Communication from the Commission - The EU Economy : 2002 Review - Summary and main conclusions -
Date: 2002-12-11
Institutions: European Commission
Subjects: European Union, economic convergence, economic policy, economic situation, enlargement of the Union, financial market, labour market, short-term economic prospects

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 11.12.2002
COM(2002) 712 final

COMMUNICATION FROM THE COMMISSION

The EU Economy : 2002 Review
- Summary and main conclusions -

TABLE OF CONTENTS

1.

2.

3.

4.

5.

6.

Introduction .................................................................................................................. 3

Macroeconomic developments in the euro area ........................................................... 4

Structural reforms in labour and product markets and macroeconomic
performance in the EU ................................................................................................. 8

Bond market integration in the EU............................................................................. 10

Economic and financial market consequences of ageing populations ....................... 11

Real and nominal convergence in accession countries: Selected issues .................... 13

2

Three years of
buoyant growth gave
way to a protracted
period of sluggish
growth.

Conflicting
explanations for the
slowdown, but the
solution appears
evident – vigorous
policy action to
strengthen resilience,
dynamism and thus
the growth potential.

1.

INTRODUCTION

In  early  2000,  a  sustained  growth  rate  of  3  per  cent  seemed  within
reach. Annual growth rates had exceeded 3 per cent in 1998-2000. The
expectation  that this  growth  performance  was  sustainable  was  fuelled
by the successful introduction of the euro in 1999, the ‘new economy’
hype,  the  global  stock  market  boom,  resilience  of  the  euro-area
economy  to  the  Asian,  Russian  and  Brazilian  crises  and  favourable
world  trade  developments.  Moreover,  the  key  macroeconomic  policy
challenges  of  the  1980s  and  early  1990s  had  been  overcome
convincingly alongside a persuasive start to strengthening the structure
of  the  economy.  Monetary  authorities  had  credibly  established  price
stability. Most Member States presented budgets in surplus for the first
time in decades. Structural reforms contributed to  strong  employment
growth and unemployment was on a declining trend. Despite all of this,
the  three  years  of  buoyant  growth  in  the  euro  area  up  until  2000
unexpectedly gave way to a period of sluggish growth and increasing
pessimism. The slowdown, that was initially deemed to be short-lived
and  shallow,  has  developed  into the  most subdued  performance  since
the  1992-93  recession.  Average  growth  is  only  1¼  per  cent  over  the
years  2001  and  2002  and  is  expected  to  accelerate  only  during  the
course of 2003.1

Whatever the underlying causes for the slowdown and its persistence,
either  an  unfortunate  combination  of  global  shocks  or  internal
structural  supply-side  deficiencies,  additional  structural  efforts  are
required to meet the challenges put forward by the European  Council
in  Spring  2000.  The  Lisbon  agenda  remains  appropriate  but  must  be
better implemented. The  credibility  of  the  budgetary  framework  must
be  safeguarded  to  underpin  the  confidence  of  businesses  and
households  during  a  period  of  adverse  economic  conditions  and  to
ensure  a  balanced  policy  mix.  Moreover,  effective  implementation  of
far-reaching  structural  reforms,  particularly  those  characterised  by  a
growing delivery gap, and furthering of economic integration needs to
be  addressed  to  improve  growth  and  welfare  in  the  medium  term.
Finally, growing concerns about the impact of ageing populations must
be  dealt  with  convincingly  to  reduce  citizens’  uncertainty  about  their
future disposable income.

As a background to
the policy challenges,
the 2002 EU Review
provides an analytical
focus on five issues
related to the EU
economic policy
agenda.

The 2002 issue of the EU Review analyses in-depth five specific topics
the  current  policy  challenges.  First,  recent
in  the  context  of 
macroeconomic  and  policy  developments  in  the  euro  area  are
discussed.  Second,  a  chapter on  structural  reforms  in  labour  and
product markets examines the main patterns of reforms across Member
States and scans their impact on macroeconomic performance in terms
of  growth  and  productivity,  real  wages  and  employment.  Third,  as  a
follow-up to the chapter on financial market integration in the 2001 EU

1

See European Commission Autumn 2002 forecast.

3

                                                
Although an outright
recession has been
avoided, domestic
demand remains
sluggish in a lenient
macroeconomic
environment.

Employment growth
has been resilient, but
labour cost
developments could be
constraining
investment recovery.

Review, a chapter on European bond market integration takes a closer
look at this market segment where financial integration should advance
rapidly with potential for important welfare benefits. Fourth, a chapter
on  ageing  analyses  the  potential  impact  of  demographic  changes  on
savings,  capital  markets  and  real  interest  rates.  Finally,  a  chapter  on
enlargement  identifies  the  conditions  that  would  allow  the  accession
countries to best manage the convergence process.

