year and construction output fell. The service sector provided most of the 
rise in GDP throughout 1995. 
The reasons for these production trends seem to be associated with changes in the 
pattern of growth of final demand. Net exports contributed significantly less to growth in 
1995 than in 1994. However, private consumption, despite weak retail sales, grew by 
2'/2% in 1995 as a result of growth in spending on services. Real disposable income was 
depressed in these quarters due to subdued wages growth and the introduction of some 
personal tax rises: consequently, growth in consumption was associated with a fall in the 
saving ratio. While the economy is well into the fourth year of recovery, fixed investment 
has yet to enjoy the growth normally observed at this stage of the cycle and in 1995 it 
rose by only 1 Vt%. Chart 1 contrasts the current investment performance with that of the 
previous recovery. The performance has not, however, been uniformly disappointing. Tallel 
United Kingdom: Microeconomic performance 
| 1986-90 1991-93 1994 1995 
GDP growth rate 3.3 -0.1 3.8 2.6 
(% change) 
Total domestic demand 4.0 -0.3 3.3 2.0 
(% change) 
Employment (% change) 1.9 -2.3 0.0 0.8 
Unemployment rate (#) 9.0 9.8 9.6 8.8 
Inflation (% change) 5.0 5.2 1.5 3.0 
Balance of current account -3.8 . -2.6 -2.1 -2.1 
(% ofGDP) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
6.3.1996 
- 130-
Chart 1 - United Kingdom 
Total fixed investment - recoveries compared 
(seasonally adjusted) 
Trough in GDP = 100 v . J * ' 
Quarters from trough in GDP 
Source: Commission services Though investment in 
buildings and works 
remained depressed, 
manufacturing investment 
in the first three quarters 
of the year grew by 14% 
at an annual rate. 
Stockbuilding continued 
to increase during most of 
1995 and may be partly 
involuntary in the face of 
subdued final demand. 
Growth of exports of goods was 10% in 1994 and contributed considerably to the 
strength ofGDP. However, in 1995 growth of exports slowed down - partly as a result 
of subdued oil exports and partly as a result of the pause in growth in other EU member 
states which account for 59% of exports of UK goods. Even netting out oil, exports rose 
by only an annuaUsed 2J/2% between the final quarter of 1994 and the third quarter of 
1995 despite the improvement in competitiveness associated with sterling's depreciation 
in 1995. 
The latest indicators of the 
economy are mixed though 
they do not suggest that 
growth in activity is much 
different, currently, from that 
throughout most of 1995. 
Retail sales grew strongly, by 
3A%, in the fourth quarter of 
1995 having been flat for most 
of 1995. Export volumes rose 
by 1% in the three months to 
November while imports fell 
by Vz%. In contrast, 
manufacturing output remained stagnant and shorter and longer leading indicators of the 
economy continued to fall suggesting, and confirming, a slowdown. However, forward TaHe2 
United Kingdom: Economic policy indicators 
"" 1986-90 1991-93 1994 1995 
Money growth 16.3 4.6 3.5 10.1 
(% change) 
Government budget balance -1.1 -5.6 -6.8 -5.1 
(% ofGDP) 
Gross government debt 43.5 42.0 50.3 52.5 
(% ofGDP) 
Nominal wages per head 8.3 6.0 3.5 3.2 
(% change) 
Real wages per head 3.2 0.8 1.0 0.2 
(% change) 
For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
6.3.1996 
131 
looking survey indicators for manufacturing suggest a pick-up in output and increased 
orders in the first quarter of 1996. 
Underlying inflation, measured by the rise in retail prices excluding mortgage interest 
payments, crept up very gradually throughout the year to average 2.9% in the final 
quarter of 1995, though this is comfortably within the Government's target range of 
1-4%. This acceleration was associated with a rise, over this period, in annual producer 
price inflation. In turn, this followed the earlier strong increases in input prices resulting 
from rises in world commodity prices. Annual input price inflation declined significantly 
in the latter months of 1995. In addition, wage inflation remained law despite a 
tightening of the labour market: underlying earnings growth was no more than 3^4% in 
the third quarter of 1995 - the lowest for two years. These trends are shown in Chart 2. 
