1997 ANNUAL ECONOMIC REPORT - Growth, employment and convergence on the road to EMU
Date: 1997-02-12
Institutions: European Commission
Subjects: EU situation, Economic and Monetary Union, activity report, economic policy, short-term economic prospects

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels,  12.02.1997 
COM(97)27  final 

1997  ANNUAL  ECONOMIC  REPORT 

Growth,  employment  and  convergence 
on  the  road  to  EMU 

(presented  by the Commission) 

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1997 Annual Economic Report 

PART A:  COMMUNITY-WIDE TRENDS 

SUMMARY  AND  CONCLUSIONS 

CHAPTER  1: THE CURRENT ECONOMIC  SITUATION AND THE OUTLOOK TO  1998 

1.1. 

1.2. 

1.3. 

DISAPPOINTING GROWTH AND JOB PERFORMANCE IN THE FIRST HALF OF THE 1990s 
/ . / . /. 
1.1.2. 
1.1.3. 
1.1.4 
1.1.5 

1990-93:  Overheating  and recession 
Mid-1993  to mid-1995:  Soundly-based  recovery 
Abrupt  slowdown and extended growth pause from  mid-1995 to mid-1996 
Main  causes  of the  1995/96 growth pause 
Macroeconomic  obstacles  to growth 

PROGRESSIVELY  STRENGTHENING UPTURN IN 1996-98 
1.2.1. 
1.2.2. 
1.2.3. 

An  accelerating  and well-balanced  rebound  in activity has taken hold 
Positive  growth forces 
Uncertainties  and short-term  risks 

GRADUALLY IMPROVING EMPLOYMENT OUTLOOK 
1.3.1. 
1.3.2. 

Recent  and prospective  trends  in employment  and unemployment 
Recent  labour market performance  of selected  countries 

1.4. 

ENCOURAGING INFLATION OUTLOOK 

BOX  1:  REGIONAL UNEMPLOYMENT IN THE COMMUNITY 

CHAPTER  2: KEY  STRUCTURAL  CHALLENGES  FACING THE COMMUNITY 

2.1. 

TECHNOLOGICAL  PROGRESS 

2.2. 

GLOBALISATION 
Trade 
2.2.1. 
Foreign  direct  investment 
2.2.2. 
Financial  capital movements 
2.2.3 
Economic  implications 
2.2.4. 

2.3. 

COMPETITIVENESS 

! 

2.4. 

CAPITAL-LABOUR  SUBSTITUTION  AND EMPLOYMENT GROWTH 
2.4.1. 
2.4.2. 

Substitution  of labour by capital 
Substitution  andwage  developments 

2.5. 

POLICY IMPLICATIONS 

BOX  2 : THE  IMPACT .AND EFFECTIVENESS OF THE  SINGLE MARKET -  THE 1996  REVIEW 
BOX  3:  WAGE  DISPERSION IN THE COMMUNITY IN  1994 
BOX 4:  ECONOMIC  GROWTH AND THE ENVIRONMENT 

i 

1 

l 
2 
3 
4 
4 
8 

10 
10 
13 
17 

18 
18 
21 

25 

28 

31 

31 

35 
36 
40 
43 
43 

45 

49 
49 
52 

56 

58 
60 
61 

CHAPTER  3:  CONSOLIDATING  AND RESHAPING PUBLIC FINANCES 

IN THE  COMMUNITY 

3.1. 

LONG-TERM TRENDS IN PUBLIC FINANCES IN THE COMMUNITY 
3.1.1. 
3.1.2. 

Government  spending 
Government  receipts 

3.2.  BUDGETARY DEVELOPMENTS IN 1996  AND OUTLOOK FOR 1997  AND 1998 

3.2.1. 
3.2.2. 
3.2.3. 
3.2.4. 

Accelerated  progress  in the reduction of budget deficits 
The pace  and size of consolidation  efforts 
The composition  and durability  of consolidation efforts 
Trends in government  debt-to-GDP ratios 

3.3. 

THE ECONOMIC IMPACT OF BUDGETARY CONSOLIDATION IN THE COMMUNITY 
Short-term  growth  impact of budgetary consolidation  in 1996-97 
3.3.1. 
Budgetary  policy  in a medium-term perspective 
3.3.2. 

BOX  5:  AUTOMATIC  STABILISERS  IN THE COMMUNITY 

BOX  6:  PENSION EXPENDITURE  AND LIABILITIES IN THE COMMUNITY 

63 

..64 
64 
66 

69 

69 
71 
73 
75 

76 

76 
80 

84 

86 

CHAPTER 4: EXCHANGE-RATE  STABILITY AND INTEREST-RATE  CONVERGENCE  IN 

THE COMMUNITY 

.%. 

4.1. 

OVERVIEW 

4.2. 

4.3. 

UNEVEN  APPRECIATION IN THE US  DOLLAR 

APPRECIATING DOLLAR  AND EMU  OPTIMISM FAVOUR  MONETARY  STABILITY IN THE 
COMMUNITY 
4.3.1. 
4.3.2. 

Strong  dollar reflected  in intra-EC exchange-rate  movements 
Appreciation  of other EC currencies against DEM accompanied  by convergence  in 
short-term  interest rates 
Long-term  interest rates also converge, helped  by EMU optimism 

4.3.3. 

4.4. 

EMU  PROSPECTS CONFIRMED IN ECU  MARKET AND FORWARD INTEREST RATES 

89 

89 

90 

92 
92 

94 
96 

98 

4.5. 

EASING MONET.ARY CONDITIONS COMBINES WITH BUDGETARY CONSOLIDATION TO REBALANCE 

THE MACROECONOMIC POLICY MIX 
4.5.1. 
4.5.2. 

Monetaiy  conditions  ease over the year 
Monetary  easing provides  scope for  continued budgetary consolidation 

100 
100 
102 

A^ 

Tables 

1. 

Growth and employment, EUR, USA and Japan 

2. 

3. 

4. 

5. 

6. 

7. 

8. 

9. 

10. 

11. 

12. 

13. 

14. 

15. 

16. 

17. 

18. 

19. 

20. 

21. 

22. 

23. 

24. 

25. 

26. 

27. 

Recovery and slowdown in the Community 

Real  GDP growth 

Improved  economic policy-mix 

External  environment 

Employment  growth 

Unemployment  rate 

Recent labour market performance  of selected countries 

Inflation 

Nominal  compensation per employee 

Long-term trends in total factor  productivity growth 

Geographical  structure of extra-Community trade 

The regional structure of extra-EC imports of manufactured  products 

Foreign direct investment 

Structure of foreign  direct investment  in the EC 

Export performance,  total goods 

Macroeconomic competitiveness  in the Triad 

Output, employment, productivity and capital-labour  substitution 

, 

Employment potential, EUR 

Size of public finances  in the EC, US and Japan 

Receipts and expenditure of general government, EUR 

General government  net lending or net borrowing 

Cyclically-adjusted  general government balances 

General government  receipts and expenditure 

General  government  expenditure 

Gross public debt 

Five-vear forward  rate on five-year  loans 

1 

3 

11 

13 

17 

19 

20 

22 

25 

26 

32 

38 

40 

41 

43 

45 

47 

50 

52 

64 

65 

70 

72 

73 

74 

76 

99 

AC-

This  performance  is  clearly  worse  than  that  of  the  Community's  main  international 

partners.  The US  economy,  helped  by higher  growth  and a  more  responsive  labour 

market,  has  created jobs at an average rate of 1.2 per cent  per  year  over  the  first  half  of 

the  1990s.  And  although  Japan  experienced  a severe recession  and  average  growth  over 

the  period  was only  slightly  higher  than  in  the  Community,  the Japanese  economy 

managed to create jobs at a rate of 0.7 per cent per year. 

The  comparatively  poor  performance  of the  Community  over  the 1990s  reflects  the fact 

that  the  Community  economy  has  repeatedly  come up against  important  macroeconomic 

constraints on growth. 

1.1.1  1990-93: Overheating and recession 

Graph  1 

index: 

:i5o; 

Production capacity and GDP, EUR 

In  1988-90,  the  macroeconomic 

policy-mix  in the Community on 

average  became too expansionary 
relative  to  available  production 

potential. 

Insufficient 

efforts 

were  being  made 

to 

reduce 

budgetary 

imbalances  while 

average  monetary  conditions had 

90: 

been  eased  in  the  wake  of the 

; %•••: change per year ; 

October  1987 stock market  crash. 

With 

business 

expectations 

buoyed  also  by the prospects for 

the implementation  of the  Internal 

Market, 

output 

growth 

accelerated  to  around  4 per cent 

per  year  on average  in  1988-89. 

This  was  considerably  faster  than 

the  potential  growth  rate  of the 

Community  and  with  no  spare 

96 

J 

I 

L. 

I 
85 

I, 

I 
9Û 

I 

L 

capacity  available  it  led  to  an 
overheating  in the economy. The 
debt-financing 
massive 
unification-related  expenditure led to a high budget deficit  and rising inflationary  pressures 
in Germany.  For the Community  as a whole, the current  account  balance  turned  from a 

*  Ratio of actual to potential  GDP. 
Commission  services. 
Source: 

of 

Part A : Community-wide trends 

i.iuo 

SUMMARY AND CONCLUSIONS 

The  Community 

is  on  course  towards  a successful 

transition  to  EMU... 

Since  the  adoption  of  last  year's  Annual  Economic  Report,  substantial  progress  in  institutional 
preparations  for  EMU  and  a  reinforced  commitment  to  budgetary  adjustment  in  many  Member 
States  has brought  important  benefits.  Both short-  and  long-term  interest  rates  have  converged 
towards  lower  levels  and  exchange  rate stability  has  improved.  Thus, progress towards  EMU  is 
helping  Member  States  to  overcome  some  of the  most  important  obstacles to  sustained  growth 
and  job  creation  in  recent  years,  namely  high  real  interest  rates  and  monetary  turbulence. 
Against  the  background  of  a  widespread  easing  of  monetary  conditions  and  the  increased 
credibility  of budgetary consolidation  in many  Member States, the prospects for a sustained  pick 
up in economic  activity  and employment  in the Community  have improved  considerably. 

...helped  also  by  progress 

in  institutional 

preparations. 

On the  institutional  front, the  Community  has achieved  substantial  progress with  preparations  for 
stage  three  of  EMU.  This  concerns  the  technical  preparations  for  the  introduction  of  the  euro 
and  arrangements  guiding  currency  relations  between  the  euro  and  the  currencies  of  Member 
States  that  may  not  be  in  a  position  to  participate  in  the  single  currency  from  1 January  1999. 
Equally  importantly,  agreement  has  been  reached  on  the  framework  for  ensuring  budgetary 
discipline  and  co-ordination  in  the  third  phase  of  EMU  (the  Stability  and  Growth  Pact). 
Prospects  for  exchange  rate  stability  have  also  been  enhanced  by  the  entry  of  the  Finnish 
markka  and the  Italian  lira into the exchange  rate mechanism  of the EMS. 

This  institutional  progress  has played  an important  role  in underpinning  confidence  in EMU.  It is 
essential that the Community  continues to work determinedly  to  ensure that  all the  conditions  for 
a successful  transition  to the third  stage  of  EMU on  1 January  1999  are  put  in  place  in  a timely 
fashion. 

A  gradually  strengthening  upturn  in  economic  activity  is  underway 

Following  the  set-back  to  economic  growth  in  the  second  half  of  1995  and  in  early  1996,  the 
Community  economy  now  appears  to  be  back  on  a  more  favourable  track.  Activity  has 
recovered  in  virtually  all  Member  States  and  for  the  Community  as  a  whole  the  pace  of 
expansion  is expected to  pick  up to around trend rate in  1997 and above-trend  in  1998.  This will 
contribute  to  some  improvement  in  the  employment  situation.  However,  the  labour  force  will 
also  increase  and, while  unemployment  is  likely to decline gradually  during  1997 and  somewhat 
faster  in  1998,  overall  levels  will  remain  high.  Recent  inflation  trends  are  encouraging  in  most 
Member  States and the  outlook  is for continued convergence  of inflation  rates at a low level. 

A  good  basis  has  been  laid  for  achieving  strong  investment-supported  economic  growth  and 
--  in  terms  of 
sustained  job  creation  over  the  medium  term.  Supply-side  fundamentals 
reinforced  prospects  for  moderate  wage  increases  and  sound  investment  profitability  - 
are 
better than during the  period of high growth and job creation  in the second  half  of the  1980s, and 
better  also than during the  recovery  in  1994 and early  1995.  The  forecast  pick-up  in  investment 
will  ensure  a  sufficiently  rapid  expansion  of  productive  capacity  to  keep  pace  with  growing 
demand.  And the  stance  of  economic  policies  has  become  more  conducive  to  a  soundly-based 
and sustained  expansion  of output,  investment  and  employment. 

Sound  rebalancing  of  the  macroeconomic  policy-mix  has  taken  place 

In  1996  and  in their  budgets  for  1997, a large  majority  of  Member  States  have  taken  significant 
measures  to  reduce  their  budget  deficits  to  3  per  cent  of  GDP  or  below  as  a  step  towards 
moving  close  to  budget  balance  or  achieving  a  surplus  over  the  medium  term.  While  some 
countries  have  relied to  some  extent  on  one-off  measures which  will  need to  be  complemented 
by  lasting  budgetary  improvements,  the  overall  scale  and  composition  of  the  consolidation 
efforts  underlines the strong  resolve  of Member  States to  place their  public  finances  on a sound 
footing.  Budgetary  positions  would  already  have  improved  more  by  now had  it  not  been  for  the 
slowdown in economic growth in 1995/96. 

Budgetary  consolidation  is necessary  and desirable  in its own right.  The-need to  make  headway 
in  fulfilling  the  conditions  for  the  introduction  of  the  single  currency  has  provided  a  unique 
opportunity to achieve  large gains in the credibility of these adjustment  efforts.  During  1996, this 
led  to  a very  significant  reduction  in  interest  rate  premia  in  a  number  of  Member  States.  The 
most  striking  examples  are  Spain,  Italy,  Sweden  and  Portugal  where  long-term  interest  rate 
In  addition  to 
differentials  relative  to  the  lowest-yielding  currencies  have  fallen  substantially. 
strengthening  the  growth  prospects  of  the  economy  and  stimulating  investment,  lower  interest 
rates  provide  a  significant  boost  to  deficit  reduction  by  lowering  the  government  debt  service 
burden. 

Budgetary  consolidation  forms  an  integral  part  of the  overall  rebalancing  of the  economic  policy 
mix  in  the  Community.  Reduced  inflationary  pressures  and  the  prospects  for  moderate  wage 
increases  have  paved  the  way  for  a  significant  easing  of  monetary  conditions.  Against  the 
background  of  healthy  supply-side  fundamentals  and  a favourable  international  setting, the  net 
growth impact of budgetary  consolidation  and lower interest  rates in the  Community  is  consistent 
with  healthy  economic  growth  in  1997-98.  Even  if economic  activity should fail to  pick  up to  the 
extent  foreseen,  there  should  be  no  let-up  in  budgetary  consolidation  efforts.  Slippages  from 
budgetary  targets  would  put  at  risk  the  favourable  trends  in  interest  and  exchange  rates  and 
therefore  undermine the  prospects for stronger economic growth. 

Avoiding  macroeconomic  obstacles  to growth  ... 

The poor growth  and employment  performance  of the  Community  over the first  half  of the  1990s 
has  often  been  incorrectly  blamed  on  factors  such  as  globalisation  or  the  introduction  of  new 
technologies.  In fact,  it was  mainly  the  result  of  macroeconomic  obstacles  to  growth  within  the 
Community: 

(i) 

Insufficient  expansion  of  productive  capacity:  In  the  late  1980s/early  1990s  inflationary 
pressures  built  up  in  the  Community  as  demand  expanded  too  fast  relative  to  productive 
capacity; 

(ii)  Distorted  economic  policy-mix:  A  distorted  policy-mix  led  to  an  overburdening  of  monetary 
Indeed,  too  lax  budgetary  policies  (since  1988)  and  wage  developments  (since 
policy. 
1990)  inconsistent  with  the  objective  of  price  stability  caused  a  rise  in  interest  rates  which 
resulted in a slowdown  in growth and job creation and the  1992/93 recession; 

(iii)  Monetary  turbulence:  currency  crises,  which  to  a  considerable  extent  reflected  insufficient 
credibility  of  economic  policies  in several  countries  and  a lack  of  policy  co-ordination  in the 
Community,  have  had  a disruptive  influence  on  economic  growth  both  in  countries  whose 
currencies  appreciated  and  in  countries  whose  currencies  depreciated.  The  most  recent 

example  was the  currency  turmoil  of  spring  1995 which, together  with  the  rise  in  long-term 
interest  rates  and the  depreciation  of  the  US  dollar,  aborted  the  otherwise  sound  recovery 
which  had started in mid-1993. 

If  the  Community  is  to  achieve  a  sustained  period  of  healthy  economic  growth  capable  of 
ensuring  a significant  and  lasting  reduction  in  unemployment,  it  has  to  find  lasting  solutions  to 
these  macroeconomic  obstacles to growth. 

...  means  enhancing 

the  Community's  growth  potential... 

Strong  medium-term  economic  growth  must  be  supported  by  investment  to  ensure  that 
productive  capacity  increases  in  line with  rising demand.  In the short  run, economic  growth  can 
and  should  exceed  potential  output  growth  in  order  to  take  up  idie  productive  capacity  and  to 
absorb  the,  generally  small,  cyclical  component  of  unemployment.  However,  over  the  medium 
term  economic  growth  cannot  exceed  the  potential  growth  of  the  economy  without  creating 
capacity tensions  and therefore  resulting  in rising  inflation.  With the current  investment  rate, the 
Community  economy  would, in the  longer  run, barely  be  able to  grow  at  more than  2%  per  cent 
per  year.  On  the  basis  of  historical  trends, this  would  result  in  a slow  increase  in  employment. 
In  view  of  the  high  level  of  unemployment  in  the  Community  and  the  huge  potential  for  an 
increase  in  labour  force  participation,  considerably  faster  and durable  economic  growth  and  job 
creation  is required.  High growth in fixed investment, as much  as better quality  of  investment,  is 
needed  in  order  to  achieve  potential  output  growth  in  the  3  to  VA  per  cent  range  over  the 
medium term. 

Investment  conditions  are now favourable from a macroeconomic  point  of view  but they  must  be 
assisted  by  a  balanced  and  credible  policy  mix  over  the  medium  term.  On  this  account,  the 
strengthening  of the  policy framework  inherent  in the  process  leading to  EMU  is a major  positive 
factor. 

...ensuring  a  balanced  and  credible  policy-mix  over  the  medium 

term... 

The  objective  of  achieving  a  government  financial  position  close  to  balance  over  the  medium 
term  has  been  adopted  by  the  Community  in  successive  Broad  Economic  Policy  Guidelines 
since  1993.  This  objective  has  been  given  increased  credibility  and  importance  within  the 
framework  of  the  "Stability  and  Growth  Pact"  agreed  by  the  Dublin  European  Council  in 
December  1996  in  order to  ensure  budgetary  discipline  in  stage  three  of  EMU.  Member  States 
are  committed  to  taking  further  steps,  in  the  years  after  1997,  to  ensure  a  continued 
improvement  in their  budgetary  positions  in order to attain the  medium-term  objective  of  close to 
balance  or a surplus  in normal  circumstances. 

This  objective  is an essential  condition,  not only to  ensure the  viability  and  reap  all the  potential 
benefits  of  EMU,  but  also  to  achieve  sustained,  investment-supported  growth  in  output  and 
employment  over  the  medium  term.  The  latter  requires  a  rise  in  government  savings  to 
maintain  a proper  balance  between  overall  savings  and  investment,  and  low  interest  rates.  The 
medium-term  objective  of close to  balance  or surplus will also create  room for  budgetary  policies 
to  adapt  to  cyclical  disturbances  without  causing the  deficit  to  exceed  3  per  cent  of  GDP  during 
"normal"  cyclical  downturns.  Finally,  it  will  be  instrumental  in  reversing  the  upward  trend  in 
government  interest  payments,  thereby  reducing  the  crowding-out  of  non-interest  expenditure 
and facilitating  tax  reductions while  preparing for the  budgetary  consequences  of the  'ageing"  of 
populations.  Once  the  average  budget  deficit  in the  Community  has been  reduced to  3 per  cent 
of  GDP  by  1997,  the  achievement  of  budget  balance  in the  course  of  subsequent  years  will  be 
facilitated  by the  return to  healthy  economic growth. 

While  budgetary  consolidation  measures  need to  be  adapted  to  country-specific  circumstances 
in  terms  of  their  extent,  timing  and  design, they  should  be  credible  and  socially-balanced  and 
adhere  to  the  main  guiding  principles  stipulated  in  successive  Broad  Economic  Policy 
Guidelines, including the  1996 Recommendation.  This means giving  prominence  to  expenditure 
restraint  as opposed to further increases  in the overall tax  burden; shifting government  spending 
priorities  towards  productive  activities  such  as  investment  in  infrastructure,  human  capital  and 
active  labour  market  initiatives;  improving  the  efficiency  of  public  services;  and  reducing  the 
overall  tax  burden  as  possible,  especially  that  on  labour,  but  conditional  upon  firstly  placing  the 
budget deficit  on a firm downward  path. 

For the  first  time  since the  adoption  of  the  Broad  Economic  Policy  Guidelines  in  1993,  average 
wage  increases  in the Community  are now forecast to remain  at levels which  are fully  consistent 
both with the  maintenance  of  price  stability  and with  the  achievement  of  a further  improvement 
in  investment  profitability  in  the  Community,  while  also  allowing  a  moderate  increase  in  real 
wages.  Continued  respect  of  these  conditions  is essential.  The  strongly  enhanced  credibility  of 
the  monetary  and  budgetary  policy  framework  in  EMU  will  help  to  avoid  the  emergence  of 
excessive  price and wage pressures. 

Continued  appropriate  wage  developments  combined  with  sound  budgetary  policies  would 
facilitate  the  realisation  of  price stability  and durably  lead to  a balanced  policy  mix  and to  lower 
interest  rates  in  the  Community.  The  discussions  at  Community  level  of  the  Commission's 
communication  on "Action for  employment  in Europe -  A Confidence  Pact"  are  helping  to  avoid 
the risk of conflict  between the three  major macroeconomic  variables. 

...  and  preserving  monetary  stability. 

Progress  towards  EMU  acts  positively  on  exchange  rate  stability  and  reduces  risk  premia  on 
interest  rates.  The  achievement  of  EMU  in  1999  will,  by  definition,  eradicate  the  obstacle  to 
growth  stemming  from  intra-EC  currency  turbulence  for  participants  and  should  also  have 
positive  effects  for the  ,:pre-ins" as they  continue to  make  progress with  economic  convergence. 
With widespread  use  of the  euro  in  intra- and extra-European  trade, the  Community  will  also  be 
less vulnerable to the volatility  of the US-dollar exchange rate. 

Technological  change  and  globalisation  are  not  the  causes  of  unemployment 

The  unsatisfactory job  performance  of the  Community  economy during the first  half  of the  1990s 
has  sometimes  been  linked  with  the  effects  of  rapid  technological  advances  and  increased 
globalisation.  However,  such views often  fail to take  into  account  the wider  economic  impact  of 
these  phenomena. 

Technological  and organisational  advances, the move towards a knowledge-based  economy  and 
improved  international  resource  allocation  have  been  and  will  continue  to  be  the  key  driving 
forces  behind  long-term  improvements  in  productivity, economic  growth,  employment  and  living 
standards  in the  Community.  However,  such changes  imply  continuous  changes  in the  structure 
of output  and employment  and tend to reduce demand for low-skilled  labour. 

In  order  fully  to  reap  the  potential  benefits  from  technological  progress  and  globalisation,  it  is 
essential  that  macroeconomic  growth  is strong  enough to  absorb  the  resources  freed  by  higher 
productivity.  On the structural side, it is necessary: 

(i)  that  efficiently  functioning  goods  and  services  markets  facilitate  adjustment  by  allowing  for 
swift  changes  in  relative  prices,  and  that  sectoral  changes  occur  smoothly  and  in  a  socially 
acceptable  manner; 

(ii) that  improved  education  and  training  increase  the  supply  of  high-skilled  labour  and  that 

measures are taken to enhance employment  of the low-skilled. 

Enhancing 

the  efficiency  of product  and  services  markets 

In  order  to  increase  confidence  and  the  propensity  to  invest,  it  is  essential  that  Member  States 
and  the  Community  intensify  their  efforts  to  improve  competition  in  the  markets  for  goods  and 
services.  This involves  in the first  place the full  completion  of the  European  single  market  which 
has  so  far  contributed  to  a  rise  in  the  level  of  GDP  of  up  to  1.5  per  cent  and  created  up  to 
900 000 jobs.  Further  action is needed, however, to  complete the  legislative  framework  in  areas 
such  as  taxation  and  company  law  and  the  liberalisation  of  the  telecom  and  energy  markets. 
Even  more  importantly,  it  is  necessary  to  ensure  the  effective  application  and  enforcement  of 
existing  Cpmmunity  law  and  competition  policies,  and  to  reduce  the  burden  of  over-regulation, 
particularly  but  not  exclusively  at  the  national  level,  which  still  impedes  the  operation  of  the 
single  market. 

The  creation  of  a  flexible  economy  also  needs  determined  action  in  other  important  areas, 
including  the  realisation  of  the  transeuropean  transport  and  communication  networks,  the 
intensification  of  research  and  development,  the  promction  of  the  information  society  and  the 
removal  of  barriers  to  entry  and  excessive  regulation  facing  SME's.  These  policies  will 
in  the  overall 
strengthen  the  endogenous  growth  forces,  lead  to  positive  advancements 
productivity  of  the  Community  economy  and  increase  the  effectiveness  of  macroeconomic 
policies. 

The  employment  effects  of  policies  to  improve  competitiveness  and  the  functioning  of  product 
and  services  markets  depend  crucially,  however,  on  the  possibility  of  exploiting  this  potential 
through  higher  overall  growth.  EMU will  help  pave the way  for  strong  and  durable  employment-
creating growth. 

Need  for  greater 

labour  cost  flexibility  and  employment 

Over the  last two decades, the annual average  increase  in labour  productivity  in the  Community, 
of the order of 2 per  cent,  has resulted  in more  or less equal  proportion  from the  incorporation  of 
technological  progress  and  a substitution  of  labour  by  capital  at the  macroeconomic  level.  By 
comparison, nearly  no  macroeconomic  substitution  has taken  place  in the  United  States  despite 
an only  slightly  lower  pace  of technological  progress.  The substitution  of  labour  by  capital  in the 
Community  reflects  three  trends.  Firstly,  relatively  more  investment  has  been  aimed  at 
replacing  labour  rather  than  expanding  capacity.  Secondly,  within  the  international  division  of 
labour  the  Community  has  specialised  in  high-skilled  and  capital-intensive  production.  Thirdly, 
certain  labour-intensive,  low-productivity  employment  opportunities  have  ceased  to  exist  in  the 
Community. 

Capital-labour  substitution  is  a  means  of  achieving  high  growth  in  economic  activity  and  rising 
living  standards. 
In  the  current  situation  of  persistently  high  unemployment  in  the  Community, 
however, this creates  a twofold  problem. 

Firstly,  relative  to  stable  labour  productivity  growth,  macroeconomic  growth  in  the  Community 
has  been  insufficient  to  create  an  adequate  number  of  jobs  although  as  highlighted  above, 
conditions for strong growth  are improving. 

Secondly, the trend towards capital-labour  substitution can be seen to reflect  an imbalance  in the 
relative  prices of capital and labour and an insufficient  degree of adjustment  in the labour  market 
in particular.  Following the first  oil price shock,  high wage and  non-wage  labour  costs as well as, 
in  some  cases,  rigid  employment  security  rules  have  reduced  the  attractiveness  of  labour  as a 
production  factor  and  have  compelled  enterprises  to  keep  up  a strong  substitution  of  labour  by 
capital  in order to  safeguard their  competitiveness.  However,  labour  markets  in the  Community 
have  adjusted gradually.  Since the  early  1980s, productivity  increases obtained through  capital-
labour  substitution  have  broadly  ceased  to  be  reflected  in  higher  real  wages,  leading  to  a 
considerable  improvement  in  profitability.  These  developments  are  laying  the  ground  for 
economic  growth  sustained  by  capacity-widening  and  employment-creating 
investment  as 
demand  prospects  brighten, but they  impact  only slowly  on the employment-intensity  of growth. 

Another,  more  rapid  route  towards  a  more  employment-intensive  pattern  of  growth  would  be  to 
encourage  a downward widening of the wage cost scale  as in the  United  States.  Reducing wage 
costs  at  the  low  end  would  enable  activities  with  low  productivity  to  remain  and/or  to  become 
profitable.  For social  and  political  reasons, an emulation  of the  US-approach  which  has  led to a 
significant  drop  in  real wage  income  for  low-skilled  labour  is neither  feasible  nor desirable  in the 
Community.  Hence  the  need for  strong,  investment-supported  macroeconomic  growth  assisted 
by  pragmatic  solutions,  as  laid  down  in the  strategy  adopted  by the  Essen  European  Council  in 
impairing 
December  1994,  aimed  at  a  higher  employment-content  of  growth  without 
competitiveness. 

In order to  preserve,  in a reformed  and streamlined  fashion, the  key ingredients  of the  European 
social  model, the  following  pragmatic  approaches  are worth  pursuing.  The social  partners' wage 
agreements  should  provide  for  more  differentiation  according  to  qualifications,  and  between 
regions  and, to  some  extent,  sectors.  Non-wage  labour  costs  (or  payroll taxes)  at the  lower  end 
of the wage scale should  be lowered with the government  revenue  losses being compensated  for 
by  a stricter  control  of  increases  in overall  government  spending  and/or  increases  in other  taxes 
(e.g.  environmental  levies).  In a similar vein, temporary  entry-wages for the  low-skilled, youth  or 
long-term  unemployed  could  usefully  be  introduced.  Furthermore,  more  flexibility  in  working 
time  arrangements,  tailored  to  the  specific  needs  of  firms  and  workers,  the  greater  use  of 
voluntary  part-time  work  and  the  promotion  of  local  employment  initiatives  are  likely  to  foster 
both new jobs and higher participation  in the labour  market. 

More  generally,  as  emphasised  in the  1996  Joint  Employment  Report  "Employment  and  growth 
in  the  Community  -  The  way  forward"  approved  by  the  Dublin  European  Council,  there  is  a 
continued  need  to  improve  the  responsiveness  of  Member  States'  labour  markets  to  changes  in 
the  economy  through  a  modernisation  of  the  organisation  of  work,  increased  geographical  and 
professional  mobility  and  productivity-related  labour  cost  differentiation. 
In  particular,  it  is 
essential  to  reinforce  education  and training  so  that  the  work  force  is  able  to  adapt  to  evolving 
technological  changes.  These  efforts  are  also  necessary  in  order  to  avoid  labour  market 
bottlenecks  and a resumption  of wage  inflation  as unemployment  is reduced. 

With  the  realisation  of the  single  market  and  EMU, the  Community  is  increasingly  becoming  an 
thereby 
economic  entity. 
In  EMU,  sound  budgetary  policies  and  moderate  wage 
underpinning  the  ongoing  recovery. 

fundamentals  are  healthy  and  improving 

Supply-side 

further, 

developments  will  facilitate  the  maintenance  of  stable  monetary  conditions.  This  fundamental 
change in the overall  macroeconomic  policy  mix will be favourable to growth. 

These  factors  provide  the  basis  for  transforming  the  current  recovery  into  strong  and  durable 
economic  growth  supported  by  higher  investment,  thus  avoiding  capacity  constraints  and 
inflationary  tensions.  An extended  period  of sound economic  growth  of the  order  of  3 to  VA  per 
cent  per  year would  progressively  absorb the  high  employment  potential  of the  Community  and 
significantly  reduce  unemployment.  Stronger  economic  growth  and job  creation  is also  required 
to realise the full benefits  of the single  market, globalisation  and technological  progress. 

Against  such  a  background,  the  consolidation  and  restructuring  of  public  finances  would  be 
facilitated  and the  unavoidable  structural  adjustments would  be eased.  The  necessary  structural 
policies  in  the  goods,  services  and  labour  markets  would  also  be  more  effective  in  helping 
overcome  rigidities,  avoid  inflationary  pressures  and  make  growth  more  employment-creating, 
especially with respect to  low-skilled  labour, without  impairing  competitiveness. 

These  considerations  underline  the  need  for  adopting  measures  in  line  with  the  conclusions 
adopted  by the European Councils  in Florence and Dublin. 

1.  THE  CURRENT  ECONOMIC SITUATION AND THE OUTLOOK TO 1998 

Following the set-back  to economic expansion in the second  half of  1995 and early 1996, 

the Community economy now appears to be back on a more favourable  track.  A rebound 

in  economic  growth  is underway,  helped  by a  sound  rebalancing  of the  macroeconomic 

policy-mix  and an EMU-related  gain in the credibility  of the  economic  policy  framework 

in the Community which has led to  strongly  reinforced  convergence  in long-term  interest 

rates.  Against the background  of good fundamentals and sound  economic policies,  output 

is expected to grow at around its trend rate in 1997 and above trend in 1998. 

The  rebound 

in  economic  activity  should 

lead  to  progressive 

improvements  in 

employment.  In the short  term,  unemployment  is likely to remain high but it is  expected 

to  decline  gradually  during  1997  and  somewhat  faster  in  1998.  Inflation  trends  are 

favourable  in  almost  all Member  states  and the outlook  is for  continued  convergence  of 

inflation rates at a low level, underpinned by generally moderate wage increases. 

1.1  Disappointing  growth and job performance  in the first half of ihe  1990s 

The outlook for a strengthening of economic activity must be seen against the background 

of an unsatisfactory  growth and employment  performance  over the first  half of the  1990s. 

During  the last  six years,  average  GDP growth  in the Community  has been  only  1.5 per 

cent per year  (Table  1).  This lack-lustre performance  is much lower than the average 3.3 

per  cent growth  rate  achieved  in the latter  half of the  1980s,  and it is lower  also  than the 

average  2  per  cent  growth  rate  registered  during  the  years  1974-85  even  though  this 

period  was characterised  by severe  adverse 

supply shocks. 

in 

reflected 

1991-96, 

employment 

Low  growth  has  been 
in 
disappointing  employment trends.  Over the 
the 
years 
Community has fallen by an average 0.4 per 
cent  per  year,  amounting  to  a  total  of  4!/2 
million  jobs  lost  since  1990  (3V£  million 
excluding  the new  German  Lander).  As a 
result,  almost  half  the  10  million  jobs 
created  during  the  growth  period  1986-90 
have since been lost. 

Table 1 

Growth  and  employment 
EUR,  USA and  J a p an 
(average annual percentage change) 

EUR 
USA 
Japan 

Real GDP growth 

1974-85 

1986-90 

1991-96 

2.0 
2.3 
3.4 

3.3 
2.8 
4.6 

1.5 
2.3 
1.7 

Emp 

oyment growth0 

1974-85 

1986-90 

1991-96 

0.0 
1.8 
0.7 

EUR 
USA 
Japan 
!) National accounts definition. 
Source:  Commission services. 

1.3 
2.1 
1.0 

-0.4 
1.2 
0.7 

\ / i ii 

Graphs 

1. 

2. 

3. 

4. 

5. 

6. 

7. 

8. 

9. 

10. 

11. 

12. 

13. 

14. 

15. 

16. 

17. 

18. 

19. 

20. 

21. 

22. 

23. 

24. 

25. 

26. 

27. 

28. 

29. 

30: 

31. 

3 2. 

3 3. 

34. 

35. 

Production capacity  and GDP, EUR 

Long-term interest rates 

Exchange  rates relative to the DEM 

Profit  share 

Short-term interest rates 

Extra-Community  exports 

Investment  and unemployment,  EUR 

Interest rates and output, EUR 

Profitability,  investment  and  GDP growth, EUR 

Employment 

Inflation 

Gross value added and employment per sector, EUR 

Employment by type of manufacturing  industry, EUR 

Elasticity of world trade with respect to world output 

Share in world exports of goods 

Foreign  direct  investment  in EUR 

Export performance  and real effective  exchange rates, EUR 

Labour productivity  levels 

Employment,  productivity  and capital-labour  substitution 

Wage developments,  EUR 

Trends in earnings dispersion 

Implicit  tax rates on labour employed and other factors  of production,  EUR 

Actual and cyclically-adjusted  net borrowing of general government,  EUR 

Budget  deficit  and households savings rate (Sweden, Italy) 

USD  exchange rates 

Exchange  rates: DEM versus ERM currencies 

Exchange  rates: DEM versus non-ERM currencies 

Short-term  interest rates in Germany 

Short-term  interest  rate differentials  in ERM Member  States 

Long-term interest  rates in Germany and the United  States 

Long-term  interest  rate differentials  among ERM Member  States 

Long-term  interest  rate differentials  among non-ERM Member  States 

Exchange  rate and  interest  rate differential  between theoretical  and  market ECU 

Monetary  conditions  index 

Yield  curves in larger Member  States 

2 

5 

6 

7 

7 

8 

9 

14 

15 

19 

25 

34 

34 

36 

37 

42 

46 

48 

51 

53 

54 

67 

71 

79 

91 

93 

93 

94 

95 

96 

97 

97 

98 

100 

101 

surplus  of 0.6  percent  of GDP  in  1987 to  a deficit  of 0.9  percent  of GDP  in  1991.  Over 
the  same  period,  average  inflation  accelerated  from  3V4 per  cent  to  5lA per  cent  while 
average nominal wage increases accelerated from  SVi to VA per cent. 

In  response  to  rising  inflationary  pressures,  monetary  conditions  throughout 

the 

Community were progressively tightened from  1988 onwards, but budgetary policies were 

very  lax.  This  distorted  policy-mix  led  to  a  slowdown  in  growth  in  most  countries  in 

1990-91,  although  the  positive  short-term  demand  effects  of  unification  delayed  the 

downturn  in Germany.  Conflicting  demands on economic policies  caused  severe  tensions 

in  currency  markets. 

In  the  winter  of  1992/93,  the  Community  economy  slid  into 

recession.  Over just  two  years,  almost  5 million jobs  were  lost  (4  million  excluding  the 

new German Lander). 

1.1.2  Mid-1993  to mid-1995:  Soundly-based recovery 

As inflationary  pressures gradually  subsided,  monetary  conditions were eased  in almost all 
Member  States  in  late  1992  and  throughout  1993.  Against  the  background  of  healthy 

fundamentals  — in terms of lower price and wage pressures and relatively  sound  corporate 

profitability  —  recovery  took  hold  in the  middle  of  1993  driven  by  a  strong  international 

economy,  lower  interest  rates  and  an  improvement  in  the  competitiveness  of  the 

Community. 

