1996 Annual Economic Report
Date: 1996-03-06
Institutions: European Commission
Subjects: activity report, economic convergence, economic growth, economic policy, employment policy

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 

CHAPTER  1:  RECOVERY LOOKING FOR A SECOND BREATH 

1.1.  MARKED GROWTH SLOWDOWN DURING  1995 

1.1.1.  Main  trends 
1.1.2. 

Factors behind the slowdown 

1.2. 

1.3. 

1.4. 

REBOUND IN ACTIVITY EXPECTED DURING  1996 
1.2.1. 
1.2.2. 

Underlying economic fundamentals  are favourable 
Important short-term risks and uncertainties 

CONTINUED PROGRESS TOWARDS NOMINAL CONVERGENCE 
1.3.1. 
1.3.2. 

Historically low and converging price  increases 
Insufficient progress  in reducing budget deficits. 

FALTERING IMPROVEMENT IN LABOUR MARKET CONDITIONS 
1.4.1. 
1.4.2. 
1.4.3. 

Recent  developments. 
Longer-term trends in employment creation in the Community 
Incidence  of unemployment in the EC 

1.5.  WHITE PAPER MEDIUM-TERM OBJECTIVES PUT AT RISK 

B O X l:  THE GROWTH IMPACT OF THE  1995  EXCHANGE RATE TURMOIL 

BOX 2:  CURRENT OUTLOOK IN A HISTORICAL PERSPECTIVE 
BOX 3:  THE ECONOMIC COMPOSITION OF UNEMPLOYMENT 

CHAPTER 2:  ECONOMIC POLICIES FOR GROWTH AND EMPLOYMENT 

2 . 1. 

DESIRED POLICY MIX 

2.2. 

2.3. 

MONETARY POLICY 
2.2.1. 
2.2.2.  Monetary stability  affected by internal and external factors  in 1995 
2.2.3. 

Inflation  and monetary policies  in the medium term 

Room for further  easing of monetary policies. 

Recent  developments  and short-term prospects 

BUDGETARY POLICY 
2.3.1. 
2.3.2.  Medium-term  benefits of continuing and enhanced consolidation 
Fiscal consolidation and short-term growth prospects 
2.3.3. 
Priority areas for  consolidation 
2.3.4. 

2.4.  WAGE DEVELOPMENTS 

2.4.1. 
2.4.2. 
2.4.3. 

The appropriate wage trends. 
Wage adjustment in the EC since  1980 
Expected wage developments 

2 . 5. 

S T R U C T U R AL  POLICIES 
2.5.1. 
2.5.2. 
2.5.3. 

Vital complement to macroeconomic policy-mix 
Initiatives  taken in 1995 to improve the functioning  of product  markets 
Labour market reform: More needs to be done 

B O X 4:  THE DOLLAR AND THE ERM 
BOX 5:  EXAMPLES OF SUCCESSFUL FISCAL CONSOLIDATION EFFORTS 
BOX 6:  PRODUCTIVITY AND EMPLOYMENT GROWTH 
Box 7:  THE COMMUNITY IN THE WORLD ECONOMY 

i 

1 

1 
1 
2 

7 
7 
13 

14 
15 
16 

19 
19 
20 
22 

25 

5 

12 
24 

28 

28 

29 
29 
33 
36 

39 
39 
42 
48 
49 

53 
53 
56 
58 

59 
59 
67 
69 

35 
51 
61 
63 

/ ta 

6.3.96 

PART  B:  ECONOMIC SITUATION AND POLICY ISSUES IN THE INDIVIDUAL MEMBER 

STATES 

BELGIUM 
DENMARK 
GERMANY 

GREECE 
SPAIN 
FRANCE 

IRELAND 
ITALY 
LUXEMBOURG 
THE NETHERLANDS 

AUSTRIA 
PORTUGAL 
FINLAND 
SWEDEN 
UNITED KINGDOM 

: 

73 
77 
80 

85 
89 
94 

98 
102 
107 
110 

113 
117 
121 
125 
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... 
the  fears  generated  by  global  and  Community-wide  phenomena  may  be 
While 
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. 

in 

the  overall  economic  policy  framework  established 

... but confidence building measures are necessary. 
Consequently,  within 
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 
In  addition,  following  the  conclusions  of  the  Madrid 
research  and  development  efforts. 
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. 

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 
to  4  per  cent 
pace  of  3î4 
(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. 

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 
| 

' EUR 9=D,F,I,UK,E,NL1S,A,FIN 

92 

93 

94 

95 

| 

| 

| 

Table 1: 

The  C o m m u n i ty  e c o n o my  : 

use  a nd  s u p p ly  of  g o o ds  and  s e r v i c es 

(real annual percentage change) 

1986-
90 

1991-
92 

1993 

1994 

1995 
a) 

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 

3.7 

2.0 

5.7 

7.1 
4.8 

0.1 

3.9 

VA 

6 

3.3 

1.8 

1.9 

-1.3 
-2.3 
-0.5 

-0.2 

1.0 

31/* 

4 

-0.3 

1.1 

-6.6 

-10.7 
-3.3 

-0.7 

-2.0 

8 

-3 

1.6 

1.0 

2.5 
2.6 
2.4 

0.9 

2.5 

10 
41/* 

1.2 

-0.6 

"  2.8 

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) 

to 

continued 

While  economic  activity  in 
be 
1995 
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 
and 
stockbuilding 
construction investment  slow 
Investment 
ed  unexpectedly. 
in  equipment  kept  expanding 
private 
while 
solidly 

consumption 
continued 
growing at a modest  pace.  In 

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. 

recent 

recovery  with 

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 
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 ^ w j j i i ^ i l i i ^ ^ ^ ^ .i 
Q1  Q2  Q3  Q4  Q5  Q6  Q7  Q8 

09  Q10 

,fGDP 

1993 Q2 - 1995 Q3 

Q1  Q2  Q3 
EUR 4 : D, F, I, UK 

04  Q5 

06  Q7 

08  Q9  Q10 

6.3.96 

3  -

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 

Table 2 

Long-term  interest  rates 

Dec. 
1993 
5.5 
8.1 
5.8 
9.2 
7.6 
6.3 

Dec. 
1994 
7.3 
11.1 
8.3 
11.8 
10.9 
8.6 

April 
1995 
6.8 
11.8 
7.7 
12.8 
11.4 
8.4 

Jan. 
1996 
5.3 
9.1 
6.3 
10:0 
8.3 
7.8 

D 
E 
F 
1 
S 
UK 

This 

increase  was  partly  related 

some  225  basis  points  in the  Community  on  average 
while  inflation  in  general  remained  on  a  declining 
to  a 
trend. 
"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 

EUR 

7.4 

6.8 

9.0 

8.8 

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). 

| 

| 

0 

95 

92 

20 

10 

-10 

-20 

Chart 3 

2  4  6  8  1012  2  4  6  8  10  12  2  4  6  8  1012  2  4  6  6  1012 
93 
| 
| 
94 
Germany 

Currency turmoil and confidence 
EUR 

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 
by 
(exemplified 
Germany)  reflecting  anxiety  about 
the  loss  in  competitiveness,  while 
to 
confidence 
consumer 
decline 
in  depreciating  countries 
(particularly  Italy)  where  consumers 
their 
anticipated  an  erosion  of 
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. 

2  4  6  8  10  12  2  4  6  8  1012  2  4  6  8  1012  2  4  6  8  1012 
I 
Italy 

2  4 6  8 10 12 2  4 6 8 1012 2 4 6 8 10 12 2  4 6  8 1012 
| 
| 

* Index: 1987Q1=100 

tended 

tt*S:-:-:re>-»:-:+^^ 

chart 

the 

in 

-30  pS 

100 

95 

92 

94 

93 

-40 

92 

93 

94 

95 

| 

| 

1 00 

I 

I 

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 

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. 

Index, August 1992=10X3 

Table B1.1 
N o m i n al  effective  e x c h a n ge  rates 

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. 

107.9 
109.3 
106.3 
63.2 
77.1 
73.0 
83.1 

103.3 
103.1 
102.4 
72.7 
78.2 
77.5 
87.1 

I 
Esp 
Sw 
UK 

Dec. 
1994 

Dec. 
1993 

April 
1995 

Jan. 
1996 

B 
D 
F 

100.9 

105.9 

106.7 

106.7 

100.8 

78.4 

83.2 

71.7 

74.6 

80.6 

99.9 

75.1 

88.7 

82.1 

and 

M ex  1H2Q3 « 100 

price 

Export volumes in the four major  EC countries 

The  large  shifts  in  exchange  rates 
in 
led 
to  substantial  changes 
relative 
cost 
competitiveness.  As  was  also  the 
case  following  the  exchange  rate 
in  September  1992f 
movements 
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 
those  of 
improved 
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 

relative 

to 

6.3.96 

6-

meant that  currency  movements  had a less dominant,  but still  visible,  influence  on export  growth 
in those countries. 

in  early  1995  affected  macroeconomic  developments 

Exchange  rate  movements 
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. 

