Commission Communication - The EU Economy: 2003 Review - Summary and main conclusions
Date: 2003-11-26
Institutions: European Commission
Subjects: European Union, capital movement, economic analysis, economic growth, economic situation, education, euro area, macroeconomics, pay policy, productivity

COMMISSION OF THE EUROPEAN COMMUNITIES

Brussels, 26.11.2003
COM(2003) 729 final

COMMISSION COMMUNICATION

The EU Economy: 2003 Review
– Summary and main conclusions –

TABLE OF CONTENTS

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

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

2. 

3. 

Drivers of productivity growth: an economy-wide and industry-level perspective ......... 6

Education, training and growth ........................................................................................ 9

4.  Wage flexibility and wage interdependencies in EMU .................................................. 11

5. 

Determinants of international capital flows.................................................................... 13

2

Lesson from 2003:
More vigour needed to
pursue the economic
reforms agreed in the
Lisbon strategy and
the Broad Economic
Policy Guidelines.

Reason for EU’s
disappointing
economic record can
be mainly found in
domestic conditions.

The EU Economy
2003 Review provides
analytical support to
key issues of the EU
economic policy
agenda.

INTRODUCTION

The economic performance of the EU economy in 2003 has underlined
the need to pursue the Lisbon strategy with more vigour. The recovery
that started in 2002 proved short-lived and did not initiate the dynamics
necessary  to  bring  economic  activity  back  to  potential.  Although
economic  growth  failed  to  rebound,  employment  withstood  the
slowdown  better  than  in  the  early  1990's,  suggesting  a  stronger
resilience in the labour market after reforms implemented in the second
half  of  the  1990s.  However,  employment  growth  has  stalled  in  2003
and  the  rate  of  unemployment  has  slightly  risen.  Moreover,  public
finances deteriorated. Investment has been  a  major drag  on  economic
activity  and  was  held  back  by  the  required  adjustment  in  corporate
balance-sheets  and  depressed  profit  margins.  At  the  same  time,  the
euro  appreciation  weighed  on  exports,  while  the  sluggish  decline  in
inflation  did  not  stimulate  private  consumption.  These  developments
have urged policy makers to intensify efforts to design and implement
structural reforms in line with the Lisbon targets, the Broad Economic
Policy Guidelines and the Employment Guidelines.

The reasons for the subdued economic record are mainly to be found in
domestic  conditions.  True,  a  series  of  global  economic  shocks  have
initiated the slowdown from 2000 onwards and 2003 was not free from
further  disturbances  at  the  global  scale.  Oil  prices  were  high  and
volatile, the global conflicts added to economic uncertainty and world
trade did not rebound to former  strength.  Growth  nevertheless  picked
up in some economic regions, most prominently in the USA and Japan.
Among  the  possible  domestic  reasons  for the  European  Union's  tepid
economic performance, structural rigidities figure prominently. Despite
progress in recent years, activity rates and labour  force  utilisation  are
still  too  low.  Key  macroeconomic  price  variables  such  as  real  unit
labour costs and consumer price inflation, adjusted only sluggishly to
weak growth and deteriorating labour market conditions.

The  2003  edition  of  the  EU  Economy  Review  analyses  four  specific
topics  that  have  been  chosen  for  this  year  in  the  context  of  current
economic  policy  challenges.  Two  chapters  elaborate  on  key
determinants of economic growth. The review starts with a chapter on
recent  macroeconomic  and  policy  developments  in  the  euro  area  and
provides  an  in-depth  discussion  of  possible  reasons  behind  slow
growth  in  the  euro  area.  Chapter 2  deals  with  the  drivers  of
productivity growth and analyses this from both an economy-wide and
a  sectoral  perspective.  It  tries  to  identify  the  reason  behind  the  gap
between  accelerating  labour  productivity  growth  in  the  USA  and
decelerating labour productivity growth in the EU. Despite widespread
attention  in  policy  circles  devoted  to  education  and  human  capital  in
the  recent  past,  little  is  known  about  the  contribution  of  education  to
economic growth. Chapter 3 provides a detailed analysis of education
and  growth.  The  experience  from  the  early  years  of  EMU  as  regards
wage flexibility and wage interdependencies are analysed in Chapter 4.
Finally,  Chapter 5  deals  with  important  aspects  of  the  process  of
international capital flows.

3

The euro area is to
record economic
growth below
potential for three
years in a row, being
off course from 2001
to 2003.

Prolonged period of
slow growth rather
than a sharp fall in
growth.

Market adjustment
was sluggish,
suggesting an
economy not resilient
to shocks.

1. MACROECONOMIC DEVELOPMENTS IN THE EURO AREA

Despite  signs  of a  pick-up  in  economic  activity  in  the  second  half  of
2003,  the  euro  area  is  set  to  record  economic  growth  significantly
below potential for the third year in a row. Sluggish economic activity
can be associated with two main factors at work in 2003. Firstly, global
economic uncertainty persisted throughout the spring of 2003. The Iraq
conflict  dominated  headlines,  stock  markets  nose-dived  and  the  euro
continued to appreciate rapidly, especially against the US dollar. These
events  hit  an  economy  that  was  already  coping  with  the  aftermath  of
past major shocks. Secondly, there is some evidence that adjustment to
these past economic disturbances has been more anaemic than analysts
and  forecasters  had  assumed.  Market  forces  that  usually  initiate
recovery  seem  to  have  worked  less  efficiently  or  strongly,  implying
that the economy, which recovered in early 2002, was not resilient to
further adverse events.