Table 2 

Recovery  and  slowdown  in  the  Community0 
(half-yearly data; percentage change at annualised rate) 

From  the  end  of  1993 

until  the  first  quarter 

of 

1995, 

the 

93H1 

93H2 

94H1 

94H2 

95H1 

95H2 

96H1 

1.6 

1.9 

1.7 

1.8 

1.2 

1.9 

1.3 

1.3 

2.1 

2.1 

9.2 

9.4 

0.9 

3.8 

3.8 

6.9 

2.0 

2.9 

0.9 

2.5 

2.8 

9.3 

0.2 

4.2 

4.5 

-2.6 

-0.6 

-0.9 

-2.9 

-1.9 

-0.5 

-2.8 

-10.2 

pace 

Private consumption 

Final internal  demand 
-of which:  Investment 

Community  economy 
expanded  at  a  healthy 
of 
average 
around  VA  per  cent 
(annualised  rate).  The 
recovery  was  soundly 
based,  led  mainly  by 
buoyant  exports  and 
healthy 
investment 
growth.  The  growth 
of private  consumption 
gradually  rose  to  some 
2  per  cent  (at  an  annualised  rate)  for  the  Community  as  a  whole.  As  is  normal  during 

Exports  ) 
Final demandJ) 
Stockbuilding4) 
Real GDP 
Employment^ 
!) EUR5 = Germany.  France, Italy, Spain and the United  Kingdom. 
2) Goods and services; exports includes intra-EC  exports. 
3) Excluding  intra-Community  trade; Commission  services estimate. 
4) Contribution  to  GDP-growth. 
5) Labour  force  survey; seasonal adjustment  by Commission services. 
Source:  Commission  services. 

-0.3 

-0.2 

-0.8 

-1.4 

-1.6 

-0.6 

-2.1 

-0.1 

2.4 

2.9 

2.2 

3.3 

0.5 

3.4 

0.5 

0.9 

0.7 

1.3 

1.2 

1.0 

1.4 

1.7 

1.1 

the early phase of an economic recovery, growth was fuelled  also by a cyclical  turnaround 

in  stockbuilding.  Given  the  rapid  expansion  of  investment  in  equipment  (up  by  6.7  per 

cent in  1995), the Community appeared  to be on track towards transforming  the  recovery 

into strong and sustained  medium-term growth of economic activity and  employment. 

This  short  period  demonstrated  once  again  the  European  economy's  capacity  to  create 

jobs  as  long  as  economic  growth  continued  at  a  healthy  pace.  Overall  employment 

increased  by  over  1 per  cent  between  the  first  quarter  of  1994  and  the  third  quarter  of 

1995.  The  average  rate  of unemployment  in the  Community  declined  from  around  11.3 

per cent to  10.7 per cent of the labour  force. 

1.1.3  Abrupt  slowdown and extended growth pause from  mid-199 5 to mid-199 6 

This  broadly  favourable  growth  performance  was  abruptly  interrupted  in  the  second 

quarter  of  1995.  The  slowdown  was  particularly  sharp  in  countries  whose  currencies 

appreciated  during  the  currency  turmoil  in the  spring  of  1995.  Germany  and  France,  in 

particular,  experienced  3  to  4  quarters  of  stagnation.  By  comparison,  growth  initially 

continued  at a higher pace in most countries whose currencies had depreciated,  but  a clear 

slowdown soon appeared  also in these countries. 

For  the  Community  as  a whole,  the  healthy  growth  of investment  came to  a  sudden  halt 

and  the growth  of  exports was markedly  reduced  as both intra- and  extra-European  trade 

slowed.  With  a  lag  of  one  to  two  quarters,  private  consumption  growth  stagnated  as 

employment  prospects  deteriorated  in  countries  whose  currencies  had  appreciated  while 

inflation  and  interest  rates  had  increased  in  countries  whose  currencies  had  depreciated. 

Overall, the growth  of final  demand  (excluding  stockbuilding)  decelerated  from  close to 3 

per  cent  over  the  previous  VA years,  to just  1 per  cent  in  the  second  half  of  1995  (see 

Table 2). 

1.1.4  Main  causes of the 1995/96 growth pause 

The principal factors  accounting for  the abrupt  and widespread  economic  slowdown  were 
the rise in real  long-term  interest  rates during  1994 and the weaker  dollar  that  caused  the 
exchange  rate  movements  in the course  of  1994 and,  especially,  the first  months  of  1995. 
The  insufficient  credibility  of  budgetary  policies  in  many  countries  played  a  key  role  in 
both  regards. 
In  addition,  the  deterioration  in  European  cost  competitiveness  and  a 
slower growth on export  markets had a dampening effect  on Community  exports.  Finally, 
the  strong  contribution  to  growth  from  stockbuilding  in the  early  phases  of  the  recovery 
was  sharply  reduced  (from  nearly  1 percentage  point  in  1994  to  % percentage  points  in 
1995). 

Rise  in long-term  interest rates 

On  average  in the  Community,  10-year  benchmark  bond  yields  rose  by  around  250  basis 

points  between  January  1994  and  January  1995.  Evidence  from  countries  where  index-

linked bonds are traded  suggests that real interest rates rose by at least  1 percentage  point, 

and in some countries real rates are likely to have risen by considerably more. 

These  trends  were  partly  related  to  a 

similar rise in US  bond  yields and partly 

to  internal  factors  in  the  Community. 

The  international  rise  in  real  interest 

rates  was 

the  result 

inter  alia  of 

prospects  for  a  substantial  rise  in  the 

demand  for  loanable  funds  reflecting  an 

upturn  in  investment  which  was  not 

adequately  off-set  by  credible  prospects 

for  reduced  government  borrowing.  As 

far  as  the  Community  is  concerned, 

little  fiscal  consolidation  took  place  in 

1994-95.  In  cyclically-adjusted 

terms, 

fiscal  deficit 

the 
the  average 
Community  was  reduced  by  a  mere  lA 
of  a percentage  point  of  GDP  per  year 

in 

Graph  2  Long-term interest  rates 

(Monthly data) 

EUR, Germany and USA 

1992  . •.  1993 ••;:; 

19S4 
Germany, Italy, Sweden and Spain 

1995 

1996 

in  1994  and  1995.  The  initial  failure 

credibly 

to 

tackle 

large 

budget 

imbalances  led  to  widening  risk  premia 

and  a  marked  tendency  for  long-term 

interest  rates  to  rise  most  in  countries 

1991 

1392 

1993 

Source:.  Commission  services. 

with  high  public  deficit  and  debt  ratios  and/or  historically  weak  inflation  performances. 

While  rates  in  Germany  and  several  neighbouring  countries  rose  by  around  180  basis 
points,  the  increase  was  larger  in  France  and  the  United  Kingdom  (around  250  basis 
points)  and  long  rates  in Italy,  Spain  and  Sweden  continued  rising  in  the  first  months  of 
1995 which brought  the cumulative increase in yields to between 400  and 450 basis  points 

(Graph 2). 

The  rise in real long-term  interest  rates  exerted  a restraining  influence  on  activity  in  most 
industrial  economies  (GDP-growth  in  the  United  States  decelerated  from  4  per  cent  in 
mid-1994 to  less  than  2 per  cent  in the  first  half of  1995,  not  least  due  to  higher  interest 

rates).  In  the  Community,  higher  real  interest  rates  played  a  major  role,  together  with 

specific  factors  in  some  countries,  in  the  slowdown  in  construction  investment.  Other 

interest-sensitive  components  of  demand,  including  equipment  investment,  stockbuilding 

and consumer  durables, were also negatively  affected. 

US-dollar weabiess  and intra-European currency turmoil 

The Community  economy  was  further  hit 

Graph 3 

by substantial weakening  of the US-dollar 

Exchange rates  relative to the DEM 

during  1994  and  a  steep  fall  in  early 

January 1994 A. 100 

110 

(weekly  data) 

1995.  Overall,  the  US  currency  fell  by 

some  20  per  cent  relative  to  the  DEM 

(Graph  3). 

The  weaker  dollar, 

in 

combination  with  a  "flight  to  quality" 

following  the  collapse  of  the  Mexican 

peso  in  early  1995,  led  to  severe  strains 
on intra-European  exchange îates. 

By contrast  to  some previous  episodes  of 

currency  turmoil,  these  exchange  rate 

movements  did  not  reflect  a  need  to 

correct  competitive 

imbalances. 

The 

turmoil  negatively  affected  the  currencies 

of  Member  States  whose  economic 

policies,  in  particular  budgetary  policies, 

were  not  yet  perceived  as  sufficiently 

credible  by the  markets.  The  Italian  lira, 

1994 

1995 

::1996: 

January 1994 s  100 

1994 

1995 

1996: 

Source:  Commission  services. 

which  had  already  been  weakening  during  1994,  fell  sharply  in  the  first  months  of  1995 

and  both  the  pound  sterling  and  the  Swedish  krona  fell  considerably  in  trade-weighted 

terms.  Within  the  ERM,  the  central  rates  of  the  Spanish  peseta  and  the  Portuguese 

escudo  were  devalued  in March.  The  German  mark  and  currencies  closely  linked  to  the 
DEM  appreciated  by  up  to  6  per  cent  in  trade-weighted  terms.  Relatively  high  wage 
settlements  for  1995  in  some  industrial  sectors  in  Germany  limited  the  scope  for  interest 
rate reductions  and thus contributed  indirectly to the international  strength  of the DEM. 

The  exchange  rate  fluctuations  exerted  a  negative  impact  throughout  the  European 

Community.  In  most  countries  whose  currencies  appreciated,  cost  competitiveness  and 

profitability  deteriorated  sharply  (in  Graph  4  the  profitability  of  the  export  sector  is 

proxied  by  the  industrial  sector).  Moreover,  in  several  of  these  countries,  short-term 

interest  rates  had  to  be  raised  to  fend  off  speculative  pressures  (Graph  5).  Exports 

prospects  worsened  and  investment  was  rapidly  scaled  back.  Output  growth  came  to  a 

standstill, and in some countries even turned temporarily negative. 

Graph  4 [ 

Profit share* 

| [Graph 5  | short-term  interest  rates 

(annual percentage change, quarterly  data) 

{Weekly data) 

«change 

10 

G e r m a ny 

%  Germany, France, Belgium, Denmark and Spain 

12 

S p a in 

1992 

1993 

1994 

1995 

1996 

* * a h â» 

I t a ly 

1992 

1993 

1994 

1995 

1996 

* Gross operating surplus as a share  of gross value added, annua^ 

percentage change. 
Source: National data. 

1995 
source:  Commission services. 

1996 

In countries whose currencies depreciated,  short-term interest rates were raised  —  in many 

cases  considerably  ~  to  limit  the  extent  of  currency  depreciation  and  to  prevent  the 

emergence  of an inflationary  spiral. 

In addition,  long-term  risk  premia  rose  significantly 

in most  depreciating  countries (Graph  2).  This meant that budgetary  consolidation  had  to 

be  carried  out  in  much  more  difficult  circumstances.  The  result  was  a  clear  economic 

slowdown  also  in  these  countries  as  domestic  demand  was  severely  restrained  and  the 

initial export boost gradually waned. 

Slowdown in external  demand 

While  the  European  recovery  had 

benefited  from  very  high  export  growth 

Graph 6  1  Extra-Community  exports 

(quarterly and annual data) 

in  1993  and  1994,  there  was  a 

% change y/y 

slowdown  in  extra-EC  exports  during 

1995  (Graph  6).  This  was caused by 

;xi\ 

Extra-EC exports 

two  main 

factors. 

Firstly, 

the 

appreciation 

of 

the  Community 

currencies  relative to other  international 

currencies,  in  particular  the US-dollar, 

caused  a  deterioration  in  average  cost 

competitiveness 

and  a 

loss 

in 

international  market  shares.  Secondly, 

the slowdown in the US economy led to 

an  easing  of  previously  strong  US 

import  growth. 

Extra-EC  export 

growth decelerated to around 7 per cent 

1992 

1993 

1994 

for  the  year  on average  (against  10  per 

Source:  Commission services. 

cent in  1994). 

1.1.5  Macroeconomic  obstacles to growth 

The  poor  growth  and employment  performance  of the  Community  over  the first  half  of 

the  1990s  has often  been  incorrectly  blamed  on  factors  such  as  globalisation  or the 

emergence  of new  technologies  (see Chapter  2).  It  was in  fact  mainly  the result  of 

macroeconomic  obstacles to growth within the Community: 

(i)  Insufficient  expansion  of  productive  capacity:  in  the  late  1980s/early  1990s 

inflationary  pressures built up in the Community as demand  expanded  too  fast  relative 

to  production  capacity; 

(ii) Distorted  economic  policy-mix:  A distorted  policy-mix  led to an overburdening of 

monetary  policy. 

Indeed,  too  lax  budgetary  policies  (since  1988) and  wage 

developments  (since  1990)  inconsistent  with  the  objective  of price  stability  caused a 

rise  in interest  rates  which  led to a  slowdown  in growth  and job creation  and  the 

1992/93  recession; 

(iii) Monetary  turbulence:  currency  crises,  which  to  a  considerable  extent  reflected  an 

insufficient  credibility  of  economic  policies  in  several  countries  and  a  lack  of  policy 

co-ordination in the Community,  have had a disruptive influence  on economic  growth 

both  in  countries  whose  currencies  appreciated  and  in  countries  whose  currencies 

depreciated. 

Graph  7 

Inyestmeritand unemployment, EUR 

% at  labour  fores  ' 

1960 

1965 

i 

1970 

1975 

1980 

1985 

1990 

1995 

Source:  :  Commission services. 

If the Community  is to  achieve a sustained  period  of healthy  economic growth  capable  of 

ensuring  a  significant  and  lasting  reduction  in  unemployment,  it  has  to  find  lasting 

solutions to these macroeconomic  obstacles to growth. 

This means, in the first place, that  it is essential  to  maintain  a high degree  of credibility  of 

economic  policies  in  order  to  prevent  monetary  and  financial  turbulence.  Secondly,  the 

economic  recovery  must  be  supported  by a strong  rise in investment  in  order  to  secure  a 

sufficiently  rapid  expansion of productive capacity in line with increasing  demand.  Even if 

the  relationship  between  investment  and  unemployment  is  complex,  Graph  7  reveals  for 

the Community  as a whole a clear negative  correlation between  these two  variables.  This 

illustrates  that  higher  investment  is  an  inescapable  requirement  for  creating  the  physical 

working posts needed  to  reduce unemployment.  Thirdly, budget  deficits  must  be  reduced 

to  release  savings  for  the  necessary  rise  in  investment,  thereby  preventing  a  rise  in  real 

interest rates which would  stall the expansion of output.  Equally important,  all the  players 

involved  must  contribute  to  maintain  wage  developments  in  line  with  price  stability 

requirements  and the need to increase  employment. 

EMU  offers  an  important  opportunity  to  overcome  these  obstacles  to  sustained  growth 
and job-creation.  The  convergence  process  has  contributed  strongly  to  the  achievement 
of  a  more  balanced  policy-mix  and  has  decisively  strengthened  the  credibility  of  the 

stability-oriented  economic  policy-framework. 

In  addition, 

the  risk  of  currency 

instabilityleading  to  unwanted  tensions  and  widening  interest  rate  premia  will  be 

eliminated  among the countries participating in the single currency.  Such risks will also be 

reduced  for  Member  States  which  may  not  initially  adopt  the  euro  provided  convergent 

economic policies continue to be pursued. 

1.2  Progressively  strengthening  upturn  in  1996-98 

The upswing  in the Community  economy resumed  during the course  of  1996 and  growth 

is  expected  to  strengthen  in  1997  and  1998.  This  broadly  favourable  outlook  is 

underpinned  by the  sound  rebalancing  of the  economic  policy-mix  which  has  taken  place 

in  the  Community,  by  an  EMU-related  improvement  in  the  credibility  of  the  economic 

policy  framework,  and  by  favourable  supply-side  fundamentals  ~  in  terms  of  adequate 

wage  increases  and  sound  investment  profitability  —  which  appear  to  be  even  better  than 

during  the  recovery  in  1994  and  early  1995.  In  addition,  the  expansion  of  economic 

activity  among  the  Community's  international  partners  and  the  growth  of world  trade  is 

expected to remain supportive. 

1.2.1  An  accelerating  and well-balanced rebound in activity has taken hold 

The  pace  of  final  demand  quickened  from  around  1  per  cent  (annualised  rate)  in  the 

second half of  1995 to around VU per cent  in the first half of  1996.  As stocks were  pared 

back,  output  growth  accelerated  significantly  less but the rate of expansion for  the year  as 

a whole is estimated  to have been  1.6  per cent on average for  the Community.  Under  the 

impact  of continued  positive growth forces,  output  growth is forecast  to  strengthen to  2.2 

per cent in  1997 and 2.8 per cent in 1998. 

The recovery  is expected to be well-balanced  and broadly-based.  Exports  are likely to  be 
dynamic,  accelerating  gradually  from  4 per  cent  in  1996 to  around  6!/2 per  cent  in  1998. 
This  growth  will  be  driven  by healthy  extra-EC  exports  and  a rebound  in  intra-EC  trade 
sustained  by strengthening  demand,  stable  exchange  rates  and  continued  progress  in trade 
integration  among  Member  States.  Private  consumption  expanded  at  a healthy  pace  {VA 
per cent) in the first half of  1996 helped  by a rebound  in purchases  of consumer  durables. 
Some  slowing  is  likely  over  the  short  term  but  in  line with  moderate  real  wage  growth, 
gradually  improving  employment  prospects  and  a  decline  in  precautionary  savings, 
consumer  spending  is likely  to  accelerate  from just  below  2 per  cent  in  1997  to  close  to 
VA per cent in 1998. 

10 

With exports and consumption rising and excessive stock levels gradually being run down, 

capacity  utilisation  in industry  has  bottomed  out  and  is  starting  to  rise.  This  is  likely  to 

give  a boost  to  investment  in equipment  which  already  started  to  recover  in the first half 

of  1996.  Underpinned  by sound business profitability  and low interest  rates, investment in 

equipment  is  likely  to  grow  by  around  5 per  cent  in  1997,  accelerating  to  almost  7  per 

cent in  1998.  Construction  activity was generally weak in the first part  of  1996, but  there 

were  clear  signs  of  a  subsequent  rebound  and  construction  investment  is  forecast  to 

accelerate to a growth rate of just over 3 per cent in  1998. 

In  Germany, 

the  economy 

rebounded  more 

strongly  than  expected  during  1996  helped  by  a 

significant  easing  of  the  DEM  effective  exchange 

Table 3 

Real  GDP  growth 
(per cent per year) 

rate,  lower  interest  rates  and  improving  business 

1995 

1996 

1997 

1998 

expectations  underpinned  by  moderating  wage 

demands.  Between  spring  and  autumn  1996,  the 

forecast  for  output  growth  has  been  revised 

upwards  by  nearly  a  full  percentage  point  to  1.4 

per  cent  in  1996.  The  economy  is  expected  to 

improve 

further 

in  1997-98  with 

exports 

continuing  to  provide  a positive  driving  force  and 

investment 

in 

equipment 

expanding 

at  an 

accelerating pace.  Private consumption is likely to 

grow  modestly 

in  1997,  but  as  employment 

prospects 

gradually 

improve, 

consumer 

expenditure  should  rise  somewhat  faster  in  1998. 

Overall,  output  growth  is  expected  to  reach  2.2 

per cent in  1997 and 2.8 per cent in  1998. 

2.4 
2.1 
1.1 

2.8 
3.2 
2.7 

2.7 
3.0 
2.8 

2.0 
2.8 
2.2 

1.4 
2.1 
1.4 

1.9 
2.8 
1.9 

7.8 
0.8 
2.3 

10.7 
3.0 
3.4 

2.2 
3.1 
2.2 
2.5 
2.7 
2.1 

B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 
Source:  Commission  services  November 
1996 economic  forecasts. 

2.5 
1.0 
2.5 

5.8 
1.4 
2.8 

4.2 
3.0 
2.4 

3.0 
2.5 
3.2 

2.3 
1.7 
2.3 

2.8 
1.6 
2.8 

5.2 
2.6 
3.8 

2.1 
1.8 
2.3 

3.1 
2.5 
3.0 

3.7 
2.1 
3.0 

2.3 

2.8 

2.4 

1.6 

In France,  the  economy  is  stimulated  by a pick-up  in  exports  in  line  with  strengthening 

international  demand.  Despite a cautious attitude among consumers,  private  consumption 

performed  better  than  expected  in  1996.  Due  to  a large  stock  correction,  output  trailed 

significantly  behind  demand  in the first half of  1996, but  activity  accelerated  in the  second 

half.  Improving  demand  prospects,  good  fundamentals  and  a  rise  in  capacity  utilisation 

are  expected  to  lead  to  a  pick-up  in  investment  in  equipment.  Lower  long-term  interest 

rates  should  underpin  a recovery  in construction.  GDP-growth  is  expected  to  accelerate 

to 2.1 per cent in  1997 and to 2.7 per cent in 1998. 

11 

In Italy,  the  strengthening  of  the  currency  since  mid-1995  has  had  a  negative  knock-on 

effect  on exports  and  investment.  Furthermore,  high interest  rates  during  1995  and  early 

1996  meant  that  budgetary  consolidation  had  to  be  carried  out  in  difficult  conditions 

which  restrained  domestic  demand.  However,  helped  by  reduced  inflationary  pressures, 

prospects  for  agreement  on  a  social  pact  entailing  adequate  wage  increases  and  with 

greatly  improved  prospects  for  budgetary  consolidation  following  the  adoption  of  the 

budget  for  1997,  interest  rates  have  fallen  very  considerably.  The  downturn  in  the 

economy is likely to  have come to  an end,  and a gradual recovery  is foreseen  with  output 

rising by  1.4  per cent in  1997 and 2.6 per cent in 1998. 

In  the  United  Kingdom,  the  economy  has  resumed  above-trend  growth  following  a 

substantial stock  correction in the first half of  1996.  Higher growth has been underpinned 

by  earlier  interest  rate  reductions  and  a  strong  pick-up  in  exports.  Consumption  is 

expanding  rapidly,  helped  by  rising  employment,  moderate  real  wage  gains,  and  an 

improvement  in  the  housing  market,  all  of  which  are  expected  to  lead  to  a  fall  in  the 
household  savings rate.  At  the  same time, buoyant  investment  growth  is set  to  continue. 

The expansion of activity is forecast  at around 3 per cent per year in  1997-98. 

In the Netherlands  and Denmark,  domestic  demand  expanded  at  a healthy  pace  in  1996. 

Helped  also by  improving  export  prospects,  output  growth  is forecast  to  accelerate  from 
2XA  and  2 per  cent  in  1996, respectively,  to  a pace of around  3 per  cent  per year  in  1997-
In  Belgium  and  Austria,  the  prospects  for  domestic  demand  growth  are  more 
98. 

subdued  over  the  short  term,  but  exports  are  set  to  grow  at  a  healthy  pace  and  output 

growth  is expected  to  improve  gradually,  reaching  2Vi to  2% per  cent  in  1998.  In  Spain 

and  Portugal,  buoyant  exports  and  gradually  strengthening  investment  and  consumption 

should  cause  economic  activity  to  expand  by around  2VA  per  cent  in  1997  and  somewhat 

more  in  1998.  In Sweden,  double-digit  investment  growth  this year  is  expected  to  taper 

off,  but  as private  consumption  picks up  and  export  growth  continues,  the rate  of growth 

in the  economy  should  improve.  In Finland,  buoyant  domestic  demand  will be  the  main 

factor  in  sustaining  healthy  output  growth.  In Ireland, where  growth  and  job  creation 
have been very  strong,  the  economy  is likely to  slow  down  but  output  growth  is  forecast 
In  Greece,  the  improvement  in  economic 
to  remain  the  highest  in  the  Community. 
performance  is likely  to  continue  and  output  growth  is set  to  proceed  at  a pace  of 2XA  to 
23/4 per cent  sustained  mainly by buoyant investment  growth. 

12 

1.2.2  Positive growth  forces 

Healthy  rebalancing  of the macroeconomic policy-mix 

In  recent  years,  and  in  particular  in  the  course  of  1996,  the  Community  has  achieved  a 

very  significant  improvement  in  the  macroeconomic  policy-mix  as  well  as  an  important 

gain  in  the  credibility  of  the  medium-term  economic  policy  framework.  Significant 

measures have been taken in virtually all Member  States to improve the state of the public 

finances in  1996  and  in  1997.  Helped  by  an  improved  outlook  for  the  maintenance  of 

moderate wage increases  and  sounder  public finances,  abating inflationary  pressures  have 

allowed monetary conditions in the Community to be eased  significantly.  This rebalancing 

has  made  the  economic  policy-mix  more  conducive  to  a  soundly-based  and  sustained 

expansion of output,  investment  and  employment. 

Table  4 

Improved  economic  policy-mix 

Real effective 
exchange rate1* 
(Unit labour costs) 
(1993 =  100) 

Change in short-
term interest rates 
since Jan. 1994 
(3-month interbank) 

Change in long-term 
interest rates since 
Jan. 1994 
(10-year benchmark) 

Annual change 
in cyclically-
adjusted budget 
balance 

April 
1995 

December 
1996 

January 
1995 

December 
1996 

1996 

1997 

Q2 
1995 

109.1 
104.8 
106.4 

112.5 
92.9 
103.8 

93.0 
82.6 

106.0 
109.6 
106.0 

117.1 
96.2 
95.1 

Q4 
1996 

102.5 
103.7 
99.4 

122.5 
94.5 
101.9 

95.2 
102.8 

100.0 
105.5 
108.3 

116.4 
115.2 
102.7 

B 
DK 
D 
EL 
E 
F 
IRL 
I 
NL 
A 
P 
FIN 
S 
UK 

EUR 

100.32) 

106.42) 

-1.7 
0.7 
-1.2 

-3.4 
0.6 
1.5 

0.8 
2.4 

-0.5 
-0.8 
-0.3 

0.9 
1.5 
1.3 

0.5 

1) Relative 
2) Relative 
Source: Cc 

to 23 industrialised countries, 
to 9 industrial non-EC countries. 
)mmission  services . 

1.9 
3.0 
1.9 

n.a. 
3.9 
2.6 

2.7 
3.6 

2.1 
2.0 
3.0 

3.7 
4.2 
2.5 

2.6 

-0.6 
0.6 
0.1 

n.a. 
-1.0 
0.1 

-0.5 
-1.0 

0.1 
-0.2 
-1.8 

0.2 
0.0 
1.4 

0.0 

1.0 
0.3 
0.0 

0.8 
2.3 
1.2 

-0.7 
1.0 

1.4 
2.0 
1.1 

1.6 
3.8 
1.1 

0.9 

0.3 
0.6 
1.2 

1.1 
1.3 
0.8 

0.8 
3.4 

0.0 
1.8 
1.0 

0.0 
0.5 
0.7 

1.3 

-3.9 
-2.7 
-2.6 

-7.5 
-2.4 
-2.9 

-0.2 
-1.2 

-2.2 
-2.2 
-4.6 

-2.0 
-2.9 
0.9 

-1.9 

13 

Progress  towards  EMU  has  significantly  enhanced  the  credibility  of  the  economic  policy 

framework  in  virtually  all  of  the  Member  States.  The  agreement  on  a  "Stability  and 

Growth Pact" for  the third  stage of EMU at the European  Council in Dublin in December 

1996  reinforces  the  prospects  for  sound  budgetary  policies  over  the  medium-term.  The 

anti-inflationary  stance of monetary policies required by the EMU provisions in the Treaty 

is  increasingly  affecting  economic  operators  and  in  particular  price  and  wage  setters  as 

they  adapt  their  behaviour  to  a  low-inflation  environment,  thereby  contributing  to  wage 

trends which are consistent with the need to enhance employment. 

All of these  developments  have  already  had  large beneficial  effects.  Exchange  rates  have 

broadly returned  to  the levels observed  before  the currency turmoil in the  spring  of  1995, 

and  within the ERM  there  has been  a large  degree  of exchange rate  stability.  Long-term 

interest  rates have  dropped  significantly  and there  has been vastly  greater  convergence  in 

yields.  While  the  drop  in  interest  rates  during  the  year  1995  was  broadly  parallel  to  a 

coinciding  fall  in  yields  in  the  United  States,  developments  in  1996  have  been 
characterised  by  a  high  degree  of  decoupling  from  US  interest  rates.  Notably  those 

Member  States which have announced  significant  adjustment  measures in their budgets  for 

1997 have achieved  a significant  reduction in long-term interest rate premia. 

Thus,  the  economic  preparations  for 

EMU are providing Member  States with 

Graph 8 

Interest  rates and output, EUR4 

a  significant  credibility  gain.  This  is 

likely 

to  underpin  private 

sector 

confidence  and  amounts  to  a  positive 

growth factor  in its own right. 

The  stance  of  monetary  policy  has  a 

powerful 

influence 

on 

short-term 

growth  prospects  (Graph  8).  To  the 

extent 

that 

any 

direct 

demand-

of 

impact 

restraining 
budgetary 
consolidation  in  coming  years  were  to 
be  less  than  fully  off-set  by  an  increase 
and 
in  private 

confidence 

sector 

70  72  74  76 

IB  80  82  84  86 

9 0 : 9 2:  : 94:  96: 

Source:  Commission  services. 

14 

improved  expectations,  monetary  policies  would  both  have  the  necessary  room  and  the 

capability  to  maintain  adequate  demand  growth  without  prejudice  to  the  objective  of 

maintaining low  inflation. 

Furthermore,  provided  the  credibility  of the  economic  policy framework  is maintained  or 

even  strengthened,  the Community  on average is likely to  make further  headway  towards 

a reduction in the level of real long-term interest rates.  This will stimulate investment  and 

reduce  overall  cost  and price pressures, thus  contributing  to  a balanced  growth  of private 

sector  demand  and  activity  as  well  as  a  reduction  in  the  currently  high  levels  of  non-

cyclical unemployment. 

Wage trends and corporate profitability  consistent with pick-up  in investment 

Against  the  background  of  falling  inflation,  increased  credibility  of  monetary  policy  and 

high  unemployment,  wage  settlements  have  moderated  in  most  countries  over  the  last 

year.  For  the  first  time  since  the  adoption  of  the  Broad  Economic  Policy  Guidelines  in 

1993,  average  wage  increases  in  the  Community  are  now  forecast  to  remain  at  levels 

(around  3  per  cent  per  year  in  1997  and  1998)  which  are  fully  consistent  both  with  the 

maintenance  of  price  stability  and  with  the  achievement  of  a  further  improvement  in 

investment  profitability  in the Community,  while also  allowing a moderate  increase  in real 

wages.  As  recommended  in  the  Broad 

Guidelines, 

this 

trend 

should  be 

maintained  over 

the  medium 

term. 

Indeed,  a 

further 

improvement 

in 

profitability 

is  necessary 

to  sustain 

indigenous 

investment  within 

the 

Community  and  to  help  attract  foreign 

investment.  Competition 

to  provide 

good  business  conditions  in  order  to 

attract  companies,  investment  and  jobs 

has  become  ever  sharper.  The  rate  of 

business  profitability 
is  an  important 
medium-term  determinant  of  investment 
(Graph  9). 
level  of 
profitability  is  higher  than  at  any  time 
since  1970  but  real  interest  rates  are 

The  average 

Graph  9 

Profitability, investment 
and GDP growth, EUR 

1960=100  Profitability  and  investment 

:*20 

no 

Gross fixed capital formation, 
real % p.a. (rhs) 

15 

Net return on net capital stock 
Jibs 
1970 

_. 
1965 

1975 

I960 

1980 

1986 

1 9 9 0 - 1 9 95 

15 

GDP and  investment 
(realttp.a.J 

GDP  growth 

i «:L _ _ _ _ _ _ _ _ _ -_ 

_ "_ 

- ._  _ 

- _ _-

Gross fixed capital formation • 

1960 

1965  : 

1970 

1975 

1980 

1985 

1990 

1995 

Source:  Commission  services. 

15 

also  higher  than  in  the  1960s.  Strong 

profitability  is  not  in  itself  sufficient 

to 

ignite a recovery  in investment.  But  in line with  rising  capacity utilisation  and  improving 

demand  prospects  —  as  exports  and  consumption  are  expected  to  pick  up  —  the  healthy 

level  of  profitability  is  likely  to  lead  to  an  early  and  strong  recovery  in  investment. 

Greater  exchange  rate  stability  reduces  uncertainty  and  thus  also  influences  investment 

decisions positively. 

Continued favourable  external environment 

The Community  is  expected  to  continue to  benefit  from  a strong  expansion  of trade  with 

its international partners. In overall terms, the expansion of Community  export markets  is 

forecast  to  remain  buoyant  in the  coming  years  (around  8 per  cent  per  year).  However, 

the appreciation  of the Community's real effective  exchange rate in the course of  1994-96 

is  expected  to  have  a moderating  influence  on  international  export  market  shares  also  in 

the  years  ahead.  Nevertheless,  the  overall  pace  of  extra-EC  exports  is  likely  to  remain 
relatively strong in  1997-98 at around  7 per cent per year. 

In the  United  States,  the  expansion  of  economic  activity  remains  healthy.  Although  the 

economy is operating  at  employment  and capacity utilisation  levels which have  previously 

been  associated  with  an  upturn  in  price  and  wage  pressures,  so  far  there  has  been  few 

signs  of  such  pressures.  Thus,  in the  absence  of  any  unexpected  upturn  in inflation,  the 

economy  is  forecast  to  expand  at  rates  of  2V4 to  2Vi per  cent  in  1997-98,  close  to  the 

potential growth  rate of the economy.  With high utilisation  of domestic resources,  strong 

growth  of investment  in equipment  and  a high marginal  propensity  to  import,  US  demand 

from  overseas  is expected  to  grow by 7 to  TA  per  cent  per year  in  1997-98  (up  from  6% 

per cent in  1996). 

In  Japan,  the  recovery  is  expected  to  proceed  in  the  coming  years.  The  shift  towards 

higher  import  content  in  domestic  demand  in  recent  years,  which  has  been  enhanced  by 

liberalisation  measures  aimed  at  opening up the  Japanese  market,  is expected  to  continue 
in the  near  future.  Together  with  healthy  domestic  demand  growth,  this is likely to  keep 
Japanese import growth at high rates in  1997-98. 

16 

Notwithstanding 

a 

predicted 

deceleration  in  the  growth  of  their 

imports,  Community 

trade  with 

emerging  market  economies  in  Asia, 

Latin America and  Central  and  Eastern 

Europe  is  expected 

to  continue  to 

expand  vigorously.  Under  the  impact 

of 

continued 

reform 

and 

rapid 

productivity  gains,  relatively  strong 

GDP  growth 

in  the  economies  of 

Central 

and  Eastern  Europe 

expected 

to 

be  maintained 

is 

or 

strengthened 

in  1997-98  with  few 

exceptions.  Also  in  Asia  and  Latin 

America,  strong  growth  is  expected  to 
continue in  1997-98. 

Table 5 

External  environment 
(real annual percentage change) 

Weights  1995 

1996 

1997  1998 

Real  GDP 

World excl. EC 
USA 
Japan 
DAE3) 
CCEEs excl. FSU4) 

lOO.O1' 
26.9 

10.0 

6.6 

2.5 

3.6 
2.0 
0.8 
8.0 
5.4 

4.2 
2.4 
3.8 
7.1 
3.9 

4.3 
2.3 
1.8 
7.2 
4.1 

4.6 
2.4 
2.8 
7.2 
4.5 

Imports 

100.09 
17.8 
5.8 
11.5 
9.4 

Extra-EC markets 
USA 
Japan 
DAE3) 
CCEEs excl. FSU4) 
Extra-EC exports 
"Relative weights based on GDP in 1995. 
2) Relative weights based on extra-EC exports in  1995. 
3) Dynamic Asian Economies: Hong Kong, Korea, Malaysia,  Singapore, 

9 
8.9 
11.4 
15.1 
17.5 
7 

7.5 
6.8 
10.5 
10.2 
10.9 
6 

8 
7.5 
6.7 
9.5 
9.3 
7 

8 
7.2 
9.8 
9.4 
8.9 
7 

Taiwan and Thailand. 

CCEEs excl. FSU: Albania, Bulgaria, Czech republic, Slovakia, 
Hungaria, Poland, Romania and Slovenia. 

Source: Commission services; November  1996 forecasts. 

1.2.3  Uncertainties and short-term risks 

The uncertainties  surrounding the economic outlook  appear to have declined  considerably 

since the beginning  of  1996.  The main risk to the broadly favourable  outlook  would  seem 

to  reside  in  the  possible  emergence  of  doubts  on  the  determination  of  governments  to 

accomplish  the  process  of budgetary  consolidation  in terms  of full  implementation  of  the 

1997 budgets.  If the credibility of policies aimed at nominal convergence were to  suffer  in 

some  Member  States  and  if  budgetary  outcomes  were  to  disappoint  relative  to  stated 

objectives,  this  could  lead  to  renewed  pressure  on interest  rates  and  exchange  rates  with 

potentially  damaging  effects  on  output  and  employment  in  the  Community  at  large. 

However,  the firm commitment to the achievement  of the economic conditions for  EMU -

-  as reflected  in political  declarations,  in budgetary  measures  already  decided  upon  and  in 
the  state  of  the  advancement  of  the  technical  preparations  ~  to  a  large  extent  attenuate 
this uncertainty. 

Tensions might  also  surface  if insufficient  growth and job creation  in some countries  were 

to  give rise to  perceptions  of  internal  policy  dilemmas  in the  Community.  This  could  be 

the  case  if  consumer  and  investor  confidence  failed  to  pick  up  as  expected  in  some 

17 

Member  States.  Also,  budgetary  consolidation  might  result  in  smaller-than-expected 

confidence  gains if the measures taken were perceived to be only short-term  and ad hoc in 

nature rather  than  expressing  a firm  commitment  to  sound  public finances  and  addressing 

the problem of very high public expenditures and taxes relative to GDP. 

On the  other  hand,  if the  credibility  of economic  policies  and  of moderate wage trends is 

maintained,  growth  and job  creation  could  turn  out  to  be  stronger  than  forecast.  The 

prospect  of  strong  economic  benefits  from  EMU  could  lead  to  a  significant  boost  to 

private  sector  expectations  and  confidence,  similar  to  the  positive  impact  which  the 

Internal Market  programme  had in the late  1980s.  This could unleash higher  investment, 

lead  to  a  reduction  in  precautionary  savings  in  most  Member  States,  and  help  the 

Community to achieve a robust growth and employment creation  performance. 

An additional uncertainty  could lie in the risk of a reawakening  of wage pressures  towards 

the end  of the forecasting  period.  Although wage trends consistent with low inflation  and 

enhanced  investment  and  employment  now  seems  to  be  more  firmly  established,  the 
developments  in  1994-95 in some countries have shown that  inappropriate wage  demands 

may resurface  at an early stage of recovery.  As highlighted in their recent joint  opinion on 

the  stance  of economic  policies,  the  social partners  at the  Community  level recognize  the 

need  to  avoid  excessive  wage  settlements.  Too  high  wage  increases  would  fuel 

inflationary  pressures  which  in  turn  would  induce  a  dampening  response  from  the 

monetary  authorities,  put  upward  pressure  on long-term  interest  rates  and  undermine  the 

ability of the European economies to promote higher levels of employment. 

1.3  Gradually  improving  employment  outlook 

1.3.1  Recent  and prospective  trends in employment and unemployment 

A detailed  analysis  of the  latest  labour  market  trends  and  the  policy  issues which  have to 

be  addressed  in the  Community  is presented  in the  Commission's  Employment  in Europe 

Report  1996 and  in the  1997 Joint Employment  Report  prepared  for  the Dublin  European 

Council.  The  key  features  of  the  labour  market  outlook  in  the  Community  are  briefly 

outlined  in the following  section along with an overview  of the labour  market  experiences 

of  a number  of  countries  which  have  achieved  a significantly  better  performance  than  the 

majority  of other Member  States in recent years. 

Employment 

The 

relatively  strong 

rate  of  expansion  of 

economic  activity  during  1994  and  early  1995 

brought  with  it  a  moderate  improvement  in  the 

employment  situation.  For  the  year  1995,  total 

employment  growth  amounted  to  0.5  per  cent  or 

some  750.000 jobs  in the  Community  as  a whole. 