Table B1.2 

Simulated  impact  on GDP  growth 
(Percentage points) 

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, 
rate  changes 
the  exchange 
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. 

Spring  currency 
turmojl 
(Dec. 94 - April 95) 
1996 
1995 

Subsequent 
partial  reversal 
(April - Dec.95) 
1996 

first, 

1995 

EUR 

-DA 

-0.4 

-0.2 

-0.3 

-1.1 

-0.1 

-0.3 

-0.1 

UK 

0.4 

0.2 

0.2 

0.0 

0.0 

0.0 

0.1 

0.0 

0.0 

0.3 

0.1 

0.1 

D 

F 

I 

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. 

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 
In  these 
pick-up  in  the  rate  of  expansion  in  economic  activity  during  the  year. 
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 

World  economy  continues  to expand  at a healthy  pace 

outside 

activity 

the 
Economic 
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 
In  addition,  the 
import  content. 
renewed  dynamism of world trade owes 
to  the  rapid  integration  of  emerging 

Chart  4 

World* GDP growth excluding the EC 

Real  %  p a. 

•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 

90 

92 

94 

e x c l u d i ng  C E EC 

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  e c o n o m ic  e n v i r o n m e nt 
(real annual percentage change) 

-

1993 

1994 

1995 

1996 

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 

3.0 
3.4 

-0.2 
6.8 
-8.4 

10.1 
11.9 
7.0 
13.4 

4.6 

6.8 

972 

a'  Dynamic Asian Economies. 

Real GDP 

3.8 

4.1 

0.5 

7.9 

3.6 

2.1 

0.4 

7.9 

-7.4 

-4.3 

Imports 

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 

4.4 

2.3 

2.3 

7.4 

4.0 

9.2 

7.7 

10.5 

12.4 

9.0 

8.5 

61/2 

'  Central and Eastern Europe and former Soviet Union 

Source: Commission services estimates and forecasts 

in 

from  a 

In addition to strong  export  market  growth, the 
Community  has  benefitted 
large 
improvement 
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 
deflator, 
consumption 
private 
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). 
in  some  countries  were  concluded  at 
Furthermore,  although  wage  settlements 
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 

in  the 
Capital  profitability 
Community  remains  strong  on 
average  and  is  almost  back  at 
the 
the 
1960's,  after  having  suffered  a 
severe 
prolonged 
deterioration  during the  1970's 

level  prevailing 

and 

in 

and 
profitability 

the  early  1980's. 

If 
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. 

Although  monetary  policy  is  far  from 
the  only  factor  affecting  economic 

there  has  been  a  close 
activity, 
relationship 
short-term 
between 
interest  rates  and  subsequent  growth 
in  output 
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 

(over 

Chart 7 

Monetary  conditions  and  output,  EUR4 

~$^~rttentnfifërê£r 
rates 

15 

io  m 

5  « 

70  72  74  76  78  80  82  84  86  88  90  92  94 

15 

Yield curw 

In  a  detailed 
monetary  policies. 
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 
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. 

70  72  74  76  78  80  82  84  86  88  90  92  94  96 

interest 

rates) 

JYwircKtywrj 

for 

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 

Table 4 

Inflation  developments 
(percentage change, private consumption deflator 

1992 

1993 

1994 

1995 

B 
DK 
D 

GR 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR15 

Reference 
Value 

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 

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 

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 

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* 

by 

as  measured 

inflation  criterion. 

the  fluctuation  margins 

In  1995,  the  average  rate  of  inflation  in  the 
Community, 
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 
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 
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 
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. 

strong  deceleration 

showed 

a 

*  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. 

Table 5 

General  g o v e r n m e nt  deficit 
(per cent of GDP) 
1993 

1994 

1992 

1995 

B 
DK 
D 

GR 
E 
F 

IRL 
1 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR 

-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 

-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 

-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 

-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 

-6.3 

-5.5 

-4.7 

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. 

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. 

worse-than-expected 
the 
Notwithstanding 
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. 

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 

Table 6 

General government  gross  debt 
(percent of GDP) 
Level 

Change 

1993 

1994 

1995 

95/94 

95/93 

137.5 

80.3 

48.2 

136.0a 
75.6 

133.8a 
73.6 

-2.2a 
-2.0 

50.2 

58.8 

-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 

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 

114.5 

113.0 

114.4 

60.4 

45.3 

97.4 

63.0 

48.4 

91.1 

64.8 

51.5 

85.9 

119.4 

125.4 

124.9 

6.3 

81.3 

62.8 

67.2 

57.3 

76.2 

48.5 

66.2 

5.9 

78.0 

65.2 

69.4 

59.8 

79.3 

50.3 

68.1 

6.3 

78.4 

68.0 

70.5 

60.3a 
81.4 

52.5 

71.1 

B 
DK1 
D 

GR 

E 

F 

IRL 

I 

L 

NL 

A 

P 

FIN 

S 

UK 

EUR 

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. 

- 1! 

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 
current 
Irrespective  of 
footing. 
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. 

the 

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 

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 

Chart 9 

Employment and unemployment in the EC* 

%tfcMfemtabourforu 

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. 

t 
78 79  80 81  82  83  84 85  86  87 88  89 90  91 
* Including the 5 new German Ldnder since  1991 

ViUlrtHrtft.tlt3HMtJUtt>>fattM>feltttt{rfoy!iMfe: 
{right &eate} 

»  •••<•  •»• • <  +  ' •• <  > 

91  92 93  94  95 

1  L^-t 

_t 

i 

F 

E 

B 

D 

1.9 

1.5 

0.1 

0.9 

DK 

GR 

IRL 

-2.3 

-1.0 

-2.1 

-0.9 

-0.7 

-1.8 

-0.7 

-0.2 

-4.4 

-0.7 

-1.9 

-1.4 

-0.4 

1993 

1994 

1995 

1992 

-0.2a 

(%pa.) 

Table 7 

0.4a 
2.1 

Employment growth 

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. 

Source/Commission's November 1995 forecasts 

a) Taking into account latest information. 

1.0 
2.7a 
1.1 

-0.6 
2.2a 

EUR 

-0.6 

-2.0 

-0.2 

-4.3 

-1.3 

-1.8 

-6.8 

-0.1 

-2.5 

-7.1 

-6.1 

-0.4 

-1.9 

-5.5 

-1.5 

-1.0 

-1.6 

-1.3 

FIN 

UK 

0.4 

2.5 

0.2 

0.8 

2.0 

3.5 

2.5 

0.7 

0.6 

0.6 

0.1 

0.7 

0.3 

2.6 

0.1 

0.1 

1.7 

1.2 

1.8 

1.8 

1.3 

NL 

A 

P 

S 

1 

L 

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 
significant 
Kingdom. 
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. 

Ireland  and  Greece 

In 

Table  8 

Unemployment rate 
(% of civilian labour force) 

1992 

1993 

1994 

1995 

B 
DK 
D 

GR 
E 
F 

IRL 
1 
L 

NL 
A 
P 

FIN 
s 
UK 

EUR 

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 

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 

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 

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 

1981 

the 

Table 9 

1976-
1980 

1984-
1991 

during 

J ob  creation  in t he  EC 
(ESA basis; million jobs) 

The  Community  suffered  large  job 
losses 
economic 
the  early  1980's. 
downturn  of 
However, 
subsequent 
the 
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 
the  Community. 
million  jobs 
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 

Total economy, EUR15-
Total economy, EUR13-a> 
- of which: private 
- of which: public 
a) EUR15 except Portugal and Greece. 
'  November  1995 forecasts; including the new German Lander. 
Source: National accounts and Commission services estimates. 

Ub> 
l . lb> 
1.2b> 
-0.1b> 

1983 
-3.0 
-3,1 
-4,1 
1,0 

10.4 
10,0 
7.4 
2.6 

-4.4 
-4.4 
-3.4 
-1.0 

2,9 
2,8 
0,0 
2,8 

1992-
1994 

in 

1995 

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 
intensely 
growth". 

Despite 

the 

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 
countries,  a 
including  taxes.  Non-wage  labour  costs  represent,  in  many  European 
substantial share of total wage costs, and generally weigh most heavily on the lower paid. 