In a broader perspective, 2001-03 can best be described as a period of
sustained growth slowdown rather than mild recession. A comparison
of the last three major downturns in the region that now forms the euro
area shows that they all started from a similar level of a positive output
gap between 2 and 2 ½ per cent. The current change of the output gap
is  broadly  comparable  to  that  observed  in  the  early  1980s  and  early
1990s.  In  international  comparison,  the  deterioration  of  the  euro-area
output gap has not been particularly large. Moreover, the cross-country
perspective points to a consistent relationship between the size  of  the
output  gap  in  2000  and  its  subsequent  deterioration.  Those  countries
that witnessed the strongest deterioration in the output gap 2002-2003
were also those where actual GDP was higher than potential in 2000,
and vice versa. This suggests that the recent slowdown should not  be
analysed  in  isolation  but  with  reference  to  the  events  during  the
previous boom period.

The fact that the slowdown has persisted for three years suggests that
supply-side  dynamics  has  been  important  and  the  growth  weakness
cannot solely be attributed to demand shocks. Against the background
of  both  receding  inflation  and  a  considerable  weakening  of  labour
productivity growth at the early stage of the slowdown, steady nominal
wage growth contributed to a marked increase in nominal unit  labour
costs.  Both  employment  and  private  consumption  growth  decelerated
broadly  in  line  with  the  weakening  of  overall  economic  activity.
Compared  to  historical  experience,  the  fact  that  employment  growth
remained  slightly  positive  despite  a  considerable  weakening  of
economic  activity  is  indicative  of  improved  labour  market  resilience,
and  reflects  a  different  path  in  job  creation  and  destruction  than  in
previous slowdowns as a result of labour market deregulation measures
implemented  in  several  Member  States.  Finally,  exchange  rate
movements had a pro- rather than a counter-cyclical effect. During the
previous  period  of  strong  growth  in  1999-2000,  the  weakening  euro
increased  price/cost  competitiveness  while  the  strengthening  euro
did  not  support  export  demand  when  economic  growth  slowed  in
2002-2003. Interest rates declined in accordance with the slowdown in
economic  activity.  Nominal  interest  rates  have  not  been  so  low  for
some  50  years  and  the  real  long-term  interest  rates  have  not  been  as
low  as  they  are  now  since  the  late  1970s.  Nevertheless,  investment

4

Corporate adjustment
to slow growth yielded
depressed profit
margins and a
pronounced weakness
of investment.

Forces of recovery are
well intact.

Monetary policy has
been accommodative.

Budgetary policy:
easing did not
stimulate economic
activity.

activity  remained  particularly  weak,  reflecting  the  importance  of
macroeconomic  factors  such  as  weak  demand  prospects,  a  worsening
of profit margins and a low degree of capacity utilisation but also the
increase of risk aversion and high debt in the corporate sector despite
the ongoing correction of corporate balance sheets.

The  perception  of  risk  seems  to  have  fundamentally  changed  due  to
economic  (slowdown  in  growth),  financial  (bursting  of  the  stock
market bubble) and political factors (terrorism). All these factors raised
corporate  capital  costs.  In  a  nutshell,  the  typical  euro-area  company
adjusted  to  the  erosion  of  revenues  by  trimming  down  capital  costs
whereas  the  US  company  reduced  both  capital  and  labour  costs.  The
effect was a profound weakening in the growth of labour productivity
in  the  euro  area,  which  translated  into  depressed  profit  margins.
Investment  was  cut  considerably  on  both  sides  of  the  Atlantic.  The
main  difference  was  that,  whilst  almost  all  the  adjustment  in
investment in the USA took place in the years 2001 and  2002,  in  the
euro area weak investment performance lasted until 2003.

Optimism  as  regards  the  outlook  for  the  euro-area  economy  was  and
still  is  based  on  significant  structural  improvements  in  the  euro  area
that imply a clear break with past patterns. Four positive factors stand
out: 
framework;
(2) growing  resolve  to  tackle  structural  reforms;  (3) continuously
moderate  wage  growth;  and  (4) technological  advances  providing
scope for improvements in labour productivity growth.

(1) a  stability-oriented  macroeconomic  policy 

Monetary  policy  had  to  act  against  the  background  of  only  slowly
receding  rates  of  headline  and  core  inflation.  While  most  of  the
increase in headline inflation in 2001 was related to one-off effects (oil
price hikes and food price hikes linked to bad weather and BSE), there
was  a  substantial  risk  of  second-round  effects.  Despite  this,  the  ECB
cut  interest  rates  from  May  2001  onwards  by  a  cumulative  275 basis
points.  A  positive  lesson  from  the  recent  experience  is  that  the
monetary  policy  stance  has  been  accompanied  with  continuously  low
and  stable  inflation  expectations.  Forward  interest  rates  suggest  that
financial  market  participants  seem  to  consider  that  neither  the  strong
growth  in  monetary  aggregates  nor  the  currently  low  level  of  money
market  rates  represents  a  threat  to  price  stability  in  the  short  to
medium-term.

