Source: EURLEX
Language: en
Format: md

**COMMISSION OF THE EUROPEAN COMMUNITIES**

**Brussels, 06.03.1996**
**COM(96) 86 final**

**1996 Annual Economic Report**

**(presented by the Commission)**

**1996** **ANNUAL ECONOMIC REPORT**

PART A: COMMUNITY-WIDE TRENDS

SUMMARY AND CONCLUSIONS i

CHAPTER 1: RECOVERY LOOKING FOR A SECOND BREATH 1

1.1. MARKED GROWTH SLOWDOWN DURING 1995 1

_1.1.1._ _Main trends_ 1

_1.1.2._ _Factors behind the slowdown_ 2

1.2. REBOUND IN ACTIVITY EXPECTED DURING 1996 7

_1.2.1._ _Underlying economic fundamentals are favourable_ 7
_1.2.2._ _Important short-term risks and uncertainties_ 13

1.3. CONTINUED PROGRESS TOWARDS NOMINAL CONVERGENCE 14

_1.3.1._ _Historically low and converging price increases_ 15
_1.3.2._ _Insufficient progress in reducing budget deficits._ 16

1.4. FALTERING IMPROVEMENT IN LABOUR MARKET CONDITIONS 19

_1.4.1._ _Recent developments._ 19
_1.4.2._ _Longer-term trends in employment creation in the Community_ 20
_1.4.3._ _Incidence of unemployment in the EC_ 22

1.5. WHITE PAPER MEDIUM-TERM OBJECTIVES PUT AT RISK 25

B O X l : THE GROWTH IMPACT OF THE 1995 EXCHANGE RATE TURMOIL 5

BOX 2: CURRENT OUTLOOK IN A HISTORICAL PERSPECTIVE 12

BOX 3: THE ECONOMIC COMPOSITION OF UNEMPLOYMENT 24

CHAPTER 2: ECONOMIC POLICIES FOR GROWTH AND EMPLOYMENT 28

2.1. DESIRED POLICY MIX 28

2.2. MONETARY POLICY 29

_2.2.1._ _Inflation and monetary policies in the medium term_ 29
_2.2.2._ _Monetary stability affected by internal and external factors in 1995_ 33
_2.2.3._ _Room for further easing of monetary policies._ 36

2.3. BUDGETARY POLICY 39

_2.3.1._ _Recent developments and short-term prospects_ 39
_2.3.2._ _Medium-term benefits of continuing and enhanced consolidation_ 42
_2.3.3._ _Fiscal consolidation and short-term growth prospects_ 48
_2.3.4._ _Priority areas for consolidation_ 49

2.4. WAGE DEVELOPMENTS 53

_2.4.1._ _The appropriate wage trends._ 53
_2.4.2._ _Wage adjustment in the EC since 1980_ 56
_2.4.3._ _Expected_ _wage_ _developments_ 58

2.5. STRUCTURAL POLICIES 59

_2.5.1._ _Vital complement to macroeconomic policy-mix_ 59
_2.5.2._ _Initiatives taken in 1995 to improve the functioning of product markets_ 67
_2.5.3._ _Labour market reform: More needs to be done_ 69