2. MACROECONOMIC DEVELOPMENTS IN THE EURO AREA

Prior to the slowdown that started in the second half of 2000, the euro
area  experienced  three  major  cycles  over  the  past  three  decades.
Growth cycles peaked respectively in 1974, 1980 and 1992. Although
the euro area has avoided an outright recession in the latest cycle, the
downturn  has  been  only  slightly  less  sharp  than  during  the  1992-93
recession.  The  current  downturn  is  characterised  by  the  nearly
simultaneous slowdown of all components of domestic demand and of
world trade. Nevertheless, due to notable achievements in the field of
macroeconomic and structural policies over the last decade, the overall
economic picture looks, at first sight, brighter than in previous cycles.
Both the strength of the continuing investment recession and sluggish
household  consumption  growth  are  at  odds  with  developments  in
traditional  macroeconomic  determinants,  such  as  real  interest  rates,
profitability  and  capacity  utilisation  for  investment,  and  employment
and  real  disposable  income  developments  for  consumption.  These
remain  supportive  to  growth  from  a  historical  perspective.  This
suggests that, in the absence of the considerable progress that has been
made  in  the  field  of  macroeconomic  stability  and  structural  reforms,
the euro area would likely be faced with outright recession.

Progress  in  meeting  policy  challenges  is  reflected  in  labour  market
developments. Employment growth in the euro area has been positive
throughout  the  slowdown  and  unemployment  has  only  crept  up
marginally  from  a  ten  year  low  of  8  per  cent  in  mid-2001  to  8.4  per
cent in October 2002. Continued moderate increases in nominal wages
in  combination  with  sustained  employment  growth  underpinned
disposable income and consumption during the slowdown, limiting the
depth  of  the  downturn.  However,  a  side  effect  of  the  positive
employment growth in the environment of slow economic growth, has
been  a,  largely  cyclical,  reduction  in  labour  productivity  growth.2
Moreover,  limited  downward  sensitivity  of  wages  to  the  economic
slowdown  puts  the  burden  of  adjustment  largely  on  firms.  In
combination  with  the  deterioration  of  labour  productivity,  there  is  a
risk that profitability and, thus, investment prospects may suffer from
relatively high increases in real unit labour costs. This would, in turn,
jeopardise  future  labour  market  performance  and  the  strength  of  the
recovery.

2

Labour productivity is understood here as GDP per employee.

4

                                                
Downgrading of
medium-run
corporate growth
prospects contribute
to the stock market
slump which, in turn,
is affecting balance
sheets, capital costs
and confidence in the
short-run.

Despite headwinds
and greater
uncertainty,
continued moderate
recovery is likely in
the short run.
Confidence is a key
factor

For a sustainable
recovery the euro-
area’s policy agenda
has to be forcefully
implemented.

The  feebleness  of  domestic  demand  components  coincided  with  the
largest  losses  on  equity  markets  since  the  1930s.  The  global  stock
market correction that started early in 2000 quickened in the course of
2002 despite the bottoming out of the economic cycle. Developments
in  financial  markets  and  heightened  uncertainty  have  given  rise  to
concerns about the sustainability of the recovery and growth prospects
in the short and medium run. The dramatic stock price fall since 2000
followed a sharp acceleration of an already rising trend of equity prices
in the 1990s. In an environment of buoyant expectations with the ‘new
economy’  hype  reaching  its  zenith,  markets  priced  in  a  spectacular
increase in corporate profits and trend growth and a decrease of output
growth  volatility.  The  declining  capital  costs  and  excessive  profit
expectations,  especially  in  the  ‘new  economy’  sectors,  induced  over-
investment and misallocation, particularly in the US but with important
knock-on  effects  in  the  euro  area.  The  downgrading  of  optimistic
medium-term perspectives and gradual uncovering of these supply-side
disturbances  is  reflected  in  the  stock  market  slump,  which  has  been
more  pronounced  in  the  euro  area  than  in  the  US.  Domestic  demand
has been affected directly by the less buoyant expectations. In addition,
stock  market  developments  have  functioned  as  a  catalyst  for  further
denting  short-run  growth  prospects.  Wealth,  capital  cost  and
confidence are negatively affected, thereby providing ingredients for a
‘vicious cycle’.

Despite downside risks and medium- to long-run concerns, a continued
moderate recovery of demand is likely in the short run. The inventory
cycle turns and the negative contribution of investment growth is likely
to fade out. Still, as long as uncertainty and worries about the medium-
term outlook for profitability prevail and the cost of capital increases,
investment  is  unlikely  to  rebound  strongly.  A  full-blown  recovery
depends crucially on the return of strong consumer demand, for which
confidence is a key factor. Increased uncertainty about future pension
income may have also been a contributing factor to increased savings
low  household  consumption  growth.  Ageing  and  pension
and 
challenges  are  increasingly  at  the  centre  of  economic  policy  making,
leading  to  increased  media  coverage  affecting  households’  lifetime
wealth perception. The savings effect of pension income worries may
have been strong recently since it has been compounded with declining
stock market wealth both directly and indirectly through pension funds.

In this economic setting, characterised by a high degree of uncertainty,
it is crucial to press ahead with sound policies that foster consumer and
investor confidence. This will strengthen domestic demand in the short
run. Therefore, macroeconomic stability has to be preserved while the
growing  delivery  gap  in  the  implementation  of  announced  economic
reforms  needs  to  be  addressed.  In  turn,  this  will  increase  the  euro-
area’s  growth  potential  and  its  ability  to  adjust  to  short-term  shocks
and  structural  changes  in  the  economy.  The  alternative  to  forceful
action is muddling ahead with protracted, slow and vulnerable growth
in a rigid economic environment, similar to the early 1980s.