In  terms  of  both  actual  budgetary  developments  and  as  regards  the
implementation  of  the  EU  framework  for  fiscal  surveillance  the  past
few years have been a difficult period. The play of automatic stabilisers
in  the  context  of  the  slowdown  implied  a  considerable  worsening  of
government  finances.  But  the  increase  in  the  nominal  deficit  for  the
euro  area  as  a  whole  reflects  also  discretionary  loosening  by  some
Member States. Available evidence suggests that the impact of the tax
cuts,  which  were  enacted  in several  EU  Member  States  (D,  F,  I,  NL,
and  A)  since  2001,  did  not  yield  the  hoped-for  increase  in  private
consumption  and  investment.  The  less  energetic  pursuit  of  budgetary
consolidation may, also in view of the growing awareness of the need
to  reform  pension  systems,  have  dented  private  consumption  through
negative confidence effects. Moreover, worsening public finances may
have prevented any further lowering of interest rates.

5

Budgetary
consolidation needs to
resume to tackle on
time the looming
budgetary
implications of ageing
...

… supplemented by
further progress with
encouraging labour
market participation
and economic growth.

The deterioration of public finances witnessed since 2000, particularly
in some Member States, has cast doubts on the commitment of several
euro-area  countries  to  achieve  sound  public  finances  over  the  coming
years.  This  unfortunate  development  has  been  clearly  marked  by  a
breach by some Member States of the EU´s fiscal rules. In responding
to this it is important that fiscal authorities do not settle for short-term
solutions that undermine the EU fiscal framework and the need to pay
adequate attention  to sustainability  issues.  Indeed,  the  increased  focus
on the quality of public finances has highlighted that about half of the
Member  States  face  a  serious  problem  of  sustainability.  Achieving
sound public finances is an important prong in the strategy to tackle on
time  the  looming  budgetary  implications  of  ageing.  Member  States
should  demonstrate  a  clear  willingness  to  pursue  the  medium-term
strategy  that  in  some  cases  has  already  delivered  periods  of  high  and
sustained growth.

Moreover,  encouraging  labour  market  participation  and  economic
growth  will  be  key  to  alleviating  the  problem  of  ageing  populations.
For  example,  enhanced  efforts  to  help  parents  combine  work  and
family  life,  which  Member  States  are  committed  to  undertake,  may
contribute to raise employment rates. In order to bolster and speed up
implementation  of  the  Lisbon  strategy,  the  European  Initiative  for
Growth  seeks  to  mobilise  investment  in  areas  that  will  reinforce
structural  reforms,  stimulate  growth  and  create  jobs.  It  targets  public
and private investment in networks and knowledge.

2. DRIVERS OF PRODUCTIVITY GROWTH: AN ECONOMY-WIDE
AND INDUSTRY-LEVEL PERSPECTIVE

A new growth pattern
has emerged in the
USA and a small
number of the EU’s
Member States since
the mid-1990s.

A new  growth  pattern  has  emerged  in the  US and  a small  number  of
the EU’s Member States since the mid-1990s. For the first time since
World War II, the EU is now on a lower trend productivity growth path
than  the  USA.  Over  the  1996-2002  period,  the  EU  has  proved
incapable  of  reversing  the  long-run  decline in  its  productivity  growth
performance  whereas  the  USA  has  enjoyed  a  notable  recovery  in  its
secular trend.

Deterioration in EU
productivity growth is
due to inadequate
investment and
innovation.

The  1 percentage  point  decline  in  EU  labour  productivity  growth
experienced  over  the  1990s  emanates  from  two  factors.  Half  of  the
decline can be attributed to a reduction in the contribution from capital
deepening. Within this category, whilst investment in information and
communication  technologies  (ICT)  contributed  positively  (but  not  as
much  as  in  the  USA),  the  rest  of  investment  performed  poorly.  The
remaining half emanates from deterioration in total factor productivity
(TFP). This should probably be seen as the greatest source of concern
for policy makers.  Improvements  in TFP  are  generally  attributed to  a
more  efficient  resource  utilisation  emanating  from  enhanced  market
efficiency;  from  technological  progress  resulting  from  investments  in
human capital, R&D and information technology;  or  from  the  natural
catching-up  process  of  the  less  developed  EU  countries  through
increased business investment in general.

6

Economic growth in
the EU in the 1990s is
characterised by more
labour input and less
productivity.

Several Member
States have
outperformed the
USA in terms of
labour productivity
growth.

The industry-level
analysis shows that
superior US
performance is
concentrated in four
ICT-producing and
ICT-using industries.

In terms of GDP growth, the EU and the USA experienced significant
breaks  in  the  1990s  not  only  in  terms  of  labour  productivity  but  also
with regard to labour input. The EU in fact achieved a sharp increase in
its  contribution  from  labour  which,  as  mentioned  above,  was
accompanied  by  equally  sharp  reductions  in  the  contribution  from
productivity.  The  opposite  pattern  emerged  in  the  USA.  These
divergent labour input and labour productivity trends are clearly linked.
Up  to  one  quarter  of  the  1  percentage  point  slowdown  in  EU
productivity growth can be attributed to the higher employment content
of  growth.  No  policy  trade-off  should,  however,  be  implied  since
boosting  employment  rates  through  bringing  low-skilled  workers  into
employment  only  leads  to  a  temporary  reduction  in  measured
productivity  growth,  with  no  effect  on  the  long-run  productivity
growth of the existing workforce.