BOX4: THE DOLLAR AND THE ERM 35

BOX 5: EXAMPLES OF SUCCESSFUL FISCAL CONSOLIDATION EFFORTS 51

BOX 6: PRODUCTIVITY AND EMPLOYMENT GROWTH 61

Box 7: THE COMMUNITY IN THE WORLD ECONOMY 63

**/ta**

6.3.96

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

STATES

BELGIUM 73

DENMARK 77

GERMANY 80

GREECE 85

SPAIN 89

FRANCE 94

IRELAND 98

ITALY 102

LUXEMBOURG 107

THE NETHERLANDS 110

AUSTRIA 113

PORTUGAL 117

FINLAND 121

SWEDEN : 125

UNITED KINGDOM 129

**6.3.96**

**PART** **A**

**COMMUNITY-WIDE TRENDS**

**6.3.96**

**Summary and conclusions**

_In presenting the Commission's views_ _on_ _the current economic situation_ _and_ _main policy issues_ _in_
_the_ _Community,_ _the_ _1996 Annual Economic Report_ _is_ _intended_ _to_ _initiate_ _a_ _debate_ _on_ _the_ _policy_
_options_ _to_ _be_ _considered in_ _the_ _forthcoming 1996 Broad Guidelines_ _exercise._ _Job_ _creation_ _is_ _the_
_principal_ _social,_ _economic and political objective_ _of the_ _Union_ _and its pursuit_ _requires_ _a_ _whole_
_variety_ _of_ _measures._ _This report_ _concentrates_ _on_ _macroeconomic policies_ _and_ _also_ _deals with_
_structural_ _policies,_ _in_ _particularly_ _those_ _initiated_ _and_ _agreed_ _at the_ _Community_ _level._ _These_
_policies have been_ _set out in_ _detail_ _in a_ _number_ _of_ _reports,_ _including_ _in_ _particular the_ _joint_
_employment report approved by the December 1995_ _Madrid_ _European_ _Council._

_**The Community needs to stay on course**_

Creating jobs and reducing unemployment is the single greatest challenge facing the

Community at the present time. Policy-makers in the Community are faced with a

situation in which decisions taken in the short term will fundamentally affect the evolution

of the Community's growth, employment and convergence performance in the coming

years. However, the juxtaposition of cyclical difficulties and slow progress with structural

reforms has raised uncertainties about the short-term economic prospects and pointed to

the need for affirmation about the effectiveness and soundness of the policies followed by

Community governments. In this situation, there is a clear need to articulate policy

intentions more effectively in order to stabilise expectations and to mobilise political

supportibr stated objectives. This is all the more essential in order to avoid a weakening in

the determination to implement the appropriate policy framework in the face of the current,

less than ideal, economic conditions.

This situation has certain parallels to the conditions prevailing in the first half of the 1980s

but decisive and concerted action provided the key to a turnaround in economic sentiment

and performance. The challenge facing policy makers is therefore:

   - to revive the recovery by introducing national and Community co-ordinated

measures aimed at restoring confidence; and

   - to achieve the latter whilst simultaneously supporting the medium-term orientation

of Community policy aimed at transforming the upswing into a strong and sustained

growth process supported by capacity and employment-creating investment coupled

with the necessary progress towards nominal convergence.

The maintenance of this medium-term orientation is crucial to the realisation of the two

complementary objectives of Community policy, namely:

   - a substantial reduction in the level of unemployment; and

   - successful transition to Economic and Monetary Union on 1 January 1999.

**6.3.96**

**11-**

_**Disappointing growth trend**_ _**during 1995**_ **...**

The Community economy is experiencing a marked slowdown. Contrary to expectations

prevailing at the begmning of 1995 of output growth of around 3 percent per year in 1995

and 1996, the economic expansion lost considerable steam throughout 1995 and came to a

virtual standstill in the closing months of the year. Overall, the performance was

disappointing not just in terms of the average growth rate achieved (available evidence

suggests GDP growth of the order of _2Vi_ per cent) but especially because the momentum

was insufficient to prevent unemployment from rising in some Member States at the end

of last year and since progress with fiscal consolidation was modest. Better results on

these two fronts are crucial to the credibility of the Community's medium-term ambitions.

The slowdown was initially induced by "inherent cyclical forces", including an end to the

early-cycle boost from stockbuilding. These forces were exacerbated by the rise in long
term interest rates during 1994, the currency turmoil in the spring of 1995 and the ensuing

decline in private sector confidence. The abrupt and sizeable movements in exchange

rates — reflecting a combination of dollar weakness and doubts in the financial markets

concerning the credibility of fiscal and structural policies in a number of countries —

heightened financial uncertainties and created perceptions of risks to the proper

functioning of the internal market. These developments in combination with inadequate

progress in combatting unemployment have contributed to a decline in confidence and a

scaling back of spending and hiring decisions.

**...** _**threatens confidence in the Community**_

Consequently, the Community enters 1996 in a less confident mood. Although the

balance of probability is still pointing towards a renewed strengthening in activity, the

ongoing deterioration in business and consumer sentiment suggests that confidence
enhancing action remains essential to prevent a prolongation of the current pause in

economic activity. Increasing levels of uncertainty among economic agents stem from a

variety of sources. Externally, the global technological revolution, increasing competition

from low cost producers and an accelerated pace of structural change in all areas of the

economy are having an impact. Internally, insufficient reduction of high unemployment

and uncertainty surrounding the implementation of measures needed to realise key

economic and political objectives are negatively affecting the medium-term expectations

of investors and consumers alike.