Monetary policy is set to achieve a target of underlying inflation of 1-4% with an aim of 
securing it in the 1-2V&% range by the end of this parliament (May 1997 at the latest) and 
beyond. Successive rises in base rates from 5lA% to 6VA% from September 1994 to 
February 1995 ensured that inflation remained comfortably within the wider target band 
despite sterling's depreciation of some 7% in 1995. However, as described above, 
economic activity remained sluggish throughout 1995 and was accompanied by subdued 
inflationary pressures. Base rates were reduced to 6Vz% on 13 December 1995 and to 
6lA% on 18 January of this year. The challenge facing the Government is to bring 
underlying inflation within the narrower range in the short term specified and to hold it 
there but, at the same time, to deliver adequate economic growth. 
Though economic growth slowed down, employment continued to grow in 1995 albeit 
modestly. The 
Chart 2 - United Kingdom 
Underlying consumer price inflation (CPI*) and wages 
% change on previous year 
* Retail price index excluding mortgage payments 
Source: Commission services employer-based survey 
showed annual growth 
of 0.9% in the first 
three quarters of 1995 
whereas the 
household-based 
Labour Force survey 
suggested employment 
growth was more 
rapid. The possibility 
remains that the former 
6.3.1996 
132-
is not picking up new jobs in newly created businesses adequately or rising employment 
in parts of the construction sector. Unemployment continued to fall and at the end of 
1995 was just over 8% of the labour force: more than 2 percentage points below the EU 
average. However, falls in the second half of 1995 were generally lower than those 
earlier in the year as growth has slowed down markedly. 
Employment growth, in association with recent GDP growth, resulted in a productivity 
increase of 2.5%» in the first three quarters of 1995 at an annual rate - rather slower than 
the 3.3%» of 1994. Wage inflation, as noted above, was subdued and unit wage costs in 
the first three quarters of 1995 rose by only an annualised 2.1%. However the picture is 
rather different for manufacturing where growth has recently been flat and underlying 
earnings inflation in the third quarter of 1995 was 4lA% - well above the whole economy 
average of VA%. Accordingly, productivity in manufacturing in the third quarter of 1995 
was only 0.7% up on a year earlier whereas unit wage costs were some 3.7% higher. 
Growth to continue at sustainable rates 
The outlook is for growth to continue at sustainable rates. Certainly the economy would 
seem capable of growing around productive potential of 2*/2% in the near future - a little 
above "Current growth rates - as there is little indication of capital or labour shortages and 
inflationary pressures remain subdued. 
One factor expected to contribute to growth is a long-awaited recovery in fixed 
investment though this will be moderated by falls in that of general government. 
The prospects are for subdued inflation. The current moderate nature of growth is 
expected to restrain wage inflation in the short term and expected growth is unlikely to 
lead to a major resurgence in wage inflation over the next two years. 
The UK government presented an update of the convergence programme in March 1995 
based on measures introduced in the November 1994 budget. In particular, reductions in 
cash expenditure on previous plans were introduced that were permitted by a better than 
projected inflation outturn. A more rapid improvement in government finances was 
therefore expected. In the event sluggish economic growth and, even allowing for this, 
an unexpected weakness in revenues in 1995 slowed down the fiscal consolidation. This 
arithmetic was acknowledged in the budget for 1996-97 presented in November 1995 
which was broadly neutral in its impact on public finances. 
6.3.1996 
ISSN 0254-1475 
COM(96) 86 final 
DOCUMENTS 
EN 10 
Catalogue number : CB-CO-96-105-EN-C 
ISBN 92-78-01358-7 
Office for Official Publications of the European Communities 
L-2985 Luxembourg