5

Monetary policy has
firmly established
price stability, but
inflation is rather
sticky considering the
sluggish growth
environment.

Monetary conditions
remained
accommodative to
domestic demand as
upward risks to price
stability decreased…

…but firms’
financing conditions
have tightened due to
increased uncertainty.

Four Member States
need to get their
budgets in order, to
the benefit of all.

Preserving  price  stability  is  one  of  the  key  elements  in  the
macroeconomic  policy  strategy  of  the  euro  area.  Price  stability  has
firmly  been  established  and  incorporated  in  households  and  investors
expectations  in  the  euro  area,  enabling  monetary  conditions  to  be
accommodative  to  domestic  activity.  However,  the  behaviour  of
inflation  in  the  slow-growth  environment  has  been  disappointing.
Headline  inflation  has  been  close  to  the  ECB’s  upper  ceiling  since
spring  2002  and  core  inflation  has  remained  uncomfortably  high  at
around 2.5 per cent after having risen gradually from below 1 per cent
in  1999.  Sticky  inflation  seems  to  a  large  extent  due  to  limited
competition  in  the  services  sectors.  These  are  generally  characterized
by  low  labour  productivity  growth  and,  in  mature  economies,  by
relative  strong  demand.  Wage  costs  in  the  service  sector  can  more
easily  be  passed  on  to  consumers  due  to  the  lower  degree  of
competition,  allowing  for  wage  increases  in  line  with  those  of  high
productivity growth sectors. These factors that induce structurally high
inflation in service sectors are no longer offset by large one-off labour
productivity  increases  and  price  declines  in  industries  from  the
liberalisation of network industries (e.g. telecom) in the late 1990s.

Up until the end of November 2002, the ECB has kept interest rates on
hold,  after  having  loosened  monetary  policy  in  the  aftermath  of  11
September  2001  to  alleviate  concerns  about  liquidity  and  slow
economic growth. The long awaited appreciation of the euro somewhat
reduced upward pressure on inflation. Then, gradually, as the economic
outlook  worsened  and  equity  prices  tumbled,  expectations  of  an
increase  in  policy  interest  rates  disappeared.  As  a  result,  monetary
conditions  in  the  second  half  of  2002  are  more  accommodative  to
domestic demand than was expected at the start of the year. At the end
of 2002, short-term interest rates are more than 100 basis points below
market  expectations  in  spring.  Meanwhile,  long-term  interest  rates
have declined by over 50 basis points.

Despite  the  accommodating  monetary  conditions  and  low  real  long-
term interest rates, financing conditions for firms have tightened in the
course  of  the  year.  Due  to  increased  uncertainty  about  the  general
economic outlook and industry- or company-specific risks, the cost of
raising  capital  on  the  stock  market  has  risen  significantly.  Moreover,
the decline in benchmark market interest rates has not been transmitted
to  generally  lower  financing  costs  for  the  corporate  sector.  Growing
investor  discomfort  about  accounting  practices 
the
uncovering  of  malpractices  may  have  contributed  as  well  to  difficult
conditions for firms to raise funds.

following 

The  main  fiscal  issue  confronting  the  euro  area  is  for  four  Member
States to get their budgets in order as soon as possible, in line with the
requirements of the Stability and Growth Pact (SGP). Fiscal policy in
the  euro  area  remains  a  national  prerogative,  but  through  the  Treaty
and the SGP, governments are obliged to respect a common framework
ensuring  both  fiscal  discipline  and  budgetary  flexibility.  Under  these
rules, countries have agreed that their budget deficits will not exceed 3

6

Risks of excessive
deficits are the result
of failure to
consolidate in the
‘years of plenty’.

Required adjustment
need not be costly, if
credibility of the
framework is
strengthened
simultaneously.

per cent of GDP and that budgetary positions will be close to balance
or  in  surplus  in  the  medium  run.  The  framework  is  sound  and  well-
suited to the fiscally decentralised structure of EMU. If adhered to, as
is the case in eight out of twelve euro-area Member States, it allows for
flexibility  and  the  full  working  of  automatic  stabilisers  to  cushion
downturns, while safeguarding long-run budgetary sustainability.

The current budgetary challenges stem essentially from the  failure  on
the part of these four Member States to have completed the transition
phase to balanced budgets or surpluses in 1999 and 2000 when growth
conditions  were  favourable.  As  a  result,  in  the  current  period  of
anaemic growth, the budgetary framework is strained and credibility is
dented. Already two Member State are  in breach  of the  3  per cent  of
GDP  reference  value.  There  is  a  distinct  possibility  that  budgetary
positions  deteriorate  in  others,  should  growth  conditions  continue  to
remain  subdued.  In  these  Member  States,  immediate  action  has  to  be
taken.