_**Av**_

**6.3.96**

**Ill**

_**Such pessimism**_ _**is exaggerated given**_ _**favourable**_ _**economic fundamentals...**_

While the fears generated by global and Community-wide phenomena may be

understandable, much of the anxiety should prove short-term in nature. The Community is

presently enjoying quite favourable underlying economic conditions. Extra-Community

import demand continues to expand at a healthy pace, the profitability of investment is

improving and, in overall terms, is noticeably higher than during the second half of the

1980s, inflation is at a historical low, interest rates have been substantially reduced and a

partial reversal of previous exchange rate overshooting has taken place. Furthermore,

progress is being made towards greater nominal convergence. The Community finds itself,

therefore, in a paradoxical situation. The prevailing sentiment of caution and indecision is

at odds with the fundamentals and with the broad degree of convergence amongst

governments regarding their objectives and the means for achieving them.

**...** _**but confidence building measures are**_ _**necessary.**_

Consequently, within the overall economic policy framework established in the

Commission's 1993 White Paper on Growth, Competitiveness and Employment and

embodied in successive Broad Economic Policy Guidelines adopted by the Council since

1993, confidence building measures are called for to overcome the current short-term fears

and anxieties. Measures which can be organised at the national and/or Community level

should help provide the reassurance necessary to re-ignite the recovery process and thereby

exploit the favourable underlying conditions. This is the essential rationale underlying the

Commission President's recent proposal for a European confidence pact for employment.

In this context, the Commission has suggested making supplementary resources available

for the successful realisation of the trans-European networks (TEN's) as well as for

research and development efforts. In addition, following the conclusions of the Madrid

European Council, the Commission is proposing an action plan in favour of SMEs. Display

of common action in these fields will foster confidence in the ability of the Member States

and the Community to achieve shared objectives. Furthermore, cooperation between the

social partners, in concertation with governments, on a comprehensive programme for

stability and employment could spur confidence and improve the investment climate. Such

pacts should be examined not only in the light of short-term considerations but also as a

part of an overall medium-term package of measures. To ensure the chances of overall

success, such policy packages must be credible, provide clear signs regarding the policy

course, be compatible with the agreed macroeconomic strategy, contain detailed initiatives

on ways to pursue structural reform and aim to receive broad acceptance among different

strands of opinion in society.

_**A**_
# **I**

**6.3.96**

**IV**

_**Realising the desired**_ _**"détente"**_ _**of**_ _**the**_ _**macroeconomic policy**_ _**mix....**_

The objective of policy must be to re-ignite the recovery process whilst at the same time

maintaining the credibility of the stability-oriented medium-term policy framework. With

respect to budgetary policy, there appears to be virtually no room for manoeuvre in the

vast majority of Member States in the current situation. Given the risk of adverse reactions

on forward-looking financial and foreign exchange markets, any slippage in fiscal

consolidation efforts would be counterproductive. On the contrary, the most important

contribution that macroeconomic policies can make at the present time is to bring about a

continued "détente" in the policy mix. The primary objective of monetary policy is to

achieve and maintain low inflation. But, if budgetary consolidation efforts are pursued

resolutely and wage developments remain adequate, the conditions will be created for

realising a further, durable, easing in monetary conditions. The attached report highlights

the fact that such a "détente" was hampered last year by the incomplete application of

policy intentions in some Member States. Consequently, the key to avoiding a more

prolonged economic slowdown is linked essentially to the enthusiasm and commitment of

_all_ Member States to put their _overall_ policy framework on a credible footing.

_**...will depend on**_ _**a**_ _**credible budgetary**_ _**consolidation process...**_

Despite the generally promising trends towards more fiscal rectitude in recent years,

excessive budget deficits continue to exert downward pressures on current and prospective

living standards in the Community. In a number of Member States, high budgetary

imbalances fuel inflationary expectations and contribute to high interest rate premiums.

More generally, high budget deficits depress national saving, lead to higher expected tax

rates, impair additional actions to combat unemployment, hamper efforts to raise

production and employment potential, and reduce the ability of budgetary policy to respond

to economic downturns. The urgency of fiscal consolidation efforts in the Community is

recognised by all Member States.