A  much  more  nuanced  picture emerges  at  the  individual  EU  Member
State level. As regards labour productivity growth, seven EU Member
States  (Belgium,  Greece,  Ireland,  Austria,  Portugal,  Finland  and
Sweden) performed well above the EU productivity average and  even
above that of the USA. Three of the seven, namely Ireland, Finland and
Sweden  were  also  capable  of  combining  both  strong  productivity  and
high  labour  utilisation  rates.  The  aggregate  EU  productivity  gap
therefore reflects the particularly poor performances of a number of the
larger Member States, most notably Italy.

in 

the  USA.  Whilst  productivity 

The industry-level analysis shows that the superior performance of the
USA in ICT-producing manufacturing and intensive ICT-using service
industries is the principal source of the diverging productivity trends in
ICT-producing
favour  of 
manufacturing  industries  has  been  growing  at  a  significantly  faster
pace  than  in  the  associated  ICT-using  service  industries,  the  latter
account  for  by  far  the  greatest  proportion  of  the  USA’s  upsurge  in
productivity.  Labour  productivity  growth  seems  to  be  dominated  by
just five, out of a total of fifty-six, industries. All of these are among
the  ICT-producing  and  intensive  ICT-using  areas  of  the  respective
economies. The USA outperforms the EU in four of these five, namely
in one ICT-producing manufacturing industry (i.e. semiconductors and
other  electronic  equipment)  and  in  three  intensive  ICT-using  service
industries (i.e. wholesale trade; retail trade; and financial services). On
a  more  encouraging  note,  the  EU  is  dominant  in  one  ICT-producing
service industry, namely telecommunications.

But with ICT
contributing also
positively to EU
productivity growth,
the slowdown has
occurred in the non-
ICT part of the
economy.

The industry analysis also re-affirms that ICT is only part of the story
behind the rising US and declining EU labour productivity trends. Just
like  in  the  USA,  ICT  also  contributes  to  both  capital  deepening  and
TFP in the EU (although the extent of the gains in the USA is larger).
The origin of the deterioration in EU productivity over the 1990s stems
therefore from developments in the non-ICT, more traditional, group of
industries,  including  services.  Indeed,  data  reveal  that  both  capital
intensity  and  overall  efficiency  patterns  in  these  sectors  appear  to  be
deteriorating.  Accounting  still  for  nearly  seventy  percent  of  total  EU
output,  these  developments  are  particularly  worrisome.  In  addition,
these  are  the  parts  of  an  enlarged  EU  economy  which  are  facing  the
greatest competitive challenges from globalisation.

7

Productivity growth
differentials appear to
be related to some
fundamental
structural differences
at the individual
Member State level.

“Lisbon strategy”
simulation highlights
the difficulties for the
EU in becoming the
most competitive,
knowledge-based,
economy in the world.

Productivity gains
from R&D and
human capital
investments ...

The  key  policy  question  addressed  is  whether  the  EU  countries  that
experienced  high  productivity  growth  and  the  USA  shared  certain
common characteristics that could explain their superior performance?
More  specifically,  what  were  the  channels  via  which  the  more
fundamental factors driving growth (i.e. institutions, trade, market size,
education  and  labour  supply/demographics)  affected  investment  and
TFP in these countries, and how did these latter two factors interact to
generate  labour  productivity  growth?  A  model-based  analysis  shows
that  EU-US  productivity  differentials  are  indeed  related  to  some
fundamental structural differences at the individual country level, with
five  areas  being  identified  as  being  quantitatively  important  and
relevant in an EU context, namely the level of regulation, the structure
of financial markets, the degree of product market integration, the size
of knowledge investment and the ageing of the labour force.

A  “Lisbon  Strategy”  simulation,  whilst  explicitly  concentrating  on
regulatory  reform  and  the  knowledge  economy,  implicitly  highlights
the importance  of  these five  factors in  determining  the  EU’s  long-run
productivity growth rate and therewith for its ambitions to outperform
the US in terms of potential growth.1  In terms of  boosting  investment
via  regulatory  reform,  the  “Lisbon  Strategy”  simulation  showed  that
even  a  relatively  rapid  policy  of  deregulation  towards  equivalent  US
levels  would  not  lead  to  sufficiently  large  productivity  gains  over  the
next seven years to close the present 10% efficiency gap with the US.
Such  a  policy  approach  would  appear  to  yield  static  efficiency  gains
rather  than  the  dynamic  efficiency  benefits  needed  to  achieve  an
outward  shift  of  the  “technology  frontier”.  This  suggests  that
deregulation alone, whilst crucial for investment, would be insufficient
to meet the strategic Lisbon goal. It must therefore be accompanied by
concerted efforts aimed at boosting the production of knowledge.