6.3.96 

- 23 

in  net  disposable 

some  cases  generate  very 

Furthermore, 
the  degree  of  protection 
provided  through  income  support  schemes 
small 
in 
incomes 
differences 
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. 

economic 
unemployment 

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 
downturn. 
the 
recent 
remains 
Furthermore, 
significantly  higher  among  women 
than 
among  men,  even 
incidence  of 
unemployment  has  become  less  imbalanced 
in  recent  years.  During  the  economic 
downturn, 
rate  of  unemployment 
increased  more  among  men  than  among 
women, in part reflecting  the larger  share of 
in 
the  male  working 
cyclically sensitive sectors. 

force  employed 

if  the 

the 

Table 10 

Unemployment  features,  1994 

Unem 
ploy 
ment rate 

Youth 
unem 
ployment 
rate 

Long-term 
unem 
ployed  2) 

Low-
skilled 
unem 
ployed 3) 

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 

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 

Share of total 
unemployment 
58 
32 
44 

52 
31 
22 

40 
68 
46 

64 
59 
63 

32 
79 
58 

51 
53 
38 
591) 
62 
30 

49 
43 
45 

10D 
21 

B 
DK 
D 

GR 
E 
F 
IRL 
I 
L 

NL 
P 
UK 

A 
S 
FIN 

48 

EUR 

11.2 

21.8 
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 

50 

Chart  12 

Unemployment  Rate in the EC* 
(by age) 

iiiiHiiiii 

83  84  85  86  e7  88  a9  90  91  92  93  94 

(by sex) 

84 

83 
•EUR  12 
Source : Eurostat Harmonized  Unemployment  Rates 

92 

90 

91 

85 

86 

87 

88 

93 

94 

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 

: p j ^ t 3^ 

Sttbèm^tirtèiYp6yrtie«t 

: K - . : : C : : :< : : : > : : : : < : : : + : : : O : : : - :J :•:•:•>:•:•:•:!•: :•:< :•:•:•». : :•:<•• : .*:•• ••>••:•:•:€•:•:•:+:•:•• J:-: :••<•:•• :>::::c : :H :•:•:•>:. 
7273747576777879808182838485868788899091929394 

*EUR  12 

labour  costs, 

Thé  non-cyclical  component  is  linked  in 
the first instance to the lack  of  employment 
posts  at  given 
i.e. 
real 
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. 
the 
expansion  of  productive  capacity  would 
the 
in  step  with  output,  and 
keep 
scenario  would  not  imply a  repetition  of 
the overheating  problems of the  1988-90 
period (chart  13). 

Thus, 

Chart 13 

Actual and potential output  in the EC, 
1983-2000 (WP scenario) 
GDP and Production Capacity 

1983 

1986 

1989 

1992 

1995 

1998 

%  pa 

GOP and Production Capacity 

ÏI11 l l ïl I M i ll 111 l.l it 11111 l.l.l.l 1111 l.l 1111111111 i ll 11Al i ll 1.1.11.I.I.I.I.I.1.1 MM I II 11 i ll 11111111.111111 

1983 

1986 

1989 

1992 

1995 

1998 

Output gap (*) 

a -1 

.1983 
(*) Ratio of actual to potential GDP 

1989 

1986 

1992 

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 

of 

of 

the 

fact, 

actual 

despite 

however, 

In 
the 
recovery was much stronger in 1994 
and, 
intensifying 
slowdown  during  the  year,  also 
better  than  expected  for  1995  on 
average  (chart  14).  Thus,  at  the 
the 
time 
elaboration 
1995 
Commission's  November 
forecasts,  the  achievement  of  the 
White  Paper  growth  scenario  still 
appeared  feasible.  However,  the 
subsequent  deterioration 
the 
outlook  for  1996  will  render  the 
achievement  of  the  White  Paper 
scenario  more  difficult,  even  if  it  is 
not yet  excluded. 

in 

1993  1994  1995  1996  1997  1998  1999  2000 

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 

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 
scenario, 
the  White  Paper  growth 
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. 

1995  1996  1997  1998  1999  2000 

1993  1994 

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 

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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 

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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 

Inflation and unit labour costs  in the EC 

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 

low 

they 

took 

inflation 

First,  as the  monetary  authorities  became 
increasingly  conscious  of  the  importance 
action 
of 
accordingly.  While  nominal  short-term 
regularly 
interest 
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 

declined 

rates 

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 

iTable 11 

I 

Money, credit  and  inflation  targets and  outcomes 
(per cent per year) 

II 

1994 

I 

1995 

Target 
variable3 

M3 
M3 
EITa 
M3 
ALP+CP 
ALP 
CPIb 
M2 
M4 
MO 
RPIX*5 

CPIYb 
b 
CPIb 

Germany 
France 

Spain 

Italy 
UK 

Finland 

Sweden 

Target 
(medium 
term) 
4 -6 
(around 5) 

- 
- 
4.5-7.5 

5 -7 
3 -9 
0 -4 
1-4 

- 

-(2) 

Outcome 

4.9 
1.1 
4.2 
8.2 
7.6 
8.2 
4.7 
1.6 
4.5 
6.7 
2.4 

1.3 

2.4 

I 

Target 
(medium 
term) 
4 -6 
(around 5) 

(<3) 
5 

1-4 
(<2.5) 
2 

' 

<*> 
2 ±1 
1  ( 2 ±D 

Outcome 

2.5 (Dec) 
3.9  (Nov) 
4.8 (Oct) 
10.7 (Nov) 
9.2  (Nov) 
9.7 (Nov) 
4.3 (Dec) 
2.2 (Dec) 
9.3  (Dec) 
5.6 (Dec) 
3.0  (Dec) 

-0.6 (Nov) 

2.6 (Dec) 

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) 

pursue 
of 

Whilst  all  Member 
States 
the 
price 
objective 
stability, the monetary 
policy  frameworks  in 
individual  Member 
States  target  different 
These 
variables. 

frameworks 
have 
become  more  diverse 
the  Community 
in 
years 
recent 
over 
(table 
an 
11) 
attempt  to  formulate 
the  most  appropriate 
and  credible  response 
changing 
the 
to 
and 
economic 

in 

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. 

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. 

especially 

Exchange  rate  tensions  at  the  international 
level,  related  to  the financial crisis  in  Mexico 
affecting 
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 

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 
j 

1994 

1995 

| 

JAN 
1996 

110 

^V 

75 

JAN  MAR  JUN  SEP  DEC  FEB  MAY  AUG  NOV  JAN 
I 
11996 

1994 

1995 

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. 

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 

Chart 19 

Short-term interest rate differentials 
against the DM 

JAN  MAR  JUN  SEP  DEC  FEB  MAY  AUG  NOV  JAN 
|  1996 
| 

1994 

1995 

policy. 

Almost  all  ERM  participants  were  in  a 
position to lower  rates  substantially.  Dutch 
and  Austrian  money  market  rates  followed 
closely developments in Germany,  although 
in  the  latter 
the  short-term  differential 
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  Denmark,  France  and 
in  Germany. 
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 
the 
credible  fiscal  consohdation  efforts, 

JAN  MAR  JUN  SEP  DEC  FEB  MAY  AUG  NOV  JAN 
|  1996 
"I 

differential 
significantly. 
narrowed 
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. 

1995 

1994 

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 

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 
In  Italy,  the  rate  of  inflation 
degree  of  inflation  as  well  as  in  Greece  and  Portugal. 
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 

The inpact cf the IJEDcn the S W in 1939 

OWUSD (left-hand scale) 

T14 

J ' F ' M ' A ' M ' J ' J"  A1  S"  O  "  N  "  D 

»_  s r œ 6 M ï ch 

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. 

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 

Chart 20 

INTEREST RATES AND EXPECTED INTEREST RATES IN THE EU 
The evolution of the average interest rates in EU 15 

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 

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 
interest 
long-term 
in 
rate 
the  US. 
in 
Germany 
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. 

than 

the 

Given 
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). 

%  ofCOP 

Chart 21 

Output gap and trends in budget deficit, EUR 

The  early  1990s  witnessed  a 
substantial  and  rapid  deterioration 
in the budgetary performance  due to 
both  discretionary  policies  and 
In  the  space  of 
cyclical  factors. 
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. 
strong 
there  was 
Initially, 
a 
deterioration 
cyclically-
the 
in 
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 
In 
imbalances  at  the  beginning  of  the  1990s. 

T a b le  12 

C y c l i c a l l y - a d j u s t ed  d e f i c i ts  1 9 8 5 - 95 
(per cent  of  GDP) 

1985 

1989 

1991 

1993 

1995a 

B 
DK 
D 

GR 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

-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 

-7.2 
-0.5 
0.5 

-8.2 
-1.4 
-5.2 

-5.9 
-2.4 
-3.3 

-15.5 
-4.9 
-2.4 

-12.0 
-7.3 
-3.1 

-11.7 
-6.4 
-5.0 

-1.4 
-10.9 

-2.3 
-10.9 

-5.2 
-2.9 
-3.6 

1.2 
2.2 
-3.3 

-4.5 
-3.4 
-8.3 

-0.7 
-2.4 
-2.6 

-1.1 
-8.3 
2.8 

-2.7 
-3.6 
-6.7 

-2.4 
-9.3 
-5.8 

-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 

EUR 

-3.5 

-3.7 

-5.4 

-5.1 

-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. 

several  countries 

contrast, 
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 

(Denmark,  France, 

during  1992/93. 