However,  this  improvement  was  brought  to  a 

standstill  when  economic  growth  started  faltering 

in  the  second  half  of  1995  and  in  early  1996. 

Reflecting  a  weak 

trend 

in  Community-wide 

employment  in  the  first  part  of  1996  as  well  as  a 

gradual  improvement 

in  job  prospects  in  the 

second  half of the year — in line with  strengthening 

economic  activity  —  employment  growth  for  1996 

as  a  whole  amounted  to  a  meagre  0.1  per  cent. 

However,  as  the  recovery  of  economic  activity  is 

expected  to  take  firmer  hold  in  1997-98,  and 

helped  by  low  wage  increases 

in  almost  all 

Member  States,  employment  creation  is  expected 

Table 6 

Employment  growth 
(per cent per year) 

1995 

1996 

1997 

1998 

B 
DK 
D 
EL 
E 
F 

IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 

0.4 
1.6 
-0.3 

0.9 
1.7 
1.2 

4.4 
-0.4 
2.5 

1.9 
-0.3 
-0.6 

1.1 
1.6 
0.7 

0.5 

-0.1 
0.7 
-0.8 

1.2 
1.3 
-0.2 

3.4 
0.3 
1.1 

1.5 
-0.7 
0.5 

1.2 
-0.6 
0.4 

0.1 

0.2 
0.8 
-0.0 

1.3 
1.6 
0.3 

2.5 
0.1 
1.7 

1.6 
-0.3 
0.6 

1.9 
-0.2 
1.1 

0.6 

0.3 
0.7 
0.7 

1.3 
2.0 
0.9 

1.7 
0.5 
2.3 

1.6 
0.0 
0.7 

1.5 
0.5 
1.1 

0.9 

Source:  Commission  services  November 
1996 economic  forecasts. 

Graph  10 

Employment 
(quarterly  data) 

105 

103 

95 

1993 

1993Q1 » 100 

105 

to  quicken  somewhat  to  0.6  and  0.9 

per 

cent 

in 

1997 

and 

1998, 

respectively,  corresponding 

to 

the 

creation  of  2.2  million  jobs  over  the 

UK 

two years. 

-f-
France 

Germany / 

1996 

outlook 

employment 

The 
varies 
considerably  across  Member  States, 
mainly,  but  not  exclusively,  reflecting 
differences  in  the  outlook  for  output 
growth. 
In  Ireland,  employment  is 
expected  to  grow  at  a  rate  of  over  2 
per  cent  per  year  on  average  in  1997-
98  (after  almost  4  per  cent  per  year  in 
is 
1995-96).  Job  growth  in  1997-98 
also  expected  to  be  high  in  Greece, 

1993 

1994 

Source:  Commission  services. 

19 

Spain,  Luxembourg,  the  Netherlands  and  Finland  (around  1XA to  2  per  cent  per  year)  as 
well  as  in  the  United  Kingdom  and  Denmark  (around  1  and  VA per  cent  per  year, 

respectively). 

In contrast,  disappointing  employment  trends  in  1996  are likely to  have  a.negative carry 
over effect  on job  growth in  1997 in Germany, Austria and  Sweden, where employment  is 
expected  to fall  slightly further,  as well as in Belgium, France and Italy where job  creation 
is  expected  to  be  very  modest.  However,  in  line  with  strengthening  economic  activity, 
employment  growth  is  expected  to  pick  up  in  1998  when  virtually  all  Member  countries 
are expected to achieve positive job growth. 

Unemployment trends 

The  gradual  decline  in  the  rate  of  unemployment  in  the  Community  since  March  1995 

came  to  a  halt  in  late  1995  and  early  1996.  The  average  rate  of  unemployment  in  the 

Community  rose  somewhat  in  the  second  half  of  1996  and  the jobless  rate  amounted  to 

10.9 per cent of the labour force for the year as a whole. 

Table 7 

Unemployment  rate 
(per cent of civilian labour force) 

The moderate  strengthening  of employment  growth 

in the  Community  in the  coming  years  is  expected 

to  be  sufficient  to  achieve  only  a modest  reduction 

1995 

1996 

1997 

1998 

in  unemployment.  With  the  prospects  of  finding 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 

9.9 
7.1 
8.2 

9.1 
22.9 
11.5 

12.4 

11.9 
2.9 

7.3 
3.8 
7.3 

17.2 
9.2 
8.8 

9.9 
6.2 
9.0 

9.1 
22.0 
12.3 

12.5 

12.1 
3.1 

6.8 
4.2 
7.3 

16.0 
9.8 
8.3 

10.9 

EUR 
Source:  Commission 

10.9 

9.9 
6.0 
9.1 

9.0 
21.5 
12.4 

12.0 
12.3 
3.0 

6.3 
4.5 
7.1 

14.9 
9.4 
7.8 

9.8 
5.7 
8.7 

9.0 
20.7 
11.9 

11.7 
12.1 
2.9 

5.8 
4.6 
6.8 

14.2 
9.0 
7.4 

10.8 

10.4 

employment becoming more positive, the growth  of 

the  labour  force 
its 
is  expected 
medium-term  trend  of  around  XA  per  cent  per  year. 
For  the  Community  as  a  whole,  the  average 

to  revert 

to 

unemployment  rate is expected  to  decline  slowly  to 

10.8  per  cent  in  1997  and  somewhat  faster  to 

around  10.4 per cent in 1998. 

Some  countries  are  likely  to  see  a  significantly 

faster  reduction  in  unemployment.  The  rate  of 
joblessness  is  forecast  to  fall  considerably  in  the 
United  Kingdom  —  where  it  is  already  the  lowest 
among  the  Community's  largest  Member  States  — 

services  November 

1996 economic  forecasts. 

20 

and  in the  Netherlands.  This  is the  case  also  in  Spain,  Ireland  and  Finland  although  the 

level  of unemployment  will  remain  very high  in these  three  countries.  A  more  moderate 

but  continuous  reduction  in unemployment  is likely  to  be  achieved  in Denmark,  Sweden 

and Portugal. 

By contrast,  the rate  of unemployment  is expected  to  remain unchanged  or to  rise  further 

over  the  near  term  in Belgium,  Germany,  France,  Italy  and  Austria.  However,  with  the 

possible  exception  of  Austria,  the  upward  trend  in  unemployment  is  expected  to  be 

reversed  in the  course  of the year  and  the jobless  rate  is expected  to  decline  in  1998.  In 

most  cases, this is expected to reduce unemployment to below its  1996 level. 

1.3.2  Recent  labour market performance  of selected  countries 

In contrast  to the  disappointing job  performance  of the  Community  as a whole,  a  number 

of  Member  States  have  achieved  a  considerable  improvement  in  employment  and/or  a 
large  reduction  in  unemployment  over  the  last  two  to  three  years  (Denmark,  Spain, 
Ireland,  the  Netherlands  and  the  United  Kingdom)1.  From  a  macroeconomic  point  of 
view,  the  performance  of  these  economies  in  terms  of  output  growth,  employment 

creation  and  labour  force  trends  has  been very  different.  In Ireland,  strong  employment 

growth  has  been  driven  mainly  by  a  rapid  expansion  in  output. 

In  Denmark  and  the 

United  Kingdom,  healthy  GDP-growth  has  been  accompanied  by  positive  but  not 

exceptional  job  creation  and  the  reduction  in  unemployment  has  partly  been  due  to  a 

reduction  in  the  labour  force  and/or  increased  part-time  employment.  In  Spain  and  the 

Netherlands,  more  modest  output  growth  has  coincided  with  relatively  strong  net  job 

creation  (Table 8). 

Particularly  high  economic  growth  has  been  the  main  factor  behind  the  large  gain  in job 

numbers in Ireland.  Strong growth has been facilitated  both by a strengthened  supply  side 

—  including  significantly  improved  profitability,  better  competitiveness  and  a  continued 

upgrading  of  average  work  force  qualifications—  and  macroeconomic  policies  aimed  at 

securing  low  inflation,  sound  public  finances  and  low  interest  rates.  This  has  been 

underpinned  by  Community  assistance  under  Structural  and  Cohesion  Funds.  An 

important  element  has  been  the  tripartite  agreements  between  employers,  unions  and  the 

government  to  maintain  moderate  wage  increases,  helped  by  a  lower  income  tax  burden 

and  carrying  the  benefit  of  significant  job  creation.  Wage  moderation,  in  combination 

1  In  addition,  the  unemployment  rate  has  fallen  by  more  than  2  percentage  points  in  Finland  between 
1994 and  1996.  However,  Finland  is to some extent  a special  case  reflecting  the  ongoing  adjustment  to 
exceptional  factors  which  occurred during the late  1980s. 

21 

Table 8 

Recent  labour  market  performance  of selected  countries 
(1994-96) 

Ireland  Denmark 

UK 

NL 

Spain 

Rest of 
EUR 

EUR15 

Unemployment 

Unemployment  rate  1993 
1996 

Change since  1993 

15.6 
12.5 

-3.1 

10.1 
6.2 

-3.9 

-- per cent of the labour force — 
6.61 
6.8 
0.21 

22.81 
22.0 
-0.81 

10.4 
8.3 

-2.1 

9.5 
10.4 

0.9 

Employment  and  labour  force 

— average growth  rate  1994-96; per cent per year — 

Labour  force  growth 
Employment  growth2 

GDP,  wages  and  productivity 

GDP 

Labour  productivity 
Real wage costs per  head3 
Real unit  labour costs4 
Capital/labour  substitution5 

2.1 

3.6 

8.6 

4.8 

1.1 

-3.5 

-0.4 

-0.9 

0.6 

-0.2 

0.4 

1.3 

1.2 

0.5 

0.8 

0.1 

-0.2 

-- average  growth  rate  1994-96; per cent per year — 

3.1 

2.5 

2.0 

-0.5 

-0.1 

2.8 

2.5 

0.8 

-1.6 

0.5 

2.7 

1.5 

0.1 

-1.3 
%0.4 

2.3 

1.5 

-0.9 

-2.4 

0.7 

2.0 

2.3 

0.8 

-1.5 

0.8 

Participation  and  employment 

— in per cent of working  age population  (aged  15 to 64)  — 

Participation  rate  1993 
1996 

Employment rate  1993 
1996 

60.8 
62.5 

51.2 
55.0 

82.2 
79.3 

73.9 
74.5 

75.2 
73.8 

67.3 
67.7 

67.8 
69.8 

63.4 
65.3 

58.8 
58.7 

45.6 
46.1 

65.7 
65.4 

59.5 
58.7 

10.9 
10.9 

0.0 

0.1 

0.1 

2.3 

2.2 

0.6 

-1.6 

0.7 

66.7 
66.3 

59.5 
59.2 

1  The  unemployment  rate  peaked  in  1994  at  7.2  per  cent  in  the  Netherlands  and  24.1  per  cent  in  Spain;  it 

changed  by -0.4 and  -2.1 percentage points, respectively,  between  1994 and  1996. 

2  National  accounts  definition  (for  the  Netherlands:  full-time  equivalent  basis).  According  to  labour  force 
surveys, the  average  growth  of employment  over the  1994-96 period  was  slightly  higher  on this  basis  in  Spain 
( 1.0 per cent), the Netherlands  (1.4 per cent) and the United Kingdom (1 per cent). 

? Nominal  compensation  per employee deflated  by the GDP  deflator. 
4 Real  labour costs per head  divided  by labour productivity per head. 
5 A positive  figure  indicates  substitution  of capital  for  labour  in  the  production  process  (a  higher  capital/labour 
ratio).  Over  short  periods,  the  concept  is  influenced  by  cyclical  effects.  See  chapter  2  for  medium-term 
analysis of the role  of capital-labour  substitution  in the Community's  employment  performance. 

Source:  Commission  services. 

with  a  shift  in  the  composition  of  growth  towards  indigenous  sectors,  has  helped  arrest 

the  previous  trend  towards  capital-labour  substitution  in  the  economy.  The  average 

annual  rate  of  substitution  of  labour  by  capital  has  declined  from  1.4  per  cent  per  year 

over  the  1974-85  period  to  0.4  per  cent  in the  second  half of the  1980s  and  0.1  per  cent 

per  year  in  the  first  half  of  the  1990s.  At  the  same  time,  high  capacity-expanding 

investment  has  led  to  a  fast  incorporation  of  technical  progress.  Thus,  helped  also  by 

improving  skills  and  qualifications,  labour  productivity  growth  has  remained  high. 

Agreement  on  a  renewal  of  the  tripartite  agreement  is  expected  to  underpin  continued 

wage moderation  and high employment growth in the coming years. 

22 

The  large  reduction  in unemployment  in Denmark  since  1993  has  resulted  not just  from 

improved job  creation  in  line  with  stronger  economic  growth  but  predominantly  from  a 

decline  in  the  labour  force  due  to  the  introduction  of  government  subsidised  leave 

schemes  (mainly  for  the  purposes  of  education  or  child  care)  and  an  increase  in  the 

number  of  workers  taking  early  retirement.  While  the  employment  rate  in  Denmark 

remains  among  the  highest  in  the  Community  there  is  also  a  high  proportion  of  the 

working  age  population  which  receive  transfer  incomes  in  the  form  of  unemployment 

benefits,  social  security  benefits,  early  retirement  benefits,  disability  benefits,  leave 

schemes  etc.  These  schemes  represent  a  considerable  cost  and  reduce  effective  labour 

supply.  Recent  tightening  of  some  schemes  and  positive  labour  market  reforms  are 

intended  to  reduce  passive  dependency  and  enhance job  creation.  In  recent  years,  real 

wage costs have risen somewhat faster  than in other countries whose currencies  are linked 

to  the  DEM.  If  sustained  and  robust  employment  gains  are  to  be  made  in  the  coming 

years it is essential to avoid excessive labour cost increases. 

In  the  United Kingdom,  the  reduction  in  unemployment  since  1993  has  resulted  partly 

from  growing employment,  in line with higher output  growth  and reflecting  an increase in 

part-time  work,  and  partly  from  a  reduction  in  the  labour  force.  Labour  force 

participation has failed  to pick up as in previous economic upturns inter alia because of an 

upsurge  in the  number  of young  people  entering  higher  education.  Notwithstanding  the 

considerable  reduction  in  unemployment,  there  has  as  yet  been  no  significant  upturn  in 

earnings growth.  Wage increases have been moderate  and real wage costs  (compensation 

per  employee  deflated  by  the  GDP  deflator)  have  been  growing  at  a  pace  considerably 

below  the  growth  in productivity.  This  may  indicate  that  the  structural  reforms  carried 

out in the United  Kingdom  since the early  1980s have helped  increase labour  and  product 

market flexibility and  thus  to  reduce  price  and  wage  pressures.  If  robust  and  sustained 

employment  gains are to be made in the years to  come it is essential  that  favourable  wage 

trends are maintained. 

In  the  Netherlands,  the  favourable  job  performance  since  1994  is  a  continuation  of  a 

relatively  strong  employment  creation  trend  since  the  mid-1980s. 

In  addition,  while 

increased  part-time  employment  accounted  for  almost  half  of  the job  creation  between 

1983  and  1994,  this factor  did  not  contribute  significantly  to  the  increase  in  job  numbers 

in the  last  two  years.  Since  1983, employment  growth  has been  underpinned  by  a policy 

of  wage  moderation  based  on  a  consensus  between  unions,  employers  and 

the 

government.  Compared  to  other  Member  countries,  moderate  nominal  and  real  wage 

growth  in the Netherlands  has reduced  the  substitution  of  capital  for  labour,  lowered  the 

23 

employment  threshold  of growth and resulted  in comparatively  strong job  creation.  These 

trends  have  reasserted  themselves  during  the  current  economic  upturn.  Continued  wage 

moderation  has  been  underpinned  by  an  almost  universal  consensus  on  the  necessity  of 

wage  restraint,  the  maintenance  of  a stability-oriented  macroeconomic  framework  and by 

rapid  increases  in  the  labour  force.  Structural  improvements  in  the  labour  market  have 

included  lower  taxes  and  social  security  contributions,  particularly  for  low  income/low 

skilled  workers,  efforts  to  limit  the  growth  of  the  legal  minimum  wage,  reduced  access 

and  generosity  of  disability  benefits,  and  increased  flexibility  in  the  implementation  of 

wage agreements  at the sectoral or firm level. 

In Spain,  economic growth  in line with the average  of the Community  has coincided  with 

comparatively  strong job  creation  since  1994.  The  favourable  job  performance  has  been 

helped  by moderate  wage  increases  —  contributing  to  a fall  in real wage  costs  per head  in 

1994  and  in  1995  «  and  by  labour  market  reforms  which  have  eased  restrictions  on 

working  time,  dismissals,  job  demarcation  lines  and,  to  some  extent,  wage  setting.  A 

large part  of the recent  increase in employment has taken place in temporary  and  part-time 

jobs.  Although this may have reduced  the unemployment  risk for  non-temporary  workers 

and reinforced  their insider power,  recent wage trends are encouraging  and wage costs  are 

expected  to grow  only slightly faster  than prices in  1996. 

Just  as  the  reasons  for  the  relatively  favourable  labour  market  performance  in  these 

selected  countries  vary  considerably,  so  too  do  the  reasons  for  the  less  favourable 

performance  in the majority  of the remaining Member  States.  One important  factor  is that 

economic  growth  has  been  considerably  lower  in  most  other  countries  as  compared  to 

Denmark,  Ireland,  the Netherlands  and the UK.  At the same time, the rate  of job  creation 

relative  to  economic  growth  has  generally  not  improved  to  the  same  extent  as  in  Spain 

and  the  Netherlands.  In  some  countries,  labour  shedding  has  continued  despite  recent 

wage  moderation,  partly  reflecting  the  previous  build-up  of  excessive  labour  cost  levels 

and/or  low economic  activity.  In  sum,  cyclical  divergences  and varying  degrees  of labour 

market  reform  has  so  far  prevented  the  benefits  of  improved  fundamentals  from  fully 

asserting themselves  in a number of Member countries. 

24 

1.4  Encouraging  inflation  outlook 

Progress  with  the  achievement  of  a 

Table  9 

high  degree  of  price  stability  has 

been  examined  in  detail  in  the  1996 

Report  on Convergence  presented  by 

the  Commission  in  accordance  with 

Article  109J  of 

the  Treaty  on 

European  Union.  The  recent  trends 

and 

the  short-term  outlook 

for 

inflation  convergence  are  briefly 

reviewed  in this section. 

Member  States  have  been  making 

considerable  headway  towards  price 

stability  and  inflation  convergence 

which  is  an  essential  requirement  for 

the  adoption  of  the  single  currency. 

Average  inflation  (as  measured  by 

the  private  consumption  deflator)  in 

the  Community  decelerated  to  2.6 

per  cent 

in  1996  and 

inflation 

dispersion  among  the Member  States 

narrowed  significantly. 

In'  Belgium,  Denmark,  Germany, 

France, Ireland,  Luxembourg  and  the 

Netherlands,  having  been 

in 

the 

narrow  band  of  the  ERM,  as well  as 

in  Austria,  broadly  sound  wage 

trends and low import  price increases 
promoted  price  stability  in  1996. 
consumption 
Inflation 
deflator)  remained  at  or  below  2  per 
countries. 
cent 

(private 

those 

all 

in 

Inflation 
(percentage  change) 

ncPs° 

Nov. 
19962) 

1995 

Private consumption  deflator 

1995 

1996 

1997 

1998 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

1.4 
2.3 
1.6 

9.0 
4.7 
1.7 

2.4 
5.4 
1.9 

1.1 
2.0 
3.8 

1.0 
2.9 
3.0 

1.9 
2.3 
1.3 

8.3 
3.6 
2.1 

2.1 
4.2 
1.4 

1.4 
1.8 
2.9 

1.1 
1.1 
3.0 

1.6 
2.1 
1.9 

9.3 
4.7 
1.7 

2.0 
5.8 
2.0 

0.9 
2.3 
4.2 

0.2 
2.7 
2.6 

2.1 
2.4 
1.7 

6.9 
2.9 
1.4 

2.2 
2,9 
2.1 

2.0 
1.9 
3.0 

1.6 
2.3 
2.4 

2.0 
2.7 
1.8 

5.8 
2.7 
1.5 

2.6 
26 
2.1 

2.0 
2.0 
2.9 

2.0 
2.6 
2.5 

2.0 
2.0 
1.8 

8.5 
3.6 
1.9 

2.0 
3.9 
1.7 

1.9 
2.0 
3.3 

0.9 

2.5 
2.6 

3.0 

3.0 

2.6 

EUR 
1J Interim indices of consumer prices. 
2) Measured  by the percentage  change  in the arithmetic  average 
of  the  twelve  monthly  indices  relative  to  the  arithmetic 
average of the twelve monthly  indices of the previous  period. 

2.2 

2.2 

Source:  Commission  services  and  November  1996  economic 

forecasts. 

Graph 11 

Inflation 
(annual  change) 

Greece 

Average  of the  other  Member  States 

94 

95 

96 

Source: 

Commission  services. 

25 

Furthermore,  among  the  countries where  monetary  policy  is conducted  with  reference  to 

an inflation  target,  the rate  of price increases  remained  low  at  around  2.5  per  cent  in  the 

UK,  and  reached  a  level  of  less  than  1 VA  per  cent  in  Sweden  and  Finland,  helped  by  a 

significant  appreciation of their currencies from previous lows. 

Also the four remaining Member States, in which inflation ranged from  4.2 per cent to  9.3 

per  cent  in  1995, have  made  significant  progress  towards  price  convergence  (Graph  11). 

In Portugal,  the  inflation  rate  dropped  to  3.3  per  cent  and  in Italy  and  Spain,  the  rate  of 

price increase slowed  to 3.6 per cent in Spain and 3.9 per cent in Italy in  1996.  In Greece, 

the  rate  of  inflation  declined  to  8.5  per  cent. 

In  the  countries  whose  currencies  had 

depreciated  significantly  in  early  1995,  the  tightening  of  monetary  conditions  and 

enhanced  prospects  for  sounder  budgetary  positions  brought  about  the  subsequent 

exchange  rate  appreciation.  Together  with  prudent  wage  agreements  this  helped  bring 

down inflation  rapidly in late  1995 and early 1996. 

The  credibility  of  anti-inflationary  policies  has 

increased  everywhere  and  the  objective  of  low 

inflation  is  now  widely  accepted  throughout  the 

Community. 

Against 

this  background,  price 

convergence  is  expected  to  strengthen  further  in 

the  coming years.  The  average rate  of inflation  in 

the  Community  is forecast  to  decelerate further  to 

2.2  per  cent in  1997 and  in  1998.  These rates  are 

historically  low  and  close  to  what  is  normally 

meant by price stability. 

In  Germany  and  in  the  countries  whose  monetary 

policies are closely  linked to that  country,  inflation 

is  expected  to  remain  below  or  around  2  per  cent 

in  1997-98  with  two  exceptions:  in  Denmark  and 

Ireland,  continued  strong  domestic  demand  and 

wage  cost  increases  in  excess  of  those  of  other 

countries  whose  currencies  are  closely  linked  to 

Table 10 

Nominal compensation 
per employee1* 
(percentage change) 
1995  1996  1997  1998 

B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 
l)  Total 
Source: 

2.5 
3.6 
3.6 

12.7 
3.0 
2.3 

1.1 
5.2 
3.8 

2.0 
3.8 
5.3 

4.7 
3.1 
2.9 

1.6 
4.1 
2.6 

11.1 
3.9 
2.2 

4.0 
6.2 
3.4 

1.0 
2.9 
5.8 

4.0 
6.6 
3.3 

2.6 
3.8 
2.5 

9.2 
3.2 
2.2 

4.2 
4.1 
3.8 

2.3 
2.4 
5.0 

3.2 
4.3 
4 . 1. 

2.6 
4.2 
2.5 

7.5 
3.0 
2.5 

4.3 
3.1 
3.6 

2.9 
3.2 
4.0 

2.9 
2.9 
4.3 

3.1 

3.4 

3.4 
wages and  indirect  wage costs. 

3.2 

Commission  services,  November 
1996 economic  forecasts. 

the  DEM  (around  or  above  4  per  cent  per  year) 
could lead to an acceleration of inflation  to above 2lA per cent 

26 

In  the  United  Kingdom,  Sweden  and  Finland,  continued  prudent  monetary  policies  are 
expected  to  secure the maintenance of inflation.in the range of 2 to 2lA per cent, helped in 
the latter two  countries  by a significant  reduction  in the pace of nominal  compensation  of 

employees.  Italy,  Spain  and  Portugal  are  all  expected  to  achieve  a  further  reduction  of 

inflation  to  a rate  of  around  2VA  per  cent  by  1998  against  the  background,  inter  alia,  of 

decelerating wage costs.  In Greece, the inflation  rate is forecast  to drop to around  SVA per 

cent by 1998. 

27 

Box 1 : Regional unemployment in the Community 

Unemployment  rates  across  Member  States  differ  widely,  ranging  from  3  per  cent 
in 
Luxembourg  to  nearly  22  per  cent  in  Spain  (1995  data).  At the  level  of  individual  regions,  the 
disparity  across the  Community  is even  larger.  In 1995, among the  nearly  100 regions for  which 
harmonised regional unemployment  data are available, the unemployment  rate  ranged from  less 
than  4  per  cent  in  the  central  region  of  Portugal  to  nearly  32  per  cent  In  the  south  of  Spain 
(Table B1.1). 

Table  B1.1 

Regional  unemployment  in the Community  -1995 
(NUTS1  regions) 

B  DK  WD  EL 

IRL 

Highest  regional  rate 

12.9 

12.3 

11.2 

11.0 

31.8 

15.3 

15.8 

25.9 

National  rate 

Lowest  regional  rate 

Ratio:  high/low 

9.9 

6.9 

1.9 

7.1 

4.5 

2.7 

6.6 

5.5 

2.0 

9.1 

22.9 

11.5 

14.3 

11.9 

7.4 

18.5 

8.7 

13.5 

1.5 

1.7 

1.8 

1.2 

6.0 

4.3 

Source:  Commission  services. 

NL 

8.9 

7.3 

6.9 

1.2 

FIN 

UK  EUR 

11.4 

21.2 

12.0 

11.0 

31.8 

7.3 

17.2 

3.9 

15.2 

2.9 

1.4 

9.2 

7.7 

1.6 

8.8 

10.9 

6.7 

1.6 

3.9 

8.2 

n  1995, the unemployment  rate was below 6 per cent of the labour force in  10 of the  around  100 
regions  (Table  B1.2).  To  some  extent,  the  low-unemployment  regions  were  concentrated  in  a 
limited  number  of  areas:  the  south  of  Germany,  the  adjacent  north  of  Italy,  the  south  of  the 
Netherlands,  regions  in the  north-east  and south-west  of  Denmark,  and the  north  and  centre  of 
Portugal.  This  picture  has  been  relatively  stable  during  the  past  ten  years.  Noticeable 
exceptions  are  regions  in the  south  and  east  of  Sweden  and  most  of  Finland  which  used to  be 
low unemployment  regions, as well as the  Ile de France  (Paris)  and south-eastern  regions  of  the 
UK which saw a deterioration  in the unemployment  situation at the beginning  of the  1990s.  In all 
of  these  cases,  the  deterioration  resulted  not  from  specific  regional  causes  but  rather  from  an 
increase  in nation-wide  unemployment. 

At  the  opposite  end  of  the  spectrum,  around  20  regions  experienced  an  unemployment  rate 
above  15  per  cent  in  1995.  These  regions were  concentrated  in  Spain, the  south  of  Italy  and 
parts of  Ireland and Finland. With the exception of Finland, the regions which suffered  most  from 
high unemployment were  broadly the same throughout the last ten years. 

Graph  B1.1 

unemployment rate 

12 

Dispersion  of regional  unemployment 
in the  Community 

standard deviation 

Standard deviation of regional unemployment rates (rhs) 

EUR 15 unemployment rate (Ihs) 

1983 

1985 

Source: Commission: seryvces . 

1987 

1989; 

1991 

1993 

3 
1995 

28 

In  addition  to  the  inertia  of  the  geographical  concentration  of  unemployment  there  has  been  a 
widening  of the  unemployment  dispersion  between  regions over the last few years.  One way  of 
measuring  the  dispersion  is the  standard  deviation  of  the  regional  unemployment  rates1.  This 
standard  deviation  is  positively  correlated  with  the  cyclical  fluctuations  in  the  Community 
unemployment  rate  (Graph  Bt.1). 

I Table B1.2 

Distribution  of  regional 
unemployment  rates 

Number of regions 

Jobless rate 

Average 
1983-95 

^ ggc 

This picture of worsening regional imbalances has been  valid 
for  most  Member  States  between1983  and  1995  which  are 
comparable  years  in  terms  of  their  position  in  the  business 
cycle  (Table  B1.3). 
is 
The  change 
the  national 
positively  correlated  with 
unemployment  rate.  In  some  countries  where  substantial 
labour  market  reform  has  been  implemented  (Netherlands, 
United  Kingdom),  the  dispersion  of  unemployment  and  the 
national employment  rates have both decreased. 

in  the  dispersion 

the  change 

in 

4 
6 
13 
13 
11 
15 
10 
6 
4 
5 
8 
2 

< 5% 
5  -  6% 
6  -  7% 
7  -  8% 
8  -  9% 
9  - 1 1% 
11-13% 
13-15% 
15-17% 
17-20% 
20-25% 
> 25% 

7 
9 
10 
14 
13 
15 
10 
2 
8 
7 
1 
1 

Notwithstanding  the  persistent  gap  between  high  and  low 
unemployment  regions  in  most  countries,  unemployment 
was  highly  cyclical  in  both  types  of  regions  (for  selected 
countries, see Graph  B1.2). In most  countries, the  peaks  and 
troughs  of  the  jobless  rate  in  high  unemployment  regions 
have  tended  to  follow  those  of  the  low  unemployment 
regions with  a lag  of around  one  year.  This  shows that  high 
unemployment 
responsive  but  also 
remain 
dependant  on  the  level  of  activity  in  low  unemployment 
regions.  This  is  mainly  because  of  demand  linkages:  high 
and  rising  levels  of  activity  in  low  unemployment  regions 
increased 
generate 
demand 
Furthermore,  more 
companies  choose  to  expand  in  regions  with  abundant 
labour  supply.  And  with  the  increased  probability  of 
falling 
finding  a 
unemployment  more  workers  are  willing  to  move  from 
high unemployment  to low unemployment  regions. 

Dispersion  of  regional 
u n e m p l o y m e nt  rates 

Standard 
deviation 

National 
unemployment 
rate 

these  regions. 

regions  with 

low  and 

Table B1.3 

regions 

Total 

from 

job 

97 

97 

in 

| 

in 

to  changes 

responsiveness 

in  particular.  With 

The  persistence  of  regional  unemployment  imbalances 
in  most  Member  States  generally  reflects  a  relatively 
low 
the  economic 
environment  and  a  relatively  high  rigidity  of  regional 
limited  wage 
wage  structures 
flexibility,  productivity  differentials  between  regions  are 
often not adequately  reflected in wage cost  differentials. 
Therefore,  reducing  regional  unemployment  disparities 
may  require  a higher degree  of  regional wage  flexibility. 
Both  the  relocation  of  activity  towards  less  favoured 
regions,  the  mobility  of  workers  between  regions  and 
the avoidance  of  excessive  nation-wide  wage  increases 
in  the  face  of  wage  pressures  in  low  unemployment 
regions  would  all  be  facilitated  by  a  higher  degree  of 
regional  wage  differentiation 
in  accordance  with 
regional differences  in productivity  levels. 

19831 
0.81 
2.08 
1.71 

2.02 
3.28 
1.45 

0.58 
2.77 
1.31 

1995 
3.40 
2.01 
1.84 

2.23 
4.69 
1.89 

0.86 
7.14 
0.58 

19831 
11.9 
9.5 
6.9 

7.8 
21.4 
7.6 

14.G 
8.5 
11.7 

1995 
9.9 
7.1 
6.6 

9.1 
22.9 
11.5 

14.3 
11.9 
7.3 

B 
DK 
WD 

EL 
E 
F 

IRL 
I 
NL 

3.18 
1.87 
0.55 
2.79 

1.97 
2.38 
1.29 
0.87 

P 
FIN 
S 
UK 
EUR 
5.70 
1  1988  for  EL  and  NL,  1986  for  P,  1989 

7.3 
18.1 
9.2 
8.8 
10.9 

8.6 
3.7 
1.4 
11.1 
9.1 

4.06 

for  FIN,  1990 for S. 

1  The standard  deviation is sensitive to the degree of regional disaggregation.  For a measurement  of the 

standard  deviation  at NUTS2  level, see the Commission's  "First Cohesion  report"  (Nov.  1996). 

29 

Graph  B1.2  Cyclical trends in regional unemployment rates 

% Western Germany 

^ 

F r a n ce 

:i683;-;;:;::;i?85:::;.;;;:i98r::;::;;l?»;i.;':;;;-;i8?|i::;;::;:i9»;;;;;;;;i?».; 

Italy 

: !983 

" : 1985: : : : : : 1987: :.:::: 1989. : : : : :  1991: :•..::: : 1993: : : : : : :  1995: : 

The Netherlands 

1983 

1985 

1987 

1989 

19B1 

1993 

1995 

Source;  Commission  services. 

30 

2.  K EY  STRUCTURAL  CHALLENGES  FACING THE  COMMUNITY 

The  unsatisfactory  performance  of  the  Community  economy  during  the  first  half  of  the 

1990s  has  sparked  new  concerns  about  the  effects  of  certain  long-term  structural  trends 

affecting  the Community.  One is the  emergence  of new technological  advances which,  it 

is often  felt,  not  only tend  to  be  skill-biased  but  also  labour-saving,  reducing  the  demand 

even  for  skilled  workers.  Another  trend  is  the  increased  globalisation  of  the  world 

economy which has given rise to fears that jobs  are being siphoned  out  of the  Community 

by  the  newly  industrialised  countries,  especially  in  Southeast  Asia,  and  that  under  these 

market  forces,  low-skilled  workers  in  the  Community  face  either  downward  pressure  on 

wages  or  high  unemployment.  These  apprehensions  have  been  exacerbated  by  the 

relocation  activities  of  Community-based  firms  towards  emerging  newly-industrialised 

countries. 

While  these  concerns  and  fears  are  understandable,  they  tend  to  be  built  upon  an 

erroneous  analysis  of  the  economic  impact  of  technological  progress  and  globalisation. 

These  factors  have  been  and  will  continue  to  be the  key  driving  forces  behind  long-term 

improvements 

in  productivity,  growth,  employment  and 

living  standards 

in 

the 

Community.  But  in  the  short  run  they  require  sometimes  painful  adjustments  in  some 

sectors  of the economy.  The achievement  of the potentially  significant  long-term  gains of 

enhanced  technological  progress,  greater  globalisation  and  intensified  efforts  to  improve 

competitiveness  crucially  hinges  upon  the  fulfilment  of  two  essential  conditions:  the 

inevitable  adjustments  must  occur  in  a  smooth  and  socially-acceptable  manner  and 

economic  growth  must  be  sufficiently  strong  to  absorb  the  -resources  freed  by 

technological progress and globalisation. 

2.1  Technological  progress 

The last three decades have  seen the  emergence  of a new wave  of technological  advances 

in  important  areas  such  as  electronics,  computers,  telecommunications  and  bio-  and 

ecotechnologies.  Most  of these new technologies  have ramifications  for  all sectors  of the 
economy.  In  particular,  information  and  communication  technologies  (ICT)  are  driving 
the  ongoing  process  of  structural  change.  Their  impact  on  the  economy  is  pervasive. 
They  not  only  entail  rapidly  falling  costs  but  they  also  bring  about  fundamental 
modifications  in  working  methods  and  relations,  the  organisation  of  companies  and  the 
way in which knowledge is produced  and  distributed. 

31 

In  macroeconomic  terms,  the  role  of  technology  in the  economy  can  be  assessed  by  the 

trend in total factor  productivity  (TFP) growth.  The latter is defined  as the proportion  of 

output  growth which is not  accounted  for by increases in inputs of labour  and  capital,  the 
two  most  fundamental  factors  of pçpduction2.  In this  sense,  improvements  in TFP  reflect 
the  impact  of  technological  progress,  human  capital  endowments  and'  organisational 

efficiency  incorporated  in the  economic  process.  TFP  can therefore  be  interpreted  as  an 

indicator of the strength of the endogenous growth forces in the economy. 

As  shown 

in  Table  11,  TFP 

growth in the  Community,  as well 

as  among  the  Community's  main 

partners, 

slowed 

down 

significantly  between  1960-73 and 

1974-85. For the Community,  this 

slowdown can to  a large extent be 

explained  by  three  factors:  the 

Table 11 

Long-term trends in TFP growth1) 

1961-73 

1974-85 

1986-95 

1986-90 

1991-95 

EUR 
USA 
Japan 

2.8 

1.6 

6.3 

1.0 

0.4 

1.1 

1.2 

0.8 

0.9 

1.5 

0.6 

2.3 

1.0 

0.9 

-0.5 

*) Total factor productivity: average labour and capital 

productivity weighted by factor income shares. 

substantial  narrowing  of the  room 

Source: Commission services. 

to  catch-up  with  the  technological  leader,  the  United  States;  the  adverse  impact  of 

macroeconomic  shocks  resulting  from  large  and  abrupt  changes  in  relative  prices  with 

slow  adjustment  to  the  new  conditions  in the  post-1973  era;  and  the  trend  decline  in  the 

share of investment  in GDP in the Community. 

During the last  decade,  despite  significant  changes in technology,  especially  in the field  of 

information  and  communication,  there has not been a pronounced  rebound  in TFP  growth 

from  the  low  rate  experienced  during  the  second  half  of  the  1970s  and  the  early  1980s. 

Nevertheless,  since  the  launching  and  implementation  of  the  Single  Market  Programme, 

the  slowdown  has  been  arrested  and  a  slight  recovery  is  even  noticeable.  The  latter 

2 

Total factor  productivity  has been calculated within  a production function  framework  where the  level 
of  output  is  assumed  to  be  determined  by  the  level  of  input  of  two  production  factors,  labour  and 
capital,  and  a certain  rate of technological  progress  (total  factor  productivity):  Y = A(t)F(L,K)  where 
Y  is the  level  of output,  L  and K  the  inputs  of labour  and  capital,  and A(t)  the  effect  of  technological 
progress.  Under  the  assumption  of  constant  returns,  the  rate  of  technological  progress  can  be 
calculated  approximately  as  g  = y  - ak  where g  is the rate of technological  progress  (change  in total 
factor  productivity), y  is the growth  rate of the volume of GDP per person employed,  a is the  share of 
profits  in  GDP at factor  cost and k is the growth rate of the  capital  stock  per person  employed.  Thus 
total  factor  productivity  is  measured  ex post  as  a  residual  item  and  includes  factor  inputs  other  than 
capital  and  labour. 
In  the  new  growth  theories,  by  contrast,  technical  progress  is  an  endogenous 
element  of  the  economic  system  that  can  be  influenced  by  economic  policies  and  investment  in 
physical and  human  capital. 

32 

essentially  reflects  a  partly  cyclical  pick-up  in  TFP  growth  in  the  second  half  of  the 

eighties  when  buoyant  investment  characterised  the  Community  economy.  Over  the  last 

two  decades, TFP in the Community grew at a broadly  similar pace as in Japan and  about 

twice as fast  as in the United  States. 