Regarding knowledge production, long run productivity gains seem to
stem  above  all  from  investments  in  both  education  and  R&D.
Regarding  education,  investment  that  fosters  higher  educational
attainment can be expected to yield productivity gains as explained in
the next section. Regarding R&D, the focus should be on creating the
framework  conditions  that  would  promote  an  increase  in  total
investment  in  R&D.  These  conditions  include  a  higher  degree  of
product  market  integration  (e.g.  through  completion  of  the  internal
market) and an investment environment which ensures the development
of  a  more  active  risk  capital  market.  The    reforms  in  this  direction
would undoubtedly improve the EU’s economic fortunes, even if taken
by themselves they would still not allow the EU to overtake the US in
productivity terms over the timescale laid out by the Lisbon agenda.

1 

The Lisbon simulation captures two supply-side initiatives linked to the Lisbon strategy, namely
(1) a reduction of the level of regulation in the EU to the US level and (2) higher spending on third
level  education,  software  and  R&D.  It  suggests  that  the  effect  of  implementing  such  a  large
package of reforms would be to significantly boost EU potential growth rates, on average by ½ to
¾ percentage point annually over a 5-10 year horizon.

8

                                                
… will be partially
offset by the parallel
efforts to boost
employment growth
and from the effects
of the EU’s ageing
labour force

The productivity
analysis supports the
conclusions of the
2003 Spring Report.

Reversing declining
labour productivity
trends depends
ultimately on the
policy choices made
by governments in the
five areas highlighted
in the analysis.

Investment in
education is a
powerful influence on
economic growth ...

Apart from the time it takes for the reforms to yield visible effects, two
further obstacles need to be overcome  to  reach the  productivity  target
put forward in Lisbon. Firstly the temporary efficiency trade-off faced
in  attaining  the  parallel  employment  target  of  70%  and  secondly  the
continuous  drag  on  productivity  induced  by  Europe’s  ageing  labour
force.

Realising  the  difficulties  of  measuring  progress  in  structural  reforms,
the Commission and the Council devised a  set  of  structural indicators
which  have  become  one  of  the  main  tools  for  assessing  progress  in
achieving the Lisbon objectives. This year, the Spring Report presented
a  simple,  but  very  informative,  exercise  counting  the  frequency  with
which  each  Member  State  was  amongst  the  three  best  or  three  worst
performing  Member  States  in  the  EU  on  each  indicator.  Certain
countries  appeared  again  and  again  amongst  the  top  three  Member
States, most notably Denmark, Sweden and Finland. It is important to
note  that  these  are  precisely  the  same  countries  that  had  already
undertaken  deep  and  successful  reforms  well  before the launch  of  the
Lisbon strategy. On the other hand, the largest Member States, such as
Germany, France and Italy, came out as clear laggards with respect to
structural  reforms.  The  strong  productivity  growth  performances  of  a
small  number  of  Member  States  vindicate  the  policy  framework
established by the Lisbon strategy. To bear fruit, however, the strategy
has  to  be  backed  up  by  commitment  and  the  timely  and  thorough
implementation of the different reform measures.

forceful 

Finally,  whether  recent  EU  productivity  trends  are  likely  to  be
permanent or transitory will depend on the policy choices governments
make.  The  analysis  confirms  the  importance  to  the  EU’s  long-run
productivity  performance  of  a 
implementation  of  a
comprehensive reform strategy. It should aim at reducing the regulatory
integrating  markets,  promoting  human  capital
burden, 
investment  and  enhancing  the  innovation  potential  of  the  economy.
Implementation of such a wide-ranging reform agenda would create  a
more flexible, dynamic and investment-friendly business environment.
Together  with  better  functioning  markets,  and  more  risk-oriented
financing  mechanisms,  this  will  set  the  conditions  for  a  significant
increase in the EU’s underlying labour productivity growth rate.

further 

3. EDUCATION, TRAINING AND GROWTH

Rising educational attainment has been a major influence on economic
growth.  Attainment  can  be  defined  as  the  successful  completion  of  a
given  level  of  education,  such  as  lower-secondary  school  or  an
undergraduate  degree.  Given  the  difficulties  in  comparing  education
systems in different countries, the number of years of study required to
obtain a given qualification is usually used as a proxy. Several recent
studies, based on improved attainment data, suggest that an extra year
of average attainment in the 25-64 population could raise productivity
by as much as 4 to 6 per cent. In the EU, average attainment has grown
by  about  0.8  years  per  decade  since 1960.  This  means  that  education
might  have  accounted  for  as  much  as  0.3  to  0.5  percentage  points  of
annual GDP growth. Further possible benefits might result if education

9

... and yields long-
term benefits.

The quality of
education is as
important as the
number of years spent
in education ...

... and greater
efficiency would
encourage investment
in education.

indirectly promotes technical progress in the longer term. Whether this
continues to be the case in the future depends on many unknowns, not
least  the  nature  of  technical  change  and  the  consequent  demand  for
skills. Nevertheless, educational attainment in the EU as a whole is set
to continue increasing in the medium term at a similar pace to that of
recent  decades.  Thus,  a  similar  contribution  to  growth  might  be
expected, though this will vary considerably among Member States.