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 

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 

' 1 9 7 0 - 1 9 7 8:  EUR11  (CR, L, P and 8 excluded). 

43 

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 

37.6 

45.2 

44.8 

46.2 

46.2 

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 

12.7 
10.2 
12.0 
2.7 

13.5 
12.9 
14.9 
4.1 

13.4 
13.3 
14.6 
3.4 

13.6 
12.9 
15.9 
3.7 

13.9 
12.8 
16.0 
3.4 

38.5 

49.4 

46.8 

52.5 

50.9 

16.1 
13.1 
1.8 
16.1 
0.9 
3.6 

3.7 
-0.9 
36.8 

21.8 
17.9 
5.0 
19.2 
1.0 
2.9 

-0.6 
-4.5 
53.9 

20.7 
17.1 
4.6 
18.2 
0.9 
2.8 

1.2 
-2.4 
54.1 

23.7 
20.0 
5.5 
19.5 
1.0 
2.8 

-2.5 
-6.3 
66.2 

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 

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 

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 

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. 

in  hand  with 

A  high  level  of  national  savings  must 
therefore  go  hand 
the 
Community's  ambitions  to  generate  the 
higher investment levels which are vital to 
underpin  a 
satisfactory  medium-term 
growth  performance.  Given the  observed 
in  private  savings, 
long-term  stability 
there  is  widespread  agreement  that  the 

National, private and government  saving,  EUR 

%  of  GDP 

PftetMSawng 

t 
60  62  64  66  68  70  72  74  76  78  80  82  84  86  88  90  92  94 

I  ,  1  r < ,l 

.  >  • 

•  •! 

•  < 

•  < 

I-  • 

.  < 

-I 

> 

• 

• 

. 

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 

4 7-

Chart 26 

Cyclical component of general government  deficit 

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 

(chart 

decades 

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. 

about half of the time over the last 
26). 
two 
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. 

1.9 

1.4 

5.4 

7.8 

3.4 

7.1 

5.1 

6.1 

5.5 

3.5 

0.9 

3.6 

3.0 

4.3 

4.4 

2.5 

-9.1 

-2.0 

-3.1 

-7.2 

-4.1 

12.6 

14.4 

17.1 

12.9 

72.0 

14.0 

75.1 

20.5 

63.9 

73.4 

12.2 

63.7 

1985 

1984 

1982 

1983 

1986 

Inflation (%  p.a.) 

GDP (real %  p.a.) 

Employment(%  p.a.) 

Budget  balance (%  GDP) 

Long term  interest  rate (% ) 

Denmark 

Primary balance (% of  GDP) 

Government debt (%  of  GDP) 

-of which  Investment (%  p.a.) 

Domestic  demand (real %  p.a.) 

the  economy 

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 
into 
than  plunging 
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 
the 
was  predominantly  driven  by 
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 
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 

Cyclically-adjusted budget deficit (% of GDP) 

strained 

Unemployment (%) 

Denmark 

Public debt (% of GDP) 

10.6 

10.2 

11.6 

4.3 

2.9 

2.9 

4.3 

0.2 

6.8 

9.0 

0.7 

8.5 

2.6 

7.1 

6.4 

5.4 

89 

12 

0 

5 

6 

3 

4 

6.3.96 

52 

Ireland 

89 

1.3 

7.6 

6.1 

0.3 

5.7 

3.7 

9.4 

0.0 

2.1 

6.0 

4.3 

2.4 

5.5 

0.3 

4.7 

0.8 

4.2 

-1.8 

-1.6 

-4.4 

-1.4 

-8.5 

-2.3 

-2.3 

7-8. 

13.8 

10.1 

11.1 

11.1 

11.3 

96.5 

-10.6 

1986 

1988 

1989 

1987 

1990 

101.7 

111.6 

114.9 

116.0 

Inflation (%  p.a.) 

GDP (real % p.a.) 

E m p l o y m e n ts  p.a.) 

Budget balance (%  GDP) 

Long term  interest rate (% ) 

Primary balance (%  of  GDP) 

Government  debt (%  of  GDP) 

-of which Investment (%  p.a.) 

Domestic  demand (real %  p.a.) 

the  1987  budgetary 
In 
Ireland, 
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. 

8 
CycMcaJly-adJustad budget d e l e* (% of OOP) 

10  11  12  13  14  15  16 

Unemployment (%) 

Pubic debt (% of OOP) 

Ireland 

16.6 

13.4 

16.8 

16.1 

14.7 

-0.2 

4.2 

2.0 

4.0 

0.2 

0.0 

0.8 

40 

S 

6 

5 

3 

4 

7 

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 
It  was  embodied  in  the  Council's  Broad  Guidelines  of  1994  and  the 
widely  accepted. 
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 

5 4-

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 
In  the  next  few  years, 
compensate  for  the  comparatively  higher  capital/output  ratio. 
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 
In  this  context,  experience  has  indicated  that  in  the 
changes  in  economic  conditions. 
through 
absence  of  such  flexibility, 
disproportionate losses in working posts. 

to  adverse  shocks  occurs 

the  adjustment 

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 

Chart 27 

Nominal wages and inflation - EUR 

% change  p.a. 

Over the  past  15 years,  the  evolution  of 
nominal  wages  in  the  Community  has 
generally  not  only  accompanied  but  also 
the  remarkable  disinflation 
facilitated 
in  chart  27, 
As  shown 
process. 
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 

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. 

labour 

productivity 

The 
long-term  macroeconomic 
evolution  of  real  wages  in  relation 
and 
to 
investment  profitability 
shows  a 
the  nominal 
similar  pattern  as 
During 
indicators. 
the  1980s, 
increases 
real  wages,  while 
remaining  positive,  fell  clearly  short 
of 
labour  productivity  growth, 
resulting  in  a  substantial  decline  in 
This 
real  unit 

labour  costs. 

in 

Chart 28 

Real  wages and labour  productivity  - EUR 

annual %  changes 

•7^Ubfmff9ikffMfy0fMi9h-

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 

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  w a ge  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 

- 5 9-

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. 

to  adjust  swiftly 

(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  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 
the  endogenous  growth  forces  of  the 
common  the  objective  of  reinforcing 
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 

Period 

Total 

Agriculture 

Industry 

Value added 

Employment 

Productivity 

Relative price 

1961-73 
1974-85 
1986-90 
1961-73 
1974-85 
1986-90 
1961-73 
1974-85 
1986-90 
1961-73 
1974-85 
1986-90 

4.9 
2.1 
3.1 
0.3 
0.2 
1.0 
4.6 
1.9 
2.1 

-

1.8 
1.7 
1.7 
-4.6 
-2.9 
-3.1 
6.5 
4.7 
4.9 
-0.4 
-2.5 
-2.0 

5.5 
1.0 
2.4 
0.5 
-1.4 
0.3 
5.0 
2.4 
2.1 
-1.0 
-0.4 
-0.4 

a) Comparable data over the whole period are only available for B, D, F, I and NL. 
Source: Eurostat and Commission services. 

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 

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 

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. 

for 

1970-79 

Table B7.1 

World  Trade3) 

G r o w th  of  t r a de  and  GDP 
(annual percentage change) 

These  developments  play  an  important 
role 
economy. 
the  Community 
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. 

EC  GDP 
a)  Average of exports and imports of goods 

1980-89 
41/2 
31/2 
2.2 

World  GDP 

1990-95 

3.4 

1.7 

TA 

7 

4 

6 

US 

17.6 

10.6 

19.0 

23.2 

23.5 

25.3 

EUR12 

1982-84 

1992-94 

1972-74 

Table B7.2 

Japan 
DAEb) 

Shares  in  w o r ld  t r a de  (goods)3) 
(per cent) 

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, 
a 
has 
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). 

World 
a)  Exports;  world and EC trade excludes intra-. EC trade 

b)  Dynamic Asian Economies 

the  Community 

100.0 

100.0 

100.0 

14.2 

15.1 

18.4 

12.5 

10.9 

5.6 

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 

6 4-

Table B6.3 

F o r e i gn  d i r e ct  i n v e s t m e nt  f l o w s,  EUR12 
(billion ECU) 

1984 

1989 

1993 

Inward  FDl 

-  from  OECD 

-  from  US 

-  from  Japan 

Outward  FDl 

-  to  OECD 

-to  US 

-  to  Japan 

-to  rest  of  Asia 

-  to  CEEC 

6.2 

5.0 

3.0 

0.4 

17.4 

13.0 

11.5 

0.3 

n.a. 

n.a. 