The failure  of the rapid  technological  advance to  show up  in  economy-wide  TFP  growth 

in the  1980s  and  1990s  (the  so-called  "productivity  or  Solow  paradox")  may  be  related 

to 

insufficient 

largely 
investment. 
Otherexplanations  have also been offered3,  including problems in measuring  technological 
change and productivity,  especially in services; the need for  complementary  organisational 

economic  growth 

and,  particularly, 

low 

investment  and  institutional  changes;  shifts  in the  nature  of  innovation,  with  more  effort 

devoted  to  product  differentiation  rather  than  to  productivity  enhancement  or  radically 

new products; and lags for new technologies to ripple through the economy. 

None of these explanations  puts into  doubt,  however,  that technological  progress  and  the 

move to a knowledged-based economy are the driving forces  behind medium and long run 

growth  of  economic  activity,  productivity  and  living  standards  in  the  Community. 

Technological  progress  implies  a  continued  shift  in  the  structure  of  output  and 

employment,  out  of  agriculture  and  manufacturing  and  into  services  and  the  new  growth 

areas  of  communication,  bio-  and  ecotechnologies,  health  care,  leisure,  and 

the 

environment.  In particular,  the use of new technologies  eliminates certain low-wage,  low-

productivity jobs of the unskilled  and creates jobs that  are more productive,  high-skill  and 

better paid.  Such a transformation  process has continuously taken place in the  Community 

since its inception. 

As shown in Graph  12, over the last 25 years, employment  in agriculture  and industry  has 

been  on a downward  trend.  But  in contrast  with the steady  fall  in the number  of  persons 

employed  in  agriculture,  employment  in  industry  stabilised  or  even  increased  at  times 

when  macroeconomic  growth  was  relatively  strong.  The  job  losses  in  agriculture  and 

industiy have been  compensated  for  by increased  employment  in the services  sector.  The 

latter upward  trend  was  only temporarily  interrupted  during the  1992/93  recession,  partly 

under the impact  of a more competitive environment,  for instance in financial  services, and 

due to the cyclical vulnerability of many small and medium-sized  enterprises. 

See OECD  (1996), "Technology,  productivity  and job creation.  Analytical  report.",  especially pp. 26-
29. 

33 

Graph 12 

Gross value added per sector *, EUR 
(constant prtcaa) 
index 1:970* WO 

Graph 13 

Employment by type of 
manufacturing  industry, EUR 

:tô70 - too 

Sectoral employment trends, EUR 
index 197Û» 100 

197Q=KW 

1990 

1970 

1974 

1978 

1982 

1986 

1990  1994 

1975! 

1990:: 

1970 

-1974 

1978 

1982 

1986 

1990 

1994 

* GVA for EUR excl. E.IRLL and P. 
Source: Commission services and DECD LFS. 

Source:  OECD STAN database. 

Within  the  manufacturing  sector,  Graph  13  indicates  that  employment  in  the  high-
technology  manufacturing  industries in the Community  has expanded  markedly  during  the 
1980s although these  employment  gains have been lost  during  the  slow-growth  period of 
the  first  half  of the  1990s.  By contrast,  low-technology  manufacturing  industries  have 
seen pronounced  and steady job losses since the early  1970s. 

To  reap  the full  benefits  of the  new  wave  of technological  progress,  it is necessary  that 

four  requirements  are met. 

Firstly,  efficient  goods  and services  markets  must  allow  for  swift  changes  in  relative 

prices. 

In  sectors  where  productivity  rises  relatively  fast  under  the  influence  of 

technological  innovation,  the  opening-up  of markets or deregulation,  relative  prices  must 
fall  in order  to pass  on the  productivity  gains to the rest  of the  economy.  In  this  way, 
relative  prices  could  increase  in sectors  with  below-average  productivity  growth.  Only 
under  this  condition  will  the  more  labour-intensive  sectors  be  capable  of  creating 
profitable jobs.  There is evidence  that  this  requirement  is relatively  well  respected  in the 

34 

Community4.  Competitive pressures  and effective  competition policies  should  ensure that 
this condition is even better fulfilled  in future. 

Secondly,  the  unavoidable  sectoral  changes  must  occur  smoothly  and  be  socially 

acceptable.  In  the  Community  economy  it  appears  that  this  condition  is  fulfilled  albeit 

with  some  difficulties. 

Increased  professional  and  geographical  mobility  as  well  as  a 

lowering  of  non-wage  labour  costs  and  temporary  entry  wages  targeted  at  low-skilled 

workers  could  help  cushion  the  adjustments  resulting  from  technological  progress, 

globalisation and falling  subsidies for  ailing sectors and industries. 

Thirdly,  the  move  towards  a  knowledged-based  pattern  of  production  of  goods  and 

services  must  be  assisted  by  policies  to  improve  human  capital  formation  in  the 

Community  in general  and by measures to  enhance the employability  of the low-skilled  in 

particular  (for  instance  through  lower  non-wage  costs,  lower  taxes,  temporary  entry 

wages, better  education and training, etc.) 

Fourthly,  the  production  potential  created  by  technological  progress  and  enhanced 

competition  must  actually  be  absorbed  by  higher  economic  growth,  exceeding  the 

productivity  trend.  If the resources  freed  are not  put to  use, the  overall balance  between 

job  creation  and job  destruction  will  not  be  sufficiently  positive  to  employ  the  growing 

labour  force  and  to  reduce  unemployment.  Deficient  economic  growth  has  been  the 

Community's  major  problem,  underscoring  the  need  to  resolutely  eliminate  the  obstacles 

to macroeconomic  growth highlighted  in Chapter  1. 

2.2  Globalisation 

Technological  progress,  competition  and  globalisation  are  mutually 

reinforcing. 

Globalisation  can  be  defined  as the  process by which  markets  and  production  in  different 

countries  are becoming  increasingly interdependent  due to the dynamics of trade in goods 

and  services  and  flows  of  capital  and  technology.  It  is  not  a  new  phenomenon  but  the 

continuation  of developments that  have been in train for  some considerable time.  Indeed, 

a greater  integration  of the world  economy has been  actively  pursued  since the  end  of the 
second  world  war.  The  well-recognised  case  for  globalisation  is  that  it  has  played,  and 
will  continue  to  play,  a  major  role  in  the  rise  in  living  standards  by  improving  the 
allocation  of  resources  and  by  exerting  discipline  on  economic  policies.  Since  its 

For  a  more  detailed  analysis  of  the  relationship  between  productivity  and  employment  growth,  see 
Box 6 in AER1996, European  Economy,  n° 61, p. 64. 

35 

inception,  the  Community  has  had  an  important  effect  on  this  process.  European 

integration  may  not  only  be  considered  as  an  integral  part  of  this  process,  it  also  adds 

another  dimension.  The  quest  for  further  integration through  inter alia  the  creation  of a 

customs  union,  the  completion  of  a  single  market  and  the  forthcoming  economic  and 

monetary  union  has  been  accompanied  by  important  institutional  developments  and  a 

sharing of sovereignty in certain policy areas. 

Over  the  last  two  decades,  globalisation  has  gained  additional  momentum.  Driven  by 

various  powerful  forces,  the  economic  links  between  the  industrialised  countries  have 

intensified  significantly  since  the  mid-1970s.  Chief  amongst  these  forces  are  the 

impressive  reductions  in communication  and  transport  costs,  the  progressive  world-wide 

reduction  of  barriers  to  trade  (including  since  the  Uruguay  Round  agricultural  products 

and  with  the  GATS  agreement  a  first 

liberalisation  of  services),  the  continued 

liberalisation  of  capital  movements  and,  finally,  changes  in  enterprise  organisation  and 

strategy.  In addition, hitherto inward-looking  developing countries have gradually  opened 
up  their  markets  and  have  increasingly  become  integrated  in  the  world  economy.  The 

most  recent  development  in  this  context  is  the  opening  of  the  former  state-controlled 

countries of central and  eastern Europe  (CCEEs) and the Former  Soviet Union (FSU).  In 

the  medium  to  longer  run,  this  trend  is  bound  to  accelerate  and  to  encompass  a  larger, 

more populated  group  of countries. 

The  scale  of  globalisation  can  be 

assessed  on  the  basis  of  trends  in 

international trade and capital flows. 

2.2.1  Trade 

During  1950-73,  the  volume  of  world 

trade  (in  goods  and  services)  increased 

at  an  annual  rate  of  nearly  8  per  cent, 

while world  GDP rose annually by 5 per 
cent in volume.  In the decade  following 
the  abandoning  of  the  fixed  exchange 
rate  regime  under  Bretton  Woods  and 
the  first  oil  price  shock,  the  rate  of 
trade  and 
expansion  of  both  world 
world  GDP  slowed  down  substantially. 

Graph 14 

Elasticity of world trade with 
respect to  world output  * 

-1.5 

1970: 

1975 

1980 : 

1985 

1990 : 

1995: 

* World trade  includes goods and services and is calculated  as the 
average  of annual percentage change for  real world exports and 
imports. The elasticity is calculated as the annual  percentage  change in 
world trade divided by the annual percentage change in world GOP 
(both in real terms). 
Source:  IMF. 

36 

However,  since  1983, the pace  of world  trade  has accelerated  again  (average  annual  rate 

of  5.7  per  cent)  thereby well  outpacing  the expansion  of world  GDP  (which  rose  at  only 

3.4  per  cent per  year).  Since the beginning  of the  1990s,  the  elasticity  of world  trade  to 

world  GDP  has  even jumped  to  above  2  (see  Graph  14).  As  a  corollary,  the  ratio  of 

exports  (goods  and  services)  to  GDP  for  the  world  as  a  whole  has  risen  considerably. 

Having  doubled  between  1950 and  1973 to  16 per  cent,  it reached  almost  25  per  cent  in 
19955. 

j Graph 15 

35! m 

Share in world exports of goods' 

E UR 

1968 

1963 
" Expressed in nominal terms; excluding intra-EC  exports. 
Source:  Commission services, foreign trade statistics. 

1983 

1973 

1978 

1988: 

1993! 

The Community has participated  actively and positively in this globalisation process. It has 

also withstood  the increased  competitive  pressures  relatively  well.  Since  the  early  1970s, 

the  Community's  share  in  world  merchandise  exports  has  shrunk  but  it  remains  high  at 

about  24  per  cent  (excluding  intra-EC  trade).  To  the  extent  that  the  drop  in  its  world 

market  share  reflects  the  emergence  of  new  trading  partners  on  the  world  scene  and 

increased 

trade 

integration  amongst  member  countries, 

this 

is  not  a  worrying 

phenomenon.  In  this  respect,  it  is  noteworthy  that  the  bulk  of  the  rise  of  the  share  in 
world  trade of the Asian countries6  came primarily  at the expense  of the other  developing 
countries. 

Including  intra-EC trade. 

5 
6  The share of the Dynamic Asian  Economies  in world exports  has increased  from  5 to 6 per cent  in  the 

early  1970s to about  15 per cent at present. 

37 

Table  12 

Geographical  structure of extra-Community  trade 
(goods, extra-EC) 

As % of nominal GDP 

% change p. a. in value 

19761)  19822)  19953) 

82/771)  87/822)  95/873) 

%of 
total 

1995 

10.9 
4.6 

11.5 
5.0 

1.2 
0.2 

6.2 

0.3 
0.1 
0.2 
0.9 

1.7 
0.3 

6.4 

0.4 
0.1 
0.5 
0.7 

12.1 
4.9 

12.9 
5.7 

1.9 
0.5 

7.2 

0.5 
0.1 
0.3 
0.8 

2.2 
0.7 

7.2 

0.6 
0.1 
0.3 
1.0 

9.8 
4.9 

1.6 
0.5 

4.9 

1.1 
0.2 
0.4 
1.0 

9.6 
5.1 

1.6 
0.8 

4.5 

0.9 
0.4 
0.4 
1.0 

-1.3 

-1.4 

0.3 

12.5 
13.0 

17.9 
14.6 

12.1 

17.7 
10.5 
25.9 
5.7 

12.6 
14.3 

13.5 
18.8 

11.4 

14.7 
12.0 
13.3 
15.9 
(7) 
-1.2 

3.3 
9.3 

10.9 
15.5 

-2.5 

11.3 
18.7 
3.7 
1.4 

0.8 
5.6 

0.9 
12.4 

-3.9 

10.3 
14.2 
5.8 
0.8 
(V) 
-0.5 

8.7 
4.9 

100.0 
49.7 

15.8 
5.0 

50.3 

10.6 
2.2 
4.0 
10.7 

100.0 
53.2 

17.1 
8.8 

46.8 

9.4 
4.3 
3.9 
10.9 

3.3 
10.2 

12.9 

16.4 
11.3 
8.5 
16.4 

8.2 
5.9 

7.2 
4.8 

10.7 

9.3 
21.5 
10.0 
13.2 
(7) 
-0.5 

-0.3 

-0.7 

-0.2 

-0.4 

-0.1 

-0.4 

-0.7 
-0.3 

-1.0 

-0.4 
-0.5 

-0.7 

-0.1 
-0.3 

0.5 

-0.5 
-0.4 

-0.8 

0.2 
-0.5 

-0.4 

-0.1 
-0.5 

-0.1 

Exports to: 
•  Total 
•  OECD 

of which: 
USA 
Japan 

•  Non-OECD 
of which: 
DAEs4> 
China 
Rest of Asia5) 
CCEEs6) 
Imports from: 
•  Total 
•  OECD 

of which: 
USA 
Japan 

•  Non-OECD 
of which: 
DAEs 
China 
Rest  of Asia 
CCEEs 
Trade  balance 
•  Total 

•  OECD 

of which: 
USA 
Japan 

•  Non-OECD 
of which: 
DAEs 
China 
Rest of Asia 
CCEEs 

-0.2 
0.0 
0.0 
-0.1 

-0.1 
0.0 
0.1 
-0.3 

0.1 
-0.2 
0.0 
0.0 

-0.2 
0.0 
-0.1 
0.1 
1 ) EUR9: EUR15 excluding EL, E, A, P, FIN and S 
2) EUR10: EUR15 excluding E, A, P, FIN and S. 
3) EUR12: EUR 15 excluding A, FIN and S. 
) Hong Kong, Korea, Malaysia, Singapore, Taiwan, and Thailand. 
5) Afghanistan, Pakistan, India, Bangladesh, Maldives, Sri Lanka, Nepal, Bhutan, 

-0.1 
-0.1 
0.0 
-0.1 

-0.1 
0.0 
0.1 
-0.3 

Myamnar, Laos, Vietnam, Kampuchea, Indonesia, Brunei, Philippines, Mongolia, Macao 
") Albania, Bulgaria, Czech republic, Slovakia, Hungary, Poland, Romania, Ex-USSR and 

Slovenia. 

7)Average trade balance over the period in % of GDP. 
Source: Commission services. 

38 

The Community  has  a comparatively  low  share  of extra-EC  exports  directed  towards  the 

Asian markets which have been growing quickly and are likely to  continue to  do  so in the 

foreseeable  future. 

In  1995,  Community  exports  to  Asia  (including  China)  represented 

only  17 per  cent  of  total  extra-EC  exports  against  20  per  cent  and  44  per  cent  for  the 

United  States  and  Japan  respectively. 

It  should  be  noted,  however,  that  Community 

exports  to  these  countries  have  risen  strongly  since  the  late  1980s  (see  Table  12). 

Furthermore,  the  share  of  Community  exports  directed  towards  the  CCEEs,  which  also 

constitute  high-growth  markets,  is  significantly  higher  than  that  of the  United  States  and 

Japan. 

However,  there is some cause for  concern.  The Community  exhibits  a comparatively  low 

degree  of  specialisation  in the  strong-demand,  high-tech  sectors.  The  share  of  the  high-

demand  sectors  in  total  extra-EC  exports  amounted  to  30  per  cent  in  1994  which 

compares with  39 per  cent in the United  States and  34 per  cent  in Japan; the  share  of the 

high-tech  sectors  in  total  extra-EC  exports  (in  1993)  amounted  to  23  per  cent  against 

about 37 per cent in the United  States and Japan. 

One of the most prominent features  of the recent globalisation process is the emergence  of 

newly  industrialised  countries  as  major  suppliers  and  exporters  of  internationally  traded 

goods  (especially  manufactures). 

Imports  from  Asian  countries  to  the  EC  rose 

dramatically  during the last  decade, resulting in a sharp  increase in their  share in  extra-EC 

imports.  While  imports  from  Asian  countries  only  accounted  for  1.3  per  cent  of 

Community  GDP  in  1995,  these  countries  are  increasingly  establishing  themselves  as 

serious  competitors  in  EC  markets.  In  1995, they  accounted  for  around  18  per  cent  of 

total EC imports from  the rest of the world (Table 12). 

Table  13  shows  that  the  growth  of  Asian  exports  to  the  Community  is  not  restricted  to 

traditional,  low-skilled  sectors  such as clothing  and textiles.  High-skilled,  capital-intensive 

sectors  such  as  machinery  and  transport  equipment  and  high-tech  products  represent  a 

rising  share  of  Asian  exports  to  the  Community.  Greater  global  mobility  of  financial 

capital  and  easier access to technology  since the early  1980s have contributed  importantly 
to  this  trend.  Moreover,  restricted  market  access  for  "sensitive"  products  (e.g.  textiles 
and  clothing,  steel  and  iron)  may have  encouraged  the  shift  in Asian  countries  towards  a 
greater  specialisation  in  more  sophisticated  market  segments.  As  a  result,  part  of  the 
adjustment  burden in the EC has been shifted  towards  sectors in which EC  countries  have 
not until very recently faced  direct competition from  Asian exports. 

39 

Table 13 

The regional structure of extra-EC1' imports of manufactured products 
*i) 

Total 

% of total  imports of manufactured goods from 
each country or group of countries. 

% of total extra-EC 
imports of 
manufactured  goods 

Machinery 
transport 
equipment 

Chemicals  Clothing . 
and textile 

Hi-tech 

USA 

Japan 

Developing 
countries2) 
of which: 

DAE 

China 

Other Asia 

CCEEs 

1980 
1995 
1980 
1995 
1980 
1994 

1980 
1995 

1980 
1995 

1980 
1995 
1980 
1995 

22.9 
21.6 

8.6 
12.4 

27.4 

36.4 

7.6 

12.2 

0.9 
5.7 

2.5 
4.6 

5.2 

11.6 

26.4 
30.8 

37.6 
47.4 

4.7 

13.7 

3.1 
30.8 

0.8 
9.6 

1.5 
4.1 

9.8 
14.0 

9.1 
8.9 

3.5 
5.0 

6.2 

4.7 

0.4 
1.7 

13.5 
5.8 

1.1 
2.9 

12.7 
7.3 

4.3 
2.2 

3.1 

1.4 

23.7 

23.7 

31.3 
11.1 

44.1 
23.9 

42.2 
50.2 

16.9 
17.5 

24.3 
33.5 

38.9 
36.1 

7.4 

17.3 

20.2 
34.3 

1.9 
21.3 

2.9 
8.6 

3.6 
9.0 

^EUR  9 for  1980 and EUR  12 for  1995. 
2) African-,  Caribbean- and Pacific  countries  signatories  of the Lomé convention,  Central  and  South America, 

Middle East, DAEs, China, Other Asia, CCEEs. 

Source:  Commission  services. 

Growth  in  Community  exports  to  and  imports  from  other  regions  in  the  world  have 

remained  roughly  in  balance.  At  the  same  time,  the  Community's  trade  balance  against 

the  developing  countries  has  shifted  from  a deficit  of  the  order  of  1 per  cent  of  GDP  just 

after  the  first  oil price  shock  to  a modest  surplus  at present.  On the  other  hand,  trade  with 

the  new  "emerging"  economies  of Asia  and  the  CCEEs  has been broadly  in balance  during 

the  last two  decades. 

2.2.2  Foreign  direct  investment  (FDI) 

Since the  second  half  of the  eighties, world-wide  FDI  flows  have  grown  very  rapidly,  both 

absolutely  and  relative  to  trade  flows  and  output  growth.  Annual  flows  jumped  from  an 

average  of  $50  billion  during  the  period  1981-85  to  an  average  of  $155  during  the  period 

1986-90,  reaching  $200  billion  in  1990.  In  the  early  1990s,  in  line  with  the  slowdown  of 

40 

the  world  economy  and  weak  corporate  balance  sheets  in  a  number  of  industrialised 

countries,  FDI  flows  dropped  substantially  but  have  recovered  remarkably  strongly  from 
1994  onwards.  According  to  UNCTAD7,  the  level  of  global  FDI  flows  reached  $315 
billion in  1995.  Over the last  10 years, global FDI flows rose in nominal terms on average 

more than twice as fast  as world GDP. 

The  Community  has  been  both  a  major 

source  and  destination  for  FDI  flows. 

Although there was  a setback  in the  early 

Table  14 

Foreign  direct  investment  (Mrd $) 

1990s under  the  impact  of  the  economic 

1975 

1980 

1985 

1990 

1995 

slowdown,  the  level  of  both  inward  and 

outward  FDI flows was high by historical 

standards 

(see  Table 

14). 

The 

Community  (including  intra-EC  flows) 

was  the  source  of  42  per  cent  of  global 

FDI  flows  in  1995  and  absorbed  36  per 

cent of inflows. 

Following 

the 

launch  of 

the  Single 

Market  Programme  in  the  mid-eighties, 

the  Community 

has 

become 

an 

increasingly  attractive  destination 

for 

both  traditional  investors  like  the  United 

States  and Japan  and  also the  newcomers 

of  Southeast  Asia  as  they  sought  to 

strengthen  their  position  in  the  internal 

market.  The  abolition  of  non-tariff 

barriers, 

the 

simplification 

of 

EUR15 
(extra + intra) 

Inflows 
%  World 
% GFCP) 
Outflows 
%  world 
% GFCP) 
Net  flows 

Inflows 
% GFCP) 
Outflows 
% GFCP) 

9.9 
45.9 
2.6 
9.9 
36.0 
2.6 
0.0 

2.6 
0.9 
14.2 
5.1 

21.3 
40.9 
2.8 
27.0 
46.8 
3.6 
5.7 

16.9 
3.1 
21.9 
4.0 

0.2 
0.1 
1.8 
1.1 

Inflows 
% GFCP) 
Outflows 
% GFCP) 
l) Gross fixed capital formation. 
Source: UNCTAD. 

0.3 
0.1 
2.4 
0.7 

15.4 
31.1 
2.9 
25.5 
42.6 
4.8 
10.1 

97.4 
47.8 
7.0 
133.0 
55.4 
9.5 
35.6 

111.9 
35.5 
7.0 
132.3 
41.6 
8.3 
20.4 

USA 

19.2 
2.5 
15.2 
1.9 

Japan 

0.6 
0.2 
6.4 
1.7 

47.9 
5.1 
27.2 
2.9 

1.7 
0.2 
48.0 
5.1 

60.2 
4.9 
95.5 
7.8 

0.5 
0.0 
21.3 
1.5 

administrative  formalities,  the  prospect  of  a  large  and  growing  market  demand  and  the 

scope for  economies  of scale seem to have provided  strong incentives to  invest  in the EC. 

The  Single  Market  Programme  has  also  provoked  unprecedented  amounts  of  FDI 

between EC  member  countries.  As a proportion  of total EC FDI  outflows,  intra-EC  FDI 

flows soared  from  20 per cent in  1983 to 59 per cent in 1994. 

7  UNCTAD  (1996),  World investment  report,  Geneva. 

41 

As  regards  outward  investment  flows  from  the  EC  to  non-EC  countries,  a  large 

proportion  (about  60 per cent in 1994) is directed  towards  other  industrialised  countries. 

This  figure  is on a  declining  trend,  down  from  about  75 per cent  in the mid-eighties. 

Among the developing  countries, the Asian countries are increasingly important  recipients 

of investment  from  the  EC.  The  same holds for China whose  share in EC FDI outflows 

has grown  strongly in recent  years.  It is noteworthy  that  the  size of EC  FDI  outflows is 

small relative to gross fixed  capital formation  in the Community  (about 2 to 3 per cent for 
total extra-EC FDI  outflows)8. 

Direct 

investment  abroad  is  a  normal 

element in corporate  growth  strategies  that 

enables a company  to exploit  its particular 

strength  on  a  broader  scale.  From  this 

perspective,  FDI  outflows  to  dynamic, 

fast-growing  economies  might  be  an 
indicator  of a competitive  edge.  It is only 

when  this  relocation  is not matched  with 

broadly  equivalent  FDI  inflows  or when it 

is  accompanied  with  weak  domestic 

investment  that  the  attractiveness  of  a 

country  as  a  production  site  may be in 

question.  So far, the Community  has done 

fairly  well  in international  competition for 

direct  investment  as witnessed  by both the 

strong  growth  in inflows  and its moderate 

surplus  in net FDI flows. 

It  seems  that 

Community 

location 

and 

foreign 

production  are  complementary  given  the 

Graph 16 

Foreign direct investment in EUR12 
Extra- and intra-EC flows 

Mrd ECU 

1984  1386  1986  1987  "1988  1989  1990  1991  1992  1993  1994 

Source:  Commission  services. 

strong,  albeit  declining,  correlation  between  the direction  of exports  and FDI outflows. 

Furthermore,  there  are no signs  that  the foreign  transfer  of production  is predominantly 

This  analysis  is  confined  to  Community-wide  trends  which  mask  important  differences  between 
countries.  For instance  in  Germany  the size  of FDI  inflows  has traditionally  been  low relative to 
outward  FDI.  Whereas  during  the  1980s  substantial  net FDI outflows  were  the mirror-image  of a 
solid  surplus  on the current  account,  the widening  gap since  unification  when  the current  account 
turned  negative  has fueled  the current  debate on the attractiveness  of Germany  as a production  site. 
The  strong  appreciation  of  the  DEM over  recent  years  has  undoubtedly  played  a  role,  though 
structural  weaknesses  in the German  economy  have  significantly  added  to current  concerns  in this 
field.  Conversely,  following  the  deregulation  and  privatisation  of  the  early  1980s,  the  United 
Kingdom  experienced a sharp increase in inward FDI in the late  1980s, especially by Japanese  firms. 

42 

determined  on wage-cost  grounds,  even  if this  might 

Table 15 

be the  case for  some labour-intensive  sectors  such  as 

clothing, footwear  or toys. 

2.2.3  Financial  capital  movements 

Not  only  have  FDI  flows  risen  significantly  over  the 

last  20  years,  but  also  international  financial  capital 

movements  have  expanded  enormously  under  the 

combined 

impact  of  financial  deregulation  and 

innovation.  For instance,  cross-border transactions in 

bonds  and  equities  soared 

in  major 

industrial 

countries  from  less than  10 per  cent  of  GDP  in  1980 

to  between  150  and  250  per  cent  in  1995.  The 

world-wide  volume  of  foreign  exchange  trading  has 

also  risen  very  fast,  with  the  daily  turnover  now 

amounting to  $1500 bn.  It should be noted that these 

transactions  primarily  concern  movements  in  stocks 

of  financial  assests  (including  government  bonds) 

which  have  been  built  up  over  time  and  which  react 

instantaneously to  even marginal differences  in yields. 

Structure  of foreign  direct 
investment  in the  EC 
(MrdECU) 

19841}  1990"  19942) I 

From: 

Extra-EC  inflows 

-USA 
- Japan 
-Asia3) 
- Others 
To: 

-USA 
- Japan 
-Asia3) 
- China 
- CCEEs 
- Others 
Intra-EC 

3.0 
0.4 

9.2 
5.4 

2.8 

18.2 

8.5 
1.4 
0.5 
9.5 

Extra-EC  outflows 

11.5 
0.3 

7.2 
0.9 

0.2 
12.2 

0.0 
5.6 

4.2 

39.3 

37.4 

6.4 
0.3 
2.4 
0.5 
3.3 
8.6 

(1) EUR12. 
(2)EUR15. 
(3) Asia: Thailand, Malaysia,  Indonesia, 
Singapore, Philippines,  South  Korea, 
Taiwan, Hong Kong and India. 

Source:  Commission services. 

The liberalisation  of financial  markets  also  contributes  to  a better  allocation  of resources. 

Since  holdings  of  financial  assets  are very  sensitive  to  shifts  in  sentiment  in  international 

financial  markets,  they  exert  a  strong  discipline  on  exchange  rates  and  economic  policy. 

Ignoring  market  signals  inevitably  leads  to  turbulence  on  currency  and  bond  markets 

which  in  turn  —  as  shown  in  Chapter  1  — constitutes  an  important  obstacle  to 

macroeconomic  growth. 

2.2.4  Economic  implications 

There  is  little  evidence  that  globalisation  in  itself,  and  especially  increased  trade  and 
investment  with  developing  countries,  is  a  major  cause  of  unemployment  in  the 
Community.  On the  contrary,  increased  trade is a major  source  of economic  growth  and 
rising living standards due to improved  allocation of resources. 

43 

First  of all,  it  should  be  borne  in mind  that  the  degree  of  openness  of the  Community  to 

Japan. 

the world  economy  is relatively  small and broadly  similar to that  of the  United  States  and 
In  1995,  the  degree  of  openness9  in  the  Community  was  about  10  per  cent, 
compared with  12 per cent in the United  States and 9 per cent in Japan.  This implies that 

the globalisation  of trade direcly affects  only a limited part of the Community  economy. 

Secondly,  it  should  be  noted  that  the  majority  of the EC's  economic  links  are within  the 

Community  and  with  its  major  industrial  partners.  This  means  that  globalisation  is 

primarily  taking  place between  countries with broadly  similar  economic  structures,  factor 

endowments and wage and productivity levels.  Hence, the primary impact of international 

trade  and  FDI  flows  on  employment  creation  is  within  the  Triad  (i.e.  between  the 

Community,  the United  States  and Japan).  The intensification  of economic links between 

industrial  countries  should not be perceived  as a disadvantage but rather as a boon for  the 

Community's  prosperity.  This  has  been  the  motivation  for  a  variety  of  EC  policies, 

notably the new Market Access Initiative, which seek to maximise the benefits  accruing  to 
the Community from  globalisation. 

Thirdly,  the  size of the  Community's  trade with  low-wage  economies  is still  small:  extra-

EC  imports from  low-wage  countries amount to  less than 3 per  cent  of Community  GDP 

at  present  and  the  Community's  trade  with  these  economies  is broadly  in  balance.  It  is 

sometimes  argued  that  even  a balanced  trade  account  with these  countries  could  involve 

overall job  losses  for  the  Community  because  imports  from  low-wage  economies  tend  to 

have  a higher  (low-skill)  labour-intensity  than the  Community  exports  to  these  countries. 

However,  this  argument  does  not  take  account  of  the  dynamic  effects  resulting  from  a 

better  resource  allocation  nor  of  the  fact  that  cheap  imports  mean  an  increase  in 

Community  real incomes  and internal  demand.  Overall, this trade  embodies the  exchange 

of low-skilled work  against high-skilled  and better paid work. 

Fourthly, the extent  of outward  relocation of certain types of economic activity  should  not 

be exaggerated  nor  is it necessarily undesirable.  A job  created  in the  low-wage  countries 
cannot  be  equated  with  a job  lost  in the  Community  and  it  cannot  be  assumed  that  this 
foreign  production  and  employment  could  be  relocated  to  the  Community.  Rather  than 
displacing Community exports, sales-oriented  investment  abroad  can open up markets and 
lead  to  additional  exports  by  competitive  Community  industries.  Community  businesses 
are  exploiting  these  opportunities  as  can  be  seen  from  the  Community's  continued  trade 
surplus with the CCEEs and the newly industrialised  countries of Asia. 

9  Aritmetic average of exports and imports of goods and  services as a percentage of nominal  GDP. 

44 

Nevertheless,  the  globalisation  of  product  and  financial  markets  accelerates  sectoral 

change  and  exerts  downward  pressures  on  the  wages  of  low-skilled  labour. 

It  also 

exercises  powerful  pressures  on  the  Community  economy  to  apply  new  technologies,  to 

maintain  and  improve  competitiveness,  to  optimise  the  allocation  of  resources  and  to 

conduct  sound economic policies. 

2.3  Competitiveness 

Technological  progress  and  globalisation  puts  constant  pressure  on  Member  States  to 

maintain  and  improve  their  competitive  position.  Competitiveness  is  a  complex  and 

ambiguous concept that is often  confused  with other notions, for instance  profitability. 

At the firm level, the meaning of competitiveness  is clear-cut:  an enterprise  is competitive 

if  it  can  sell  its  products  at  the  market  price  and  be  profitable  in  the  medium  and  long 

term. 

At 

the  country 

level, 

the  notion  of 

Table 16 

competitiveness  is  less  straightforward.  For 

a  country,  the ultimate  policy  objective  is to 

improve  its  citizens'  living  standard's  and 

well-being. 

In  this  context,  the  external 

performance  of  a  country 

is  generally 

considered  important  because  it  is  a  useful 

indicator  of  the  long-term  ability  to  raise 

productivity 

and 

to 

turn 

international 

economic growth  into  domestic jobs.  In this 

respect,  a country's  competitiveness  is  often 

assessed  on  the  basis  of  trends  in its  export 

Export performance,  total goods 
% gain or loss of market share in real terms1), 
(annual average change) 

1981-85 

1986-90 

1991-95 

1996(2) 

EUR 

USA 

JAP 

Non-OECD 

of which: 
- DAEs(3) 

- Rest Asia 

1.6 

-2.8 

1.6 

-1.4 

3.0 

2.5 

-1.9 

4.3 

-3.9 

1.0 

3.3 

2.4 

-0.1 

-0.2 

-7.8 

1.6 

1.7 

5.5 

-1.6 

1.7 

-5.9 

1.9 

3.1 

3.6 

* > Measured  as the ratio between  export  volume 
growth and export market  volume  growth. 

performance.  As  shown  in  Table  16,  the 

2) Estimated. 

Community  has  experienced  a 

steady, 

moderate  decline  in  export  markets  shares 

3) DAEs excl. Thailand  and  Malaysia. 

Source: OECD. 

since the mid-1980s.  As regards the other regions listed in the table,  it is noteworthy  that 

Japan  also  has  suffered  from  continued,  marked  losses  in  export  market  shares  whereas 

the  United  States  (in  the  second  half  of  the  1980s  )  and  the  Asian  economies  (since  the 

early  1980s) have enjoyed  considerable gains. 

45 

Graph 17 

Export performance and real effective exchange rate, 

EUR 

1997 =100 

;i4tt; 

1978 

1980 

1982 

1984 

1985 

1988 

1990 

1992 

1994 

1996: 

'  Relative to 6 Industrial nan. member countries; double export-weights. Deflatonnomlnal unit labour costs, 
** Measured as the ratio b*tw*en export volume growth and export market volume growth. 
Source;  Commission services and OECD. 

The  evolution  in  export  market  shares  can  in  part  be  explained  by  movements  in 

international  cost  competitiveness  (as measured  by real  effective  exchange  rates).  In  this 

context,  Graph  17  reveals  that  the  deterioration  in  export  performance  over  the  last 

decade in the Community has partly been a consequence of the substantial  appreciation  of 

its  real  effective  exchange  rate.  A  negative  correlation  between  the  two  variables  is 

apparent  at the time of the hike in the value of the Community currencies in the mid-1980s 

and the early  1990s. 

Though  trends  in  export  performance  and  cost  competitiveness  may  contain  interesting 

insights,  they  only  shed  a  partial  light  on  the  competitiveness  of  a  country. 

In 

macroeconomic  terms,  and  viewed  in  a  medium  to  long-term  perspective,  a  convenient, 
comprehensive  definition  of  the  notion  of  competitiveness10  is  as  follows:  A  country  is 
internationally  competitive if concurrently: 

- 

its  productivity  increases  at  a  rate  which  is  similar  to  or  higher  than  that  of  its  major 

trading partners with a comparable level of development; 

it maintains external equilibrium in the context  of an open free-market  economy; and 

it realises a high level of employment. 

- 

- 

10  See also Competitiveness Policy Council  (1993), "v4 competitiveness  strategy for  America". 

46 

Table  17  shows  that  according  to  this  definition  the  Community's  record  is mixed.  The 

Community  has  had  higher  labour  productivity  growth  than  the  United  States  and,  in 

recent  years,  Japan  while  maintaining  external  equilibrium,  but 

its  employment 

performance  is significantly  worse than in its two main trading partners. 

Table  17 

M a c r o e c o n o m ic  competitiveness  in  t he  T r i ad 

1961-73 

1974-85 

1986-95 

1986-90 

1991-95 

Labour  productivity  growth  (%  p a .) 

4.4 
1.9 
8.2 

0.3 
0.5 
0.6 

2.0 
0.5 
2.7 

1.9 
0.8 
2.0 

1.9 
0.6 
3.6 

Current  account  (%  of  GDP) 

-0.3 
-0.4 
0.9 

-0.2 
-1.9 
2.7 

0.1 
-2.5 
2.8 

1.9 
1.1 
0.6 

-0.4 
-1.3 
2.7 

1960 

1973 

1985 

1990 

1995 

Employment  rates  (%)x) 

64.8 
66.7 
70.8 

59.1 
68.5 
70.6 

62.2 
72.6 
72.6 

Unemployment  rate  (%) 

2.6 
4.9 
1.3 

10.0 
7.2 
2.6 

7.8 
5.5 
2.1 

67.0 
62.7 
74.3 

2.4 
5.5 
1.7 

59.6 
73.0 
73.9 

10.9 
5.4 
3.3 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

l) Ratio of employment to the working population (15-64 years). 
Source:  Commission  services. 

All  industrial  countries  have  been  affected  by  a  structural  break  in  apparent  labour 

productivity  growth  in  the  wake  of  the  first  oil  price  shock.  In  the  Community,  labour 
productivity  has  risen  at  a  stable  rate  of  2  per  cent  per  year  on  average  over  the  last 
In 
twenty  years,  thereby  increasing  about  three  times  as  fast  as  in  the  United  States. 
Japan,  which  showed  the  strongest  performance  over  the  period  1960-90,  labour 
productivity  growth  fell  dramatically  in  the  first  half  of  the  1990s,  to  rates  well  below 
those  experienced  in  the  Community  and  even  the  United  States.  Japan's  recent  record 
reflects  labour  hoarding  during the  strong  and  protracted  economic  downturn  in the  early 
1990s. 

47 

The  better 

labour  productivity  growth 

performance  of 

the  Community  has 

resulted  in  a  steady  catching-up  with  the 

productivity  level of the United  States  (see 

100 

Graph 181  Labour productivity levels 

GDP at constant 1990 prices per person employed 

(PPS; USA-1D0) 

Graph 

18). 

The 

economy-wide 

Community  productivity 

level 

(on  a 

purchasing-power-standard  basis)  relative 

to  the United  States  increased  from  45  per 

cent  in  1960  to  82  per  cent  in  1995,  still 

well  above  the  Japanese  level  despite  the 

latter's  leadership  in  some  manufacturing 

industries.  However,  over  this period,  the 

140 

Community  did  not  succeed  in  narrowing 

the gap in living  standards with the  United 

States  to  a  similar  degree.  GDP  per  head 

of population  relative  to  the  United  States 

increased  from  55 per  cent in  1960 to  only 

1960  1965  1970  1975  1980  1985  1990  1995 

GDP per person employed at current prices 
and exchange rates. 

(ECU; USA=100) 

71  per  cent  in  1995.  This  essentially 

1 

1 

I 

! 

I 

1 

reflects  divergent  trends  in  employment 

rates in both economies (see below). 

1960 

1965 

1970 

1975 

1980 

1985 

1990 

1995 

Source: Commission services. 

Community  output  per person employed  measured  in current prices and  exchange  rates is 

now  similar  to  that  in  the  United  States  but  well  below  the  Japanese  level.  This  means 

that, at prevailing exchange rates, a worker in the Community on average  creates  a similar 

amount of economic wealth as a worker in the United  States. 