The  full  productivity  benefits  of  investment  in  young  people’s
education  accrue  over  the  whole  professional  life.  Three  quarters  or
more  of  the  increase  in  average  attainment  over  the  next  decade  will
result from investments already made, in some cases many years ago,
as older workers retire and are replaced by younger and better-educated
cohorts. In comparison, investments made today will have a relatively
small impact on average attainment over the next decade. Nevertheless,
for the benefits of education to be reaped throughout the working life
of  an  individual,  knowledge  and  skills  must  be  maintained  and
updated. Indeed, education should be interpreted in the broadest sense
of  lifelong  learning,  from  pre-school  and  basic  education  to  adult
education  and  training  in  the  workplace.  The  impact  of  education  on
growth  is  expected  to  be  highest  in  countries  where  enrolment  in
secondary  and  tertiary  education  has  risen  most  rapidly  over  the  past
30-40 years, and lowest in countries where enrolment was already high
and has grown less rapidly. There is some evidence of high returns to
education particularly in the case of people who would otherwise enter
the labour market with low levels of attainment. Since initial education
leads to further training opportunities, inequalities in attainment tend to
widen over time. Those with few qualifications are faced with a higher
risk of unemployment and the need for later and more costly attempts
to improve employability.

The  economic  evidence  suggests  that  the  quality  of  educational
outcomes  –  measured  by  scores  in  internationally  comparable  tests  –
may be at least as important as the number of years spent in school or
college.  In  fact,  when  quality  is  taken  into  account,  the  estimated
growth impact of the number of years of schooling tends to fall. A key
question,  then,  is  how  quality  can  be  improved.  It  is  self-evident  that
adequate resources are necessary for a high-quality  education system.
On the other hand, the link between expenditure and outcomes across
countries is weak at best, which suggests that resources are being used
with varying efficiency. Improving teachers’ incentives to deliver high-
quality outcomes may be more of a priority than increasing spending in
some countries. Where increased resources are available, decisions on
how  these  are  spent  –  for  example,  on  books,  computer  equipment,
smaller  class  sizes,  higher  salaries  for  staff  and  so  forth  –  may  have
important implications for quality.

Greater  efficiency  in  the  use  of  resources  would  increase  the  rate  of
return to investment in education. At tertiary  level, for  example,  high
drop-out  rates  and  studies  that  often  last  well  beyond  the  standard
duration  are  equivalent  to  years  spent  outside  the  labour  market
without tangible benefits in the form of higher attainment. At primary
and lower-secondary levels, demographic developments mean that the
number  of  pupils  is  falling.  This  should  in  principle  free  resources.
But, in practice, expenditure per student has tended to grow faster than

10

Additional public
resources should be
focused where social
returns are highest
compared to private
returns.

Adult education and
training may offer the
greatest scope for
raising average
attainment in the
longer term, but
policies to encourage
it must be efficient.

GDP in recent years. If this continues, the additional cost in a decade
could  comfortably  exceed  the  cost  of  an  ambitious  programme  to
increase  enrolment  in  pre-school,  upper-secondary,  tertiary  and  adult
education.  Reforms  in  other  areas,  such  as  labour  markets,  tax  and
benefit  systems  and  retirement  incentives,  would  also  increase  the
returns to education, thus encouraging investment.

The available evidence suggests that the social returns to an additional
year of schooling (i.e. the benefits to the whole economy) are broadly
comparable  to  the  private  returns  (i.e.  the  benefits  to  the  individuals
concerned).  But  both  private  and  social  returns  are  likely  to  vary
considerably  between,  and  indeed  within,  specific  areas  of  education
and  training.  There  may  be  a  case  for  targeted  increases  in  public
investment  where  the  social  returns  appear  high  enough,  and  where
they exceed the perceived private returns (otherwise government would
merely  subsidise  investments  that  might  anyway  be  made,  leaving
other  more  deserving  projects  unfunded,  or  unnecessarily  raising  the
tax burden). A good case might be made for broadening access to pre-
school  education  or  for  increasing  upper-secondary  participation,
especially since these investments have long-lasting benefits and may
help to even out inequalities in access to education that tend to widen
over time. Where private returns are high and apparent, policy-makers
should  question  whether  increased  public  funding  is  needed  to  meet
their  objectives.  Potential  external  benefits  in  terms  of  longer-term
technical  progress  might  justify  certain  public  investments,  including
aspects of tertiary education.

Since  upper-secondary  and 
tertiary  participation  cannot  grow
unboundedly, adult education and training is likely to offer the greatest
scope for increasing educational attainment in the long term. Of course,
the  duration  of  the  benefits  is  shorter  than  for  children  and  young
adults.  Nevertheless,  theory  suggests,  with  some  empirical  support,
that there are significant failures in the market for training, leading to
under-provision. In addition, lifelong learning could play a crucial role
in  maintaining  and  renewing  human  capital  acquired  earlier  in  life,
something which is not taken fully into account in the basic ‘returns to
education’ framework. Lifelong learning could also help older workers
to  remain  longer  in  the  labour  market,  thus  extending  the  benefits  of
earlier investments in  human  capital.  If  policies could  be  designed  to
address market failures in an efficient way, the returns could be higher
than those for traditional schooling. Experience suggests, however, that
tax  incentives,  subsidies  and  co-financing  schemes  to  encourage
training  will  need  to  be  designed  and  evaluated  much  more  carefully
than in the past. This would help to maximise incentives to undertake
genuinely  additional  training,  and  to  minimise  deadweight  losses,
substitution effects and other inefficiencies that may otherwise quickly
consume the potential benefits of such programmes.