The  required  adjustment,  especially  in  less  prosperous  times,  is
difficult but feasible, and need not be costly in terms of output losses.
A  credible  fiscal  adjustment  will  lead  to  a  more  balanced  policy  mix
throughout  the  adjustment  period.  Furthermore,  forceful  budgetary
consolidation, in combination with unambiguous support for the SGP,
may  have  important  beneficial  effects  on  business  and  consumer
confidence, reflecting positive implications for future tax burdens and
improved  financial  market  sentiment    The  effects  may  lead  to  non-
conventional  effects  of  fiscal  easing  and  tightening  on  growth.  As
such, fiscal consolidation, if done in the right way, may not entail high
short-term  costs  in  terms  of  growth  and  may  even  be  growth-
enhancing.  Furthermore,  in  EMU,  these  so-called  non-Keynesian
effects may be stronger than before for two reasons. First, capital flows
may react more strongly to expected future taxes. Second, the Treaty's
deficit  rules  will  reinforce  expectations  that  any  fiscal  expansion  is
likely  to  be  followed  by  future  –  and  not-too-distant  -  fiscal
intangible,  but
contraction.  Confidence  effects  are  generally 
considering  the  alternative  of  no  consolidation  with  a  breakdown  of
EMU’s  fiscal  co-ordination  framework,  resulting  in  uncertainty  and
interest  rate  premiums,  the  actual  effect  of  the  simultaneous  fiscal
adjustment in the four Member States may in fact turn out significantly
positive  for  all  euro-area  Member  States.  Moreover,  the  medium-  to
long-run benefits of a swift completion of the budgetary transition are
undisputedly of a much larger magnitude than any costs or benefits in
the  short  run,  both  in  terms  of  credibility  and  the  functioning  of  the
macro-economic framework.

7

Strict annual
requirements and
improved surveillance
should improve
budgetary
consolidation in the
future.

In the medium run,
growth depends on
efficient markets to
provide for flexibility
and smooth
adjustment of
resource allocation.

To reinforce the Pact, the Commission has suggested strengthening the
surveillance  for  countries  that  are  in  transition  to  the  medium-term
balanced position, in order to obtain consistent improvements in good
and bad economic times.3 Until a budget position of “close to balance
or  in  surplus”  has  been  reached,  effective  budgetary  surveillance
requires  a  strict  and  enforceable  adjustment  path.  The  3%  of  GDP
reference  value  for  deficits  is  and  remains  a  binding  constraint.  Any
breach of the limit, or risk thereof, will be dealt with decisively in full
compliance with Treaty requirements and the Regulations of the Pact.
In  addition, a  required rate  of  structural  annual  adjustment  of  at  least
0.5 per cent of GDP should take the cyclically-adjusted deficit back to
its  medium-term  position  in  a  foreseeable  time  horizon.  Moreover,
countries  with  debt  levels  above  the  60  per  cent  of  GDP  reference
value should outline a detailed strategy to reduce their debt level at a
satisfactory pace. Fiscal objectives should err on the side of caution, in
particular with regard to growth and potential growth assumptions. The
updated  stability  programmes  should  clearly  define  the  measures  that
are being taken to obtain structural adjustment of at least 0.5 per cent
of GDP. It should be considered that one-off measures only postpone
structural  adjustment  and  do  not  help  in  the  long  run.  Moreover,  the
quality and timeliness of budgetary statistics needs to be improved to
ensure adequate surveillance and policy co-ordination.

In  the  medium  run,  the  capacity  to  grow  at  a  sustainable  high  rate
depends  on  efficient  use  of  production  factors.  Flexibility  and
adjustment to changing circumstances between and within sectors will
contribute  to  fully  using  the  potential  for  growth  in  the  euro  area.
Ageing  of  populations  makes  smooth  and  effective  economic
adjustment  all  the  more  important.  The  euro-area  economy  requires
efficient  product,  labour  and  financial  markets,  in  addition  to
financially  and  socially  sustainable  pension  and  health  systems  and
sound public finances, to weather the imminent demographic transition
to an aged population.

3

On  27  November,  the  European  Commission  adopted  two  communications  on  “Strengthening
the co-ordination of budgetary policies” and “On the needs and the means to upgrade the quality
of budgetary statistics”.

8

                                                
Growth slowdown
underlines need for
structural reforms to
improve the medium
and long run growth
performance…

…by inducing
employment and
investment growth
and enhancing
efficiency.

Spill-over effects
across countries and
sectors call for a
broad-based reform
strategy.

3. STRUCTURAL  REFORMS 

IN  LABOUR  AND  PRODUCT
MARKETS  AND  MACROECONOMIC  PERFORMANCE  IN  THE
EU

Building an economic framework that is both flexible enough to adjust
to  shocks  quickly  and  robust  enough  to  weather  adverse  economic
developments  and  prevent  the  building-up  of  imbalances  requires
stepping  up  the  pace  of  economic  reform.  Credible,  judicious  and
forceful  action  will  underpin  confidence,  increase  resilience  and
smoothen adjustment. Both in the short and in the long run, the average
short-fall  of  actual  output  from  the  economy’s  potential  will  be
reduced.  In  addition,  microeconomic  structural  policies  can  make  a
significant  contribution  to  achieving  faster  sustainable  growth  with
high levels of employment. By improving the functioning of markets,
structural reforms can remove impediments to full and efficient use of
resources and allow for higher dynamic efficiency, making it easier to
achieve widely accepted economic and social goals.