Despite the positive medium-term effects, governments may be reluctant at present to

continue budgetary reforms due to concern about their short-term impact. However,

depending on the particular circumstances that a country finds itself in, this impact may

well be limited, or indeed positive in countries with high interest rate premia and

insufficient fiscal credibility. The right fundamentals are in place to induce a significant

crowding-in of private sector demand. The impact also depends on the overall package of

measures decided and the manner in which implementation is achieved. The most critical

requirement is that budgetary consolidation must form part of an overall economic

approach which is credible.

**6.3.96**

**....** _**and on continuing appropriate wage**_ _**developments.**_

Within the macroeconomic framework, the Social Partners carry a vital responsibility in

maintaining appropriate wage trends. The Broad Economic Policy Guidelines emphasise

the necessity of nominal wage increases which are compatible with the inflation objective of

the monetary authorities. Furthermore, real wage developments should ensure a continuing

recovery in investment profitability, whilst also providing for increases in standards of

living.

From a macroeconomic point of view, recent and prospective aggregate wage

developments do not constitute a serious constraint on growth in most Member States. In

some, however, wage trends have not been fully compatible with the stability objective of

the monetary authorities and/or with the need to improve and safeguard the economy's

growth potential. On the micro side, labour cost levels are often not in line with

productivity levels. Consequently, a greater degree of skill-related, regional and sectoral

wage cost differentiation will be necessary in order to ensure a more employment
generating growth process.

_**Macroeconomic policies**_ _**must**_ _**be**_ _**accompanied by structural**_ _**reforms.**_

Re-igniting the recovery process should go hand-in-hand with progress towards the

realisation of the Community's key medium-term objectives in terms of unemployment and

the move to a single currency. In order to achieve these objectives, macroeconomic

policies must be accompanied by action on the structural side with essentially three aims: (i)

to ensure a tension-free macroeconomic growth process by measures aimed at a better

functioning of goods and services markets allied to a greater flexibility of the labour

market; (ii) to enhance the endogenous growth forces by actions geared towards promoting

innovation, competition and improving human capital and (iii) to increase the employment
intensity of growth through a widening of the wage cost scale, especially by reducing

indirect labour costs at the lower end, and reorganising working conditions.

Structural policies are largely the responsibility of national authorities, but in order to

increase their potency and effectiveness, national actions should be co-ordinated and

complemented by specific actions at the Community level when appropriate. At present,

Community actions comprise a series of competitiveness and labour market initiatives with

particular attention being devoted to the internal market, the trans-European networks

(TENs) and the monitoring of the implementation of the Community's employment strategy

adopted at the Madrid European Council in December of last year. This strategy is focused

on action in the five key areas defined by the European Council in Essen: (i) improving

_**4 +**_ _**k**_

**6.3.96**

**-** **VI**

employment opportunities for the labour force by promoting investment in vocational

training; (ii) increasing the employment intensity of growth (flexible work organisation,

appropriate wage agreements, environmental and social services activities); (iii) reducing

non-wage labour costs extensively enough to ensure a noticable effect on decisions

concerning the hiring of employees and in particular of less qualified workers; (iv)

improving the effectiveness of labour-market policy by avoiding practices which are

detrimental to the readiness to work and by moving from a passive to an active labour

market policy; and (v) improving measures to help groups which are particularly hard hit by

unemployment.

_**A**_ _**complete application**_ _**of**_ _**the**_ _**Broad**_ _**Economic Policy Guidelines**_ _**is**_ _**the key**_

In overall terms, therefore, the key to solving the Community's present short-run difficulties

and achieving its medium-term ambitions lies in the credible application of the Broad

Economic Policy Guidelines framework and the employment strategy agreed by the

European Council in Essen and subsequent European Councils. These respective

frameworks embrace macroeconomic, labour market and structural elements which will

produce mutually reinforcing effects crucial to the simultaneous promotion of growth and

employment creation and to the realisation of EMU on 1 January 1999.

**6.3.96**

**Chapter** **1:** **Recovery looking for** **a** **second breath**

**1.1. Marked growth slowdown during 1995**

**1.1.1. Main trends**

**Chart** **1** The surprisingly strong recovery

**Quarterly rates of GDP** **growth,** **EUR 9'**
**`Real`** **`% p.a.`** of the Community economy in

1994 gave way to a marked

slowing of the rate of expansion

during 1995. Output growth

progressively decelerated from a

pace of 3î4 to 4 per cent

(annualized rate) throughout most

`| Q1 Q2 Q392` `Q4` `Q1 Q2 Q3 Q4|` `93` `Q1` `| Q2 Q394` `Q4 Q1` `| Q2 Q3 Q4 95` of 1994 to around 2 per cent in the

`'` `EUR` `9=D,F,I,UK,E,NL` `1` `S,A,FIN` second and third quarters of 1995

(chart 1). On the basis of the latest available indicators, the Community economy may have

seen virtual stagnation in the final quarter of the year. Output may even have contracted

slightly in some countries, notably Grermany and France. If these expectations are borne

out, output growth in the Community for 1995 as a whole would turn out to be slightly

below the 2.7 per cent anticipated in the Commission's November 1995 Economic

Forecasts, but likely remain of the order of 2*/2 per cent.