4. WAGE FLEXIBILITY AND WAGE INTERDEPENDENCIES IN EMU

Wages play a key role
in macroeconomic
adjustment in EMU.

Over recent years, a near consensus view has emerged on the roots of
high and persistent unemployment in many Member States,  including
all the  major  economies  of  the  euro  area  and,  more  generally,  on  the
low  employment  rates.  Broadly  speaking,  this  view  regards  the  poor
labour market performance of the countries concerned as the result of

11

The downturn has
exposed both the
strength and the limits
of wage setting
mechanisms in the
euro area.

Wage moderation
should be pursued if
EMU is to continue to
deliver strong job
growth.

the  interaction  of  a  series  of  adverse  macroeconomic  shocks  with
unfavourable  labour  market  institutions,  and  also  product  market
regulations  that  have  significantly  limited  the  capacity  to  adjust  to
changes  in  economic  conditions.  Obviously,  wages  as  the  price  of
labour  have  a  key  role  to  play  in  determining  the  overall  balance  of
supply and demand in the labour market. Furthermore, the formation of
economic  and  monetary  union  (EMU)  is  often  taken  to  put  further
demands  on  the  flexibility  of  wages  to  compensate  for  lack  of
(national) instruments to deal with economic disturbances. If wages are
too  rigid,  the  necessary  adjustment  will  come  slowly  and  with
considerable economic and social costs.

and 

shocks 

common  macroeconomic 

Both 
country-specific
developments  have  put  the  flexibility  of  wage  setting  mechanisms  in
the  euro  area  to  a  stress  test  in  recent  years.  It  was  expected  that
nominal wage growth would remain consistent with price stability and
productivity gains, thereby allowing companies to increase job-creating
investment.  Regarding  actual  developments,  on  the  positive  side,
overall wage discipline has been preserved and risks that the inflation
overshoot  would  lead  to  extended  second-round  wage  effects  have
been averted. On the negative  side,  with  nominal  wage  growth rather
invariant to the cyclical situation, the slowdown in labour productivity
growth translated into significant increases of nominal unit labour costs
in  2001  and  2002.  Hence,  wage  flexibility  appears  to  have  provided
little, if any, support to the expected cyclical recovery so far.

After a prolonged period of wage moderation, the fall of the share  of
wages  in  GDP  came  to  halt  at  the  turn  of  the  decade  and  remained
broadly stable throughout the downturn. There are indications that the
wage share will decrease again when the economy gathers momentum
in  2004.  Moderate  real  wage  increases,  consistent  with  productivity
gains  and  the  need  of  restoring  profitability  where  necessary,  help  to
increase  employment  and  to  lower  structural  unemployment  over  the
medium term, without necessarily compromising domestic  demand  in
the  economy.  This assertion  is backed  up  by  both  standard  economic
theory  and  by  the  factual  experience  of  many  euro-area  countries,  in
particular in the second half of the 1990s. Hence, in light of still high
structural unemployment, further wage moderation is necessary in the
euro area.  However,  it  should  also  be  noted  that  aggregate  real  wage
moderation is a fairly poor substitute for wage differentiation, when it
comes  to  helping  to  price  the  low-skilled  back  into  jobs.  It  needs
therefore to be accompanied with specific measures targeted at raising
employment among low-skilled workers.

Conventional wisdom
has it that wage
formation
mechanisms in
Europe are
characterised by a
high degree of rigidity
and slow adjustment
to shocks but evidence
is still inconclusive.

Conventional  wisdom  has  it  that  wage  formation  mechanisms  in
Europe  are  characterised  by  a  high  degree  of  rigidity  and  slow
adjustment  to  shocks.  A  number  of  institutional  features  in  the  euro-
area labour  market  could account for  a  lack  of  nominal  as  well  as  of
real  wage  flexibility.  Factors  typically  mentioned  in  this  context
include  union  power,  coordination/centralisation  of  bargaining,
bargaining  coverage,  the  impact  of  collective  bargaining  on  contract
length, the use of wage rules in collective bargaining, including wage
indexation, and, last but not least various insider-outsider mechanisms
in the labour market affecting the sensitivity of wages with respect to
unemployment.  However,  in  line  with  findings  from  other  studies,

12

EMU is affecting the
wage bargaining
system in several ways
with potentially
important
implications for the
adjustment to shocks
in the euro area.

formal  econometric  analysis  of  Phillips  curve-type  wage  equations
suggests that wage inflation persistence in the euro  area is not higher
than  in  the  USA.  The  finding  of  broadly  similar  degrees  of  nominal
inertia  across  euro-area  Member  States,  and  in  the  euro  area  and  the
USA,  makes  it  difficult  to  identify  institutional  labour  market
characteristics  as  the  major  determinants  of  nominal  rigidities.  Thus,
while institutional and structural factors are a key to an understanding
of  what  determines  the  level  of  equilibrium  unemployment  over  the
medium term, institutional labour market characteristics appear to be of
less importance for the degree of nominal inertia in the economy.