Both  labour  and  product  market  reforms  have  notable  effects  on
productivity  and  employment.  Labour  market  reforms  firstly  provide
stronger incentives to participate in the labour market. They are aimed
at  cracking  down  on  insider-outsider  barriers  and  reducing  structural
unemployment  as  well  as  increasing  productivity  through  skill
upgrading  and  improvement  of  working  conditions.  Secondly,  better
working labour markets allow for a more efficient allocation of labour,
thereby further raising productivity growth and real incomes. Similarly
for  product  market  reforms.  They  increase  competition  and  reduce
monopoly  rents  in  previously  sheltered  sectors,  leading  to  higher
efficiency  and  productivity  growth.  There  is  increasing  evidence  that
more competition drives up the rate of technological and organisational
innovation  and  leads  to  a  higher  variety  and  quality  of  goods  and
services. Product market reforms also effect labour market functioning.
Equilibrium  unemployment  is  lowered  and  employment  increased  by
reducing  excess 
for  producers  or  workers,  as  market
imperfections  are  addressed.  Moreover,  as  prices  and  wages  become
more sensitive to market conditions, they adjust faster than in the past
to  changing  economic  conditions.  As  a  result,  cumulative  losses  in
output and employment due to slow adjustment are reduced.

rents 

Interactions between different structural reform policies make a strong
case  for  a  broad-based  reform  strategy,  exploiting  synergies  arising
from a comprehensive approach to improve the functioning of product,
capital and labour markets. Sound macroeconomic policies provide the
best framework for reaping, as quickly as possible, the full benefits of
structural  reform  policies.  Stability-oriented  fiscal  and  monetary
policies  have  a  direct  bearing  on 
lowering  unemployment,
predominantly  via  reducing  risk  premiums  on  interest  rates,  inducing
higher investment. Successful structural reform policies affect potential

9

output  and  raise  the  speed  limits  for  growth,  allowing  aggregate
demand  expansion  without  generating 
inflationary  pressures.
Therefore, implementation of structural reform policies should be done
in  a  co-ordinated  manner.  As  a  single  country  cannot  expect  a
loosening of monetary  policy  in  response to  structural  improvements,
the  momentum  for  reform  may  be  reduced  in  individual  countries.  A
broad-based  approach  could  limit  the  initial,  and  possibly  adverse,
adjustment effects of reforms. These occur as economic agents adjust
to  the  reduction  and  redistribution  of  rents  that  are  intended  by  the
reform and which will benefit the economy in the medium run.

Reform efforts in the second half of the 1990s have been successful in
stimulating  employment  and  strengthening  the  EU  economy.  The
reforms  included  cuts  in  payroll  taxes  for  targeted  groups,  in-work
financial  support  for  low-wage  earners,  more  active  and  preventive
labour  market  policies,  and  a  modernisation  of  work  organisation,
including  the  facilitation  of  part-time  work  and  more  flexible  work
contract  arrangements.  There  is  little  doubt  that  they  have  produced
significant  results  in  terms  of  a  trend  increase  in  labour  force
participation  and  employment  rates,  and  a  reduction  in  levels  of
structural unemployment. While it is difficult to establish precisely the
contribution of the various reform efforts, illustrative macro-economic
simulations  indicate  that  labour  and  product  market  reforms,  in
combination with observed wage moderation, in the period 1996-2001,
may  have  increased  the  level  of  potential  output  by  3-4  per  cent
relative  to  a  no-reform  baseline  path.  This  translates  into  an
acceleration of annual output growth of a little less than ½ percentage
point  over  a  period  of  7  to  8  years.  Without  reforms  and  moderate
wage  developments,  average  growth  in  the  EU  would  have  been
around 2.2 per cent instead of 2.6 per cent over the 1996-2001 period.
This  would  translate  into  5-6  million  fewer  jobs  in  the  EU  and
unemployment would have been 2 million higher.

However,  the  growth  stimulus  of  reforms  has  to  be  maintained.  If
reform efforts are not continued forcefully in the EU, the medium term
growth  path  is  unlikely  to  exceed  2  per  cent  by  much.  To  achieve  a
higher  annual  rate  of  growth  over  a  prolonged  period  of  time,  the
momentum  and  the  breadth  of  structural  reforms  will  have  to  be
increased, in  line  with  the  Lisbon  agenda.  Forceful  action  is  required
with  regard  to  the  growing  delivery  gap  in  implementing  the
announced  structural  reforms.  The  current  weakness  in  economic
activity must not be taken as an excuse for delays in implementing the
comprehensive  structural  reform  agenda  as  agreed  in  Lisbon  and
reinforced in Stockholm.

Reforms have already
raised both
employment and
output growth…

…but forceful action
is required now, as
effects of past reforms
fade out over time.