27.9 

23.0 

9.8 

4.4 

33.3 

26.8 

24.1 

0.7 

n.a. 

n.a. 

Net  inflow 
Source: Eurostat.  FDl excluding reinvested earnings. 

-11.2 

-5.4 

21.0 

16.0 

9.0 

1.7 

21.9 

13.4 

10.2 

-1.2 

1.8 

2.4 

-0.8 

for 

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 
Foreign 
the  Community. 
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 
the  economic 
under 
remained 
the 
slowdown,  but 
relatively  high  in  a  historical  perspective. 
FDl  flows  were  largely  m  balance  for  the 
Community (EUR12) as a whole in 1993. 

impact  of 

level 

the 

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 

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(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 

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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 
initiatives  involve  both 
growth,  and  structural  adjustment. 
continuing improvements in the functioning  of product  and service markets,  along the lines 

Structural  adjustment 

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 
providing and those seeking employment; 

•  promoting local employment initiatives. 

information-sharing  between 

those 

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 

- 7 2-

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%. 

3^ 

7J6 

23 

04 

14 

22 

3J0 

1.1 

8.7 

0.8 

0.8 

-0.7 

102 

-0.6 

10.0 

1995 

1994 

15  * 

1.9  * 

1991-93 

1586-90 

Inflation (%  change) 

Unemployment rate (%) 

Employment (% change) 

GDP growth rate 
(% change) 

Total domestic demand 
(%  change) 

Balance of current account 
(% of GDP) 

TaUel 
Belgium: Macroeconomic performance 

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. 

For definitions, see Table 2 
Source: Commission's November J 995 forecasts 
* Taking into account latest information 

•A 

JL 

1.5 

25 

43 

14 

3J0 

2J6 

5J0 

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 

- 7 4-

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 

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. 

T a b id 
Belgium: Economic policy indicators 

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) 

1986-90 

1991-93 

1994 

1995 

9.1 

-4.8 

-72 

-6.8 

-53 

-45 

131.4 

133 D 

136.0* 

133.8  * 

3.8 

5.7 

49 

2.7 

15 

3.1 

IX 

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. 

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 
lower 
together  with 
VA%, 
interest  charges  due  both  to 
rates 
lower 
and 
debt  management 
improved 
techniques. 
general 
government  gross  debt  ratio 
a 
second 
declined 
attaining 
consecutive 
year, 
133.8%  of  GDP 
in  1995 
(137.9% in 1993). 

interest 

The 

for 

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 

- 7 5-

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" . 

Difference  in percentage points 

labour force as % of population  1S-64 years 

Chart 1 - Belgium 

low 
and 

Difference  between EUR3 and B 
(right-hand «ale) 

Participation rates in Belgium and EUR3 (D*, F, NL) 

market 
Labour 
is 
participation 
in 
relatively 
Belgium, 
the 
average  duration  of 
unemployment 
spells 
high.  This  suggests 
that  there  might  be  a 
correlation 
between 
the relatively generous 
rules 
eUgibility 
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 . 

*  Unified  Germany  from  1991  onwards 

Commission  services 

Source: 

1988 

1972 

1980 

1978 

1976 

1982 

1970 

1990 

1986 

1992 

1974 

1984 

1994 

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. 

1.4 

1.2 

5.2 

0.4 

0.0 

4.4 

4.5 

1995 

1994 

1991-93 

1986-90 

capacity 

Unemployment rate  (%) 

Employment (% change) 

GDP growth rate 
(% change) 

Total domestic demand 
(% change) 

utilisation 
the 

Tahlel 
Denmark: Macroeconomic performance 

Investment 
equipment 
in 
picked  up  strongly  in  1995, 
mainly  due  to  the  high  degree 
of 
in 
good 
industry 
profitability  in  manufacturing. 
Construction,  on 
the  other 
hand,  increased  only  modestly, 
given the  high  level  of  interest 
rates  earlier 
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. 

For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 

Balance of current account 
(%  of GDP) 

Inflation  (%  change) 

and 

in 

-0.2 

-1.1 

-2.1 

2.2 

2.0 

2.0 

2.1 

0.9 

3.7 

9.2 

6.7 

6.4 

8.2 

1.5 

1.0 

1.8 

6.3.1996 

78 

| 

6.8 

0.9 

-2.0 

6.3 

-3.2 

-5.6 

-3.8 

75.6 

60.7 

71.3 

1994 

1986-90 

1991-93 

Money  growth 
(%  change) 

Nominal wages per head 
(% change) 

Gross government  debt: 
(%  of GDP) 

Government budget balance 
(% of GDP) 

Table 2 
Denmark: Economic policy indicators 

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. 

'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 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

Real wages per  head 
(% change) 

1 

73.6 

2.2 

3.2 

3.4 

5.1 

1.6 

1.4 

3.3 

Despite strong growth and a sharp decrease in registered unemployment  Danish  inflation 
remains  subdued.  For  1995, consumer  prices increased  by 2%. The  favourable  inflation 

Chart  1 -  Denmark 

Discount  and  repo  rates  in  1994  and  1995 

—Discount rate 
—Repo rate 

i 

i 

J 

i 
i 
J  F  M  A  M  J  J 
1994 

i 

i 

' 

' 

' 

' 

» 

' 

i 

i 

' 

i 

i 

i 

i 

i 

i 

i 

i 

O N D J F M A . MJ 

J A S O N DJ 

1995 

1996 

Source:  Commission services 

of 

performance  may  in  part 
the 
be  explained  by 
appreciation 
the 
Danish  krone.  Also,  it 
seems  that  Danish  wage 
settlements  are  adjusting 
to  low  Danish  consumer 
thus 
increases, 
price 
reducing 
the  risks  of 
unfavourable  wage/price 
developments. 

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 
tightening  unemployment  benefit  eligibility  rules,  improving  state 
unemployment, 
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 
Manufacturing 

Construction 

Index 1985 = 100 
130 

% annual change 
10 

Index 1985 = 100 
130 

%  annual  change 

10 

Three  month 
moving 

average 

no 

80 

| 

w 

Three  month  moving 

average 

—confidence  indicator s.a.  (left-hand  scale) 
Oequipment investment (right-hand  scale) 

—confidence  indicator s.a.  (left-hand  scale) 
E3construction investment  (right-hand  scale) 

1994 

| 

1995 

| 

80  u 

I_J 

i 

i  i 

i 

i 

i  i 

i 

i  i_ 

Source  :  Statistisches  Bundesamt, Commission  services 

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). 

6.7 

2.8 

2.9 

-0.7 

1994 

1995 

1.8  * 

1.9  * 

-0.2  * 

1991-93 

1986-90 

Inflation  (%  change) 

Unemployment rate (%) 

Employment (% change) 

GDP growth rate 
(% change) 

Total domestic demand 
(%  change) 

Table 1 
Germany: Macroeconomic  performance 

The  loss  of  confidence  went 
renewed 
with 
together 
over 
concern 
German 
competitiveness, 
industrial 
already  negatively  affected  by 
the  preceding  combination  of 
a  strong  DM  and  high  wage 
(Chart 2).  Tough 
increases 
restructuring, 
cost  control, 
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. 

For definitions, see Table 2 for  Belgium 
Source: Commission's November  1995 forecasts 
* Taking into account latest information 

Balance of current account 
(%  of GDP) 

-0.8  * 

2.0  * 

^1.0 

-1.3 

2.7 

8.3 

8.4 

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 
in 
be  very  cautious 
hiring  personnel. 
In 
Germany, 
west 

1991 

| 

J 

i 

i 

i 

i 

i 

' 

• 

employment  continued 
to  slide longer  after  the 
the 
beginning 
upswing 
the 
recovery. 
previous 

than 

of 

in 

Source:  Commission services 

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 

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. 

In particular,  the  strong  decline  in interest  rates  which  occurred  in  the  course  of  1995 

TaUe 2 
Germany: 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) 

| 

1986-90 

1991-93 

1994 

8.3 

1.6 

1995 

2.3 

-3.2 

-2.6 

-3.6 

44.6 

50.2 

58.8 

3.2 

3.7 

0.5 

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. 

will  stimulate  the  economy, 
just  as  the 
increase  during 
1994  was  a  factor  behind  the 
short-
slow-down.  Nominal 
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 
foreign 
that  pressure 
competitors 
also 
subside somewhat. 

from 
should 

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. 