Historically,  the  Community  has never  experienced  real problems  concerning  the  external 

equilibrium.  From  1960  until  the  late  1980s,  the  Community's  current  account  was 

generally  broadly  balanced  or  in  slight  surplus.  .This  good  performance  is  somewhat 

concealed  in  Table  17  (which  presents  period  averages)  by  the  short-lived  but  non-

negligible  deficits  on  the  Community's  current  transactions  with  the  rest  of  the  world  at 
the  time  of  the  two  oil  price  shocks.  In  the  wake  of  the  overheating  of  1989-90  and 
German  unification,  the  current  account  turned  temporarily  negative  but  since  1995  the 
Community  has  again  shown  a  surplus  of the  order  of  VA  per  cent  of  GDP.  Conversely, 
the United  States has run significant  current account deficits  since the early  1980s whereas 
Japan  has  experienced  a  strong  external  surplus,  reflecting  a  significant  structural  excess 
of national saving over domestic investment. 

48 

Compared  with  its  two  major  trading  partners,  the  Community  economy  displays  dismal 

employment  performance.  In  the  Community,  employment  was  not  a  major  worry  until 

the  early  1970s.  But  since then,  apart  from  the  growth  period  of the  second  half  of  the 

eighties, the  rate  of job  creation has been too  slow  and below  the  comparatively  modest 

rise  in the  labour  force.  The  United  States,  by  contrast,  has  enjoyed  rapid  employment 

growth since the early  1960s, broadly in tandem with a strong increase in the labour  force. 

As  a  result, .the  two  regions  experienced  opposite  trends  in  the  employment  ratio  (i.e. 

employment  relative  to  the  working  age  population).  Starting  from  a  level  somewhat 

below that in the Community, the employment rate in the United  States rose to  around  73 

per cent at present whereas it declined to below 60 per cent in the Community. 

2.4  Capital-labour  substitution  and employment  growth 

2.4.1  Substitution  of labour by capital 

Against the backdrop  of rapid technological progress and increased  globalisation,  constant 
efforts  to  maintain  and  reinforce  competitiveness  are  required.  The  Community  and  its 
two  main trading  partners have been confronted  with  similar adjustment  problems but  the 
results  for  the  labour  market  have  been  strikingly  different.  A major  explanation  for  the 
divergent  employment trends on both sides of the Atlantic  seems to  reside in the  interplay 
of labour productivity,  capital-labour  substitution and growth11. 

As  discussed  in  the  previous  section,  over  the  last  35  years  the  Community  has 
continuously  experienced  stronger  labour  productivity  growth  than  its  principal  trading 
partner,  the  United  States,  and  recently  even  outperformed  Japan.  However,  it  appears 
that  almost  half  of  the  increase  in  labour  productivity  has  resulted  from  substitution  of 
labour by capital. 

Labour  productivity  growth  can  be  decomposed  into  growth  of  embodied  technological 
progress (total factor  productivity)  and capital-labour  substitution.  Table  18 indicates that 
in the  Community  about  3 points  of the annual increase  in labour  productivity  of 4lA per 
cent in the period  1961-73 can be attributed  to  an increase in total  factor  productivity  and 
the  remainder  or  VA  points  to  the  substitution  of  labour  by  capital.  During  the  two 
decades  following  the  first  oil  price  shock,  labour  productivity  rose  at  a  stable  annual 
rateof 2 per cent.  Only a little over half of this can be explained by technologicalprogress. 
Nearly half of labour productivity growth is caused by substitution of labour by capital. 

11  No comparison is made with the Japanese performance  as its approach is too specific,  culturally and 

socially, to be applicable to the Community. 

49 

Table  18 

O u t p u t,  e m p l o y m e n t,  p r o d u c t i v i ty  a nd  c a p i t a l - l a b o ur  s u b s t i t u t i on 
(annual % change) 

1961-73 

1974-85 

1986-95 

1986-90 

1991-95 

1.  Technical  progress  = Total  factor  productivity  =  endogenous  growth 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

EUR 
USA 
Japan 

2.8 
1.6 
6.3 

1.5 
0.3 
1.8 

1.0 
0.4 
1.1 

1.2 
0.8 
0.9 

1.5 
0.6 
2.3 

2.  Macroeconomic  capital-labour  substitution 
=  labour-saving  growth  (2 =  3 - 1) 

1.0 
0.1 
1.6 

0.7 
0.1 
1.1 

0.4 
0.0 
1.2 

1.0 
0.9 
-0.5 

1.1 
0.2 
1.1 

3.  Apparent  labour  productivity  =  GDP per  person  employed 
=  economic growth without  employment  (3  =  1 +  2) 

4.4 
1.9 
8.2 

2.0 
0.5 
2.7 

1.9 
0.8 
2.0 

1.9 
0.6 
3.6 

1.9 
1.1 
0.6 

4.  Employment  = employment-creating  growth  (4  =  5 - 3) 

0.3 
1.9 
1.3 

4.7 
3.9 
9.7 

0.0 
1.8 
0.7 

0.4 
1.7 
0.9 

1.3 
2.1 
1.0 

5.  Actual  GDP  growth  (5 =  1+2+4  =  3+4) 

2.0 
2.3 
3.4 

2.3 
2.5 
2.9 

3.3 
2.8 
4.6 

-0.5 
1.2 
0.7 

1.4 
2.3 
1.3 

A  strikingly  different  picture  is  noticeable  in  the  United  States.  During  1961-73  and 

1974-95, the growth in labour productivity was about  one third  of that in the  Community, 

and capital-labour  substitution contributed  only a marginal fraction.  The US economy has 

thus  been  expanding  its  input  of  capital  and  labour  broadly  in  parallel.  It  is  noteworthy 

that  since the  mid-1980s  the rate  of TFP growth  in the United  States  seems to  have  risen 

from  the  very  low  rate  experienced  in  the  previous  decade,  in  part  reflecting  a  strong 
expansion of investment. 

50 

Graph 19 

Employment, productivity and 
capital-labour substitution 

(Index 1960* 100) 

«$« 

: 

• : « :• 

. : ::  7 o : : : : : : . : : r s . : : : : : : ( « 1; 

:; ::  8 5:  ^ • • :-  91 

ReaJ compensation 
per worker 

Total factor productivity 

EUR 

' Source: i : : : ; •: Commission isérvicés.: 

85 : : : 

:.  so 

' ' :••.iS  : 

I960:  ••: ' - «5  • : : .. 

. 70  .  . : . : . . : 7 *: 

In  itself,  capital-labour  substitution  is  not  a  distressing  phenomenon.  A  high  degree  of 

capital-labour  substitution  allows  continued  high  growth  in  economic  activity  and  living 

standards.  But  with  a large  part  of the  available labour  reserve unemployed,  as has  been 

increasingly  the  case  in  the  Community  since  the  first  oil  price  shock  (see  Table  18),  a 

twofold  problem  emerged: 

-  a  lack  of  adjustment  in  the  labour  market  compelled  enterprises  to  keep  up  a  strong 

substitution  of  labour  by  capital  in  order  to  safeguard  their  competitiveness  through 

productivity increases; 

-  macroeconomic  growth was insufficiently  strong relative to the given  and  stable  labour 

productivity growth to create an adequate number of jobs. 

51 

The  potential  labour  reserve,  amounting  to  about  17  million  persons  if  the  average 

employment  rate of the period  1961-73 is taken as a yardstick  or to  some 26 million if the 

benchmark  is  the  employment  rate  in  the  Scandinavian  countries,  the  USA  and  Japan, 

constitutes  an important  growth  potential.  But  this implies that  adequate  policies  should 

be implemented  to take advantage of this labour reserve. 

Table 19 

E m p l o y m e nt  p o t e n t i a l,  E UR 
(1960-95, in mio) 

1. Population in working age 

groups (15-64 years) 

2. Activity rate in % (= 3 /1) 

3.  Active population  (=4 + 5) 

4.  Unemployment 

5. Total  employment 

1960 

1973 

1985 

1990 

19911) 

19912) 

1995 

193.8 

208.4 

229.7 

234.2 

235.4 

246.0 

249.0 

68.9 

66.9 

133.4 

139.5 

3.1 

3.5 

65.7 

150.9 

14.8 

67.2 

67.3 

67.7 

66.6 

157.5 

158.3 

166.6 

165.9 

12.0 

12.7 

13.6 

17.9 

130.4 

136.0 

136.2 

145.4 

145.6 

153.0 

148.1 

6. Employment  rate  (=5/1) 

67.3 

65.2 

59.3 

62.1 

61.9 

62.2 

59.5 

7. Potential employment  at 1961-73 
average employment  rate (66.2%) 

128.4 

138.1 

152.2 

155.2 

155.9 

163.0 

165.0 

8. Employment  gap  1  (=5-7) 

2.0 

-2.1 

-16.0 

-9.7 

-10.3 

-10.0 

-16.9 

9. Potential employment  at 70% 

135.6 

145.9 

160.8 

163.9 

164.8 

172.2 

174.3 

employment  rate3) 

10. Employment  gap 2 (= 5 - 9) 

-5.3 

-10.0 

-24.6 

-18.5 

-19.1 

-19.3 

-26.2 

J)  1960-91 with West  Germany, 
2)  1991-95 with unified  Germany. 
3) Comparable to highest  employment rates registered  in Northern Europe, USA and Japan. 
Source:  Commission  services. 

2.4.2  Substitution  and wage developments 

As  highlighted  above,  in the  Community  substitution  of  labour  by  capital  explains  about 

half  the  growth  in  labour  productivity. 

In  the  United  States,  which  has  had  an  only 

slightly weaker  pace  of technological  progress,  nearly  no macroeconomic  substitution  has 

taken  place.  The  question  therefore  arises  of  whether  it  is  possible  to  slow  down  this 
substitution process without  impairing  competitiveness. 

A first answer to  this  question  is provided  by developments  in relative factor  prices  at the 
macroeconomic  level.  Following  excessive  wage  increases  in  the  wake  of  the  two  oil 
price  shocks,  which  laid  the  ground  for  the  upsurge  in  unemployment,  macroeconomic 
wage behaviour  in the Community  has become increasingly  appropriate.  Since  1982, with 
the  exception  of  1990-92,  the  trend  in  total  wage  costs  (including  social  security 
contributions)  per  head  has  kept  in  line  with  the  fall  in  inflation.  The  growth  of  unit 
labour  costs  has  remained  below  increases  in the  GDP  price  deflator  and  the  rise  in  real 

52 

wages  has  stayed  about  1  percentage  point  behind  overall  labour  productivity  growth 

(Graph  20).  This  evolution  has  led  to  a remarkable  improvement  in  the  profitability  of 

capital  (see  Graph  9  in  Chapter  1)  and  constitutes  a  solid  foundation  for  higher, 

investment-driven  economic  growth  as  demand  prospects  brighten.  As  a  consequence, 

appropriate  macroeconomic  wage  developments  are  important  to  reduce  unemployment 

through  investment-supported  growth  (in line with  the macroeconomic  part  of the  Broad 

Economic  Policy  Guidelines).  However,  econometric  analyses  suggest  that  favourable 

aggregate  wage  trends  slow  down  the  macroeconomic  substitution  of  labour  by  capital 

only very gradually. 

Graph  20  Wage developments - EUR 

(annual change) 

62  64  66!  68  70  72  74  76  78: 80  82  84  86  88  90  92  94  96  98 

Real compensation  per employee, 
GDP deflator 

T r e ( 1d  | a b o u (. 
productivity (avg  61-73) 

62:  64  66  68  70  72  74:  76  78:  80:  82  84  86  88  90  92  34;  96  98 

62  64  66  68  70  72  74  76  78  80  82  84  86  88  90  92  94  96  98 

Source:  Commission  services. 

A  faster  way  to  weaken  the 

substitution  process 

is  a 

downward  widening  of  the 

wage 

(cost)  scale. 

The 

market  forces  acting  in  this 

direction  are  strong  and  will 

probably 

strengthen  as  a 

result 

of 

globalisation, 

especially  with  the  opening 

up  of  the  CCEEs  and  the 

Former  Soviet  Union.  In  the 

case  of  a  very  dispersed 

wage 

structure, 

economic 

growth 

becomes 

more 

employment-creating 

because 

the  wide  wage 

spread  enables  activities  with 

low  productivity  to  remain 

and/or to become viable. 

53 

During  the  1970s  and  1980s,  in 

the  United  States  the  wage  scale 

Graph 21  Trends in earnings  dispersion 

for  male  workers  underwent  a 

downward  widening  of more than 
30  per  cent12.  This  means  that 
the  relatively  small  increase  in 

average  real  wages  observed  in 

the  United  States  (annual  average 
rate  of  growth  of  around  lA  per 
cent  during  the  period  1974-90) 

was  accompanied  by  a  dramatic 

fall  in real wages  at  the lower end 

of the earnings  distribution.  It can 

be argued  that  the large degree of 

wage  dispersion 

in  the  United 

States  has  been  the  price  to  pay 

for  high  employment. 

The 

downward  wage  flexibility  has 

ensured  a  closer  match  between 

relative  wages  and  the  widening 

{men.OWOD 

1979 

1983 

1987 

1991 

1995 

Change between 1979*  and 1995** 

ratios of the upper and lower deciles of the 
earnings dispersion, relative to the mean 

_ __ 

ES3D1  BSD9 

20 

15 

10 

::;'5: 

o 

::.5; 

-io: 

-15 

France 

Germany 

Italy 

Japan 

UK 

USA 

* Germany  1983 = 100, 
** Data for Italy available  until  1992, France 1994, Germany 1993, 

Japan 1994. 
Source:  OECD. 

of 

labour  productivity  differentials 

(resulting 

from 

technological  progress  and 

globalisation). 

Although  this  tendency  may  have  tended  to  weaken  somewhat  in  the  United  States  in 

recent  years,  the  wage  distribution  remains  very  wide  and  continues  to  influence  the 

employment-intensity  of  output  growth  positively.  Furthermore,  the  United  States  is 

implementing  policies  aimed  at  more  investment,  higher  productivity  growth  and  higher 

wages for the unskilled.  In this context,  evidence suggests that the bulk of the jobs which 

have been  created  in recent  years  in the  United  States  are not  low-paid,  low-quality jobs 

but  rather  they have been  concentrated  in highly  skilled  activities.  Indeed,  68  per  cent  of 
the  net  growth  in  full-time  employment  between  1994-96  was  found  in job  categories 
paying above-median wages13. 

12  See  BURTLESS,  G.  (1993),  "The  contribution  of  employment  and  hours  changes  to  family  income 

inequality", American  Economic Review,  Papers and Proceedings,  Vol. 83, n° 2, pp.  131-135. 

13  US  Council  of  Economic  Advisers  (1996),  "Job creation  and  employment  opportunities:  The  United 

States  labour market,  1993-96 ". 

54 

Conversely, 

in  the  Community, 

the  earnings  distribution  either  remained  broadly 

unchanged  or widened  only  slightly  despite the  changes  in the  pattern  of  labour  demand. 

The  exceptions  to  this  general  situation  have  been  the  United  Kingdom  and,  to  a  lesser 

extent,  Italy  since  1991  (see  also Box  3). A major  explanation  for  the  discrepancy  in  the 

degree  of  earnings  inequality  between  the  United  States  and  the  Community  are 

differences  in  labour  market  institutions.  These  differences  reside  essentially  in  a  much 

greater  reliance  on  market  forces  in  the  United  States  than  in  the  Community.  For 

example,  compared  with  the  Community,  minimum  wages  are  low  and  unemployment 

benefits  and  other  social transfers  are markedly less generous  in the United  States.  Other 

differences  are  less  widespread  collective  wage  bargaining,  a  smaller  proportion  of 

government  employment  and  less  support  for  education  and  job  training  in  the  United 

States than in the Community. 

For  social  and  political  reasons,  an  emulation  of  the  US-approach  is  neither  feasible  nor 

desirable  in the  Community  as  it  would  mean  a  dramatic  change  in  the  European  social 

model.  For  instance,  the application  of the US model  to  the  Community  would  require  a 

substantial  lowering  of  unemployment  compensation  and  social  benefits.  This  would 

ceteris  paribus  imply  a  widening  of  the  wage  structure  and  generate  greater  income 

inequality.  It would  introduce in the Community the working poor  syndrome —  a form  of 

exclusion just  as harmful  for  the social fabric as unemployment. 

The  above  considerations  do  not  mean,  however,  that  some  relief  should  not  be  sought 

through  pragmatic  solutions,  in  line  with  the  strategy  adopted  by  the  Essen  European 

Council  aiming  at  a higher  employment-intensity  of  growth.  In  particular,  the  following 

principles  are worth pursuing in this context.  The wage  agreements  of the  social  partners 

should  provide  for  more  differentiation  according  to  qualifications,  between  regions  and, 

to  some extent,  sectors.  Non-wage labour  costs (or income taxes)  at the lower  end  of the 

wage  scale  should  be lowered with the government  revenue  losses being  compensated  for 

by a stricter  control  of increases  in overall government  spending  and/or  increases  in other 

taxes  (e.g.  environmental  levies).  In  a  similar  vein,  temporary  entry-wages  for  the  low-
skilled,  youth  or  long-term  unemployed  could  usefully  be  introduced.  Such  measures 
should  be carefully  targeted  and gradually  phased  out.  Furthermore,  a higher flexibility of 
working  time  arrangements,  tailored  to  the  specific  needs  of firms and  workers,  greater 
use  of  voluntary  part-time  work  and  the  promotion  of  local  employment  initiatives  are 
likely to foster  both new jobs and higher participation  in the labour  market. 

Hence,  the  solution  to  the  Community's  unemployment  problem  must  primarily  be  found 

through  high economic growth,  structural  reforms  and microeconomic  flexibility. 

55 

2.5  Policy  implications 

Since  the  early  1960s,  unemployment  in  the  Community  has  risen  from  around  2lA  per 
cent  of  the  civilian  labour  force  to  about  11  per  cent  at  present.  During  this  period, 

employment  has grown  at  an average annual rate  of barely  0.3  per  cent whereas  both  the 

activity  rate  and  the  employment  ratio  have  been  on  a  downward  trend.  The  result  has 

been  that  the  Community  presently  displays  a  large  reserve  of  unused  labour.  As 

discussed  above,  there  is  little  evidence  to  suggest  that  the  Community's  dismal  labour 

market  performance  is  closely  related  to  technological  progress,  globalisation  and 

competitiveness. 

Nevertheless,  the  inherent  consequences  of technological  advances  and  globalisation,  viz 

fierce  world-wide  competition  and  far-reaching  sectoral  change,  underscore  the  urgent 

need  to  implement  measures  to  enhance  competitiveness  on  the  one  hand  and  to 

modernise  product  and  labour  markets  on  the  other.  The  policy  requirements  are  those 

already presented  in the White Paper  on  "Growth,  competitiveness  and  employment"  and 
in  successive  Broad  Economic  Policy  Guidelines  adopted  since  1993.  Recognizing  this 

urgency,  Member  States  have  introduced,  sometimes  bold,  reform  programmes  aimed  at 

responding  positively  to  the  key  structural  challenges  confronting  their  economies. 

Efforts  should  continue  and  be  stepped  up,  especially  in those  areas  where  progress  has 

been less visible or lacking. 

In  order  to  safeguard  and  promote  the  EC's  competitiveness  and  employment  in  a world 

of free  trade  and  evolving  technological  change it is essential that  Member  States  and  the 

Community,  in  line  with  the  Broad  Guidelines  for  Economic  Policies,  intensify  their 

efforts  to  modernise  their  markets for  goods  and  services.  This involves in the first place 

the  full  completion  of  the  European  Single  Market,  the  importance  of  which  has  clearly 
been  highlighted  in  the  Commission's  recent  evaluation14.  According  to  this  study,  the 
Single Market  Programme has so far  contributed  to  a rise in the level of GDP  of up to  1.5 

per  cent  and  created  up to  900 000 jobs  due to  increased  trade  and  competition.  Further 

action  is needed  to  complete  the legal framework  in  areas  such  as taxation  and  company 

law and the liberalisation  of the telecom and energy markets.  Even more importantly,  it is 

necessary  to  ensure  the  effective  application  and  enforcement  of existing  Community  law 

and  reduce  the  burden  of  over-regulation,  particularly  but  not  exclusively  at  the  national 

level,  which  still  impedes  the  operation  of  the  single  market.  The  creation  of  a  flexible 

14  European  Commission,  (1996),  "The  impact  and  effectiveness  of  the  Single  Market",  COM(96)  520 

final. 

56 

economy  also  needs  enhanced  structural  reforms  in  other  important  areas,  including  the 

realisation of the transeuropean  transport  and communication  networks,  the promotion  of 

research  and  development,  the  promotion  of the  information  society  and  the  removal  of 

barriers to  entry and  excessive regulation facing  SME's.  These policies will all  strengthen 

endogenous  growth  and  lead  to  strong  improvements  in  the  overall  productivity  of  the 

Community  economy.  Provided  the  appropriate  policy  framework  is put  in  place,  there 

need  not  be  any  contradiction  between  sustained,  investment-supported  growth  and  the 

preservation of a healthy environment  (see Box 4). 

As  emphasised  in  the  1996  Joint  Employment  Report  from  the  Council  and  the 

Commission  "Employment  and  growth  in the  Community  -  The way  forward"  approved 

by  the  Dublin  European  Council,  there  is  a  continued  need  to  further  improve  the 

responsiveness  of  Member  States'  labour  markets  to  changes  in  the  economy  through  a 

modernisation  of  the  organisation  of  work,  increased  geographical  and  professional 

mobility and productivity-related  labour cost differentiation.  In particular,  it is essential  to 

reinforce  education  and  training  so  that  the  skills  of  the  workforce  are  able  to  adapt  to 

evolving  technological  and  other  changes.  These  efforts  are  also  necessary  in  order  to 

avoid  labour  market  bottlenecks  and  a  resumption  of  wage  inflation  as  unemployment 

comes  down.  Furthermore, pragmatic  solutions to  increase  the  labour-content  of  growth 

(see sub-section  2.4.2)  should  be pursued  actively.  They not  only contribute  to  increased 

employment  but they also help to cushion the painful  adjustment  efforts. 

15  See "The  composition  of unemployment  from  an  economic  perspective",  European  Economy,  n°  59, 
1995 and "Grown,  employment  and employment-intensive  growth", European  Economy,  n° 62,  1996. 

57 

Box 2: The impact and effectiveness  of the Single Market 

-  the 1996 Review 

The  Single  Market  Programme  (SMP)  is  the  most  ambitious  and  comprehensive  supply-side 
programme ever launched.  It aimed to remove  all remaining  non-tariff  barriers to trade  between 
EC Member States.  The Commission's recent evaluation -  The Impact and Effectiveness  of the 
Single  Market  Programme  (COM(96)  520  final)  presented  in  October  1996  -  and  a  more 
detailed  analysis  to  be  published  in  a  forthcoming  edition  of  European  Economy  entitled 
Economic  Evaluation  of the Internal Market1  offer some  economic  evidence  of the impact  of the 
Single  Market  so  far. 
It  concludes  that  there  have  clearly  been  positive  effects  on  the 
Community  economy,  especially  in the  manufacturing  sectors.  Problems  remain  to  be tackled, 
and vigilance  is  still  essential  to  guard  against  any  refragmentation  of  the  Community  market, 
but the Single Market  is undoubtedly  becoming a reality. 

The positive effects of the Single  Market fall into three main areas: 

•  changes  in  trade  and  foreign  direct  investment  flows;  according  to  theory,  removing 
trade  barriers  between  countries  would  expand  trade  between  Member  States  and  replace 
less  efficient  domestic  production  with  imports  produced  more  efficiently,  thereby  improving 
welfare.  The  SMP  may  also  lead  either to greater  Member  State  specialisation  on the  basis 
of comparative  advantage,  increasing inter-industrial trade  between  Member  States, or to the 
exploitation  of scale  economies,  imperfect  competition  and product  differentiation,  increasing 
intra-industry  trade  (i.e., the  simultaneous  import  and export  of  similar  product  lines, such as 
cars for  cars).  The  former  carries  efficiency  gains  as  Member  States  specialise  in  activities 
where they  are  relatively  more  efficient,  and consumers  benefit  from  lower  prices,  but it  can 
also  be  accompanied  by  painful  industrial  restructuring.  By  contrast,  intra-industry  trade 
offers  the  consumer  a  wider  variety  of  products,  and  producers  lower  adjustment  costs. 
Meanwhile,  by  changing the  attractiveness  of the  EC  relative  to  other  sites  around the  world 
as a location  for  multinationals'  production  facilities, the  SMP was  also  expected to  have  an 
impact  on foreign direct  investment  flows (FDI); 

•  changes  in  Member  States'  production  structures,  levels  of  competition  and  the 
consequent  impact  on  prices;  it  was  expected  that  many  of  the  beneficial  effects  of  the 
SMP  on  the  Community  economy  would  result  from  competitive  forces  unleashed  by 
integration, stimulating  greater  efficiency,  with  lower costs  and  prices,  and  increased  product 
variety.  Driving  these  forces were  expected  to  be  the  exploitation  of  scale  economies  and 
increased  competition.  As  a  result,  inefficient  firms  would  be  eliminated  and  industry 
restructured.  Greater  competition  would  also  ensure  that  lower  production  costs  resulting 
from efficiency  gains would translate into lower consumption prices. 

•  changes  in  EC  total  factor  productivity,  growth,  employment  and  convergence; 

the 
SMP  can be  expected  to  have  a  positive  impact  on the  accumulation  of  production  factors, 
leading  to  higher  growth  rates  in the  EC.  First  of  all, the static,  efficiency  gains of  the  SMP 
translate  into  higher  incomes,  which  may  generate  investment  and  raise  growth  in  the 
medium-term.  Secondly,  the  SMP  could  improve  the  benefits  and  reduce  the  costs  of 
producing innovations in the EC, boosting growth in the long run. 

1... 

Changes  in trade and foreign  direct investment flows 

Analysis  estimates  that  the  SMP  impact  of  lifting  trade  barriers  has  increased  trade  volumes 
between  Member  States  of  manufacturing  products  by 20-30%.  Moreover,  from  1985  to  1995, 
the share  of intra-EC  imports  in total  manufacturing  imports  increased  by 6.7  percentage  points 
from  61.2% in  1985 to  67.9% in  1995.  For services during  the  same  period, the  share  of  intra-
EC  imports  in total  imports  of  services  increased  3.1  percentage  points from  46.9%  in  1985 to 
50.0%  in  1995.  Such  increases  in trade  amongst  Member  States  have  not,  however,  come  at 
the  expense  of trade with third  countries -  extra-EC  manufacturing  imports  have  increased  their 
share  of  consumption  over the  period  1980-93 from  12 to  14%, and  it  is estimated that  70%  of 
this increase is down to the SMP. 

1  Economic  Evaluation  of  the  Internal  Market,  European  Economy  -  Reports  and  Studies,  1997, 

Office  for Official  Publications of the European Communities,  Luxembourg. 

58 

At the beginning of the  1980s, intra-Community  trade  could  be classified  as mainly  inter-industry 
(around  45%  of  total  manufacturing  trade)  corresponding  to  specialisation  based  on  Member 
States' comparative  advantages.  Due to the SMPr this started to decline  in the  mid-1980s whilst 
the  share  of  intra-industry  trade  rose.  However,  intra-industry  trade  can  be  further  sub-
differentiated:  either  as trade  in similar  products in terms  of  both  prices  and quality,  or  in  trade 
in  products  differentiated  by  price  and  quality  (e.g.,  one  country  exporting  brand-name 
expensive  shirts  and  the  other  inexpensive  low  quality  shirts).  The  rise  in  intra-industry  trade 
has predominantly  been the  latter type (from  less than  35% of total  manufacturing  trade  in  1985 
to  more than  42% in  1994), whilst  the  former  type  has  remained  broadly  stable  (around 20%  of 
total  intra-EC  manufacturing  trade). 
In  other  words,  Member  States'  production  structures 
appear  to  be  converging  as  a  result  of  specialising  in  increasingly  similar  sectors  but  different 
price-quality  niches.  This facilitates the move to EMU. 

Meanwhile, the  SMP  impact  on  FDI seems to  have  been even  more  positive  than  its  impact  on 
trade.  The  EC  absorbed 44.4%  of FDI inflows from all countries  in the world  at the  beginning  of 
the  'nineties,  compared  to 28.2% in the  period  1982-87.  Between  1984  and  1992,  intra-EC  FDI 
increased four times faster than  intra-EC trade. 

2. 

Changes  in  Member  States'  production  structures,  levels  of  competition  and  the 
consequent  impact on  prices 

Industrial  restructuring  inside  the  EC  has  been  characterised  by  an  explosion  in  the  number  of 
mergers  and  acquisitions  (M&A).  This  growth  has  been  particularly  strong  in  cross-border 
activity,  although the  bulk  of  M&A  operations  have  remained  domestic  (over  70% of  operations 
for  the  EC-15  between  1990  and  1995),  indicating  that  restructuring  is  taking  place,  at  least 
initially, through changes to domestic  market structures. Between  1988 and  1992,  manufacturing 
was the  more  active target  for  M&As.  Latterly, services  have taken the  lead, in  accordance  with 
the  delayed  introduction  of  SMP  measures  in  these  sectors.  This  has  led  to  greater  industrial 
concentration  at  the  EC  level  (but  not  at  the  Member  State  level).  Many  industries  have 
five  percentage  points,  especially 
experienced 
technologically  intensive industries. 

in  concentration  exceeding 

increases 

Such  increases  in  concentration  could  result  in  reduced  economic  welfare  were  it  to  stifle 
competition.  The  promotion  of  an  active  competition  policy  is therefore  particularly  important. 
However,  evidence  on  price  cost  margins  and  business  perceptions  seems  to  indicate  that  the 
efficiency  gains  associated  with  large  size  have  been  passed  on  to  consumers  thanks  to 
increased competition.  The  key to this seems to be the intensification  of cross-border trade. 

3. 

Changes  in  EC total factor  productivity,  growth, employment  and  convergence 

Community  income  in  1994 is estimated to have been 1.1  to  1.5  percentage  points higher than  it 
would  have  been  in  the  absence  of  the  Single  Market.  Outlying  Member  States  have,  in 
general,  benefited  most  from this  improvement.  In other words, there  has been  convergence  of 
Member  States'  real  per  capita  income  levels.  Levels  of  employment  are  also  higher  with 
somewhere  between  300,000  and  900,000  extra jobs  created  thanks to  the  SMP,  although  the 
effect  has  been  overshadowed  by  unfavourable  economic  conditions  unconnected  with  the 
Single  Market.  The  significant  growth  in the  Structural  Funds corroborated  the  growth  impact  of 
the SMP. 

To  arrive  at  these  conclusion,  the  Economic  Evaluation  of  the  Internal  Market  distills  the 
economic  findings  of  almost  40  studies  carried  out  for  the  1996  Single  Market  Review  -  a  two 
year  long  major  Commission  research  project  on  the  SMP  launched  in  response  to  a  request 
from  the  Council  at  the  end  of  1992.  Around  half  the  studies  were  devoted  to  analysing 
developments  in  some  relevant  manufacturing  and  service  sectors  (i.e.,  sectors  where  the 
Community  market  in  1985  was  highly  fragmented  by  those  significant  non-tariff  trade  barriers 
targeted  for  elimination  in  the  Single  Market  Programme),  the  other  half  to  horizontal  issues 
(e.g., the development  of  prices  around the Community  thanks to the  Single  Market,  progress  in 
eliminating  the  most  important  non-tariff  barriers,  and  the  impact  on  trade  both  within  the 
Community  and  with  third  countries,  amongst  others).  Most  of  the  studies  were  carried  out  by 
independent  consultants,  each  one  supervised  by  an  evaluation  committee  made  up  of 
Commission  Services.  To  complement  the  essentially  quality  control  role  of  the  evaluation 
committees  and  to  enhance  the  objectivity  of  the  studies,  an  advisory  panel  of  independent 
academic  experts  from  around  the  Community  was  constituted.  These  experts  also  played  a 
key advisory  role during the drafting  of the Economic Evaluation of the Internal Market. 

59 

Box  3:  Wage  dispersion 

in  the  Community 

in  1994 

The  new  EC  Household  Panel-94  survey  provides  a good  opportunity  to  get  a  recent  and  fairly 
detailed  picture  of  the  dispersion  of  gross  wages  in the  EU.  Table  B3.1  presents  data  on  the 
distribution of gross earnings for full-time workers in 1994. By surveying these measures of wage 
inequality, some  major conclusions seem to emerge: 

• 

• 

• 

overall wage disparity  is  markedly  high  in  E, F,  L, A,  UK  and, especially,  IRL and  P,  which 
are  well  above  the  Community  average.  The  presence  in  this  group  of  countries  with  high 
and  low employment  growth  seems to suggest that  at the  macroeconomic  level, the  degree 
of wage dispersion  is only one, albeit  important, factor explaining employment growth. 

relatively  wide  disparity  affects  both  the  higher  and  lower  wage  deciles  for  the  same 
countries  except  for  P  and  F,  where  the  lower  half  of  the  earnings  scale  appears  to  be 
relatively  compressed  (most  likely,  because  of  the  incidence  of  relatively  high  wage 
minima). 

the  distribution  of  gross  wages  is  markedly  compressed  in  B,  DK,  I,  NL,  FIN  and  S,  in 
particular  as regards the  lower wages  in the case  of  B,  DK  and S. A  greater  homogeneity  of 
the economic structure of these countries, alongside with  historical and social  reasons,  helps 
in explaining the  narrower wage  hierarchy. 

Table B3.1. 

Wage  dispersion  in  the  EC 

ECHP 

OECD(96) 

ECHP 

OECD  (96) 

ECHP 

OECD  (96) 

Overall 
Dispersion 
(D9/D1) 

Overall 
Dispersion 
(D9/D1)  (3) 

Upper-Half 
Dispersion 
(D9/D5) 

Upper-Half 
Dispersion 
(D9/D5) 

Lower-Half 
Dispersion 
(D5/D1) 

Lower-Half 
Dispersion 
(D5/D1) 

B 
DK 
DO) 
GR 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 

EUR12 

US 

2.42 
2.10 
2.95 

2.50 
3.64 
3.20 

4.18 
2.13 
3.38 

2.33 
n.a. 
4.20 

n.a. 
n.a. 
3.73 

3.05 

n.a. 

2.25 
2.17 
2.32 

n.a. 
n.a. 
3.28 

n.a. 
2.80 
n.a. 

2.59 
3.66 
.  4.05 

2.38 
2.13 
3.38 

n.a. 

4.39 

1.64 
1.53 
1.76 

1.60 
2.04 
1.98 

2.00 
1.52 
1.94 

1.62 
n.a. 
2.63 

n.a. 
n.a. 
1.94 

1.83 

n.a. 

1.57 
1.57 
1.61 

n.a. 
n.a. 
1.99 

n.a. 
1.60 
n.a. 

1.66 
1.82 
2.47 

1.70 
1.59 
1.87 

n.a. 

2.10 

1.47 
1.37 
1.68 

1.56 
1.78 
1.62 

2.08 
1.40 
1.74 

1.44 
n.a. 
1.60 

n.a. 
n.a. 
1.92 

1.66 

n.a. 

1.43 
1.38 
1.44 

n.a. 
n.a. 
1.65 

n.a. 
1.75 
n.a. 

1.56 
2.01 
1.64 

1.40 
1.34 
1.81 

n.a. 

2.09 

Key: (1 )  OECD data referring  to Western Germany only. 
(2)  Average 5 yearly change of the decile ratios D9/D5 and D5/D1 respectively, since 1989. 
(3)  (D9/D1)  =  (D9/D5)*(D5/D1) 
Note:  Based on (provisional) data of the ECHP-94, the earnings dispersion have been calculated on 

normal gross monthly earnings (for NL : net monthly earnings) for full-time employees. Figures are ratios 
of upper/lower  deciles in the distribution of earnings. The ratios for EU12 have been calculated as the 
sum of the dispersion rates for each Member States, weighted with the respective share in total 
employment  (from Labour Force Survey 1994). 

Source:  Commission  services  and  OECD. 

60 

Box 4:  Economie growth  and the environment 

Would  sustained  economic  growth  automatically  lead to  increased  environmental  degradation? 
Empirical  work  indicates  that  there  is  no  linear  relationship  between  economic  growth  and  its 
impact on the environment. Although  an increase in the production of goods and services  would 
a  priori  lead  to  an  increase  in  resource  use  and  in  pollution,  countervailing  forces  - 
like 
technological  progress, structural change, and increasing  preferences for a clean environment  -
frequently  compensate  for this  increase.  Economic  growth  necessitates  investment  and,  if  an 
adequate  environmental  policy  framework  is  put  in  place,  the  new  capital  stock  will  be 
characterised  by  higher  resource  efficiency  and  cleaner  technologies.  Under  the  same 
conditions,  growth  will  facilitate  structural  change  implying  a  gradual  phasing-out  of  traditional 
polluting heavy industries and an increase in more environmentally-friendly  service activities. 

Hence, the often  perceived trade-off  (including a high  level  of employment)  between  economic 
growth and environmental  protection does not have to be accepted  as unavoidable.  Moreover,  it 
should  not  be forgotten that  GDP as traditionally  measured  largely  ignores  the  economic  costs 
of  environmental  depletion  and  pollution.  Policy  makers  have  a  number  of  concepts  and 
instruments  at  hand  that  allow  the  integration  of  both  concerns.  There  are  even  convincing 
indications  that  economic  growth  and  sound  environmental  policy  making  are  mutually 
supportive.  In  any  case,  an  economy  cannot  remain  prosperous  in  the  long  run  if  it  has  run 
down  its  natural  environment  and  resource  base.  However,  it  has  to  be  underlined  that  a 
decoupling  of  economic  growth  from  rising  environmental  pressures  can  only  be  achieved  if 
environmentally  effective  and economically efficient  policy actions are taken, i.e.  an appropriate 
environmental  policy  framework is established. 

Elements  of an appropriate  policy framework  are  (1)  providing  economic  actors with the  right 
price  signals  for  environmentally  sustainable  behaviour,  (2)  designing  environmental  policy 
measures  in  the  most  cost-effective  way  possible  taking  into  account  local  environmental 
conditions  and the  likely  impact  on the functioning  of the  Single  Market,  (3)  seeking  to  integrate 
environmental  objectives  into other policies. 

By  providing  the  appropriate  price  signals,  i.e.  by  internalising  environmental  costs  into 
market  prices,  market-based  policy  instruments  such  as  environmental  taxes  or  tradable 
emission  permits  have  a  number  of  advantages  over  traditional  regulatory  policies.  For 
instance, they  give  a permanent  economic  incentive for  reducing  pressures  on the  environment 
and hence push for innovative  and cost-effective  long-run solutions. They also tend to  compress 
the  costs of policy  measures  by simultaneously  exploiting  several  channels for  reducing  a given 
environmental  problem.  For  example,  a  carbon  tax  to  limit  global  warming  reaches  emission 
reductions  on  functioning  markets  by  providing  incentives  for  improvements  in  equipment 
energy  efficiency,  behavioural  changes  (e.g. driving  a car  less  often),  and favourable  structural 
change  (e.g. towards  'clean' sectors  of the  economy).  However,  introducing  price  signals  for 
environmental  protection makes little  sense  if existing  prices are  distorted,  e.g. if  existing 
taxes or tax provisions and subsidies  produce unintended and unwanted environmental  effects. 