4. BOND MARKET INTEGRATION IN THE EU

Financial market
integration improves
economic
performance by better

Well-functioning  financial  markets  are  crucial  for  an  efficient
channelling  of  savings  to  investment.  Financial  integration  enhances
the development of the EU’s financial system. This, in turn, will result
in  an  improved  economic  performance.  Much  of  the  benefit  of

10

channelling savings to
investment.

The euro-area
government bond
market is highly
integrated, but the
private bond market
needs more time.

The historically
underdeveloped
corporate bond
market has taken off.

financial  market  integration  stems  from  scale  and  scope  effects.
Increasing  breadth  and  depth  of  the  market  increases  efficiency  as  it
reduces transaction costs and widens the possibilities for risk sharing,
thereby improving the allocation of savings to investment opportunities
within countries and across borders. In addition, increased competition
as  result  of  market  integration  has  similar  effects  by  reducing  the
quasi-rents enjoyed by financial intermediaries. These benefits in terms
of improved resource allocation translate into lower costs of capital for
the borrower and higher returns for investors.

There is evidence that the government bond market is highly integrated
in the euro area. The  elimination  of exchange  rate risk  led  to  a  sharp
downward  convergence  in  bond  yields  among  the  euro  area  Member
States.  However,  yield  spreads  of  between  10  and  50  basis  points  –
mainly  relative  to  Germany  –  have  persisted  since  1999.  These
remaining  spreads  between  the  government  bonds  of  the  different
Member States are largely due to institutional and size factors. Part of
the spreads can be explained by the benchmark role that German long-
term  government  bonds  have  acquired.  Another  reason  for  the
persistence  of  spreads  is  related  to  differences  in  liquidity.  Member
States with relatively limited issuance face a liquidity premium. Credit
quality  premiums  play  a  limited  role  as  ratings  have  reached  a  very
high level in euro-area countries and have been broadly stable since the
introduction of the euro. The integration trend of the private euro bond
market  has  also  progressed,  albeit  at  a  slower  pace.  Progress  in  the
integration  of  the  euro-denominated  bond  market  is  likely  to  proceed
more  rapidly  in  the  future  supported  by,  inter  alia,  increased  co-
operation  of  supervisory  bodies  and  regulators,  the  EU’s  Financial
Services  Action  Plan  and  a  strong  private-sector  trend  towards
consolidated market infrastructures.

Europe’s  historically  underdeveloped  corporate  bond  sector  made  a
promising  takeoff  in  2001.  Difficult  market  conditions  and  increased
investor’s  risk  aversion  have  overshadowed  this  positive  start  during
2002.  Nevertheless,  growth  of  the  euro  corporate  bond  market  is
expected to resume as soon as the financial market climate improves.
Efficient long-term debt management is of key importance to European
firms.  Traditional  financial  bond  issues  continue  to  underpin  banks
refinancing,  but  product  innovation  like  asset-backed  securities  have
the  potential 
to  expand  further,  stimulated  by  a  competitive
environment.  Direct  corporate  bond  issuance  increasingly  provides  a
close  substitute  for  bank  lending.  This  reduces  the  dependence  on
to
banks 
investment and provides a potential for further efficiency gains.

the  channelling  of  savings 

intermediary  function  in 

11

Ageing will affect
growth and standards
of living in the EU
dramatically.

A large pool of
retirement savings
will affect domestic
markets and global
financial flows.

5. ECONOMIC  AND  FINANCIAL  MARKET  CONSEQUENCES  OF

AGEING POPULATIONS

Demographic  factors  play  an  important  role  in  the  economic  outlook
for countries in the medium and long run. Over the next 50 years the
EU  will  witness  dramatic  changes  in  the  structure  of  its  population.
The  ageing  of the large  post-war  cohorts  (‘baby  boom’),  low  fertility
rates  and  growing  life  expectancy  will  decrease  the  size  of  the
working-age  population  and  increase  the  number  of  pensioners.  The
overall  economic  impact  of  these changes  over  the  period  2000-2050
might be that EU potential growth will fall from the present underlying
rate of 2-2½ per cent to around 1¼ per cent, in a scenario of no policy
changes. This translates into a reduction of per capita GDP growth in
the  EU  on average  by  about  0.4  per  cent  per  year.  A  similar  outlook
applies to Japan. For the US, a much more sanguine picture emerges,
especially for potential growth rates due to a better outlook for the size
of  the  working  age  population  and  for  investment.  These  persistent
differences in potential growth rates between the EU and the US could
result  in  large  changes  in  their  relative  economic  importance  in  the
world.  In  a  scenario  of  no  policy  changes,  the  EU’s  present  share  of
18%  of  world  production  is  expected to  fall  to  10%  in 2050. That  of
the US could continue to rise from 23% in 2000 to 26% in 2050.