Growth 

of 

private 

T a f c l el 

|  (% change) 

Inflation {%  change) 

Total dorrestic demand 

Unemployment rate (%) 

Employment (% change) 

GreecM-Macroeconomic performance 

GDP growth rate 
(% change) 

Balance of current account 
(%  of GDP) 

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 
in  1995,  after 
by  0.5% 
growing  at  1.3%  in  1994. 
real  disposable 
However, 
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 

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) 

underindexing 

a  disinflation 

strategy 
With 
largely based  on fiscal  adjustment 
and 
the 
on 
the  drachma 
depreciation  of 
exchange 
to  Greece's 
rate 
inflation  differential  vis-à-vis  the 
ECU, the exchange rate  objective 
has been  supported  by  a positive 
sentiment  about  stabilisation  and 
prospects. 
depreciation 

For definitions, see Table 2for  Belgium 
Source: Commission's November  1995 forecasts 

Following 
successful 
the 
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. 

scale) 

scale) 

• D e f i c it  (right-hand scale) 

—Primary expenditure  (left-hand 

Chart 1 - Greece 

Cyclically adjusted variables as % of trend GDP 

Cyclically adjusted variables as % of trend GDP 

—Revenues  (left-hand  scale) 
ea Primary balance  (right-hand 

Fiscal adjustment  (general government) 

Chart  1  presents 
the 
composition  of  fiscal 
the 
adjustment  since 
end  of the  past  decade 
by  comparing  data  on 
revenues  and  primary 
spending  adjusted  for 
fluctuations 
cyclical 
and  reported  as  ratios 
of  trend  GDP;  thus, 
be 
data  may 
the 
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. 

Commission  services 

Source: 

1989 

1988 

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 

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 

4.5 

0.6 

2.1 

3.0 

6.6 

-0.2 

1.1 

3.3 

3.2 

18.9 

6.6 

-1.3 

-2.1 

19.2 

6.1 

-2.7 

-0.9 

2.7 

24.3 

4.9 

-1.2 

22.7 

4.9 

-1.3 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 
* Taking into account latest information 

growth, investment began to decelerate in mid-1995. 

After  a cumulative fall of  14% in 
investment 
1992  and  1993, 
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 
rate. 
capacity 
However,  given  subdued  private 
some 
consumption 

utilisation 

and 

deceleration  in  external  demand 

6.3.1996 

- 9 0-

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 

rate 

taking 

consumption 

Private 
is 
assessed  to  have  grown  by 
1.6%  in  1995,  a  relatively 
into 
low 
account  the  sharp  rise  in 
employment  (Chart  1)  and 
in  real  gross  disposable 
income 
The 
household  saving  ratio  is 
estimated to have picked up 
to  12.8%  in  1995,  as  a 
growing 
result 

(3.1%). 

of 

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 
the  earlier 

fading  effects  of 

TaMe 2 
Spain: Economic policy indicators 

peseta  depreciation 

and 

the 

J recovery in domestic demand. 

1 

1986-90 

1991-93 

1994 

14.5 

7.5 

Money growth 
(% change) 

-6.6 

64.8 

-5.9 

-5.5 

-3.8 

63.0 

51.5 

44.1 

Gross government debt 
(%  of GDP) 

Nominal wages per head 
(% change) 

Government budget balance 
(%  of GDP) 

The  Spanish  external  accounts 
improved  significantly  in  the  last 
few  years  as  a  consequence  of 
the 
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 
into 
balance  in  1994.  Although  in 
1995  real  import  growth  once  again  outpaced  the  growth  of  real  exports,  an 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

Real wages per  head 
(% change) 

depreciation 

in  1991 

peseta 

-0.9 

-1.7 

2.0 

8.2 

7.7 

3.9 

3.1 

1.0 

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 

- 9 2-

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 

Spanish 
The 
have 
authorities 
gained  credibility  by 
their 
meeting 

targets 

convergence 
programme/budget 
in 
deficit 
1994  and  in  1995. 
This  has  been  mainly 
through  a 
achieved 
in  the  primary 
cut 
(which 
deficit 

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 

- 9 3-

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 
the  support 
momentum  and 

jj  1986-90  1991-93 

1994 

I ^ S^  measures  taken  in  1994  have 

in 

Inflation (%  change)  -

Unemployment rate (%) 

Employment (%  change) 

GDP growth rate 
(%  change) 

Total domestic demand 
(% change) 

been  prolonged  in  1995.  The 
distinct 
the 
increase 
purchasing  power  of  personal 
disposable 
resulting 
income, 
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. 

For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 

Balance of current account 
(% of GDP) 

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 

- 9 5-

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 

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 

1991-93 

8.9 

1.4 

1994 

1.9 

-1.8 

-4.1 

-6.0 

-5.0 

33.7 

40.2 

48.4 

51.5 

4.2 

3.6 

2.1 

3.0 

1.3 

0.9 

0.3 

1.1 

in 

percentage 
the 
points 
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 
the 
beginning of  1995 and consumer 
caution is likely to keep retailers' 
margins under pressure. 

since 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

Unit  labour  costs  are  estimated 
to  have  increased  by  about  1% 
in  1995  as  a  result  of  lower 
in  productivity  and 
growth 
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%. 

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 

1991 

| 

1992 

| 

1993 

| 

1994 

| 

1995 

| 

Source: 

Commission  services,  INSEE 

Growth 

Changes 
in 
employment  have  been 
the 
consistent  with 
productivity 
standard 
cycle. 
in 
which 
employment, 
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 

' 

1989 
Source:  Commission services, INSEE 

1988 

1987 

The  consolidation  of 
central 
government 
finances  will  continue 
efforts 
in  1996  and 
will 
to 
be  made 
remedy  the  recurrent 
social  security  deficit, 
which  constitutes  a 
to 
obstacle 
major 
the 
compliance  with 

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 
in 
unskilled 
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). 

labour  and  placing  young  people  and 

the  long-term  unemployed 

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. 

| 

I 

I 

1.0 

3.5 

5.9 

6.7 

3.2 

3.3 

0.4 

6.7 

2.6 

4.6 

4.2 

3.1 

-0.2 

14.4 

15.5 

14.7 

15.3 

1995 

1994 

1991-93 

1986-90 

Irish 

(%  change) 

Inflation (% change) 

Total domestic demand 

Unemploy ment rate (%) 

Employment (% change) 

GDP growth rate 
(%  change) 

Balance of current account 
(%  of GDP) 

TaHel 
Ireland: IVfacroeconomic  performance 

The 
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 
to 
important 
growth.  The  buoyancy  of 
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 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

contribution 

-1.2 

2.7 

2.5 

2.4 

3.4 

5.1 

6.0 

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 

\  Favourable prospects  over  the 

medium term 

2.8 

2.7 

although 

Real wages per  head 
(%  change) 

Gross government debt 
(% of GDP) 

Nominal wages per head 
(%  change) 

G overnment budget balance 
(% of GDP) 

The  prospects  for  continued 
non-inflationary  growth  remain 
favourable, 
some 
moderation  from  the  very  high 
rates  of  1994  and  1995 
is 
expected.  The  general  outlook 
slowing 
is  one  of  growth 
toward  its  trend  rate  following 
the  rapid  surge  of  1994  and 
in 
1995. 
consumption 
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 

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 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995  forecasts 
* Taking into account latest information 

growth 

The 

in 

0.2 

0.4 

• 

Chart  1 -  Ireland 

favourable 

business 

annual %  change 

•  Domestic demand 
ED Net exports 
—  GDP 

Contributions to GDP growth 

climate  suggests 
that 
investment  will  remain 
However, 
buoyant. 
investment  growth 
is 
expected to fall from its 
1995  rate  to  about  6% 
to  7%  in  the  following 
two 
Public 
years. 
is 
consumption 
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. 

Source:  Commission services 

1991 

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 

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 

~ 

situation.  Inflation  accelerated 
during  the  year  but  peaked  in 
whereas 
November 
1995, 
was 
employment 
lagging.  Italy's  economic  cycle, 
however,  might  have reached  its 
peak in 1995. 

creation 

initiated 

the  economic 
The  path  of 
recovery 
last 
in  the 
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 

Employment by sector 
(Absolute  changes  on end-period  data,  seasonally  adjusted) 

Thousands 

10 

50 

-50 

-100 

-150  h 

-200 

1991 

1992 
Note: Expressed as man-years according to national accounts definitions. 
Source  Commission services, ISTAT 

1993 

1994 

1995 

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 

10 

—Producer  prices 
—Consumer prices 

Inflation indicators 

J 

I 

I 

1_ 

i 

' 

I 

I 

l 

I 

I 

I 

l 

,  I 

1995 

Source:  Commission services, ISTAT 

the 

1995, 

In 
net 
increase  in  employment 
was 
very  marginal 
(81 000 units)  and  only 
force 
labour 
the 
surveys  of  April  and 
July  showed  positive 
creation 
employment 
figures.  On  average, 
by 
employment 
J  0.5%  compared  to  the 

fell 

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-

in  particular, 

in  the  services  sectors, 

previous surveys of April and July). Most  of this increase took  place among  independent 
increased  by  2% 
workers.  Employment 
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 

TaUe2 
Italy: 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) 

I  1986-90 

8.7 

1991-93 

1994 

1995 

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 

developments  are  not  putting  a 
pressure  on  inflation,  given  that 
wage  setting  did  not  seem to  be 
affected  by  the  upwards  trend 
during  1995. 

role 

Monetary  policy  is  playing  a 
major 
combatting 
in 
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. 