in 

is  somewhat 

While  it  is  still  too  early  to  draw  final  conclusions  on  potential
channels through which EMU could impact on the incentives faced by
its economic agents and on its wage bargaining systems, the picture is
nevertheless  becoming  progressively  clearer.  Research  has  already
identified  a  strong  positive  impact  of  the  euro  on  product  market
integration  via  increased  trade  and  foreign  direct  investment.  This
should  lead to  enhanced  competition  on  product  markets. The  impact
of  EMU 
the  case  of  wage
less  clear-cut 
interdependencies. The convergence of wages and unit labour costs has
not  waited  for  the  single  market,  let  alone  EMU,  to  be  completed.
Available  sectoral  evidence  suggests  that  convergence  was  in  fact
stronger  in  the  1980s  than  in  the  1990s.  The  emergence  of  higher
goods  market  integration  and  of  stronger  interdependencies  in  wage
setting across countries – be it due to EMU or other factors – can affect
the way in which shocks are absorbed and transmitted in EMU. Model
simulations show that this partly depends on the nature of the shocks.
Increased wage interdependency does not lead to major differences in
the  absorption  of  supply  shocks  but  entails  a  more  protracted
adjustment to demand shocks. In the case of demand shocks, the wage
and price response slows down if wage setting is interdependent, with
simulations showing that it takes approximately one more year for the
output  adjustment  process  to  work  out than in  the  case  without  wage
interdependencies.

The creation of the
internal market and
the launch of EMU
have fostered
international capital
flows.

5. DETERMINANTS OF INTERNATIONAL CAPITAL FLOWS

The strong increase of international capital flows (portfolio flows and
direct  investments)  over  the  past  ten  years  is  the  combined  result  of
legal and economic forces. As regards the EU, the full liberalisation of
capital movements within the Community was finally accomplished on
1 July 1990 while capital movements between Member States and third
countries  were  fully  liberalised  on  1  January  1994.  The  rapid
expansion of domestic financial markets and surging international trade
have  been  two  of  the  main  driving  economic  forces.  In  addition,  the
adoption of the euro and the resulting elimination of foreign exchange
risk within the euro area have accelerated financial  integration  within
the EU.

Increased
international capital
flows have strong
implications for the
global economy.

Enhanced  financial  integration  has  strong 
the
functioning  of  the  global  economy.  International  capital  flows  may
serve  both  as  a  source  of  growth  and  as  a 
transmitter  of
macroeconomic shocks. By smoothing consumption, capital flows play
an  important  role  in  the  adjustment  to  disturbances.  Sudden  shifts  in
the flow  of  foreign  finance  can,  however,  also  create  major  domestic

implications  for 

13

The need to finance
high investment ratios
without adequate
national savings
continues to lead to
external deficits
financed by FDI
inflows in acceding
countries.

Adoption of EU
acquis should
contribute to financial
stability in the
acceding countries.

Improving corporate
governance systems
should help the EU to
attract capital flows.

problems,  as  demonstrated  by  financial  crises  in  several  emerging
economies in the past decade.   Many  emerging  economies  liberalised
their  capital  flows  in  the  1990s,  while  maintaining  weak  financial
institutions  and  pursuing  macroeconomic  and  financial  policies  that
turned out to be inconsistent with exchange rate stability. The outcome
has  been  large  financial  imbalances  driven  by  capital  inflows  and
eventually financial crises and distress.

Current  account  deficits  are  a  common  feature  in  the  acceding
countries. In several cases they amount to more than 5 percent of GDP,
having  increased  over  recent  years  in  connection  with  rising  foreign
direct investment. Thus, the current account deficit in most cases is a
reflection  of  large  FDI  inflows  and  not  the  main  reason  for  the
worsening  of  the  external  accounts.  With  the  notable  exception  of
Hungary, the external deficits are largely covered by non-debt-creating
FDI inflows. In some acceding countries, privatisations are still under
way. In others, second-round investment in the form of inter-company
loans provide an important source of current account financing. On the
whole,  the  acceding  countries  are  likely  to  run  considerable  current
account deficits for some time to come in order to compensate for their
lack of domestic savings. Thus, foreign investments will continue to be
a major motor of growth.

In  the  area  of  financial  sector  development  and  supervision,  in
particular,  there  are  striking  differences  between  acceding  countries
and  many  other  emerging  markets.  Here  the  acceding  countries  have
gradually  implemented  the  EU  acquis  for  regulation  and  supervision
and  have  opened their  markets to  large-scale  foreign  ownership.  This
experience suggests that the acceding countries - by pursuing adequate
policies - can avoid the negative experiences in other regions, thereby
setting  the  pre-conditions  for  strong  real  convergence  in  a  setting  of
financial stability.

these 

inflows 

Countries with good corporate governance systems are likely to attract
international  capital  flows  on  better  terms  than  countries  with  weak
systems  that  invite  fraudulent  behaviour.  With  rising  competition  for
capital 
important
determinants of capital flows in the coming years. The EU has already
taken  a  number  of  steps  to  improve  corporate  governance  in  Europe,
including  the  Financial  Services  Action  Plan  (FSAP)  and  the  Market
Abuse  Directive.  Work  is  also  underway  to  strengthen  accountancy
standards,  auditor  independence  and  share-holders'  rights.  This  will
make the EU more attractive for growth-enhancing capital flows.

to  become 

issues  are 

likely 

14