**Chart** **1**

**Quarterly rates of GDP** **growth,** **EUR 9'**

```
Real % p.a.

```

```
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4
| 92 | 93 | 94 | 95

```

```
' EUR 9=D,F,I,UK,E,NL 1 S,A,FIN

```

Table 1:

The Community economy :

use and supply of goods and services

(real annual percentage change)

1994

1.6

1.0

2.5

_2.6_

_2.4_

0.9

2.5

10

4 [1] /*

" 2.8

While economic activity in

1995 continued to be

supported by healthy extra
EC exports, domestic demand

within Community countries

slowed down. In the first half

of the year, there was a sharp

reduction in the contribution

from stockbuilding and

construction investment slow
ed unexpectedly. Investment

in equipment kept expanding

solidly while private

consumption continued

growing at a modest pace. In

**6.3.96**

1993

-0.3

1.1

-6.6

_-10.7_

_-3.3_

-0.7

-2.0

8

-3

-0.6

1995

a)

1.9

1.0

4.5

_8.0_

_1.9_

0.1

2.3

814

_5%_

2.7

Private consumption

Government consumption

Gross fixed capital formation

  - _of_ _which:_ _equipment_

_- of_ _which:_ _construction_

Stocks (contribution % GDP)

Domestic demand (incl. stocks)

Exports of goods and services b)

Imports of goods and services b)

Gross domestic product

1986
90

3.7

2.0

5.7

_7.1_

_4.8_

0.1

3.9

_VA_

6

3.3

1991
92

1.8

1.9

-1.3

_-2.3_

_-0.5_

-0.2

1.0

3 [1] /*

4

1.2

a) November 1995 Forecasts. Growth rates are likely to be revised down.

b) Extra-Community trade only (estimates)

_**A**_

**-2**

the latter half of the year both investment and private consumption slowed down markedly.

The loss of growth dynamism was particularly marked in countries whose currencies

appreciated significantly in the spring of 1995, but the pace of expansion moderated in

virtually all Member countries. In the former group of countries, exports generally levelled

off and investment grew less rapidly than previously expected. While private consumption

initially held up well, the worsening labour market prospects led to a moderation in

consumer expenditures in the second half of the year. In countries whose currencies

depreciated markedly, the boost to export market shares was to some extent off-set by

slowing growth on their export markets, and domestic demand was restrained by high real

interest rates and adverse terms-of-trade effects.

**1.1.2. Factors behind the slowdown**

The faltering of the recovery process essentially appears to have been caused by two types

of forces. First, the initial moderation of output growth was induced by what may be

termed "inherent cyclical forces", comprising an end to the early-cycle boost from stock
building and a gradual switch in the forces driving the recovery. Such factors have also

caused a short-lived pause during previous upturns. Secondly, this cyclical pause has been

exacerbated by a number of interrelated forces: the lagged effects of the rise in long-term

interest jates during 1994, the currency turmoil in the spring of 1995 and, partly as a result

of these factors, a steady decline in private sector confidence.

_**Growth pause not in itself unusual**_

The importance of the "inherent cyclical

forces" is highlighted by a comparison of the

growth profile as well as the role of stocks in

the recent recovery with previous

experiences. During 1994, the swing in

stockbuilding gave a powerful boost to the

recovery in activity, accounting for almost a

full percentage point of the 2.7 per cent GDP

growth rate, but the 1994 recovery did not

rely more heavily on stock-building than

previous upswings. Also in the two previous

cyclical upturns there was subsequently a

temporary negative contribution from stocks

which led to a short-lived growth pause

(chart 2). Thus, such an "inherent cyclical

**Chart 2**

Role of stocks during recovery, EUR 4*

_**%**_ _**1975 Q3**_ **-** _**1977 Q4**_

l^wjjii^ilii^^^^.i

**Q1** **Q2** **Q3** **Q4** **Q5** **Q6** **Q7** **Q8** **09** **Q10**
**,** **fGDP** _**1993 Q2**_ **-** _**1995 Q3**_

**Q1** **Q2** **Q3** **04** **Q5** **06** **Q7** **08** **Q9** **Q10**
**EUR 4 :** **D, F,** **I,** **UK**

**6.3.96**

**3 -**

pause" principally related to the stock cycle is not unusual, and therefore not necessarily

worrying. However, the present slowdown may prove to be more intense and more

protracted than previous growth pauses as a result of adverse developments in financial

markets.