In the  Report  on the  Development  of Tax  Systems - Taxation  in the  European  Union  (COM(96) 
546)  presented  in  October  1996,  the  European  Commission  laid  down  its  views  on  future 
environmental  taxation  in  the  Union.  The  documents  highlights  the  necessity  for  national 
environmental  tax  schemes  to  be  well  designed  and  compatible  with  the  functioning  of  the 
Single  Market.  It also  identifies  energy taxation as a domain  of  Community  action which  has  an 
important  bearing  on  C02  emission  limitation.  Consequently,  the  Commission  is  preparing  new 
proposals  for  a future  EU system  of  energy taxation.  It  aims  at  further  harmonisation  of  energy 
excise  rates  as  well  as  exploring  how  Member  States  can  integrate  environmental  objectives 
into  their  energy  taxation  schemes.  In the  transport  field,  the  Commission  proposed  a  Council 
Directive  in  July  1996  on  the  charging  of  heavy  goods  vehicles  for  the  use  of  certain 
infrastructures  (COM(96)  331). An  important  objective  of the  legislative  proposal  is to  provide  a 
harmonised  framework  for  Member  States  to  better  ensure  recovery  of  costs  associated  with 
road  use,  including  externalities,  and  to  allow  for  greater  differentiation  in  charges  in  line  with 
costs. 

61 

Designing  cost-effective  environmental  policy  approaches  is  a  major  prerequisite  for 
making  environmental  protection  economically  sustainable.  The  aim  must  be  to  provide 
environmental  policy  improvements  at  least  cost  to  society.  This  can  be  done  by  using  a 
thorough  economic  evaluation  of  the  policy  design,  for  instance  by  applying  cost-benefit 
analyses  or cost-effectiveness  analyses. A  recent  example  of  such  ex-ante  policy  evaluation  is 
the  Community  Auto-Oil  Programme  -  a  collaborative  exercise  with  the  industry  concerned  -
which was completed  in June  1996. This programme  prepared a strategy  for the  control  of  road 
transport  emissions  mainly  focusing  on  emission  standards  for  passenger  cars  and  quality 
standards  for  petrol  and  diesel  fuels  (COM(96)  248  final).  Prior  to  defining  the  strategy,  an 
extensive  cost-effectiveness  analysis  considering  technical  and  non-technical  measures  was 
carried out. 

Broadening  the  range  of  instruments  in  order  to  respond  to  local  environmental  conditions 
and at the same time  foster  a smooth functioning  of the  Single  Market  often  increases the  cost-
effectiveness  of  environmental  policies.  Clarifying  the  legal  and  institutional  framework  for 
policy  mixes  at  national  level  is  a  prime  area  of  Community  action.  For  instance,  in  its 
Communication  on Environmental Agreements  (COM(96) 561)  the Commission  discusses  a set 
of  guidelines  for  an  environmentally  effective  application  of  voluntary  policy  approaches.  A 
similar  Communication  on  environmental  taxes  and  charges  in  the  Single  Market  is  currently 
being prepared. 

The  integration  of  environmental  policy  concerns  into  other  policy  areas  would  allow  the 
existing  potential  to  improve  economic  efficiency  to  be  tapped  and  this  would  improve  the 
economic  and  environmental  performance  of  the  European  economy  simultaneously.  For 
instance,  a  number  of  Member  States  are  currently  exploring  the  possibilities  of  reaping 
synergies  in  the  field  of  ecological  tax  reforms  and  employment  policies.  In  some 
countries  such  as  Denmark^  the  Netherlands,  Belgium  and  Sweden  so  called  'Green  Tax 
Commissions' have  been set up to assess, to implement  and to monitor such tax  reforms. 

An  important  potential  for  synergies  from  policy  integration  exists  in  industry.  In  the  1996 
Competitiveness  Report  (SEC(96)  2121), a Working  Document  of the Commission  services, it is 
stressed  that  sound  environmental  policies  can  open  up  business  opportunities  by  enhancing 
economic  efficiency  and  innovation. The  report  identifies  a significant  efficiency  potential  which 
could  be tapped, for  instance,  in water  and energy  use. "Greening" of industry  and the  provision 
of environmental  goods  and services  are associated with  an expanding  employment  trend.  Firm 
but  economically  sound  environmental  policies  can  provide  the  incentives  for  the  supply  of 
competitive  and  innovative  environmental  technologies  and create  a corresponding  demand  for 
such  technologies  on  markets.  Table  B4.1. illustrates  the  magnitude  of  employment  related  to 
environmental protection  in Germany  in 1994 compared to 1990. 

Table  B4.1. 

Estimation  of  employment  effects  through  environmental  protection  in  Germany 
1990 and  1994 
1990(1) 
in  1000 

1 9 9 4 ( 2) 
in  1000 

1990(1) 
In % of total civilian 
employment 
0.9 

1 9 9 4 ( 2) 
in % of total civilian 
employment 
1.5 

Environmental  protection  activities  (e.g. 
nature  conservation,  water  purification) 
Provision  of  environmental  goods  and 
services 
-  direct 
-  indirect 

Total 

255 

341 

203 
137 

597 

1.2 

0.7 
0.5 

2.1 

508 

448 

256 
192 

956 

1.3 

0.7 
0.6 

2.8 

(1)  West  Germany 
(2)  United  Germany 
Note: The  figures  have  to  be  interpreted  with  caution.  Especially  the  1994 employment  figures  may  be dominated  by  the 
impact  of  German  unification.  Furthermore, the definition of the "environmental  protection  sector"  used  in the  underlying 
IFO survey does not correspond to the OECD/Eurostat definition. 

Sources: 

Ifo  Schnelldienst  28/1996  and  Commission  services. 

62 

3.  CONSOLIDATING  AND RESHAPING  PUBLIC  FINANCES  IN THE  COMMUNITY 

A  determined  correction  of  existing  fiscal  imbalances  is an  indispensable  macroeconomic 

and  structural  requirement  for  virtually  all  Member  States  today.  This  correction  is 

required  to  provide  the  conditions  for  a  strong  and  durable  expansion  of  investment, 

output  and  employment  over  the  short  and  medium  term;  to  reduce  the  burden  of 

government  indebtedness  and  debt-servicing;  and  to  ensure  that  budgetary  policies  can 

regain  their  flexibility  in  response  to  cyclical  fluctuations  without  causing  a  continued 

escalation of government  debt.  Furthermore,  the  objective  of achieving fiscal  discipline is 

embedded  in  the  wider  aim  of  reducing  the  share  of  public  finances  in  the  economy,  of 

creating  an  environment  more  conducive  to  business  activity,  and  of  improving 

competitiveness  against  the  backdrop  of  increased  globalisation.  Finally,  and  equally 

importantly,  it is necessary  to  ensure  a successful  transition to,  and the lasting  success  of, 

EMU. 

In  recent  years,  most  Member  States  have  made  progress  in  reducing  the  budgetary 

imbalances  that  had  built  up  over  the  two  decades  following  the  first  oil  price  shock. 

However,  more  is  clearly  needed.  While  budgetary  consolidation  measures  need  to  be 

adapted  to  country-specific  circumstances  in terms  of their  extent,  timing  and  design,  the 

main  guiding  principles  have  been  stipulated  in  successive  Broad  Economic  Policy 

Guidelines, including the  1996 Recommendation: 

•  giving  prominence  to  expenditure  restraint  as  opposed  to  further  increases  in  the 

overall tax burden; 

•  shifting  government  spending  priorities  towards  productive  activities  such  as 

investment  in infrastructure,  human capital and active labour market initiatives; 

• 

improving the efficiency  of public services; 

•  reducing  the  overall  tax  burden,  especially  that  on  labour,  but  conditional  upon  firstly 

placing the budget  deficit  on a firm downward  path. 

By  basing  their  consolidation  programmes  on  these  principles,  Member  States  will 

simultaneously  ensure budgetary  discipline and reap large efficiency  and employment gains 

through  the  control  and  rationalisation  of government  expenditures  and  the reduction  and 

shifting  of  the  tax  burden.  The  process  of  fiscal  consolidation  provides  a  valuable 

opportunity  for  Member  States  to  scrutinise  the  design  and  structure  of  their  respective 

expenditure programmes and taxation systems. 

63 

3.1  Long-term  trends in public finances  in the  Community 

The  current  large  fiscal  imbalances  in  the  Community  are  the  result  of  certain  long-term 

trends in spending and taxation which have to a large extent been common to all, or nearly 

all, Member  States. 

3. J. 1  Government  spending 

Over  the  last  35  years,  the  Community  has 

witnessed  a rapid  growth  in the  share  of public 

finances in the  economy.  General  government 

expenditure,  which  represented  34  per  cent  of 

GDP  in  1961,  rose  to  above  52  per  cent  in 

Table 20 
Size of  public  finances  in  the  E C, 
US  and  J a p an 
(%ofGDP) 

1961 

1973 

1982 

1996 

1993,  before  falling  back  somewhat  in  recent 

Total  expenditure 

years.  While  the  rising  share  of  government 

common 
in  GDP  was 
expenditure 
phenomenon  in  all  industrial  countries  at  least 

a 

until the early  1980s, it was more marked  in the 

Community  than  in  its  major  trading  partners 

(see Table 20). 

Public  spending  in  the  Community  in  fact  has 

climbed  markedly  in  every  downturn  phase  in 

economic activity, while the  subsequent  periods 

of  recovery  have  failed  to  reverse  this  upward 

shift. 

EUR 
USA 
JAP 

EUR 
USA 
JAP 

EUR 
USA 
JAP 

33.6 

30.3 

17.3 

38.7 

32.9 

22.3 

49.3 

38.9 

33.6 

50.6 

36.7 

36.6 

Total  current  receipts 

34.3 

29.5 

19.7 

38.2 

33.2 

22.8 

44.3 

35.0 

30.0 

46.2 

34.6 

31.6 

Net  lending(+)/  borrowing(-) 

0.7 

-0.6 

2.4 

-0.6 

0.3 

0.5 

-5.1 

-3.9 

-3.6 

-4.4 

-2.2 

-5.0 

Source:  Commission  services. 

The  fastest-growing  spending  category  since  the  early  1960s  has  been  current  transfers, 

the  growth  of  which  has  accounted  for  more  than  half  of  the  increase  in  the  total 

government  spending ratio in the Community (see-Table 21).  At present,  current  transfers 

is the largest  spending category representing  almost one quarter  of GDP and about  half of 

total government  expenditure.  The rapid increase in current transfers  have almost  entirely 

been  due  to  rising  transfers  to  households  whereas,  as  a  proportion  of  GDP,  direct 

subsidies to  enterprises  have remained broadly stable at around  3 per cent. 

The  growth  in  household  transfers  was  essentially  due  to  the  expansion  of  three  major 

social  policy  areas:  pensions,  health  care  and  unemployment  compensation. 

The 

expansion  of the welfare  state  during  the  1960s  and  1970s,  which was  characterised  by a 

64 

broadening  of  the  coverage  of  programmes,  a widening  of  the  eligibility  criteria  and  an 

increase  in  the  levels  of benefits,  contributed  to  a  marked  increase  in  payments  in  these 

areas. 

In  addition,  demographic  and  economic  developments 

(ageing,  higher 

unemployment  as well  as rising  costs  and  a  high  income  elasticity  of  demand  for  health 

care)  have  played  an  important  role.  Since  the  mid-1980s,  growing  concerns  regarding 

the  pressures  on  government  budgets  and  labour  market  disincentives  have  led  to  a 

tightening  of transfer  schemes in many Member  States.  This has resulted  in a deceleration 

of the growth  of these expenditures  during the last  decade  but undiminished  demands  for 

welfare  services  and  the  renewed  rise  in  unemployment  in  the  -1990s  have  exerted 

continued  upward  pressure.  To  control  the  growth  of  social  transfers  in  the  future, 

policies  need  to  be  aimed  at  achieving  sustained  high  economic  growth  and  rising 

employment  and, 

in  order 

to  prepare  for  mounting  demographic  pressures,  at 

restructuring  and/or  streamlining pension, health care and unemployment  schemes. 

Table 21 

Receipts  and  expenditures  of general government  -  EURa) 
(in % of GDP) 

Levels 

Changes 

1961 

1973 

1982 

1989 

1993 

1996 

73/61 

82/73 

89/82 

93/89 

96/93 

33.6 

38.7 

49.3 

47.2 

52.4 

50.6 

5.1 

10.6 

-2.1 

5.2 

-1.8 

11.5 

16.0 

21.6 

20.7 

23.7 

23.3 

4.5 

5.6 

-0.9 

3.0 

-0.4 

Total  e x p e n d i t u re 

of  which: 

1.  Current  transfers 
Ibis,  of  which: 
Households 

2.  Actual  interest  payments 
3.  Public  consumption 
4.  Net  capital  transfers 
5.  Gross  capital  formation 

3.1 
13.7 
0.8 
4.5 

13.0 

1.7 
16.4 
0.9 
3.7 

17.9 

4.1 
19.6 
1.0 
2.9 

17.1 

4.6 
18.2 
0.9 
2.8 

19.9 

5.4 
19.6 
1.1 
2.8 

19.8 

5.4 
18.9 
0.6 
2.4 

C u r r e nt  receipts 

of  which: 

6.  Indirect  taxes 
7.  Direct  taxes 

8.  Social  security 
contributions 

34.3 

38.2 

44.3 

44.8 

46.3 

46.2 

13.9 
8.7 

10.2 

12.9 
10.7 
11.8 

13.2 
12.4 
14.7 

13.5 
13.3 
14.6 

13.6 
12.9 
16.0 

14.0 
12.8 
16.1 

4.9 
2.4 
3.2 
0.1 
-0.8 

6.1 

0.3 
1.7 
2.9 

-0.8 
0.5 
-1.4 
-0.1 
-0.1 

0.5 

0.3 
0.9 
-0.1 

2.8 
0.8 
1.4 
0.2 
0.0 

1.5 

0.1 
-0.4 

1.4 

-0.1 
0.0 
-0.7 
-0.5 
-0.4 

-0.1 

0.4 
-0.1 
0.1 

-1.4 
2.7 
0.1 
-0.8 

3.9 

-1.0 
2.0 
1.6 

9.  Other  current  receipts 

1.5 

2.8 

4.0 

3.4 

3.7 

3.4 

1.3 

1.2 

-0.6 

0.3 

-0.3 

Memory 

items 

10.  Gross  saving 
11.  Net  lending(+)/ 
borrowing(-) 

12.  Gross  public  debtb) 

6.0 
0.7 

4.1 
-0.6 

-1.0 
-5.1 

1.2 
-2.4 

-2.5 
-6.3 

-1.3 
-4.4 

-1.9 
-1.3 

-5.1 
-4.5 

2.2 
2.7 

-3.7 
-3.9 

1.2 
1.9 

65.2 

35.3 

45.6 

54.1 

66.1 

73.5 

-29.9 

10.3 

8.5 

12.0 

7.4 

a)  1961  : EUR  15  excluding  Greece,  Portugal,  Austria,  Sweden  and  Finland;  1973  : EUR  15  excluding  Luxembourg, 

Greece  and  Portugal. 

")  1973  : E UR  15  excluding  France  and  the  Netherlands. 

Source:  Commission  services. 

65 

Interest  pavments  on  outstanding  public  debt have been  another  important  component  of 

the  rise  in  government  spending.  Having  declined  to  below  2  per  cent  of  GDP  at  the 

beginning  of the  1970s,  debt  interest  payments  have  risen  rapidly  thereafter  to  reach  5.5 

per cent of GDP at present.  This strong rise reflects the interplay  of an increased  recourse 

to  borrowing  rather  than  taxation  to  finance  the  surge  in  government  expenditure,  a 

concomitant  steep  upward  trend  in  the  government  debt  to  GDP  ratio  and  high  interest 

rates.  The  rising  share  of  the  debt  service  burden  has  severely  hampered  budgetary 

flexibility  and  increased  the  vulnerability  of the  budget  to  increases  in  interest  rates.  To 

reverse this trend  it is essential to  create a stable macroeconomic framework  conducive  to 

reductions in borrowing costs. 

Public consumption  contributed  importantly  (about  6 percentage  points)  to  the  rise in the 

total  government  spending  ratio  during  the  1960s and  1970s, but  since then  its  share  has 

been  relatively  stable,  fluctuating  around  19  per  cent  of  GDP  in  the  Community  on 

average. 

In  contrast  to  other  spending  categories,  public  investment  as  a  share  of  GDP  has  been 

falling  steadily  over  the  last  35  years.  Its  present  share  of  2.5  per  cent  of  GDP  is just 

above half the level  it attained  in  1961.  While to  some extent this reflects  the  completion 

of major  infrastructure  systems,  it also reveals the  political  reality that  constraining  public 

investment  has  proved  easier  than  controlling  current  spending.  The  privatisation  of 

certain  public  utilities  may  also  have  played  a  role.  Savings  on  public  investment  may 

entail  considerable  long-term  economic  costs  since  these  expenditures  are  an  important 

contributor  to  productivity  growth  in  the  private  sector  as  is  highlighted  by  recent 
analyses on the potential benefits  of realising the Trans-European  Transport Networks16. 

3.1.2  Government  receipts 

The growth  of  public  expenditure  in the  Community  has brought  with  it  a significant  rise 

in  the  overall  tax  burden  (i.e.  the  sum  of  indirect  taxes,  direct  taxes  and  social  security 

contributions).  Over  the last  three  decades  and  a half,  government  receipts,  as  a share  of 

GDP,  have grown  by  12 percentage  points to  reach 46 per  cent  in  1996.  The bulk  of the 

rise in the government  receipts  ratio  occurred  in the  period  1960-82 while  the  tax  burden 

remained  broadly  stable  during  the  rest  of  the  1980s.  In  the  early  1990s,  a  sharp  rise  in 

expenditure  —  partly caused  by the economic downturn  — was accompanied  by a  further 

16  See 'Trans-European Networks:  1996 Annual Report", COM(96) 645  final. 

66 

increase in tax pressure.  While not  fully  successful,  widespread  government  efforts  since 

the  early  1980s  to  stabilise  or  to  reduce  the  tax  burden  reflect  various  factors.  Firstly, 

greater awareness of the distortionary and employment-dampening  effects  of high taxation 

as well  as voters'  resistance  have made  many governments  reluctant  to  introduce  further 

tax  increases.  Secondly,  both  a  flattening  of  the  tax  scales  and  the  indexation  of  tax 

systems  as well  as reduced  inflation  have  resulted  in  a reduction  in  fiscal  drag.  Thirdly, 

tax reforms,  increased  tax  competition  between  countries  and,  in some  cases,  the  growth 

in the underground  economy may also have contributed to slower tax revenue growth. 

The  growth  of the  tax  burden  has  been  accompanied  by  considerable  changes  in the  tax 

structure.  The  main  factors  contributing  to  the  overall  growth  of  government  receipts 

were  social  security  contributions  and,  to  a somewhat  lesser  extent,  direct  taxation.  The 

fall in the average employment  ratio (from  67 per cent  of working  age population in  1961 

to  59  per  cent  in  1996)  implied  a  reduction  in  the  number  of  persons  paying  taxes  and 

contributing  to  social  security  funds  while  leading  to  an  increase  in  the  number  of 

recipients.  The strong increase in social security contributions was not  sufficient  to  match 

the  upsurge  in  social  benefits.  As  a  result,  a growing  proportion  of  the  latter  had  to  be 

financed  through  other  fiscal  resources,  notably  direct  taxes. 

Indirect  taxes  remained 

almost  unchanged  as  a  proportion  of  GDP  throughout  most  of  the  period  but  in  recent 

years  there  has  been  a  tendency  to  increase  indirect  taxes  while  reducing  the  relative 

importance of other government receipts. 

The  changes  in the  structure  of  taxation  have  resulted  in  an  increasing  tax  burden  being 

imposed  on  employed  labour  with  the  opposite  trend  evident  for  other  factors  of 

production  such as capital,  energy  and  natural resources.  Over  the period  1980 to  1994, 

the  Community's  average  implicit  tax  rate  on  employed  labour  (i.e.  tax  revenues  divided 

by  the  tax  base)  increased  from  an  already  high  level  of  35  percent  to  over  40  per  cent. 

Graph 22 

Implicit tax  rates on  labour employed  and 

other factors of  production, EUR 

so 

45 

40 

35 

30 

1980 

Other factors of production 

-V 

Labour employed 

1982 

1984 

1986 

1988: 

1990 

1992 

1994 

Source:  Commission services. 

67 

On the other hand, the implicit tax rate on the other factors  of production fell from  around 

44 per  cent to  a little over  35 per  cent  (see Graph 22).  The upward  trend  in the  taxation 

of  labour  is  discouraging  employment  creation  since  it  increases  non-wage  labour  costs, 

adds to wage pressures and reduces incentives to work.  High  social  security  and  income 

tax rates interact with transfer  and  benefit  systems to  produce  high  effective  marginal  tax 

rates on low-income workers, high reservation wages and high "wedges" between the cost 

of labour to employers and the net income received by employees. 

One  factor  underlying  the  changes  in  the  structure  of  taxation  has  been  the  progressive 

erosion of tax bases in Member  States, linked to factors  of both domestic and international 

origin.  At  the  domestic  level,  high  levels  of  taxation  and  high  tax  wedges  for  labour-

income  appear  to  have  stimulated  the  development  of  the  underground  economy. 

Internationally,  tax  competition  between  countries  has led  to  fiscal  erosion  of the  mobile 

tax  sources,  such  as  capital,  with  international  relocation  of  taxable  bases  responding  to 

differentials  in  effective  tax  rates.  These  developments  have  provoked  a  change  in  the 

structure  of  the  tax  systems  of  many  Member  States,  with  the  tax  burden  being  shifted 

towards  labour,  which  is  relatively  immobile,  in  order  to  recover  the  tax  lost  from  the 

steady erosion of other more "exportable" sources of government revenue. 

There  is  broad  agreement  amongst  Member  States  that  the  long-term  trend  towards 

higher taxation  on labour  must be reversed.  This  may be achieved  both  through  targeted 

approaches  (for  instance  reduction  in  non-wage  labour  costs  for  specific  categories  of 

workers  such  as  the  low-skilled,  young  or  new  entrants)  and  through  general  measures, 

notably  a  lowering  of  public  expenditure  as  a  share  of  GDP  and  a  shifting  of  the  tax 

burden towards  other  factors,  especially  energy  and  capital.  Actions  in this field must  be 

compatible  with  and  should  contribute  to  the  achievement  of  other  objectives  in  the 

Community,  namely  stabilising Member  States'  fiscal  systems  and  removing  tax  obstacles 

to  the  internal  market  whilst  creating  a  tax  environment  conducive  to  a  strong, 
employment-creating  growth process and an efficient  environmental policy.17 

17  The  need  for  a  comprehensive  approach  was  underlined  in  the  Commission's  Communication 
"Taxation  in the  European  Union" presented to the informal  Ecofin  Council  in Verona  in April  1996 
and in the Commission's  "Second Report on Taxation in the European Union",  October  1996. 

68 

3.2  Budgetary  developments  in  1996 and  outlook for  1997 and  1998 

Efforts  to  achieve  sound  public  finances  have  recently  been  stepped  up  throughout  the 

Community.  In their  budgets  for  1996  and  for  1997,  a large  majority  of Member  States 

have taken  significant  steps to  reduce their  deficits  to  3 percent  of GDP  or less  as  a  step 

towards  reaching  budget  balance  over  the  medium  term.  The  driving  forces  behind  this 

process  are  twofold.  First,  the  experiences  of  recent  years  have  underlined  the  adverse 

consequences  for  interest  rates,  exchange  rate pressures  and  ultimately  economic  growth 

which  may  result  from  excessive  budget  deficits  and 

insufficient  credibility  of 

consolidation  efforts.  Second,  the  need  to  make  headway  towards  the  fulfilment  of  the 

convergence  criteria  for  participation  in  EMU  has  provided  an  imminent  focus  for  the 

budgetary  adjustment  efforts  of Member  States  and  has,  in many  countries,  been  seen  as 

offering  a unique  opportunity  for  achieving  significant  up-front  gains in the  credibility  of 

such  efforts. 

As a result  of these  efforts  and given the forecast  for  economic growth  and  interest  rates, 

the  average  budget  deficit  in the  Community  is  expected  to  be halved  between  1995  and 
1998,  falling  to  2XA per  cent  of  GDP.  This  represents  a  large  step  towards  the  re-
establishment  of sound public finances. 

3.2.1  Accelerated  progress  in the reduction of budget deficits 

Almost  all Member  States made progress towards further  reducing their budget  deficits  in 

1996.  The only exceptions were  Germany, where the deficit  widened  for  the  second  year 

running,  and Luxembourg where the surplus declined.  Particularly  large reductions  in the 

deficit  were  achieved  in Sweden,  Spain  and  Finland  but  deficit  reductions  of  1 percent  of 

GDP or more were achieved  also in several other countries (Table 22). 

The  budget  deficit  remained  comfortably  below  3 per  cent  of GDP  in the  three  countries 

which  are  currently  not  subject  to  a  Council  Decision  on  the  existence  of  an  excessive 

deficit  (Denmark,  Ireland  and  Luxembourg).  And  in  the  Netherlands,  the  budget  deficit 

was reduced to below the Maastricht reference value. 

According to the Autumn  1996 forecasts  of the Commission services, virtually all Member 

States  are expected  to make additional headway in  1997.  Progress is expected  to  be very 

significant  in  Italy  (around  VA  percentage  points  of  GDP)  and  it  is forecast  to  be  in  the 
range of  1  to  1XA percentage points in almost all the remaining Member States. 

69 

Against 

this 

background 

of 

widespread  and  significant  deficit 

reductions,  no  less  than  12  Member 

States are expected to achieve a deficit 

at or below  3 percent of GDP in 1997. 

The  only  exceptions  are  Greece, 

where  the  budget  deficit  is  high  but 

declining,  and  Italy  and  the  United 

Kingdom  both  of which  are  expected 

to  have a deficit  of around  3 Vz percent 
of  GDP  on  current  projections18. 
Among  the countries  whose  deficit  is 

below  3  percent  of  GDP,  both 

Denmark  and  Ireland  are  likely  to 

come  closer 
balance. 

to  achieving  budget 

Table 22 

General  government  net lending (+) 
or  net borrowing  (-) 
(%ofGDP) 

Level 

C h a n ge 

1995 

1996 

1997 

1998 

1996 

1997 

1998 

B 
DK 
D1J 
EL2) 
E 
F3* 
IRL2) 
I4) 
L 

NLP 
A 
P 

FIN 
S 
UK2) 

-4.1 
-1.6 
-3.5 

-9.1 
-6.6 
-4.8 

-2.0 
-7.1 
1.5 

-4.0 
-5.9 
-5.1 

-5.2 
-8.1 
-5.8 

-3.3 
-1.4 
-4.0 

-7.9 
-4.4 
-4.0 

-1.6 
-6.6 
0.9 

-2.6 
-4.3 
-4.0 

-3.3 
-3.9 
-4.6 

-2.9 
-0.3 
-2.9 

-6.5 
-3.0 
-3.0 

-0.9 
-3.3 
0.5 

-2.5 
-3.0 
-2.9 

-2.2 
-2.9 
-3.5 

-2.5 
-0.3 
-2.4 

-5.3 
-2.8 
-2.9 

-0.5 
-3.0 
0.9 

-2.0 
-2.9 
-2.9 

-1.4 
-1.0 
-2.2 

0.8 
0.2 
-0.5 

1.2 
2.2 
0.8 

0.4 
0.5 
-0.6 

1.4 
1.6 
1.1 

1.9 
4.2 
1.2 

0.6 

0.4 
1.1 
1.1 

1.4 
1.4 
1.0 

0.7 
3.3 
-0.4 

0.1 
1.3 
1.1 

1.1 
1.0 
1.1 

1.4 

0.4 
0.0 
0.5 

1.2 
0.2 
0.1 

0.4 
0.3 
0.4 

0.5 
0.1 
0.0 

0.8 
1.9 
1.3 

0.5 

No budgets are yet available for  1998. 

EUR 

-5.0 

-4.4 

-3.0 

-2.5 

In  the  forecast  scenario  for  1998, 

which  is based  on an extrapolation of 

expected 

trends 

in  1997,  budget 

deficits  are  generally  projected  to 

decline 

further 

and  all  Member 

countries  except  Greece  are  expected 

to  have  deficits  below  3  per  cent  of 

GDP by 1998. 

^ Not including unification-related  debt and asset 

assumptions by the federal  government in 1995 (Treuhand, 
eastern housing companies and Deutsche  Kreditbank), 
equal to DEM 229 bn. 

2)  At the time of the elaboration of the Commission  forecasts 
Greece, Ireland and the UK had not yet presented  their 
budgets for 1997. The "no policy change" assumption  was 
used also in 1997. According to new data for Greece the 
deficit  for 1996 is estimated at 7.6%. 

3) Including for 1997 the payment by France Telecom to the 

French state of FRF 37.5 bn. 

4) Including for 1997 6 trillion ITL of reductions  in transfers 
to state owned enterprises, but not including 6.5 trillion 
ITL of other operations whose conformity  with  ESA rules 
is currently being examined. 

^  Not including for 1995 a net amount of NLG 32.84  bn of 

exceptional expenditure  related to the reform of the 
financing  of the social housing societies. 

Source: Commission  services. 

18  The  Commission  services'  Autumn  1996  deficit  forecast  for  Italy  does  not  include  ITL  6.5  trillion  of 
deficit-reducing, operations  whose  conformity  with  the  ESA  rules  is  currently  being  examined.  As 
regards  the  United  Kingdom,  the  forecast  does  not  incorporate  measures  announced  in  the  November 
1996 Budget.  These  measures  are expected  by the  UK authorities  to  result  in  an  additional  budgetary 
consolidation  in the financial  year  1997/98. 

70 

Graph 23 

% of GDP 

Actual and cyclically-adjusted  net borrowing 
of general government, EUR 

Cyclically-adjusted 

1980 

1982 

1984 

1986 

1988 

1990 

1992 

1994 

1996 

1998 

Source:  Commission  services. 

3.2.2  The pace  and size of consolidation efforts 

For  the  Community  as  a whole,  the  deterioration  in  the  cyclical  position  in  1996  had  an 

adverse  impact  on  spending  and  tax  revenues.  Therefore,  while  actual  deficits  were  on 

average  reduced  by  0.6  percentage  points  of  GDP  in  1996,  the  general  government 

balance  adjusted  for  the  budgetary  impact  of  cyclical  deviations  of  output  from  its  trend 

(the  "cyclically-adjusted"  budget  balance)  improved  somewhat  more,  by an  estimated  0.8 
percentage  points  of  GDP19.  In  1997,  changes  in  the  cyclical  position  are  expected  to 
have a broadly  neutral  budgetary  impact  for  the Community  as a whole,  and  the  expected 

deficit  reduction  of  around  1.4  percentage  points  of  GDP  fully  reflects  a reduction  in  the 

cyclically-adjusted  deficit.  This  represents  an  unprecedented  effort  and  clearly  highlights 

the  strong  resolve  of  Member  States  to  place  their  public  finances  on  a  sound  footing. 

19  Estimates  of  the  cyclically-adjusted  budget  balance  are  surrounded  by  considerable  uncertainty, 
relating  both  to  the  level  of  trend  (potential)  GDP  and  to  the budgetary  impact  of  cyclical  deviations 
from  trend  (potential)  GDP.  The Commission  sendees" method  of cyclical  adjustment  takes  a  cautious 
approach  in  that  it  produces  levels  of  cyclically-adjusted  budget  deficits  which  tend  to  be  higher 
compared  to those  of other  methods,  such  as those used  by the  OECD  and  the  IMF.  Given  that  these 
discrepancies  mainly  relate  to  differences  in  the  estimated  level  of  trend  (potential)  GDP,  annual 
changes  in the cyclically-adjusted  deficit  do not vary significantly  across the various methods. 

71 

The  cyclically-adjusted  budget  deficit 

Table 23 

is  estimated  to  be  at  or  below  3 

percent  of  GDP  in  13  countries  by 

1997 according  to  the method  used  by 

the  Commission  services. 

For  the 

Community  as  a  whole, 

the 

total 

reduction 

in 

the  cyclically-adjusted 

deficit  between  1992  and  1998  is 

expected  to  amount  to  more  than  3 

percentage  points  of  GDP  with  most 

of it occurring in  1996 and  1997. 

For  1996 and  1997 taken together,  the 

cyclically-adjusted  budget  deficit 

is 

expected  to  decline  in  all  Member 

States  (except  Luxembourg). 

Four 

countries  (Spain,  Italy,  Austria  and 

Sweden)  are  expected 

to  achieve 

extraordinarily  large  reductions  in  the 

underlying  deficit  ranging  from  VA  to 
AXA percentage points  of GDP  over the 
large 
In 
two  years. 

addition, 

Cyclically-adjusted  general  government 
balances0 
(%ofGDP) 

Level 

1995 

1996 

1997 

1998 

Change 
1996  1997  1998 

B 
DK 
D2) 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

-3.7 
-1.5 
-3.5 

-8.3 
-5.8 
-4.6 

-3.2 
-7.1 
1.7 

-3.7 
-6.1 
-4.6 

-3.8 
-6.8 
-5.1 

-2.7 
-1.2 
-3.5 

-7.5 
-3.5 
-3.4 

-3.9 
-6.1 
1.3 

-2.3 
-4.1 
-3,5 

-2.2 
-3.0 
-4.0 

-2.4 
-0.6 
-2.3 

-6.4 
-2.2 
-2.6 

-3.1 
-2.7 
0.9 

-2.3 
-2.3 
-2.5 

-2.2 
-2.5 
-3.3 

-2.5 
-1.1 
-2.0 

-5.7 
-2.3 
-2.9 

-2.4 
-2.8 
0.6 

-2.1 
-2.5 
-2.9 

-2.1 
-1.3 
-2.2 

EUR 

-4.7 

-3.8 

-2.5 

-2.4 

1.0 
0.3 
0.0 

0.8 
2.3 
1.2 

-0.7 
1.0 
-0.4 

1.4 
2.0 
1.1 

1.6 
3.8 
1.1 

0.9 

0.3 
0.6 
1.2 

1.1 
1.3 
0.8 

0.8 
3.4 
-0.4 

0.0 
1.8 
1.0 

0.0 
0.5 
0.7 

1.3 

-0.1 
-0.5 
0.3 

0.7 
-0.1 
-0.3 

0.7 
-0.1 
-0.3 

0.2 
-0.2 
-0.4 

0.1 
1.2 
1.1 

0.1 

J) General government balances adjusted  for  an estimate of the 
budgetary impact of the cyclical deviation of GDP from  its 
trend level; Commission services'  estimates.  The 
methodology is explained  in European Economy; n° 60, 
1995, pp.  35-90. 

2)See footnote  1 in table  19. 

reductions  of  between  1  and  2 

Source:  Commission  services. 

percentage  points 

of  GDP 

are 

expected  in the  eight  other  Member  States where the actual  deficit  exceeded  3 percent  of 

GDP in 1995. 

Several of these countries have concentrated  the bulk of their consolidation  efforts  already 

in  1996.  This  applies  in  particular  to  Belgium,  the  Netherlands,  Finland  and  Sweden 

where  only  moderate  tightening  is  expected  in  1997,  if  at  all.  In  contrast,  in  Germany 

there  was  no  underlying  improvement  in  1996  and  consolidation  efforts  will  occur 

exclusively  in  1997, while in Italy  a very  ambitious budget  for  1997 implies  a  particularly 

large effort  in that year. 

72 

3.2.3  The composition  and durability of consolidation  efforts 

For  the  Community  as  a  whole, 

budgetary  adjustment  in  1996 was 

achieved in broadly  equal measure 

through  reductions  in the  share of 

public  expenditures  in  GDP  and 

increases  in the already high share 

of  government  revenues  in  GDP. 

Provided  current  spending  plans 

for 

1997 

are 

adhered 

to, 

budgetary  consolidation  in  that 

year  is  expected  to  be  achieved 

mainly 

through 

expenditure 

restraint.  The  slight  rise  in  tax 
pressure is likely to be reversed in 

1998.  Thus, for  the three years as 

a  whole, 

the  Community 

is 

expected  to  achieve  a  significant 

reduction  in  the  share  of  public 

Table  24 
General  government  receipts  and  expenditures 
( % o f G D P) 

Receipts 

Expenditures 

1995 

1996 

1997 

1998 

1995 

1996 

1997 

1998 

B 
DK 
D 
EL1' 
E 
FD 

IRL15 
I» 
L 
NL1* 
A 
P 

FIN 
S 
UK1J 

50.3 
58.1 
46.3 

37.6 
39.7 
49.5 

35.4 
44.8 
40.8 

49.1 
46.9 
40.1 

53.5 
60.1 
37.8 

50.5 
58.8 
45.7 

38.0 
40.3 
50.6 

34.7 
46.3 
41.7 

48.3 
48.2 
40.4 

55.3 
63.0 
37.6 

50.1 
58.0 
46.0 

38.4 
40.5 
50.5 

34.3 
47.7 
41.2 

47.7 
48.7 
41.3 

54.3 
61.7 
37.7 

49.7 
56.4 
45.9 

38.7 
40.2 
50.2 

33.9 
47.1 
40.8 

47.0 
48.3 
41.1 

53.9 
60.5 
38.0 

54.5 
59.7 
49.9 

46.7 
46.3 
54.3 

37.4 
51.8 
40.0 

53.2 
52.8 
45.3 

58.8 
68.2 
43.5 

53.8 
60.3 
49.7 

46.0 
44.8 
54.7 

36.3 
52.9 
40.7 

50.9 
52.5 
44.5 

58.7 
66.9 
42.3 

53.0 
58.2 
48.9 

44.9 
43.5 
53.5 

35.2 
51.0 
40.7 

50.1 
51.7 
44.3 

56.5 
64.6 
41.3 

52.1 
56.7 
48.2 

44.0 
43.0 
53.1 

34.3 
50.1 
39.9 

49.0 
51.2 
44.0 

55.3 
61.5 
40.2 

EUR 

45.8 

46.2 

46.4 

46.1 

50.9 

50.6 

49.4 

48.5 

expenditure  in  GDP  (of  around 
2lA  percentage  points)  while  tax 
pressure is forecast  to remain broadly unchanged. 

l} See footnotes  in table  19. 

Source:  Commission  services. 

Both  with  respect  to  the  balance  between  expenditure  and  revenue  measures  and  with 

respect  to  the  durability  of  consolidation  measures,  differences  are  discernible  between 

Member  States.  Nevertheless,  public  expenditure  as  a  share  of  GDP  is  expected  to  be 

reduced  significantly  in  all  Member  States  except  Portugal  and  Luxembourg.  The 

encouraging  outlook  for  expenditure  restraint  is  contingent  upon  strict  spending  plans 

being  adhered  to.  Most  of the  expected  reduction  in expenditure  growth  reflects  efforts 

to  restrain  the  growth  of  public  consumption  and  transfer  payments.  In  general,  these 

measures  appear likely to have lasting  effects. 

In  several  countries  where  the  debt-to-GDP  ratio  has  been  placed  on  a  downward  path 

and where  interest  rates have fallen  considerably,  reduced  debt-servicing  is likely to  make 

a  significant  contribution  to  budgetary  consolidation  in  the  years  to  come. 

In  Italy, 

73 

interest  payments  are  forecast  to  fall  by  3  percentage  points  of  GDP  between  1995  and 
1998.  Interest payments are expected  to decline significantly  also in other Member  States 
where the debt  ratio  is set to  decline.  In  1998, debt servicing is expected  to  decline  in all 
Member States. 