A  growing  pool  of  developed-world  retirement  savings  will  intensify
the  search  for  high  returns  and  geographical  diversification.  These
global  capital  flows  will  result  in  significant  changes  in  countries’
balance  of  payment  and  net  foreign  asset  positions.  They  imply
adjustments of real exchange rates and generate a world-wide decline
in rates of return of about ¾ of a percentage point over the next fifty
years. In order to avoid stock market bubbles and over-investment, EU
and global financial markets will need to efficiently channel savings to
productive investments in developed and developing economies. In this
context, the  EU  has  a  large  vested  interest  in  encouraging  significant
institutional  reforms  in  the  developing  world,  where  ageing  will
become  an  issue later  than  in  the  EU. This  would  open  an  additional
channel for efficiently allocating surplus savings in the future through
current account  surpluses  with the  developing  world.  At the  moment,
global capital flows are dominated by two-way capital flows amongst
developed  economies  with  similar  demographic  outlooks.  This
situation  is  likely  to  continue  in  the  future  unless  developing
economies  are  more  effectively  integrated  into  the  global  financial
system.

Budgetary
sustainability needs to
be safeguarded, while
employment and
productivity growth

To moderate the economic burden of ageing, EU  Member  States  will
have  to  pursue  a  range  of  macro  and  structural  policies.  In  terms  of
fiscal  policy,  the  EU  already  has  an  appropriate  framework:  the
Stability and Growth Pact (SGP). In the face of substantial age-related
spending  pressures,  balanced  budgets  over  the  cycle  are  crucial  in

12

are promoted.

Partial shift to funded
pension system needs
to be accompanied by
growth-promoting,
substantive reforms
and to be monitored
in view of possible
distribution effects.

The EU-15 will
become EU-25. The
process of economic
convergence is
crucial.

avoiding  the  emergence  of  unsustainable  deficit  and  debt  positions
later. EU labour markets have an important role to play in enabling EU
economies  to  withstand  the  demographic  developments.  Increases  in
labour force participation rates, reductions in structural unemployment
and  a  progressive  increase  in  the  EU’s  effective  retirement  age  from
less than 60 at present by about 5 years as called for by the Barcelona
European Council.4 are highly desirable reforms. Finally, the EU must
also  continue  to  promote  higher  factor  productivity  growth  through
structural reforms aimed at both enhancing allocative efficiency and at
increasing the flexibility of goods, services and capital markets, whilst
simultaneously ensuring open and competitive trading conditions at the
global level.

While  a  partial  shift  to  funding  of  EU’s  pension  systems  would
contribute to their long-term sustainability, it must be ensured that the
social  policy  objectives  of  the  pension  provisions  continue  to  be
achieved. The partial shift to funding would lead to additional savings
and  to  a  significant  build  up  of  financial  assets  in  public  and  private
pension funds in the EU. In the absence of growth–promoting reforms
in  the  EU,  this  increase  in  EU  pension  funds  will  to  a  large  extent
result  in  additional  investments  occurring  outside  the  Community.
Consequently, a partial shift to funding, if implemented on its own as
opposed to being part of a broad growth promoting package of reforms,
would  do  little  to  enhance  the  EU’s  productive  capacity.  This
underlines the need to boost the effectiveness of a shift to funding by
enhancing  domestic  growth  and  investment  opportunities  through  the
implementation  of  fundamental  labour,  product  and  capital  market
reforms.  Illustrative  model  simulations  predict  that  a  significantly
higher  proportion  of  the  additional  pension  fund  assets  would  be
invested in the EU due to the improved domestic growth environment,
if a package of reforms aimed at increasing labour force participation
rates and lengthening working lifetimes is introduced first.

6. REAL  AND  NOMINAL  CONVERGENCE 

IN  ACCESSION

COUNTRIES: SELECTED ISSUES

Upon  recommendation  of  the  European  Commission,  the  European
Council of Brussels gave its green light to conclude negotiations on the
enlargement of the EU, with the accession of ten new Member States
in  mid-2004.  Most  of  the  new  Member  States  have  been  in  a
transformation  process  from  centrally  planned  regimes  to  market
economies  for  over  a  decade.  The  initial  phase  of  the  transformation
has  been  very  costly  in  terms  of  output  and  income  losses.  In  the
course  of  the  1990s,  positive  growth  rates  returned  in  all  prospective
Member States. Macro-economic stabilisation has played a major role
in  the  transition  countries  in  helping  the  economy  to  turn  around.
Overall,  all  acceding  countries  have  made  impressive  progress  in
nominal  convergence.  In  particular,  all  countries’  inflation  rates  are

4

Presidency Conclusions, Barcelona European Council, 15-16 March 2002, Point 32.

13

                                                
Full convergence will
take its time.

Differences between
countries are large
and affect the pace of
real convergence and
the nature of
adjustment.

The evolution of
exchange rate regimes
in the transition is a
key question.

down  to  one-digit  levels  from  two-  (or  even  three-)digit  levels  at  the
beginning  of  the  1990s.  However,  the  real  convergence  process  of
GDP per capita has proceeded at a much slower pace.

The  convergence  process  will  be  lengthy  as  the  average  per  capita
income in the prospective new Member States was 40 per cent of the
EU average in 2001. In a number of countries, income levels have just
started  to  exceed  the  levels  prevailing  before  the  dramatic  fall  in  the
wake of the initial transition shock. If current output growth rates are
extrapolated,  catching-up  to  the  EU  average  income  level  might  be  a
process  of  decades  rather  than  years.  An  acceleration  of  the  real
convergence  process  can  be  expected  after  EU  membership.  Capital
flows to these  countries  might  increase  notably  should  the  conditions
for  high  expected  real  rates  of  return  be  met.  This  could  lead  to
continued  rapid  modernisation  and  upgrading  of  production  facilities
and  infrastructure.  To  benefit  fully  from  the  potential  of  EU
membership,  conditions  should  be  identified,  including  those  at  the
Community level, that would allow accession countries to best manage
the real convergence process. Since their application for membership, a
large part of the required reforms has taken place in the adoption of the
single market ‘acquis’.