_**Long-term interest rates increased markedly during 1994**_

First came the marked increase in long-term interest

rates on world and Community financial markets

during 1994. Between December 1993 and

December 1994, long-term bond yields increased by

D

E

F

1

S

UK

Table 2

Long-term interest rates

Dec.

1993

Dec.

1994

7.3

11.1

8.3

11.8

10.9

April
1995

6.8

11.8

7.7

12.8

11.4

5.5

8.1

5.8

9.2

7.6

6.3

6.8

8.6

9.0

some 225 basis points in the Community on average

1 9.2 11.8 12.8 10:0

while inflation in general remained on a declining S 7.6 10.9 11.4 8.3
trend. This increase was partly related to a UK 6.3 8.6 8.4 7.8

EUR 6.8 9.0 8.8 7.4

"contagion effect" from a similar rise in US yields,

and partly reflected the surprising strength of the European economic upturn which seemed

to raise the prospects either of early monetary tightening or an eventual build-up of

inflationary pressures. However, the rise in yields varied considerably across EC Member

States, reflecting _inter alia_ their economic performance, policy stance and credibility. In

particular, long-term interest rates rose significantly more in countries where uncertainty

about future fiscal policies was rife and whose public finances were not yet perceived by

the markets as having been put on a clearly sustainable path.

The rise in long-term interest rates was expected to hold back economic activity in 1995

through its demand-dampening effects, particularly on investment in construction, but

within the context of an ongoing recovery the impact was thought to be modest. However,

it appears in retrospect that the higher long-term interest rates in conjunction with other

factors may have placed a stronger-than-anticipated brake on companies' and households'

spending decisions in 1995.

_**Exchange rate turmoil and faltering**_ _**confidence**_

Chief among these additional factors was the exchange rate turmoil which erupted in spring

1995. The abrupt and sizeable shifts in exchange rates heightened financial uncertainties

and undermined confidence in the perspectives for an orderly recovery. The currency

turmoil appears to have been caused essentially by two developments. First, the US-dollar

weakened significantly in the wake of the Mexican peso crisis and shifting market sentiment

about the relative strength of the major international currencies. Secondly, the pressure

already exerted on intra-European exchange rates by the weak dollar was reinforced by

**6.3.96**

8.4

8.8

Jan.

1996

5.3

9.1

6.3

10:0

8.3

7.8

EUR

7.4

uncertainties concerning the future course of budgetary consolidation in some Member

States and/or perceived risks of renewed inflationary tensions. The resulting currency

movements, which in many cases came on top of previous shifts, were bound to have a

significant impact on the economies of appreciating as well as depreciating countries and

played a key role in the slowdown of the Community economy as a whole (see box 1).

While industrial confidence had

**Chart 3**

declined slightly before March 1995,

**Currency turmoil and confidence**

**EUR** the exchange rate turmoil set in train

a sustained decline in production

expectations in industry and caused a

weakening in consumer confidence

(chart 3). The drop in industrial

**|** **2 4 6 8** **92** **1012** **2 4 6 8** **|** **93** **10 12** **|** **2 4 6 8** **94** **1012** **|** **2 4 6** **95** **6 1012** confidence was generally more
**Germany**

pronounced in appreciating countries

**20** (exemplified in the chart by

**10**

**0** Germany) reflecting anxiety about

**-10**

**-20** the loss in competitiveness, while

**-30** **pS**

consumer confidence tended to

**-40** **tt*S:-:-:re>-»:-:+^^** **1 0 0**
**2 4 6 8** **10 12** **2 4 6 8** **1012** **2 4 6 8** **1012** **2 4 6 8** **1012**
**92** **I** **93** **I** **94** **I** **95** decline in depreciating countries
**Italy**

**100** (particularly Italy) where consumers

anticipated an erosion of their

purchasing power while having to

face higher interest rates. Much the

`2 4 6 8` `10 12` `2 4` `6` `8` `1012` `2 4 6 8` `10 12` `2 4 6 8` `1012` same pattern was discernible during
```
      | 92 | 93 | 94 | 95
```

***** **Index:** **1987Q1=100** the exchange rate crisis of September

1992 when the British pound and the

Italian lira left the ERM. Also then, economic sentiment had started deteriorating before

the currency crisis, but the latter greatly accelerated the erosion of confidence, particularly

for businesses in appreciating countries and for consumers in depreciating countries.