Table  25 

, 

General  government  expenditures 
(changes  in %  of  GDP) 

Public 
consumption 

Public 
investment 

Transfers  to 
households 

Transfers  to 
companies 

Capital 
transfers 

Interest 
payments 

Total 

97/95 

98/97 

97/95 

98/97 

97/95 

98/97 

97/95 

98/97 

97/95 

98/97 

97/95 

98/97 

97/95 

98/97 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

-0.4 
-0.3 
-0.2 

0.2 
-0.9 
-0.2 

-0.7 
0.0 
0.4 

-0.4 
-0.6 
0.8 

-0.4 
-0.6 
-0.9 

-0.3 
-0.4 
-0.4 

-0.1 
-0.3 
-0.2 

-0.2 
-0.2 
-0.2 

-0.1 
-0.3 
-0.2 

-0.5 
-0.7 
-0.4 

0.0 
0.0 
-0.4 

-0.1 
-0.9 
-0.3 

0.0 
-0.1 
0.2 

-0.1 
-0.1 
0.5 

0.2 
-0.2 
-0.4 

0.0 
0.0 
-0.1 

0.1 
0.1 
0.0 

0.0 
0.1 
0.1 

0.0 
0.0 
0.3 

0.0 
-0.1 
-0.1 

-0.3 
-1.2 
0.1 

0.3 
-0.6 
-0.1 

-0.9 
0.8 
0.0 

-1.7 
-0.4 
0.6 

-1.7 
-1.8 
-0.5 

-0.3 
-0.7 
-0.1 

-0.1 
-0.2 
-0.3 

-0.3 
0.1 
-0.4 

-0.8 
-0.3 
0.1 

^0.8 
-1.0 
-0.4 

-0.3 
-0.6 
-0.3 

-0.1 
-0.2 
0.3 

-0.3 
-0.7 
-0.2 

-0.2 
-0.4 
-0.1 

-0.2 
-0.7 
0.0 

-0.1 
-0.1 
0.0 

0.0 
0.0 
-0.1 

-0.1 
0.1 
-0.2 

-0.1 
-0.1 
0.0 

-0.1 
-0.2 
-0.1 

0.1 
1.0 
-0.1 

-0.2 
-0.2 
-0.5 

-0.1 
0.3 
.0.0 

-0.2 
-0.1 
-0.5 

-0.5 
-0.1 
-0.4 

0.0 
0.0 
0.0 

-0.1 
0.0 
0.4 

0.0 
0.4 
0.0 

0.0 
0.0 
-0.1 

-0.1 
0.0 
-0.1 

-1.0 
-0.8 
0.2 

-1.9 
-0.1 
0.1 

-0.8 
-1.6 
0.1 

-0.6 
0.3 
-1.1 

0.4 
-0.1 
0.2 

-0.2 
-0.3 
0.0 

-0.6 
-0.1 
0.0 

-0.3 
-1.5 
0.0 

-0.1 
0.1 
-0.3 

0.0 
-0.8 
0.0 

-1.5 
-1.5 
-1.0 

-1.8 
-2.8 
-0.8 

-2.2 
-0.8 
0.7 

-3.1 
-1.1 
0.2 

-2.3 
-3.6 
-2.2 

-0.9 
-1.5 
-0.7 

-0.9 
-0.5 
-0.4 

-0.9 
-0.9 
-0.8 

-1.1 
-0.5 
-0.2 

-1.2 
-3.1 
-1.1 

EUR 

-0.4 

-0.3 

-0.3 

0.0 

-0.2 

-0.3 

-0.2 

0.0 

-0.2 

0.1 

-0.1 

-0.3 

-1.5 

-0.9 

Source:  Commission  services. 

Reflecting  reforms  to  contain  social  spending  and  in  some  cases  falling  unemployment, 

transfers  to  households  are  expected  to  decline  as  a  share  of  GDP  in  nearly  all  Member 

States. As a proportion  of GDP, government  consumption is set to  decline  in virtually  all 

Member  States  over  the  period  1995-1998,  and  especially  so  in  Spain,  Sweden  and  the 

United  Kingdom.  Public  employment  is  likely  to  be  reduced  in  several  countries 

(Germany,  Spain,  Italy,  Sweden,  Austria,  the  United  Kingdom)  and  to  remain  broadly 

stable  in  others  (Belgium,  France).  Some  Member  States  have  made  savings  from 

reduced  wage growth  in the public sector. 

A  number  of  countries  are  relying  to  a considerable  extent  on  reductions  or  deferrals  of 

public investment.  This is the case particularly in Spain (albeit from  a high level) and,  to a 

lesser  extent,  in  Germany,  France  and  the  United  Kingdom. 

In  some  countries,  such 

74 

reductions  may  be  related  to  an  increased  efficiency  in  the  use  of  public  funds,  but  in 
general,  savings  on  public  investment  may  turn  out  to  be  temporary  or  otherwise  prove 
costly in the long run.  In the United  Kingdom, this trend  reflects  a switch  from  public  to 
private provisions. 

According  to  the  assumptions  underlying  the  Commission  services'  Autumn  1996 

forecasts,  budgetary  adjustment  in some Member  States has to  some extent relied  on one-

off  measures,  including  in  France  capital  transfers  from  French  Telecom  as  part  of 

restructuring  and  privatisation  of the utility  and  treasury  operations  in  Italy.  Needless  to 

say, the temporary  nature  of such measures  does not  contribute tô  an improvement  in the 

underlying fiscal position. 

In early  1998, when the decision will be made as to which countries have achieved  a high 

degree  of  sustainable  convergence  required  for  participation  in  the  third  stage  of  EMU 

from  1.1.1999,  an  assessment  will be  made  of  the  extent  to  which  once-off  measures  in 

some  countries  in  1996-97  have  been  complemented  by  lasting  improvements  to 

budgetary positions. 

On the receipts  side, tax pressure increased  in a majority  of countries in  1996 and in some 

cases it may increase further  in  1997.  Only in Ireland  and  the Netherlands  is the  share  of 

public  revenues  in  GDP  on  a  firm  downward  path.  On  the  other  hand,  the  overall  tax 

burden  is  expected  to  decline  in  almost  all  Member  States  in  1998. 

In  some  cases, 

revenue-enhancing measures have included increases in social security contributions  which 

place a further  burden on employment  (e.g. Germany,  Austria).  However,  many  countries 

have  increased  various  consumption  taxes which  can be  expected  to  be  less  distortionary 

with  respect  to  employment  to  the  extent  that  wage  demands  are  not  adjusted  upwards 

proportionately to  compensate for higher prices. 

3.2.4  Trends in government  debt-to-GDP  ratios 

The average  debt-to-GDP  ratio  in the Community  increased  by some  2 percentage  points 
in  1996 to  reach 1VA  percent  of GDP.  However,  the upward  trend  is likely to  come to a 
halt in  1997 and the debt-ratio  is expected  to  subside modestly  in  1998.  This is the  result 
of  the  significant  efforts  made  by  virtually  all  Member  State  governments  to  reduce 
budget  deficits  as  well  as  the  expected  recovery  in  economic  growth  and  falling  interest 
payments.  In  addition,  privatisation  efforts  will  play  a role  in  reducing  the  debt-ratio  in 
several Member  States. 

75 

In  France,  Luxembourg  and 

the 

United  Kingdom,  the  debt-to-GDP 

Table 26 

ratio  is expected  to  remain below  60 

per cent of GDP in the coming years. 

In  Germany  and  Finland,  the  deficit 

ratio  climbed  above  60  per  cent  of 

GDP 

in  1996  and  on  current 

projections  it  may  stay  just  above 

that level in  1997 and in  1998. 

In the majority  of  countries  in which 

the gross debt-to-GDP  ratio is above 

60  per  cent,  progress  is  expected  to 

be  made in reducing  the  debt  burden 

over the years  1996-98.  In Denmark 
is 
and  Ireland, 

the  debt  ratio 

expected  to  rapidly  approach  the  60 

percent  reference  value  (falling  by 

614  and 

16  percentage  points 

respectively,  to  a  level  of  around  65 

percent  of  GDP). 

In  Belgium, 

Greece  and  Italy,  where  the  debt-

Gross  public  debt 
(%ofGDP) 

Level 

Change 

1993 

1995 

1996 

1997 

1998 

95/93 

98/95 

B 
DK1} 
D 
EL2) 
E 
F 
DRL2) 
I 
L 

NL 
A 
P 

FIN 
S 
UK2) 

137.0 
80.1 
48.2 

111.8 
60.5 
45.6 

94.5 
119.3 
6.2 

80.8 
62.8 
68.2 

57.3 
76.0 
48.5 

133.7 
71.9 
58.1 

111.8 
65.7 
52.8 

81.6 
124.9 
6.0 

79.7 
69.0 
71.7 

59.2 
78.7 
54.1 

130.6 
70.2 
60.8 

110.6 
67.8 
56.4 

74.7 
123.4 
7.8 

78.7 
71.7 
71.1 

61.3 
78.1 
56.2 

127.0 
67.8 
61.9 

109.3 
67.1 
58.1 

70.0 
122.3 
8.8 

76.8 
72.2 
69.0 

61.5 
77.6 
57.0 

123.9 
65.5 
61.9 

107.2 
65.8 
59.2 

65.4 
119.4 
9.2 

75.1 
72.2 
67.8 

61.7 
74.9 
56.5 

EUR 

66.1 

71.3 

73.5 

73.7 

72.9 

-3.3 
-8.2 
9.9 

0.0 
5.2 
7.2 

-9.8 
-6.4 
3.8 

-4.6 
0.1 
6.4 

-12.9 
5.6 
-0.2 

-16.2 
-5.5 
3.2 

-1.1 
6.2 
3.5 

1.9 
2.7 
5.6 

5.2 

-4.6 
3.2 
-3.9 

2.5 
-3.8 
2.4 

1.6 

') Government deposits with the central bank,  government 
holdings of non-government  bonds and public  enterprise 
related debt amounted to some  18 % of GDP in 1995. 

2)  See footnote  2 in table  19. 

Source:  Commission  services. 

ratio  is  particularly  high,  as  well  as  in  the  Netherlands,  Sweden  and  Portugal,  the  debt-

ratio  is expected  to  fall  by between  4  and  10 percentage  points  of  GDP  over  the  period 

1996-98. 

3.3  The economic  impact  of budgetary  consolidation  in the Community 

3.3. 1  Short-term gi'owth impact of budgetary consolidation  in 1996-97 

The  substantial  scale  of  the  planned  reductions  in  the  budget  deficit  in  most  Member 
States  in  1996-97  has  prompted  fears  among  some  commentators  that  the  efforts  to 
comply  with  the  Maastricht  fiscal  criteria  could  have  a  significant  restraining  impact  on 
output  growth  and  employment  creation  over the  near  term.  However,  such  fears  fail  to 
appreciate both  the overall economic policy context  within which budgetary  consolidation 
is  taking  place  and  the  urgency,  irrespective  of the  Maastricht  process,  of  the  economic 
need to consolidate the public finances in the Community. 

76 

In  most  Member  States,  budgetary  consolidation  is  inescapable  if  the  rise  in  public 

indebtedness  and  the  upward  trend  in  debt  servicing  is to  be  arrested.  Continuing  large 

budget  deficits  would  be reflected  in a rapid  rise in interest  payments in the  coming  years 

which would  put  additional upward  pressure on taxation to the detriment  of  employment, 

and reduce the scope for  more productive or desirable public expenditures.  Therefore,  the 

current need for  a growth-enhancing  stance of economic policies cannot and should not be 

provided  by  "expansionary"  budgetary  policies. 

In  most  Member  States,  budgetary 

consolidation  is  necessary  and  desirable  on  its  own  merits.  Progress  towards  EMU 

strengthens the framework  within which the necessary adjustments  are being made. 

Furthermore,  even  over  the  short-term,  any  hoped-for  benefits  of  reduced  consolidation 

efforts  would  most  likely prove illusory.  A let-up  in budgetary  consolidation  would  have 

immediate  and  severe  adverse  consequences  in  financial  markets,  leading  to  a  rise  in 

interest  rate  premia  and  most  likely  causing  renewed  exchange  rate  turmoil.  As  was 

amply  demonstrated  following  the  currency  movements  in  1995  (see  Chapter  1),  the  net 
impact  of  such  turmoil  on  short-term  growth  in  the  Community  would  be  negative  and 

would  add  to  existing  problems  of  high  and  rising  unemployment  in  most  countries. 

Therefore,  in  practice  there  is  no  alternative  to  continuing  the  policy  of  budgetary 

restraint. 

The  overall  effect  of  the  current  and  planned  budgetary  policies  on  demand  and  growth 

cannot  be  considered  in  isolation  from  the  repercussions  on  interest  and  exchange  rates, 

the  stance  of  monetary  and  other  economic  policies  and  the  international  and  cyclical 

conditions  in  which  consolidation  is  undertaken.  The  direct  restraining  impact  of 

budgetary consolidation in  1996-97 is likely to be off-set  by a number of factors  which  fall 

under two broad headings. 

Firstly,  budgetary  consolidation  forms  an  integral  part  of  the  overall  rebalancing  of  the 

economic policy-mix which has taken place in the Community  and which is reflected  inter 

alia  in lower interest  rates and improved  exchange rate stability.  These benefits  extend  to 

virtually  all Member  States  and  have  resulted  in  a  particularly  large  reduction  in  interest 

rates  in  countries  which  formerly  suffered  from  high  risk  premia.  The  most  striking 

examples  are  Spain,  Italy  and  Sweden  where  long-term  interest  rate  differentials  relative 

to  Germany  fell  by  around  380,  430  and  340  basis  points,  respectively,  from  their  1995 

peak until December  1996.  In each case, the bulk of this fall was achieved  in the wake  of 

the announcement  of credible and significant  efforts  to reduce budget deficits  to 3 per  cent 

of  GDP  or  less  in  1997  and  to  bring  it  down  further  in  subsequent  years.  The  decline  in 

77 

interest  rates  significantly  eases  the  burden  on  the  public  finances  as  well  as  on  private 
sector  activity  in  nearly  all  countries.  Lower  real  interest  rates  are  likely  to  support  the 
"crowding-in"  of investment.  Since investment  profitability  is currently  sound,  and  since 
current  and  prospective  demand  trends  are  being  supported  by  monetary  relaxation, 
investment  appears to be set to take off in a relatively strong manner. 

Secondly, a credible and well-designed  policy of budgetary  consolidation  is likely to  result 

in  an  improvement  in  confidence  among  businesses  as well  as  consumers.  Especially  in 

countries  with  large  budgetary  imbalances  and/or  where  public  expenditures  have  been 

rising fast,  a general perception that substantial tax increases would follow  ~  coupled  with 

uncertainty  about which measures were going to be taken and who would have to bear the 

burden of adjustment  — have contributed  to  a cautious mood  and precautionary  savings in 

the private  sector.  In  such  cases,  action to  curb  the  rise  in public  expenditures  and  raise 

taxes by less than what  had  previously  been  expected  may well result  in  an  improvement 

in "confidence"  in the private sector  and may stimulate both  consumption,  investment  and 

companies' willingness to hire more employees. 

With respect to  private consumption,  there is an accumulating  body  of empirical  evidence 

which points towards the existence  of confidence  or "non-Keynesian"  effects,  particularly 

in  cases  where  large  budgetary  imbalances  are  addressed  through  credible  efforts  to 

restrain  the  growth  of  public  expenditures.  The  negative  correlation  between  the 

cyclically-adjusted  budgetary  position  and  the  household  savings  ratio  during  periods  of 

large fiscal  adjustments/expansions  is illustrated by the two country examples in Graph 24. 

Furthermore,  lower  interest  rates  and  reduced  financial  uncertainty  provides  a  boost  to 

asset  prices  (including  share,  bond  and  house  prices)  and  raises  private  sector  wealth 

which,  at  least  in  some  countries,  is  likely  to  provide  a  substantial  impetus  to  private 

consumption. 

78 

G r a ph  2-4 

Budget deficit and households savings rate 

: % o f Q P Pi 

C y c l i c a l l y - a d j u s t ed  b u d g et  d e f i c it 
( I h s) 

Sweden 

%  of  h o u s e h o ld  d i s p o s a b le 

I n c o me 

1882 

1984 

1886 

Source: 

Commission services and OECD. 

Italy 

%  :Qf  h o u s e h o l d:  d i s p o s a b le  ; i n c o m e; 

C y c l i c a l l y - a d j u s t ed  b u d g et  d e f i c it 
( I h s) 

1982 

1984 

1986 

Source: 

Commission services and OECD. 

Against  the  background  of  low  inflation,  healthy  fundamentals  and  a  favourable 

international  setting, the forecasts  of the Commission services indicate that the current  and 

expected  stance  of  budgetary  and  monetary  policies  is  consistent  with  a  well-balanced 

pick-up  in  economic  growth  to  around  its trend  rate  in  1997  and  above-trend  growth  in 

1998.  This  assessment  is broadly  in  line with  that  of  other  international  institutions  and 

most private  forecasters. 

Even if economic  growth  should  fail  to pick up to the extent  foreseen,  there  should  be no 
let-up  in budgetary  consolidation  efforts.  Slippages  from  budgetary  targets would  put  at 
risk  the  favourable  trends  in  interest  and  exchange  rates  and  therefore  undermine  the 
prospects for  stronger economic growth. 

79 

3.3.2  Budgetary policy  in a medium-term perspective 

Achieving  and  maintaining  sound  and  disciplined  public  finances  in the  Member  States  is 

necessary  to  create  the  appropriate  conditions  for  strong  and  sustained  output  growth 

with  improved  employment  creation  over the medium term.  The widespread  recognition 

of this fact  led the  Community to  adopt  the objective  of achieving  a government financial 

position  close  to  balance  over  the  medium  term  in  successive  Broad  Economic  Policy 
Guidelines since  199320.  This objective has been reiterated  and given increased  credibility 
and  importance  within  the  framework  of  the  "Stability  and  Growth  Pact"  for  ensuring 

budgetary, discipline in stage three of EMU.  Thus, Member  States are committed  to  take 

further  steps,  in  the  years  after  1997,  to  ensure  a  continued  improvement  in  their 

budgetary  position  in  order  to  attain  the  medium-term  objective  of  close  to  balance  or  a 

surplus in normal  circumstances. 

It has sometimes been argued  that  this commitment  to  disciplined  budgetary  policy would 

have  a  restraining  impact  on  economic  activity  in  the  years  following  1997.  However, 

such fears  seem to  be based  on a misunderstanding  of the medium-term  growth  effects  of 

sound  budgetary  policies  and ignore the fact  that  fiscal  discipline is an essential  condition 

to  ensure the viability of EMU and to reap all the potential benefits  of the single currency. 

In addition,  once  the  average  budget  deficit  in the .Community has been  reduced  to  3 per 

cent  of  GDP  by  1997,  the  achievement  of  budget  balance  in  the  course  of  subsequent 

years will be facilitated  by the return to strong medium-term growth. 

Indeed,  pursuing  a  medium-term  budgetary  objective  of  close  to  balance  or  surplus  is 

necessary in order to: 

(i)  achieve  sustained,  investment-led,  growth  of  output  and  employment  over  the 

medium term while maintaining a proper balance between savings and  investment; 

(ii)  create room for  budgetary  policies to  adapt to  cyclical disturbances without  causing 

the deficit  to  exceed  3 per cent of GDP during "normal" cyclical downturns; 

(iii)  reverse the crowding-out  of non-interest  expenditure and facilitate  tax reductions; 

(iv)  prepare  Member  States'  public  finances  for  the  budgetary  consequences  of  the 

"ageing" of populations. 

20  In  line  with  the  policy  recommendations  of  the  Broad  Economic  Policy  Guidelines,  four  countries, 
namely  Denmark,  Finland,  Sweden  and  the  United  Kingdom,  have  introduced  the  objective  of 
eliminating the deficit  or moving to a surplus in their convergence programmes. 

80 

Sound public finances  are necessary for  sustained medium-term growth and  employment 

The  central  plank  of the  Community's  strategy  to  ensure  a  sustained  upturn  in  economic 

growth  and  job  creation  over  the  medium  term  is  to  create  the  right  conditions  for  a 

significant  pick-up  in  investment  in  order  to  ensure  a  sufficiently  rapid  expansion  of 

productive  capacity.  Investment  growth  is forecast  to  pick  up  significantly  in  1997  and 

1998  and,  provided  that  the right  conditions  are maintained,  it is expected  to  continue  to 

expand  over  the following  years.  This upturn  in investment  needs to  be  accompanied  by 

an  upturn  in  national  savings  in  the  Member  States,  if  it  is  not  to  be  associated  with  a 

serious  current  account  deterioration  for  the  Community  as  a  whole  and  with  severe 

upward  pressures  on real interest  rates.  In particular  given the relative  constancy  of  the 

private  sector  savings  rate  (households  plus  enterprises)  as  a  share  of  GDP  in  the 

Community,  this  increase  in  savings  needs  to  come  essentially  from  the  achievement  of 
sound public finances  and the restoration of positive public savings21. 

Empirical  evidence  shows  that  the  rising  public  sector  indebtedness  of  the  industrialised 
countries  over  the  last  two  decades  has  been  a major  factor  behind  the  observed  rise  in 

world-wide real long-term  interest rates (estimates range from  around  1 to 2.5  percentage 
points)22.  Conversely, the expected lower budget deficits in the Community  in the coming 
years,  in  line  with  the  Maastricht  Treaty  and  the  enhanced  framework  for  budgetary 

discipline  under  the  Stability  and  Growth  Pact,  will  lead  to  lower  borrowing  costs  in the 

Community.  Since the  Community  is a sufficiently  large player  in the  world  economy,  it 

would  also  contribute  to  lower  long-term  interest  rates  world-wide.  Improved  prospects 

for  budgetary  discipline amongst the Community's international  partners,  and in particular 

in  the  United  States,  would  likewise  contribute  to  lower  world-wide  real  long-term 

interest rates. 

21  See  "Trends  in  and  structure  of  gross  national  saving  in  the  Community",  European  Economy, 

Supplement  A,  n°  11/12,  1992. 

22  See  IMF,  World Economic  Outlook  (May  1996)  and  Group  of Ten  (1995),  "Saving,  Investment  and 

Real Interest Rates", October  1995,  and references  mentioned  therein. 

81 

l*> 

Restoring  the stabilisation function  of budgetary policies 

In  EMU,  the  use  of  budgetary  policies  for  stabilisation  purposes  is  likely  to  take  on 

increasing importance,  at least  for  those  countries which have hitherto  made use  of  some 

degree  of independent  monetary  or  exchange rate  policies.  At the  same time,  in order  to 

ensure  budgetary  discipline,  the  Maastricht  Treaty  stipulates  that  the  budget  deficit  in 

participating  Member  countries  is  not  allowed  to  exceed  3  per  cent  of  GDP  except  in 

"exceptional  and  temporary"  circumstances.  Such  circumstances  do  not  include  normal 

cyclical downturns. 

Therefore,  achieving  budget  balance  or,  according  to  national  circumstances,  a  budget 

surplus  during  "normal"  times  is  a  necessary  condition  for  restoring  the  flexibility  of 

budgetary  policies  within  a  sound  and  credible  medium-term  framework. 

It  will  create 

sufficient  room  for  budgetary  policies  to  allow  the  automatic  stabilisers  to  work  without 

exceeding  the  3  per  cent  of  GDP  reference  value  for  the  budget  deficit  during  normal 
cyclical  downturns  and  without  this  leading  to  a  relentless  upward  trend  in  government 

indebtedness  and  debt  servicing  relative  to  GDP.  Indeed,  over  the  period  1960-96,  the 

cyclical component  of budget deficits  for all but two Member  States never  surpassed  3 per 

cent  of GDP  on either  side and  even remained  below  2 per  cent  of GDP  in most  Member 

States  (see  Box  5).  Furthermore,  the  automatic  stabilisers  are  likely  to  work  more 

effectively  when  underlying  budgetary  positions  are  sound,  because  the  risk  of  either 

negative  financial  market  reactions  or  of  undermining  confidence  is  smaller.  On  past 

experience, countries with sound underlying budgetary  positions have been able to use the 

automatic  stabilisers  and  counter-cyclical  budgetary  policies  in  a  positive  way,  while 

countries  with  large  deficits  and  debt  have  repeatedly  been  forced  to  tighten  budgetary 

policies at the height of a cyclical  downturn. 

Reversing  the crowding-out  of non-interest expenditure and the upward trend in  taxation 

Over  the  last  two  decades,  the  rise  in government  interest  payments  has  "crowded  out" 
other  public  expenditures.  The  achievement  of  budget  balance  or  surplus  in  "normal" 
times  will  lead  to  a  self-feeding  virtuous  circle  of  reduced  deficits,  reduced  debt,  and 
lower  debt-servicing  costs.  By  reducing  the  debt  servicing  burden,  fiscal  discipline  will 
allow  a restructuring  of  government  expenditures  towards  productive  types  of  spending 
such as infrastructures,  education and active labour market policies. 

82 

The  bid  to  restore  sound  and  disciplined  public  finances  offers  the  opportunity  to 

introduce  lasting  measures  and  reforms  to  stem  the  upward  pressures  on  public 

expenditures  in  many  Member  States.  Reduced  expenditure  growth  and  lower  debt 

servicing  will  make  it  possible  to  reverse  the  long-standing  upward  trend  in  taxation. 

Reducing  taxation,  in  line  with  a  lower  share  of  public  expenditure  in  GDP,  will  have 

positive  supply  side  effects.  Lower  effective  tax  rates,  and  in  some  cases  an  increased 

targeting  of  social  expenditure,  will  improve  incentives  to  save  and  invest,  to  increase 

work  effort  and to create jobs, thereby contributing to higher  employment. 

Preparing for  the  "ageing"  of  populations 

Generating  higher  public  savings  is  urgent  and  necessary  in  order  to  prepare  Member 

States'  public finances  for  the great  challenges associated  with the ageing  of  populations 

in  the  21st  century  and  the  consequent  rise  in  dependency  ratios.  These  demographic 
trends  will  put  upward  pressure  on  social  spending,  especially  for  pensions  and  health 

costs (see Box 6).  In part, this must be compensated  by efforts  to tighten  spending under 

these  social  policies  whereas  higher  private  sector  savings  related  to  the  possible 

proliferation  of  private  pension  schemes  may  contribute  to  the  attenuation  of  these 

budgetary pressures. 

83 

Box 5: Automatic  stabilisers in the Community 

Cyclical  fluctuations  in  economic  activity  significantly  affect  government  budget  balances:  tax 
receipts weaken  and  social transfers  increase  during  recessions  and show reversed  movements 
during  expansions.  These  cyclically-induced  changes  in  the  budget  balance  in  turn  exert  a 
stabilising  influence on economic  activity, i.e. they fulfil the role of automatic stabilisers. 

The  Commission  services  have  developed  their 
own  methodology  for  estimating  the  cyclical 
impact  on  government  budgets1. 
These 
calculations  show  that  in  the  Community  the 
size  of  the  automatic  stabilisers,  as  measured 
by  the  cyclical  component  of  budget  balances, 
is quite  important  and  varies  substantially  over 
time  and  across  Member  States  (see  Table 
B5.1).  The  automatic  stabilisers  are  relatively 
higher  and  show  a  relatively  higher  degree  of 
variability  in  the  smaller  Member  States  but 
also  in  Spain  and  the  United  Kingdom.  The 
size  and  volatility  of  the  cyclical  component  for 
is  dampened 
the  Community  as  a  whole 
because  it  averages  out  the  different  cyclical 
positions  of  the  Member  States  at  a  given 
moment. 

the  period  1960-1996 

As  can  be  seen 
the  minimum  and 
from 
maximum  values  of  the  cyclical  components, 
over 
the  cyclical 
component  for  all but two  Member  States  never 
surpassed  the  3  per  cent  value  on  either  side 
and  even  remained  below  the  2  per  cent  value 
for  most  Member  States.  Cyclical  components 
around  4  to  5  per  cent  were  only  registered  in 
Finland  and  Sweden  at  the  beginning  of  the 
1990s. 

Table  B5.1. 

Size  of  the  cyclical  c o m p o n e nt  of 
b u d g et  balances  in  the  EC 
(1960-1996) 

Standard 
deviation 

Minimum 

Maximum 

Value 

Y e ar 

V a l ue 

Y e ar 

B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 

EUR 

1.0 
1.1 
0.9 

0.7 
1.3 
0.6 

1.0 
0.6 
1.2 

1.3 

0.8 

1.1 

2.1 

1.8 

1.3 

0.7 

-1.8 
-2.3 
-1.6 

-1.0 
-2.1 
-1.2 

-2.2 
-1.2 
-2.8 

-2.8 
-1.4 
-2.4 

-5.2 
-3.8 
-2.7 

1986 
1981 
1967 

1987 
1984-85 
1985 

1986 
1975 
1982-83 

1983 
1987 
1984 

1993 
1993 
1982 

2.0 
2.5 
1.9 

1.6 
2.7 
1.5 

2.1 
1.1 
4.1 

1.8 
1.4 
2.4 

5.2 
3.2 
3.1 

1974 
1986 
1991 

1973 
1990 
1990 

1996 
1980-90 
1974 

1974 
1973-74 
1973 

1989 
1990 
1989 

-1.2 

1983 

1.6 

1990 

The  extent  of the  automatic stabilisers  is influenced  by the degree  of openness  of the  economy, 
the  size  of  the  government  sector,  the  progressivity  of  the  tax  system,  the  generosity  of  the 
unemployment  compensation  schemes  and  the  sensitivity  of  unemployment  to  fluctuations  in 
output.  Variations  across  Member  States  in these  elements  explain  the  observed  disparities  in 
the  magnitude  of the  automatic stabilisers. 

Schematically,  the  influence  of the  above  elements  are  captured  by two  factors:  the  size  of  the 
output  gap,  on  the  one  hand,  and  the  sensitivity  of  budgetary  receipts  and  expenditures  to 
cyclical fluctuations  on the  other. 
Cyclical  fluctuations  can  be  estimated  by  determining  the  trend  output  path2  and  by  subtracting 
these trend output  estimates from the actual  output  levels. The  output  gap  is then  defined  as the 
difference  between  the  levels  of  actual  GDP  and  trend  GDP,  expressed  as  a  percentage  of 
trendGDP.  When  the  output  gap  is  positive  (negative),  the  cycle  has  a  positive  (negative) 
influence  on the government  balance. 

As  can  be  seen  in  Table  B5.2,  the  volatility  of  the  output  gap,  as  measured  by  the  standard 
deviation,  is  relatively  small  for  the  Community  a  whole,  as  cyclical  positions  differ  among 

1  See European  Commission,  "Technical  note: the Commission  services'  method  for  the  cyclical  adjustment  of 

government  budget  balances1", European  Economy,  n° 60, November  1995. 

! 

The  trend  estimation  method  used  to  produce  the  output  gaps  (Hodrick-Prescott  filter)  produces  output  gaps 
which  are  symmetric  over  the  series,  and  therefore  sum  to  zero  on  average  over  the  period  1960-1996.  In 
addition,  the  negative  output  gaps  produced  by this  method  are  relatively  small  compared  to  those  produced 
by  other  methods,  such  as  for  example  the  production  function  approach,  and  the  method  smoothes  over 
structural  breaks,  such  as  those which  occurred  in FIN and  S at the beginning  of the  1990s. 

84 

Member  States,  but  is  relatively  high  in the  "catching-up"  countries  (Greece,  Spain,  Ireland  and 
Portugal)  as well  as in  Luxembourg  and the  United  Kingdom.  The  large variability  of the  output 
gaps  in  Finland  and  Sweden,  as  indicated  by  their  minimum  and  maximum  values,  can  be 
partially  attributed to the deep recessions in these  countries at the beginning  of the  1990s. 

The cyclical sensitivity  of budget  receipts and expenditure  are calculated separately.  As  regards 
receipts, the following  categories  are taken  into  account:  corporate  taxes  (which  vary  most  with 
the  cycle  due  to  the  cyclical  sensitivity  of  profits),  personal  income  taxes,  indirect  taxes  and 
social security  contributions  (which vary  least with the  cycle due to their  regressive  nature).  The 
overall  revenue  elasticity  with  respect to GDP is close to  1.0  for the  Community  as a whole,  and 
ranges from  1.38  for the United Kingdom to 0.77  for Italy,  reflecting differences  in Member  State 
tax  rates  and  tax  structures.  The  application  of  the  revenue  elasticity  to  the  tax  to  GDP  ratio 
gives the marginal sensitivity  of budgetary  receipts to GDP. 

The  estimated  sensitivity  of  budget  revenues  to the  cycle  for  the  Community  as  a whole  is  0.4 
for  1995.  This  means  that  each  widening  of  a  negative  output  gap  by  1  percentage  point 
reduces government  budget  revenues  by 0.4 percentage  points of GDP.  The  revenue  sensitivity 
varies from 0.3 for Greece and Italy to 0.6 for Sweden. 

Government  transfers  to  households  to  cover  costs  related  to  unemployment  are  the  main 
government  expenditure  category  which  reacts  automatically  to  cyclical  variations.  As  a  result, 
the  sensitivity  of  government  spending  to  cyclical  fluctuations  is  significantly  lower  than  that  of 
budget  revenues. The  estimated  sensitivity  of  budget  expenditures  to the  cycle  for  the  EC  as a 
whole  is  -0.1  for  1995,  which  means  that  each  widening  of  a  negative  output  gap  by  1 
percentage  point  increases  government  spending  by  0.1  percentage  points  of  GDP.  The 
expenditure  sensitivity  does  not  vary  widely  among  Member  States:  it  ranges  from  -0.05  for 
France to -0.26 for  Denmark. 

For the Community  as a whole, the sum  of the  marginal  revenue  sensitivity to the  cycle  and the 
marginal  expenditure  sensitivity  gives  the  marginal  rate  of  change  of  the  budget  balance  with 
respect  to  GDP.  The  sensitivity  of  the  budget  balance  to  the  cycle  lies  around  0.5  for  the 
Community  as  a  whole.  This  means  that  each  deterioration  of  a  negative  output  gap  by  1 
percentage  point  increases  the  average  government  deficit  by  0.5  percentage  points.  The 
sensitivity  of the budget  balance to the  cycle  ranges from  0.4 for Greece to 0.85  for Sweden. 

Table B5.2. 

Table B5.3. 

Size  of  the  o u t p ut  gaps  in  the  EC 
(1960-1996) 

Cyclical  sensitivity  of  budget  revenue 
and  expenditure  in  the  EC  (1995)* 

Standard 
deviation 

Minimum 

Maximum 

Value 

Year 

Value 

Year 

B 
DK 
D 

EL 
E 
F 

IRL 
I 
L 

NL 
A 
P 

FIN 
S 
UK 

EUR 

1.7 
1.8 
2.0 

2.1 
2.5 
1.4 

2.2 
1.8 
2.8 

1.6 
1.6 
2.9 

3.5 
1.9 
2.2 

1.4 

-2.7 
-3.6 
-3.9 

-3.4 
-4.5 
-2.2 

-4.2 
-3.4 
-4.6 

-3.4 
-2.8 
-5.5 

-7.4 
-4.3 
-4.0 

-2.2 

1986 

1981 

1967 

1962 

1960 

1985 

1966 

1975 

1967 

1983 
1987 
1984-85 

1993 
1993 
1982 

1983 

3.9 

3.7 

4.2 

5.8 
5.3 
3.0 

4.2 
3.1 
8.6 

2.4 
3.2 
8.2 

9.0 
3.6 
5.1 

3.2 

1974 

1986 

1991 

1973 

1974 

1990 

1978 

1980 

1974 

1974 
1974 
1973 

1989 
1990 
1988-89 

1973 

Budgetary 
receipts 

Budgetary 
expenditure 

Budget 
balances 

B 
DK 
D 
EL 
E 
F 
IRL 
I 
L 
NL 
A 
P 
FIN 
S 
UK 
EUR 

0.5 
0.5 
0.4 

0.3 
0.5 
0.5 

0.4 
0.3 
0.4 

0.5 
0.4 
0.4 

0.5 
0.6 
0.5 

0.4 

* Fisures are rounded  off. 

-0.1 
-0.3 
-0.1 

-0.1 
-0.2 
-0.1 

-0.2 
-0.1 
-0.2 

-0.2 
-0.1 
-0.1 

-0.2 
-0.2 
-0.2 

-0.1 

0.6 
0.7 
0.5 

0.4 
0.6 
0.5 

0.5 
0.5 
0.6 

0.8 
0.5 
0.5 

0.6 
0.9 
0.6 

0.5 

85 

Box 6: Pension  expenditure  and liabilities  in the Community 

1. 

The  prospects for public  pension  expenditure 

The  demographic  structure  of  European  countries  is  changing  considerably.  The  old-age 
dependency  ratio  (i.e.  the  ratio  of  the  elderly  to  working  age  population)  is  increasing  in  most 
countries  and  reaching  historically  unprecedented  levels.  Although  the  long-term  effects  of  the 
ageing process on public budgets are uncertain and depend on the way the economy  and society 
will adapt to the  process, a significant  pressure towards higher public expenditure  is very  likely to 
occur  in  the  coming  decades.  Public  pension  schemes  will  bear  much  of  the  strain  since  their 
expenditure  is highly dependent  on the age structure  of the population. 

In  order  to  evaluate  these  prospects,  all  Member  States  have  carried  out  pension  expenditure 
projections  over  recent  years. These projections, which are  not  homogeneous  in the  coverage  of 
pension  expenditure,  have  been  examined  in  a  report  recently  published  by  the  Commission 
services *  The  report  focuses  on  the  most  recent  unchanged  policy  projections  produced  by 
public  institutions;  it  provides  comparable  estimates  of  the  impact  of  pension  expenditure  on 
public  sector  accounts  on the  basis  of  national  expenditure  projections  and  1995  ratios  of  total 
public  pension  expenditure  to  GDP. Graph  B6.1  presents the weighted  average2  of the  increase 
in  the  ratio  of  public  pension  expenditure  to  GDP  in  the  11  Member  States  that  produced 
projections  up to the year 2030. 

Graph  B6.1 

Estimates  of  public  pension  expenditure 

%  of  G DP 

(weighted averages of expenditure growth in 

11 Member States) 

growth  in the  EC* 

o  *-
1995 

2000 

2005 

2015 

2020 

2025 

2030 

Source:  Commission  services::  : 

Over  the  period  1995-2030,  the  ratio  of  pension  expenditure  to  GDP  in  the  11  countries  will 
increase  by  3 to 4  percentage  points  (respectively  under favourable  and  unfavourable  economic 
assumptions).  Expenditure  pressures,  although  non-negligible,  are  expected  to  be  relatively 
limited  over  the  next  5 years. The  outlook  worsens  in the first  decade  of the  next  century,  when 
the  expenditure  to  GDP  ratio  is  expected  to  increase  in  most  countries,  and,  even  more,  after 
the  year  2010,  when  the  baby-boom  generation  retires.  In  several  countries  expenditure 
pressures will  peak  in the  period 2030-2040.3 

The efforts  to reform  European pension  systems -  In most  countries  present  pension  policies  are 
quite  different  from  those  implemented  in  previous  decades.  The  phase  of  extension  of 
coverage  and  improvement  of  benefits  is  over.  Since  the  mid-eighties  most  pension  sctiemes 
have  been  reformed  in  order  to  reduce  pension  expenditure  growth.  Major  reforms  were 

See D. FRANCO  and  T.  MUNZI,  1996, "Public pension  expenditure  prospects  in the  European  Union: A survey 
of national  projections", European  Economy,  No. 3. 
Weighted  by  1995 GDP  in units  of Purchasing  Power  Standard. 
Over  the  last  decade,  several  national  projections  have  been  revised  upward.  Some  changes  have  been  quite 
substantial.  Past  revisions  do  not  give  any  indication  about  future  revisions  of  present  estimates.  However 
they point  to the  usefulness  of carrying  out  regular reviews of projections  and  analysing  past projection  errors. 