The  economies  of  the  accession  countries  are  in  quite  different
positions concerning their state of real convergence. This holds clearly
for  overall  output  and labour  productivity  levels. The  different  stages
in  the  convergence  process  are  even  more  striking  in  their  structural
transformations  and  pattern  of  integration  into  the  EU  economy,  in
particular  in  cross-European  trade  structures.  Such  a  diversity  will
undoubtedly have a bearing on how they will cope with the additional
adjustments  required  by  the  accession  process  and  speed  of  the
catching-up  process.  Technologically  more  advanced  industries  show
relatively  fast  catching-up,  with  a  dynamic  pattern  of  integration  into
the European division of labour. Others have so far been ‘locked in’ in
a rather traditional pattern of trade and industrial specialisation, making
it difficult to improve their position.

As a result of the enlargement strategy, the accession countries, despite
their diversity, share the goal of eventually adopting the euro. Due to
the  success  of  the  euro  in  providing  exchange  rate  stability,  price
stability  and low interest  rates,  most  new  Member  States  ambitiously
aspire to join the euro area as soon as possible. However, an adoption
when micro- and macroeconomic conditions are not yet fully adapted
to  the  requirements  of  a  monetary  union,  poses  important  risks  to
managing 
to
macroeconomic  developments  afterwards  and  to  catching-up  and  the
convergence  process 
to  euro-area
membership,  a  key  question  is  the  evolution  of  exchange  rate  policy
regimes.  Currently,  a  wide  spectrum  of  exchange  rate  regimes  exists,
with strongly fixed exchange rate arrangements in the form of currency
boards,  on  the  one  side  (Estonia,  Lithuania,  Bulgaria),  relatively  free
floating  exchange  rates,  on  the  other  (Czech  Republic,  Poland  and
Hungary),  and  a  number  of  countries  choosing  a  degree  of  exchange

to  euro-area  membership, 

transition  process 

in  general.  In 

the  run-up 

the 

14

Persistent inflation
differential favour
exchange rate
flexibility…

…while adopting the
euro eliminates
transaction costs and
exchange rate risks
and encourages
convergence.

Exchange rate
policies should evolve
on a country-by-
country basis.

rate flexibility in between these two extremes. In part, the differences
in  exchange  rate  regimes  reflect  the  general  diversity  of  approaches
with  which  these  countries  tackle  transition  but  also  the  underlying
differences in their real economies.

Persistent inflation differentials may pose a risk to fixed exchange rate
regimes. In general inflation rates in accession countries are still above
those observed for the majority of the EU Member States. Differentials
in inflation between the accession countries and the EU Member States
may represent an equilibrium phenomenon which is linked to the lower
price  levels  in  the  accession  countries  and  the  catching-up  process
itself.  More  precisely,  countries  growing  faster  tend  to  experience
higher  rates  of  inflation  (through  the  so-called  Balassa-Samuelson
effect)  without  a  deterioration  of  the  country’s  cost  competitiveness.
Estimates  of  the  size  of  this  effect  vary  widely  for  the  accession
countries,  as  it  is  difficult  to  disentangle  this  effect  from  inflationary
effects due to the transition from a planned economy with government
price  setting  to  a  market  economy.  It  has,  however,  undeniably  an
impact  on  the  inflation  rate  during  the  catching-up  process.  The
presence  of  strong  Balassa-Samuelson  effects  would  provide  an
argument  for  maintaining  some  flexibility  in  exchange  rates  in  the
period  after  accession.  In  such  a  case,  nominal  appreciation  of  the
exchange  rate  and  a  real  interest  rate  in  line  with  the  countries
requirements  can  limit  the  risk  of  overheating  of  the  domestic
economy, which could seriously disrupt the real catching-up process.

One important advantage of an early adoption of the euro would be the
elimination  of  the  transaction  costs  associated  with  maintaining  a
separate  currency  and  a  reduction  of  interest  rates  by  eliminating  the
exchange  rate  risk.  This  would  attract  badly  needed  additional
investment  which  would  foster  the  process  of  real  convergence.  It  is
sometimes argued that the costs of holding the exchange rate fixed may
be  relatively  low  for  small  and  open  economies  in  which  monetary
policy is an inherently difficult task.

Elements  pro  and  contra  early  participation  have  to  be  weighted
carefully on a country-by-country basis. The evolution will depend on
the country’s position in the transition process, its size and the progress
on  product,  labour  and  capital  market  reform  and  its  budgetary
challenges.  Joining  the  euro  is  not  an  end  in  itself.  The  ultimate
objective is full and successful economic integration. In any event, the
relevant Treaty provisions will prevail.

15