TaUe 1 

Luxembourg : Macroeconomic  performance 

j 

\ 

1986-90 

1991-93 

1994 

1995 

GDP growth rate 
(% change) 

Total domestic demand 

(% crmfige) 

4.6 

5.5 

1.6 

3.3 

3.1 

2.7 

2.3 

2.5 

Employment (%  change) 

3.1 

2.8 

,  2.5 

2.5 

Unemployment rate (%) 

Inflation  (%  change) 
Balance of current account 
(% of GDP) 

2.1 

'  3.5 
28.1 

2.2 

3.7 
21.6 

3.5 

2.4 
15.9 

3.9 

1.9 
29.6 

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 
the 
in  excise  duties, 
rise 
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 

For definitions, see Table 2 for Belgium 
Source: Commission's November  J 995 forecasts 

continue  in  1996  even  if  the 
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 

108 

substantial  financial  assets.  In  view  of  the  favourable  outlook  for  growth,  the  public 
finance  situation is unlikely to worsen in the foreseeable  future. 

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 

i ** 

1.5 

2.2 

0.4 

5.2 

5.9 

6.3 

5.7 

3.4 

3.7 

1.9 

1.0 

1.7 

8.8 

5.2 

1.7 

the 

growth 

However,  this  overall  positive 
marked 
conceals 
trend 
differences  between  sectors. 
Whereas 
in 
financial  activity  continued, 
its  role  as 
confirming 
the 
the  Luxembourg 
motor  of 
industry 
economy,  the  steel 
had 
further 
undergo 
Employing 
restructuring. 

to 

For definitions, see 'fable 2 for Belgium 
Source: Commission's November 1995 forecasts 

the 
almost  18 000  people, 
financial  sector  now  accounts 
for  about  10%  of  domestic 
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, 
(  absolute  annual  change) 

•rv. 

, 

j 

C3 Total  employment 
•  Non-resident  workers 
Q  Unemployment 

%  Ê  I  il Hf JlftllLlfl  M 

78 

80 
Source  Commission  services  and Statec 

82 

84 

86 

the 

country  or,  as  was 
case, 
primarily 
frontier  workers. 
In 
1994  resident  foreign 
workers  and 
frontier 
workers  accounted  for 
25% 
and 
28% 
respectively  of 
total 
domestic  employment, 
Luxembourg 
with 
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. 

in 

1995; 

which 

Employment, 
had 
practically marked time in  1993 
and  1994, showed a fairly  sharp 
upturn 
total 
employment increased by  1.2%, 
paving  the way  for  a  reduction 
in 
rate 
the  unemployment 
- 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 
continuing  wage 
result  of 
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 

I ll 

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. 

1.7 

6.4 

4.1 

-3.3 

-3.2 

2.3 

77.3 

78.4 

-3.1 

-5.1 

-0.5 

79.9 

78.0 

1995 

1994 

1991-93 

the 

most 

limiting 

Money growth 
(% change) 

Real wages per  head 
(% change) 

Gross government debt 
(%  of GDP) 

Nominal wages per  head 
(% change) 

Government budget balance 
(% of GDP) 

Table 2 
Netherlands: Economic policy indicators 

other 
Unlike 
the 
Member States, 
Netherlands  was 
successful, 
during  the  recession  of  the 
the 
early 1990s, 
in 
growth 
general 
in 
deficit,  which 
government 
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%» 
the  3% 
in  1996,  below 
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. 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

0.0 

3.2 

0.8 

1.5 

1.2 

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 (%) 
(Left-hand scale) 

—Unemployment rate  NL 
—Unemployment rate EUR  15 
E3 Employment  - NL 
•  Employment  - EUR  15 

Employment ( 1970 =100) 
(Right-hand scale) 

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  E U R 15  (EUR15=100),  1980=100 

130 

80 

70  h 

-Eur4inECU 
-NL,  in ECU 
•NL,  in Dutch guilder 

74 

70 

76 

72 
Eur4=B DKWDF 
iSowrce.Commission services 

in 

since 

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 
Dutch 
evolution 
unemployment  is  also  due 
to  the  strong  growth  in 
the 
employment 
second  oil  shock,  which 
resulted  in  particular  in  a 
in 
substantial 
part-time 
working, 
especially  with  women 
the  service 
in 
working 
in 
sector.  This  growth 
employment  reflects 
the 
fact  that,  for  almost  15 
years, wage growth  in the 
Netherlands  has  been  less 
than  in the  Community  as 
the  main 
a  whole  and 
in 
trading 
in 
particular, 

partners 
either 

increase 

nominal or in real terms or in national or in common currency. 

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. 

3.0 

3.4 

2.4 

1.1 

1.6 

1.5 

1.7 

3.4 

0.3 

3.8 

4.5 

3.0 

0.2 

in 

1995 

1994 

1991-93 

1986-90 

benefited 

Inflation (% change) 

Unemployment rate (%) 

Employment (% change) 

GDP growth rate 
(% change) 

Total domestic demand 
(% change) 

TaUe 1 
Austria: Macroeconomic performance 

In  recent  years,  the  Austrian 
economy 
from 
significant  productivity  gains 
and its exports  to  the  European 
car industry.  Tourism is another 
field  of  Austrian 
traditional 
sector's 
specialisation.  That 
large 
surplus  has  offset 
merchandise 
deficits, 
trade 
especially  with  Germany.  The 
opening  of  Eastern  Europe 
increased  competition,  but  also 
new 
brought 
opportunities: 
eastern  neighbours 
Austria's 
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. 

For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 
* Taking into account latest information 

Balance of current account 
(% of GDP) 

the 

-0.9 

-1.8 

-0.1 

2.2 

4.5 

4.4 

3.0 

3.6 

0.2 

2.1 

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 

5.4 

-3.0 

-3.2 

-4.4 

5.3 

4.4 

7.2 

-5.5 

58.1 

68.0 

59.9 

65.2 

1994 

1995 

1991-93 

1986-90 

translated 

Money growth 
(% change) 

Gross government debt 
(%ofGDP) 

Nominal wages per  head 
(%  change) 

Government budget balance 
(% of GDP) 

Table 2 
Austria: Economic policy indicators 

Recent  output  growth  has  not 
into 
sufficiently 
the 
employment  growth.  On 
contrary,  especially  in  manu 
facturing  increased  investment 
in  equipment  reduced  the  need 
to  hire  additional 
in 
order to  meet  increased  output. 
past 
In 
experience, 
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 
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. 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

Real wages per head 
(% change) 

with 
reduced 

infrastructural 

contrast 

labour 

to 

4.0 

2.0 

2.3 

0.1 

3.1 

5.6 

1.5 

Chart  1 - Austria 

%ofGDP 

General government net borrowing 

—A  H3EUR4  HEUR15 

80 

81 

82 

83 

84 

85 

86 

87 

89 

ii 
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. 

0.7 

2.6 

1.7 

1.1 

1.8 

5.1 

3.3 

7.6 

2.5 

-02 

-0.3 

1995 

1994 

1991-93 

1986-90 

Inflation  (% change) 

Unemployment rate  (%) 

Employment (% change) 

GDP growth rate 
(% change) 

Total domestic demand 
(% change) 

Table 1 
Portugal: Macroeconomic  performance 

Exports  continued  to  lead  the 
economic upswing  in  1995, and 
market  share  gains  are  likely  to 
have  occurred  in  some  external 
trend  of  both 
markets.  The 
export  prices  and  estimated 
production  costs  suggests  that 
margins 
profit 
exporters' 
increased  as  well.  However, 
exports  started  to  decelerate  in 
the  second  half  of  the  year  but 
large 
the  completion  of  a 
project 
automobile 
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. 