86 

to  national  projections, 

introduced  in Austria, Finland, Germany,  Italy, France, Greece, Portugal, Sweden and the  United 
the  effects  of 
Kingdom/According 
demographic  trends  (i.e.,  the  increase  in  the  old-age  dependency  ratio)  will  be  substantially 
offset  by  reforms  cutting  eligibility  and  transfer  ratios.4  While  cost  containment  was  the  main 
objective  of the  reforms, they  also  aimed  at  making  the  pension  systems  more  able  to  tolerate 
demographic  change,  more  transparent  as  to  their  distributive  effects,  less  distortive  of 
individuals' choices. 

in  several  Member  States 

In  spite  of  these  reform  efforts,  in  several  countries  the  preservation  of  present  benefit  levels 
and  eligibility  rules  will  require  a  substantial  increase  in  the  national  resources  devoted  to 
pension  systems.  Alternatively,  the  stabilisation  of  pension  expenditure  will  require  further 
substantial  reform  in pension  benefit  levels and restrictions in pension  eligibility. 

In  conclusion,  while  the  adjustment  of  European  pension  systems  to  the  new  demographic 
scenarios  is well  underway, with  reforms  gradually  affecting  pension  expenditure  dynamics,  the 
large expected changes in demographic  structure  require further policy  changes. 

2. 

Pension  liabilities 

Pay-as-you-go  (PAYG)  pension  schemes  give  rise to  unfunded  liabilities.  Within  these  schemes 
each  generation  provides  the  resources  for  paying  the  pensions  of  older  citizens  and  later 
receives  pensions  financed  by  younger  citizens.  Therefore,  at  any  point  in  time  there  exists  a 
number  of  retired  citizens  who  are  entitled  to  a  pension  for  the  remainder  of  their  life  (and 
sometimes  also  of  the  life  of their  widowed  spouse)  and  a  number  of  working  citizens  who  can 
claim a right to a pension  in the near or distant future. 

Table B.6.1 

Public  Pension  Liabilities:  Present  value  of accrued  rights 

Van  Den  Noord  -  Herd  (1993,  1994) 

A BP  (1993) 

IMF  (1996) 

%  of  1990  GDP 

%  of  1990  GDP 

%  of  1995  GDP 

Country 

Gross  Liabilities 

Existing 
assets 

Net 
liabilities 

Gross  liabilities 

Retired 

W o rk 
force 

Total 

54 

103 

157 

77 

94 

58 

42 
51 
42 

139 

216 

148 

242 

81 

70 
112 
71 

139 

113 
163 
113 

23 
18 
8 

B 

DK 
D1) 

EL 
E 
F 

IRL 
I 
L 

NL 

P 
UK 

USA 
Japan 
Canada 

157 

216 

242 

139 

89 
144 
105 

68 

69 
122 

118 
109 

69 

54 

107 

138 

137 

96 
42 

221 

265 

357 

117 

108 
166 
94 

I;  West  Germany in Van Den Noord-Herd (1993, 1994) and ABP (1993). 
Sources: Kuné J. B. - Petit W.  F. M. - Pinxt A. J. H., "The  Hidden Liabilities of Basic  Pension  Systems  in the  European 
Community",  CEPS Working Document, No. 80, November,  1993. Van den Noord P. - Herd R. "Pension  liabilities  in the 
seven major economies",  OECD, Economics Department Working Papers, n. 142, 1993,. Van den  Noord  P. - Herd  R., 
"Estimating pension liabilities: A methodological  framework",  OECD, Economic Studies, n. 23,  1994., pp.  131-166. IMF, 
Aging Populations and the Fiscal Consequences of Public Pension  Schemes, 1996. 

Respectively  the ratio of the number  of pensions to the number  of elderly  citizens  and  (he  ratu 
pension  to the average wage. 

<-|  (he ; i vera  ne 

87 

In  recent  years  a  number  of  studies  have  estimated  the  liabilities  of  PAYG  schemes.  Table  1 
reports  some  estimates  of  accrued  pension  liabilities,  which  represent  the  present  value  of 
pensions  to  be  paid  in  the  future  on the  basis  of  accrued  rights.5  Estimates  vary  considerably 
and the ranking of countries changes. 

The  relevance  of  pension  liabilities  -  Estimates  of  pension  liabilities  represent  a  useful 
complement to conventional debt and deficit  measures. 
a) 

They provide  a measure of the cost of terminating  PAYG pension schemes when 
complying  fully with present  benefits rules.6 
They bring a clearer understanding  of the impact  of fiscal policies (by representing a 
relevant  part of households' assets, pension rights influence  consumption  and  saving 
decisions). 
They are useful for the measurement  of deficits on accrual basis; the  estimates 
available for some countries show that over the last few decades accrual deficits  have 
been much  larger than conventional  cash flow deficits. 

b) 

c) 

On the  other  hand, the  ratio  of  accrued  pension  liabilities  to  GDP  is not  an  indicator  of  pension 
schemes' sustainability.  A  high  liabilities  to  GDP  ratio  does  not  necessarily  imply  an  imbalance 
in  PAYG  pension  schemes.  Nor  does  it  imply  that  an  imbalance  will  occur  in  the  future.  Any 
judgement  about  the  sustainability  of  pension  schemes  and  the  pressure  they  exert  on  public 
budgets  requires  estimates  about  the  resources  available  to  pay  for  the  accrued  pensions, 
namely  about  the  evolution  of  employment  and  per  capita  income.  The  sustainability  issue 
should be addressed with other indicators, such as the  pension expenditure to  GDP  ratio  and the 
contribution  rate that  assures the cash balance  of pension sctfemes. 

Pension liabilities and public  debt-  Accrued pension rights differ  in many ways from  conventional 
public  debt  and  there  are  practical  as  well  as  theoretical  reasons  for  not  including  accrued 
pension  liabilities  in the  deficit  and debt  statistics  used  in  defining  and  evaluating  current  fiscal 
policy. 
i) 

While conventional  public debt can be measured  precisely  and unambiguously  at any 
point  in time, pension  liabilities are uncertain  and depend on the specific  assumptions 
adopted  upon a variety  of factors, such as life expectancy,  price and wage trends, etc. 
Present value calculations  are extremely sensitive to changes in assumptions. 
Pension  rights are not embodied  in formal contracts. The debtor can modify  both the 
timing  and the amount  of the  payment. Over recent years in several  countries  benefit 
rule reforms  have substantially  reduced the future  entitlements  of current workers  and 
pensioners. The  assimilation  of pension  liabilities to financial  liabilities  might  hamper 
further  reforms. 

ii) 

iii)  While  public  bonds  are  usually  bought  freely  on the  market  by  individuals  or  companies, 
the  acquisition  of  pension  rights  is  usually  compulsory.  This  means  that  a  large  pension-
debt  does  not  determine  any  direct  pressure  on  financial  markets.  It  also  implies  that  the 
debt  is  automatically  renewed.  The  inclusion  of  pension  liabilities  in  the  debt  and  deficit 
measures would  conceal the pressure of the public sector on financial  markets. 

iv) 

Pension  rights  are  not  tradable.  This  implies  that  changes  in  the  relative  yield  and  the 
relative  risk  of  pension  rights  comparatively  to  other  assets  have  no  effect  on  financial 
markets.  Non tradability  also  implies that  social security  claims  can  be  altered  selectively, 
taking  individual  characteristics  (e.g., income, demographics)  into  account. 

The  inclusion  of  accrued  pension  liabilities  in  the  public  debt  definition  would  require  an 
analogous  change  in  the  deficit  definition.  Contributions  would  become  loans  to  the  public 
sector;  pensions  would  be  considered,  in  part,  as  loan  repayments  and  in  part  as  an  implicit 
interest  payment. 

The different  definitions  of pension  liabilities  and  their  role  in the assessment  of  fiscal  policies  are  examined 
in  D.  FRANCO,  1995;  "Pension  Liabilities  -  Their  Use  and  Misuse  in  the  Assessment  of  Fiscal  Policies", 
Economic  Papers,  European  Commission, N.  110. 
If there  is a switch  from  a PAYG  system  to a funded  system,  and  all  new  contributions  are  paid  into the  new 
system, accrued  rights measure  the amount of resources which have to be financed  from  general  taxation. 

4.  EXCHANGE-RATE  STABILITY  AND 

INTEREST-RATE  CONVERGENCE 

IN  THE 

COMMUNITY 

4.1  Overview 

Monetary  developments  in  the  European  Community  in  1996  were  influenced  by  two 

main  factors:  (i)  an  overall  -  albeit  unsteady  -  appreciation  in  the  US  dollar  and  (ii)  an 

improved  financial-market  perception  of  the  prospects  for  EMU.  Both  factors  were 

reflected  in  stable  exchange  rates  and  converging  interest  rates.  Monetary  conditions  in 

the EC eased overall, consistent with the cyclical position of the economy and a  reinforced 

commitment  to  budgetary  consolidation  in  many  Member  States  ahead  of  the  launch  of 

EMU on  1  January  1999. 

The firmer  US  dollar was mainly  attributable  to  the  relative  strength  of the  US  economy. 

However,  market  sensitivity  to  a possible  economic  downturn  and  the  consequences  for 
monetary policy  made for  an uneven  appreciation.  As the  dollar moved  higher,  the  DEM 

eased  against  most  of the  other  EC  currencies  providing  scope  for  a narrowing  of  short-

term interest rate differentials  relative to  Germany. 

The  generalised  easing  of  the  DEM  against  other  EC  currencies  also  reflected  financial-
market  sentiment  on  the  prospects  for  EMU.  EMU  optimism  was  inspired  by 
reaffirmation  of  political  support  for  the  project  throughout  the  Community,  visible 
progress  in  technical  preparations  for  the  changeover  to  the  euro  and  a  reinforced 
commitment  to  budgetary  adjustment  in  many  Member  States.  As  confidence  improved 
about  the  possibility  of  a  significant  number  of  Member  States  adopting  the  single 
currency  from  the  outset,  there  was  an  intensification  in  the  convergence  of  short  and 
long-term interest rates toward the levels in the lower-yielding Member  States. 

Given  the  overall  improvement  in  monetary  conditions  and  the  effect  of  budgetary 

consolidation  in  lowering  long-term  interest  rates,  the  macroeconomic  policy  mix  has 

become  more  supportive  of  economic  growth.  The  more  aggressive  approach  to 
budgetary  consolidation presents the prospect  of a "virtuous circle" of falling  interest  rates 
supporting  economic growth  and greater  credibility  of budgetary  adjustment  efforts  as the 
economy  strengthens.  Successful  budgetary  consolidation  is,  of  course,  the  key  element 
in sustaining these  developments  and it is essential that budgetary targets be realised  if the 
currently favourable  trends are to be sustained. 

69 

4.2  Uneven  appreciation  in the US dollar 

Early  boost for  dollar from  US bond-market rally 

In the wake  of a monetary easing in Germany  on  14 December  1995, the  dollar began  the 

year on a rising trend  against the DEM.  By early February,  the DEM/USD  exchange  rate 

was  close  to  1.49;  this implied  an  appreciation  of  about  3.5%  since the  beginning  of  the 

year  and  of  about  7%  from  a  low  of  1.39  DEM  recorded  in  October  1995.  The  dollar 

gained  more  modestly  against  the  Japanese  yen  in the  early  part  of  1996,  having  surged 

higher in the final weeks of  1995 amid gloomy prospects for the Japanese  economy. 

Demand  for  the  dollar  in the  early weeks  of the  year  was  reinforced  by  buoyancy  in  US 

financial  markets.  With  inflation  expectations  subdued  by  a  relatively  modest  pace  of 

expansion  in the  US  economy,  bond  and  equity  prices  were  discounting  the  continuation 

of  an  accommodating  monetary  policy.  Market  expectations  were  validated  on  31 

January, when US money-market  rates - which had been falling  steadily throughout  1995 -
were  again  steered  lower  by  the  Federal  Reserve;  however,  this  proved  to  be  the  only 

monetary easing by the Federal Reserve in  1996.  Apart from  interest-rate  factors,  activity 

in the US financial  markets was also supported  by continued  capital inflows  from  Japanese 

sources in response to relatively high rates of return. 

Dollar  underpinned  by stronger economy as bond market ebbs 

By mid-February,  the data  suggested  that the outlook for the US economy  had  brightened 

considerably.  Financial-market  expectations  of  inflation  were  revised  upward  and  the 

prospect  of  a further  monetary  easing  by the  Federal  Reserve  faded.  US  money-market 

rates  climbed  and  longer-term  rates  also  moved  upward  as  sentiment  in  the  bond  market 

deteriorated.  Despite  the  loss  of  bond-market  support,  the  dollar  strengthened  further 

against  both  the  DEM  and  the  yen  as  markets  now  began  to  discount  a  near-term 

monetary tightening by the Fed at the same time as a monetary  easing by the Bundesbank . 

The  DEM/USD  exchange  rate  climbed  to  about  1.55  by  early  May  and  was  hovering 

around  1.53  at  the  end  of  the  second  quarter;  this  implied  an  appreciation  of  more  than 

6% in the first half of the year.  Meanwhile, the JPY/USD  exchange rate ended the  second 

quarter  above  109, implying an appreciation of more than 5% in the first half of the year. 

90 

Source: 

Commission services. 

1995 

Equity sell-off  triggers temporary reversal in dollar rise 

The  appreciation  in the  dollar  was  interrupted  early  in  the  third  quarter  of  the  year.  An 

abrupt  deterioration  in  sentiment  toward  the  US  currency  was  triggered  by  a  significant 

one-off  fall  in  US  equity  prices  in  July,  although  the  US  bond  market  was  relatively 

unaffected.  Demand  for  the  dollar  was  further  undermined  by  mixed  signals  on  the 

strength  of the US  economy  and  a growing  market  perception  that  the  interest-rate  cycle 

in  Germany  had  bottomed  following  a  cut  in  the  Bundesbank's  key  intervention  rates  in 

April.  Speculation  concerning  a  possible  monetary  tightening  in  Japan  also  weighed  on 

the  dollar,  as  the  DEM/USD  exchange  rate  moved  below  1.48  and  the  JPY/USD 

exchange rate fell to  108 at the end  of August.  This episode  of weakness was  short-lived, 

however,  and  the  dollar  subsequently  recouped  much  of  its  losses  on  new  evidence  of  a 

robust  expansion  in the US economy.  With market  expectations  of a near-term  monetary 

tightening in the United  States fully  revived, the DEM/USD  exchange rate ended  the third 

quarter  at  close  to  1.54  —  helped  also  by  a  generalised  strengthening  of  the  other  EC 

currencies  against  the  DEM  ~  while  the  JPY/USD  exchange  rate  ended  the  quarter  at 
about  111.6. 

Dollar  ends the year  strong despite  uncertainty on US economy. 

The  dollar  consolidated  its gains  against  the yen  in the  fourth  quarter  as the  performance 

of the  Japanese  economy  continued  to  disappoint  the  markets.  The  JPY/USD  exchange 

rate ended the year at  116.1, up by about  11.5% relative to its level on  1 January.  Against 

91 

the DEM, the dollar followed  a more uneven trend as markets remained highly sensitive to 

prospects  for  the  US  economy  and  to  the  implications  of  official  comments  for  the 

direction of monetary policy in the United  States and in Germany.  From mid-October,  the 

dollar  eased  against  the  DEM  amid  a  reassessment  of  the  expected  strength  in  the  US 

economy  and  a  perception  that  the  European  economies  had  bottomed  out.  However, 

renewed  concerns  at  the  pace  of  recovery  in Europe  emerged  in  late  November  and  the 

DEM/USD  exchange  rate  surged  on  market  speculation  of  another  monetary  easing  in 

Germany.  Despite  a  temporary  downward  blip  linked  to  a  second  sharp  sell-off  in  US 

equities in early December, the DEM/USD  exchange rate ended the year  at about  1.55,  up 

by almost  8% relative to  1 January.  In nominal  effective  terms,  the  dollar  appreciated  by 
about 4%23 in 1996. 

4.3  Appreciating  dollar and EMU optimism favour monetary stability  in the 

Community 

4.3.1  Strong dollar reflected in intra-EC exchange-rate  movements 

The appreciation  of the US dollar in the course of  1996 contributed  to  an overall easing in 

monetary  conditions in the EC.  The strength  of the dollar  against  the DEM was  mirrored 

in  other  EC  currencies,  particularly  in  the  "high-yielding"  currencies.  By  the  end  of  the 

year,  the  decline  in  the  DEM  against  the  other  EC  currencies  had  largely  reversed  the 

nominal  effective  appreciation  which had  resulted  from  the  exchange-rate  disturbances  of 

Spring  1995. 

For  presentational  purposes,  it  is  convenient  to  differentiate  between  Member  State 

currencies  on the basis  of their  participation  or  non-participation  in the  ERM.  The  trend 

in  the  exchange  rates  of  ERM  currencies  which  moved  significantly  against  the  DEM  is 
illustrated  in  Graph  26.  The  high-yielding  Italian  lira24  (+11%)  and  Portuguese  escudo 
(+3.3%.)  experienced  a  significant  appreciation,  together  with  the  Irish  pound  (+13.3%) 

which  moved  in  line  with  sterling.  The  French  franc  (1.3%)  also  benefited  from  the 

generalised  easing  in the  DEM,  despite  experiencing  a bout  of  selling  pressure  linked  to 
political  uncertainties  in August.  The  remaining  ERM  currencies25  were  either  stable  or 
marginally weaker  against the DEM over the year. 

23 Against  23 industrial  countries. 
2A Which  re-entered  the ERM on 25 November,  1996. 

25  Including  the Finnish  markka,  which entered  the ERM on  14 October,  1996. 

92 

Graph  26 

Exchange rates : DEM versus ERM cu rrencies 

January  1995  =  100 

DEM nominal  effective  exchange  raté* 

Spain 

110 

105 

80 

1995 

* Relative to 23 industrialised countries. 
Source:  Commission  services. 

1996 

Systemic  conditions  in  the  ERM  generally  improved  in  1996.  The  spread  between  the 

strongest  and weakest  currencies in the grid  -- which had already come down in late  1995 

~  narrowed  progressively  throughout  most  of  the  first  three  quarters.  The  spread  fell 

from  about  5.6%  (Spain versus Ireland) in early January to  a low of about  1.99%  (Ireland 

versus  France)  on  27  September  but  widened  again  to  about  2.29%  (Ireland  versus 

France)  on 30  September.  While the vast majority  of ERM  currencies remained  inside  or 

close  to  their  former  narrow  fluctuation  margins  in  the  fourth  quarter,  a  continued 

appreciation  of the Irish pound  resulted  in a widening of the spread to  a peak  substantially 

above  9%  before  ending  the  year  at  8.9%  (Ireland  versus  France).  The  width  of  the 

spread  reflected  the  strength  of  the  Irish  pound  rather  than  the  weakness  of  the  French 

franc,  which  although  at  the  bottom  of  the  grid  was  still  relatively  close  to  its  central 

parity  against  the  DEM.  Continued  appreciation  of the  Irish  pound  within  the  grid  could 

GraPh 2?  1  Exchange  rates: DEM versus  non-ERM  currencies 

115 

110 

105 

100 

95 

90 

85 

January 1995 = 100 

Sweden 

1995 

1996 

*  Relative to 23  industrialised  countries. 
Source:  Commission  services. 

93 

pose a policy dilemma for the national authorities; the Irish economy has been  accelerating 
at  a rapid  pace in recent  years and the need  for  a further  monetary  tightening  —  implying 
a further  widening of the spread  — cannot be ruled  out.  Overall, however,  spreads within 
the ERM narrowed  so that  most  participating  currencies  ~  including  the Finnish  maarka 
and  the Italian lira which did not  participate  for  the full  year — ended  the year very  close 
to or within the former  narrow fluctuation  margins of +1-2.25%. 

The non-ERM currencies  ~  which are high yielding and relatively dollar-sensitive  ~  also 
appreciated  against the DEM.  The traditional  linkage between  movements  in sterling  and 
the  dollar,  reinforced  by  evidence  of  a  sustained  recovery  in  the  domestic  economy, 
boosted  the  UK  currency  (+18.2%),  while  the  Swedish  krona  (+3.5%)  and  the  Greek 
drachma (+3.7%)  also made steady gains over the year. 

4.3.2  Appreciation  of other EC  currencies against DEM  accompanied  by  convergence 

in short-term  interest rates 

The  generalised  appreciation  of  other  EC  currencies  against  the  DEM  was  accompanied 

by  a  significant  narrowing  in  short-term  interest-rate  differentials  with  respect  to 

Germany.  German  short rates moved  modestly lower over the year,  with the  three-month 

money-market  rate  falling  by  about  65  basis  points  to  3.1% over  the  year  in  line  with 

monetary-policy  developments.  As indicated  in Graph  28, the Bundesbank's  key  discount 

rate  and  Lombard  rate  were  both  lowered  by  50  basis  points  to  2.5%  and  4.5% 

respectively on  19 April; however,  the pace of decline in German money-market  rates was 

dictated  by  a fixed repo  rate  of  3.3% between  1  February  and  22 August,  before  it  was 

lowered  to  a fixed level of 3%  until the end  of the year.  The relatively  moderate  pace  of 

monetary  easing by the Bundesbank  reflected  high rates  of growth  in the  domestic  money 
supply  (M3),  which  expanded  at  a  monthly  rate  above  the  target  range  of  4% -7%26 
throughout  the year, falling  from  a peak of  12.8% in February to 8% in November. 

Graph 28 

Short-term  interest rates  in  Germany 

Lombard 

Source:•':•'.'Commission services. 

1995 

3  months 

1996 

26 Relative to the average monthly  growth  rate in the fourth  quarter of 1995. 

94 

j Graph 29 

Short-term interest rate differentials 

in  ERM Member States* 

* Differential on 3 month money market rate relative to Germany. 
Source:  Qommission services. 

1995 

:l996ï 

The decline in short-term interest rates was  more pronounced  in other Member  States, in 

most  cases  reflecting  a more  significant  relaxation  of  monetary  policy  than  in  Germany. 
Over  the  year,  the  average  differential  ~  among  all  the  other  Member  States27  ~  on 
three-month  money  market  rates  relative  to  Germany  fell  from  about  230  basis  points  to 

about  145  basis  points.  There  was,  however,  a  significant  variation  between  Member 

States.  Graph 29 indicates that the decline in short rates among the ERM Member  States 

was  most  striking  in  Italy,  Spain  and  Portugal,  where  the  differential  on  the  three-month 

money  market  rate  fell  from  650  basis  points  to  about  420  basis  points,  from  550  basis 

points  to  about  325  basis  points  and  from  about  500  basis  points  to  about  335  basis 

points,  respectively.  Budgetary  consolidation  and  other  measures  that  have  helped  to 

bring  inflation  down  have  allowed  central  banks  to  reduce  interest  rates.  In  France,  the 

differential  fell  from  about  120 basis  points  to  about  30 basis  points.  Ireland,  where  the 

differential  widened  from  about  170 basis points to  about  280 basis points,  was  a  notable 

exception to the convergent trend  among the ERM Member States. 

Among the non-ERM  Member  States,  the differential  on three-month  money  market  rate 

in the  United  Kingdom  with  respect  to  Germany widened  from  about  280  basis  points  to 

about  340 basis  points.  The  United  Kingdom  was  the  exception  to  a narrowing  trend  in 
short-term  interest  rate  differentials  among  these  Member  States.  The  narrowing  was 
particularly  notable  in  Sweden,  where  the  differential  on  the  three-month  money  market 
rate  fell  from  about  485  basis  points  to  about  90  basis  points.  The  Swedish  experience 
reflected  a particularly  aggressive monetary easing by the Riksbank  in the early part  of the 
year, involving a long sequence of cuts in the key repo rate. 

27  Excluding  Luxembourg and  Greece. 

95 

4.3.3  Long-term  interest rates also converge, helped by EMU  optimism 

As with short rates, there was a significant  convergence in bond yields toward  the German 

level  in  the  other  Member  States.  This  phenomenon  was  again  relatively  conspicuous 

among  the  high-yielding  Member  States.  Graph  30  indicates  that  German  long  rates 

moved  moderately  upward  over  the first half  of the year  in line with  a  similar  (but  more 

pronounced)  trend  in the  United  States.  The rise in US yields began  with  the  reverse  in 

bond  market  sentiment  early in February  and was largely  sustained  until  early  September, 

when yields began  to  fall  in response to  revised  expectations  of a monetary  tightening by 

the  Federal  Reserve.  German  yields  had  been  above  the  corresponding  US  levels  since 

early  1995,  but  in  mid-April  the  positive  differential  turned  negative  reflecting  a  partial 

decoupling between  the US and German bond markets.  The negative differential  widened 

in subsequent months and the yield on the benchmark ten-year bond in Germany ended  the 

year  about  15 basis  points  lower  than  its level  on  1 January  (the  corresponding  US  yield 

was about  70 basis points higher over the same period). 

Graph  30 

Long-term  interest  rates  in Germany and the United  States 

* Yield on  benchmark  10-year bond. 
Source:  Commission  services. 

1995 

1996 

Trends  in  bond  yields  in  the  other  Member  States  varied.  The  average  differential  ~ 
among  all other Member  States28 — in the yield  on benchmark  ten-year  bonds relative  to 
Germany  fell  from  about  160 basis  points  at  the  beginning  of  January  to  about  65  basis 
points  at  the  end  of December.  As indicated  in Graph  31,  this  decline  mainly  reflected  a 
sharp fall  in yield  differentials  in Italy (from  about 445 to  about  165 basis points) in Spain 
(from  about  360 to  about  105 basis points) and in Portugal  (from  about  375 to  about  115 
In  each  case,  the  decline  in  yields  reflected  a  lowering  of  inflation 
basis  points). 

Excluding Luxembourg and Greece. 

96 

expectations and a firmer  exchange rate against the DEM.  Among the non-ERM  Member 

States,  the  differential  in  the  United  Kingdom  widened  marginally  over  the  first  nine 

months  of  the  year,  on  rising  expectations  that  domestic  monetary  policy  would  be 

tightened  in  view  of  the  strong  cyclical  position  of  the  UK  economy  relative  to  that  of 

other Member State economies (see Graph 32). 

Graph 31 

Long-term interest rate differentials 
among  ERM Member States* 

* Yiefd differentials  on benchmark 10-year bonds relative to Germany. 
Source:  Commission services. 

19Ô5 

WM 

Convergence  in  long-term  interest  rates  toward  the  German  level  accelerated  sharply  in 

the  final  quarter. 

Inflationary  pressures  remained  subdued  throughout  most  of  the 

Community.  In  Italy,  Spain  and  Portugal,  but  also,  to  some  extent  in  Greece,  anti-

inflationary  policies  coupled  with  reinforced  fiscal  consolidation  have  succeeded  in 

reducing inflation  and stabilising expectations towards a lower rate of inflation.  As  shown 

in Graph 30, German long rates moved lower in the final quarter  ~  once again helped  by 

US developments  ~  but the fall in other EC long rates was more dramatic.  Final-quarter 

developments  brought  all  EC  ten-year  bond  yields  within  200  basis  points  of  the 

corresponding  German  yields for  the first time  since  capital  liberalisation  was  completed 

within the Community. 

Graph 32 

Long-term interest rate differentials 
among  non-ERM Member States* 

0;5 

* Yield differentials on benchmark 10-year bonds relative to Germany. 
Source:  Commission services. 

1995 

199$; 

97 

4.4  EMU  prospects  confirmed  in ECU market and forward  interest  rates 

Despite  the  convergence  in  long-term  interest  rates,  wide  (albeit  narrowing)  differentials 

relative to  Germany  persisted  in many Member  States  in the first three  quarters  of  1996. 

Moreover,  a substantial negative differential  between the theoretical  exchange rate and the 

corresponding  official  rate in the ECU market was interpreted  as implying  some  continued 

hesitation  in  the  markets  with  respect  to  EMU.  This  was  confirmed  by  differentials  in 

forward  interest  rates,  which'were  discounting  significant  exchange  rate  movements  in 

many  Community  currencies  and  the  ECU  well  beyond  the  projected  starting  date  of 

EMU. 

From  September  onward,  there  was  a marked  improvement  in  market  sentiment  toward 

EMU and the prospect  of a significant  number  of countries  participating  in the  euro  zone 

from  the  outset.  The  more  favourable  market  view  of EMU  was  the  combined  result  of 

several  factors.  Firstly,  there  was  evidence  of  a  strong  political  commitment  to  the 

project;  as  manifested  in  the  agreement  on  the  Stability  and  Growth  Pact,  on  a  new 
exchange-rate  mechanism  and  on  the  legal  framework  for  the  euro  reached  in  mid-

December.  Secondly,  the  prospects  for  growth  in  the  EC  economy  in  1997  brightened 

considerably.  Finally,  budgetary  adjustment  efforts  were  reinforced  in  most  Member 

States with  a view  to  complying  with  the relevant  Maastricht  criteria.  The  improvement 

in market  sentiment  toward  EMU  quickly became the  main factor  driving  convergence  in 

long-term  interest  rates  toward  the  (declining)  German  level.  The  fall  in  German  long-

term  interest  rates  amid  rising  EMU  optimism  seems  to  confirm  that  there  is  no  EMU-

specific  risk  premium  on  German  bonds.  Furthermore,  the  accelerated  decline  in 

differentials  among  the  high-yielding  Member  States  has  been  interpreted  as  striking 

evidence  of an increased financial-market acceptance  of  a significant  number  of  countries 

adopting the euro from the outset  of EMU. 

Graph  33 

Exchange rate and interest rate differential  between 

basis  points 

50 

theoretical and market ECU 

*MQWftitf<p^*rcw,»qQQM««tow<gfl?tf^^tfP^OgWBWMl#aul^^ 

-50 

-100 

-150 

-200 

-250 

-300 

Jan 

Feb 

Mar 

Apr  May 

Jun 

July 

Aug 

Sep 

Source:  Commission  services. 

Oct 

Nov 

Dec 

98 

A further  indicator  of growing EMU credibility in the final quarter was the performance  of 
the ECU market.  Although trading volume remained  modest,  Graph 33 indicates that  risk 
premia  with  respect  to  the  exchange  rate  fell  in  the  course  of  1996,  particularly  in  the 

fourth  quarter.  While the  gap  between  the theoretical  value  of the  ECU  and  the  market 

value  was  300  basis  points  at  the  beginning  of  the  year,  it  had  fallen  to  about  86  basis 

points  by the  end  of the year.  At the  same time, the interest-rate  spread  which  had  been 
low throughout the year virtually  disappeared. 

Finally,  the  growing  credibility  of  the  EMU  project  was  evident  in  the  movement  of 

forward  interest  rates  on all Member  State  currencies.  Forward  rates  on contracts with  a 

settlement  date  after  the  creation  of  EMU  on  1.1.1999  should  be  the  same  for  all 

currencies  expected  to  participate  in the  euro  zone  from  the  outset.  The  existence  of  a 

significant  divergence  in  such  forward  rates  in  any  Member  State  can  be  considered  as 

evidence  of a  "credibility  gap" with  respect  to  their  participation  in the  euro  zone.  Table 

27  presents  the  differential  relative  to  Germany  (which  is  assumed  to  be  a  certain 

participant  in the euro zone) in five-year forward  rates on five year loans for  a selection of 

Member  States for which data is available. 

The  forward  rates  are  derived 

Table 27 

using estimated  zero  coupon yield 

curves  in  the  relevant  Member 
States.29  It is clear from  the  table 
that  the  relevant  forward  rates  on 

the  "hard  core"  currencies  have 

been  highly  convergent  for  some 

time,  but  a  significant  divergence 

has existed  in the  forward  rates  of 

the  other  currencies.  As  with 

developments 

in  spot  markets, 

however,  this divergence has been 

narrowing 

steadily 

since 

the 

F i v e - y e ar  f o r w a rd  r a te  on  five-year  loans 
Differential  vis-à-vis Germany in basis points 

Date 

Jan-Mar 
1996 

July 
1996 

Oct. 
1996 

Dec. 
1996 

B 
E 
FIN 

F 
I 
NL 

A 
S 
UK 

ECU 

45 
239 
n.a. 

-6 
n.a. 
-7 

n.a. 
183 
94 

57 

43 
184 
n.a. 

-7 
198 
-5 

2 
n.a. 
123 

n.a. 

-2 
83 
62 

-24 
-4 
-4 

2 
96 
79 

4 

-7 
21 
43 

-31 
42 
-10 
-5 

59 
82 

10 

beginning  of  the  year  and  particularly  in  the  final  quarter.  The  differential  in  the  ECU 

forward  rate  early  in the year was  seen  as evidence  of market  scepticism  about  the  EMU 

project  itself  but  this  differential  had  largely  disappeared  by  the  end  of  the  year. 

Moreover,  the  convergence  in  forward  rates  on  the  various  EC  currencies  offers 

confirmation  of  a  growing  financial-market  acceptance  of  a  significant  number  of 

participating Member  States in the euro zone from  the outset of the third  stage of EMU. 

29 Estimation of zero-coupon yield curves is not exact and, in consequence, the derived forward  rates may 

be subject to measurement error. 

99 

4.5  Easing monetary  conditions combines with budgetary  consolidation  to 

rebalance the macroeconomic  policy mix 

4.5.1  Monetary  conditions ease over the year 

The  strength  of  the  US  dollar  and  the  generalised  decline  in  short-term  interest  rates 

throughout  most  of  1996  implied  an  improvement  in  monetary  conditions  within  the 

European  Community.  Graph  34  indicates  the  movement  in  the  Monetary  Conditions 
Index  or  MCI30,  (which  combines  the  movements  in  short-term  interest  rates  and 
exchange  rates  to  indicate  the  change  in monetary  conditions within  an  economy)  for  the 

larger  Member  States.  The  movement  in  the  MCI  for  Germany  and  France  point  to  a 

significant  relaxation in monetary conditions in  1996 relative to  1995.  A similar trend  was 

Graph  34 

;Çhiange; relative to; 1990 \ 

Monetary conditions index* 

20 

15 

10 

-5 

1992 
* Weighted  average of changes  in  real 3  month interest  rates and changes  in the 

1993 

1994 

1995 

1996 

effective  exchange  rate relative to the base year  (1990).  A  positive  (negative)  figure 
indicates  a tightening  (easing)  of monetary  conditions. 
Source: 

Commission  services. 

30  The MCI  expresses  changes in domestic monetary conditions relative  to  a pre-specified  base period  in 
terms  of  a  weighted  average  of  developments  in  short-term  interest  rates  and  developments  in  the 
effective  exchange  rate.  The  attractiveness  of  the  MCI  as  a  tool  of  current  analysis  is  that  it 
summarizes  the  (contractionary  or  expansionary)  impact  of  movements  in  the  principal  transmission 
mechanisms  of monetary  policy  to the  economy:  the  interest  rate and  the exchange  rate.  An  increase 
in  the  nominal  short-term  interest  rate  ~  implying  an  initial  rise  in  real  rates  because  of  slow  price 
adjustments  —  results  in  a  decline  in  real  money  balances  and  so  reduces  demand  in  the  economy. 
Similarly,  an  appreciation  of  the  nominal  exchange  rate  ~  implying  a  real  appreciation  in  the  short 
run  —  leads  to  a  reduction  in  net  exports  and  so  imparts  a  contractionary  impulse  to  demand  in  the 
economy.  Of course, the opposite is true  in the case of a  reduction  in  short-term  interest  rates  and  an 
exchange  rate  depreciation.  Movements  in  the  MCI  should,  therefore,  mirror  movements  in  output 
growth over the policy  horizon.  The choice of base period for  the MCI  is arbitrary  so that the  absolute 
level  of  the  index  is  not  in  itself  significant  and  the  component  variables  can  be  expressed  in  either 
nominal  or  real  terms.  The  relative  weighting  of  the  two  variables  is  derived  as  the  ratio  of  the 
elasticity of real output with respect  to the short-term  interest  rate and  the elasticity  of real  output  with 
respect  to the exchange rate. 

100 

recorded  in the MCI for  most  of the other ERM countries.  On the other  hand,  movement 
in the MCI indicates a tightening in monetary conditions in Italy (where the exchange  rate 
appreciated)  and  in  the  United  Kingdom  (where  both  short-term  interest  rates  and  the 
exchange rate firmed over the year). 

Graph 35 

Yield curves in larger Member States 

* Difference  between yield on 10-year bond and 3-month  money  market rates. 
Source:  Commission  services. 

1995 

1996 

The  scope  for  a further  easing  of  monetary  policy  in  most  of the  Member  States  will,  of 

course,  depend  on  developments  in  longer-term  interest  rates.  While  the  favourable 

inflation  environment  was  reflected  in  a  general  decline  in  EC  bond  yields,  the  pace  of 

decline in yields in many Member  States was  somewhat  less than  that  in  short-term  rates. 

In consequence, the easing of monetary policy in the Community for  much of the year was 

reflected  in  a  simultaneous  lowering  and  steepening  of  yield  curves  as  illustrated  for  the 

larger  Member  States  in Graph  35.  The "stickiness" in EC bond  yields in this period  was 

not  attributable to  latent  inflationary  pressures but to  the failure  of EC  yields to  decouple 

fully  from  corresponding  yields in the United  States.  US yields followed  an upward  trend 

for  much  of  the  year  on  market  expectations  of  a  monetary  tightening  by  the  Fed. 

However,  the graph also indicates a marked flattening  in EC yield curves (except  for  Italy) 
in  the  fourth  quarter,  as  German  yields  moved  lower  and  EMU  optimism  favoured 
convergence in EC long rates. 

101 

4.5.2  Monetary  easing provides  scope for  continued budgetary  consolidation 

Many  Member  States  have  availed  of  the  improved  growth  prospects  helped  by  easier 

monetary conditions to rebalance the macroeconomic policy mix by intensifying  budgetary 

consolidation.  The  credibility  of  budgetary  consolidation  efforts  ~  and  reinforced 

commitments  to  maintaining  and  intensifying  such  efforts  in  the  future  ~  was  greatly 

enhanced  by  the  prospect  of  a  stronger  economic  performance.  The  credibility  of 

budgetary  adjustment  efforts 

in  most  Member  States  was  the  determinant  factor 

underlying  the  decline  in  long-term  rates  linked  to  EMU  optimism  in  financial  markets 

toward  the  end  of  the  year.  The  macroeconomic  policy  mix  is  now  more  growth 

supportive. 

For  many  Member  States,  the  more  aggressive  approach  to  budgetary  consolidation 

presents  the  prospect  of  a  "virtuous  circle"  of  falling  interest  rates  supporting  economic 

growth  and  greater  credibility  of  budgetary  adjustment  efforts  as  the  economy 

strengthens. 

Successful  budgetary  consolidation  is,  of  course,  the  key  element  in 

sustaining  these  developments  and  it  is  essential  that  budgetary  targets  be  realised  if  the 

currently favourable  trends are to be sustained. 

102 

ISSN 0254-1475 

COM(97) 27 final 

DOCUMENTS 

EN 

10  17 

Catalogue  number  :  CB-CO-97-026-EN-C 

ISBN 92-78- 15234-X 

Office  for  Official  Publications of the European  Communities 

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