For definitions, see Table 2 for  Belgium 
Source: Commission's November  1995  forecasts 
* Taking into account latest information 

Balance of current account 
(%  ofGDP) 

factory 

J 

11.7 

10.2 

-0.6 

-0.5 

-2.0 

-1.4 

-1.4 

4.1 

4.6 

7.2 

6.1 

7.0 

5.5 

6.3.1996 

118 

| 

[ 

1.7 

6.0 

9.4 

0.7 

4.8 

4.2 

-5.6 

-0.7 

-4.7 

17.0 

11.0 

16.4 

12.5 

69.4 

64.4 

66.6 

70.5 

1994 

1995 

in 

to 

in 

of 

-5.7* 

-5.2* 

1986-90 

1991-93 

[ Table 2 

to  deteriorate 

Portugal: Economic policy indicators 

|  Money growth 
|  (% change) 

Real wages per head 
(% change) 

R  Gross government debt 
|  (%  of GDP) 

I  Nominal wages per  head 
I  (%  change) 

|  Government budget balance 
I  (% of GDP) 

For definitions, see Table 2 for  Belgium 
Source:  Commission's  November  1995  forecasts 
* Taking into account latest information 

the 
the  delay 
Due 
recovery  of  domestic  demand, 
labour  market  situation 
the 
in 
continued 
1995.  Total  employment  fell 
by  0.6%o  on  average,  more 
the  year  before. 
than 
However,  this  is  due  to  a 
slower 
the 
expansion 
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 
increased  significantly, 
labour  market  in  Portugal.  But  long-term  unemployment 
amounting 
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. 

to  roughly  40%  of 

total  unemployment 

(34.2% 

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 

Inflation  developments 
(12 month moving average, % change) 

—Portugal 
^ E UR  average 
itt Differential  vis-à-vis 3 best countries (percentage points) 

•Tradeables 
Non tradeables 
Differential  (percentage points 

20 

15 

10 

I  M >.« >.t< >x< ».< ».< m-».t ».<+>.« >.« >.« >.« m  >.« >.« n.t n.t ».i »•< n < » « >,« 

KatKCWttWttrev+ttX^^ 

1990  I 1991 I 1992 | 1993  | 1994 |  1995 

1990  | 1991 |  1992  1993 

1994 

1995 

Source: 

Commission services 

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. 

From recession to recovery 

r Chart 1 - Finland 

1990 Ql  = 100, seasonally  adjusted 

150 

-fsfCGDP 

' 

Domestic demand 
Exports 
—Imports 

125 

100 

75 

I 

I 

fM^K 

1990 

I 

1991 

| 

1992 

1993 

1994 

1995 

Source:  Commission services, Statistics Finland 

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, 

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 

4.4 

4.4 

4.0 

-7.3 

3.6 

4.9 

0.2 

4.7 

4.5 

-32 

-6.0 

12.9 

4.6 

-3.8 

-1.1 

18.4 

1.3 

1.3 

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 

profitability  was 

relatively 

companies 
good  and  their  balance  sheets 
were 
sound.  By 
contrast,  construction  activity 
remained  subdued  throughout 
1995: 
investment 
and 
continued 
private  building  activity  was 
depressed by an over-supply of 
old  business  premises  and 
dwellings. 

to  decline 

public 

fell 

Employment 

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 

- 1 2 3-

: 

j 

40 

35 

6.1 

135 

-5.1 

1995 

" " "" 

1994 

1986-90 

1991-93 

social 

security 

Money growth 
(% change) 

Governmentbudgetbalance 
(% of GDP) 

Table2 
Finland: Economic policy Indicators 

position.  The  recession,  however,  led  to  a  sharp  rise  in the  general  government  deficit, 
which  was  attributable  to  state 
finances,  as  local  government 
and 
funds 
showed surpluses. The recovery 
has  already  contributed  to  put 
the  deficit  onto  a  declining 
in  1995  a 
trend,  although 
and 
number  of 
exceptional 
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) 

(% change) 
For definitions, see Table 2 for Belgium 
Source:  Commission's  November  1995  forecasts 
* Taking into account latest information 

I Real wages per head 

Nominal wages per head 
(% change) 

Gross government debt 
(%  of GDP) 

temporary 

factors 

603  * 

-5J6  * 

53  * 

-63 * 

42  * 

59.8 

40.6 

-1.7 

165 

4.1 

8.8 

22 

12 

IS 

I 

I 

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%. 

1.5 

1.7 

1.8 

9.2 

3.7 

6.1 

3.1 

6.6 

6.2 

9.8 

0.8 

2.9 

2.1 

2.8 

2.6 

2.3 

-1.6 

-3.9 

-2.9 

-2.6 

-0.9 

-0.9 

1995 

1994 

1986-90 

1991-93 

point 

Inflation (% change) 

Unemployment rate (%) 

Employment (% change) 

fiscal  deficit, 

GDP growth rate 
(% change) 

Total domestic demand 
(% change) 

Balance of current account 
(%  of GDP) 

TaUel 
Sweden: Macroeconomic  performance 

During  1995,  the  situation  of 
the  public  finances  was  the 
Swedish 
of 
focal 
economic 
the 
In 
policy. 
beginning  of  the  year,  despite 
announced  measures to  reduce 
the 
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 
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. 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

in  public  finances  and  falling 

improvement 

0.3 

1.6 

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 
and 
growth 
production 
industrial 
was  registered  due  to 
economic 
recent 

indicators.  This  may 
partly  stem  from  the 
weaker 
in 
European 
other 

demand 

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 

Money growth 
(%  change) 

1986-90 

1991-93 

1994 

H 

7.4 

6.1 

Government budget balance  I 
(%  ofGDP) 

3.2 

-7.1 

-10.8 

Gross government debt 
(%  ofGDP) 

Nominal wages per head 
(%  change) 

Real wages per head 
(% change) 

51.8 

65.4 

79.3 

8.3 

4.3 

1.6 

-1.2 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 
* Taking into account latest information 

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 
points. 
5 percentage 
Together  with  rather  modest 
wage  increases  in  1995  and 
this 
employment 
resulted 
in 
disposable  income  of  1.5%. 

growth, 
in  a  decrease 

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. 

Tallel 
United Kingdom: Microeconomic  performance 

GDP growth rate 
(%  change) 

Total domestic demand 
(% change) 

Employment (% change) 

Unemployment rate ( #) 

| 

1986-90 

1991-93 

1994 

1995 

3.3 

-0.1 

3.8 

2.6 

4.0 

-0.3 

3.3 

2.0 

1.9 

9.0 

-2.3 

9.8 

0.0 

9.6 

0.8 

8.8 

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 
onstream. 
came 
fields 
and 
Manufacturing 

5.0 

3.0 

5.2 

1.5 

-2.1 

-3.8 

-2.1 

.  -2.6 

Inflation (% change) 

Balance of current account 
(% ofGDP) 

For definitions, see Table 2 for Belgium 
Source: Commission's November 1995 forecasts 

construction  output  also grew 
strongly  - by  4.3% and  4.0% 
respectively.  Service  output 
rose  by  3.6%.  However,  in 
industrial  production 
1995 
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. 

6.3.1996 

-  130-

Chart 1 - United Kingdom 

Total  fixed  investment - recoveries  compared 
(seasonally  adjusted) 
J 
v 
' 

* 

. 

Trough in GDP = 100 

Source:  Commission services 

Quarters from trough in GDP 

Though 
buildings 
remained 

investment 

in 
and  works 
depressed, 

annual 

manufacturing  investment 
in  the  first  three  quarters 
of  the  year  grew  by  14% 
rate. 
at 
an 
continued 
Stockbuilding 
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. 

"" 

3.5 

4.6 

-1.1 

-5.1 

-5.6 

-6.8 

16.3 

10.1 

1994 

1995 

1986-90 

1991-93 

suggest 

Money growth 
(% change) 

Gross government debt 
(% ofGDP) 

Government budget balance 
(% ofGDP) 

TaHe2 
United Kingdom: Economic policy indicators 

The  latest  indicators  of  the 
though 
economy  are  mixed 
that 
they  do  not 
is  much 
in  activity 
growth 
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 
contrast, 
by 
manufacturing  output remained stagnant and shorter and longer leading indicators of the 
economy  continued  to  fall  suggesting,  and  confirming,  a  slowdown.  However,  forward 

For definitions, see Table 2 for Belgium 
Source: Commission's November  1995 forecasts 

Nominal wages per head 
(% change) 

Real wages per head 
(% change) 

Vz%. 

In 

42.0 

43.5 

50.3 

52.5 

0.2 

0.8 

3.5 

3.2 

6.0 

8.3 

3.2 

1.0 

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 

Chart 2 - United Kingdom 

Underlying consumer price inflation (CPI*) and wages 

% change on previous year 

* Retail price index excluding mortgage payments 
Source:  Commission services 

modestly. 

The 

employer-based  survey 
showed  annual  growth 
of  0.9%  in  the  first 
three  quarters  of  1995 
the 
whereas 

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