**Chart 3**

**Currency turmoil and confidence**

**EUR**

**2 4 6 8** **1012** **2 4 6 8** **10 12** **2 4 6 8** **1012** **2 4 6** **6 1012**
**|** **92** **|** **93** **|** **94** **|** **95**
**Germany**

**20**

**10**

**0**

**-10**

**-20**

**-30** **pS**

**-40** **tt*S:-:-:re>-»:-:+^^** **1 0 0**
**2 4 6 8** **10 12** **2 4 6 8** **1012** **2 4 6 8** **1012** **2 4 6 8** **1012**
**92** **I** **93** **I** **94** **I** **95**
**Italy**

**100**

```
     2 4 6 8 10 12 2 4 6 8 1012 2 4 6 8 10 12 2 4 6 8 1012
     | 92 | 93 | 94 | 95
```

***** **Index:** **1987Q1=100**

Developments in early 1995, including in Germany inappropriate wage agreements together

with the appreciation of the DM, undermined the competitiveness and profitability of

industry. They also caused companies to scale back their expectations of future sales, to

revise down their desired stock levels and to postpone spending decisions. This initial drop

in purchases led to a further weakening of business confidence which again had

repercussions on spending and hiring decisions. The decline in business confidence

**6.3.96**

**5-**

continued throughout the year, but seems to have come to a halt more recently. As

confidence in the continuation of economic recovery was slipping and as the improvement

in the labour market faltered, consumer confidence declined gradually during the second

half of the year.

In sum, the progressive weakening of economic activity during the year owes much to a

"vicious circle" of declining confidence and increased caution in spending and hiring

decisions. This was in large part a result of financial turmoil, while the underlying

economic forces had in fact not deteriorated to an extent which would necessitate or justify

such a marked slowdown in the Community. This points to the need both for increased

policy credibility within the EC and for increased efforts at the international level to prevent

large and sudden movements in the major international currencies.

**Sox** _**1:**_ _**The growth Impact**_ _**of**_ _**the 1995 exchange rate turmoil**_
**Between December 1994 and** **April** **1995,** **the** _**US**_ **dollar fell by 12 per cent vis-à-vis the Deutsche**
**Mark, adding to a** **10** **per cent slide during 1994,** **The** **tali** **of the dollar, combined with**

Table B1.1 **uncertainties surrounding budgetary/inflation prospects** **in**

Nominal effective exchange rates **some** **Member** **States,** **triggered significant intra-European**

Index, August 1992=10X3 **currency** **movements.** **Between December 1994 and April**

Dec. Dec. April Jan. **1995** **the Italian lira felt by around** **13** **per cent in nominal**
1993 1994 1995 1996

**effective terms, and the pound sterling and the Swedish**

B 99.9 103.3 107.9 105.9 **krona** **weakened considerably. Within the** **ERM,** **the central**
D 100.8 103.1 109.3 106.7

**rates** **of** **the Spanish peseta and the Portuguese escudo**

F 100.9 102.4 106.3 106.7

**were devalued in March.** **The Deutsche Mark and the**

I 75.1 72.7 63.2 71.7
Esp 78.4 78.2 77.1 80.6 **currencies which are closely tied to the DM strengthened**
Sw 74.6 77.5 73.0 83.2 **significantly in** **trade-weighted** **terms, by up to 6 per cent**
UK 87.1 83.1 **between December and April.**

Table B1.1

Nominal effective exchange rates

Index, August 1992=10X3

Jan.

1996

105.9

106.7

106.7

71.7

80.6

83.2

82.1

Dec.

1993

April
1995

107.9

109.3

106.3

63.2

77.1

73.0

83.1

B

D

F

100.8

100.9

99.9

Dec.

1994

103.3

103.1

102.4

72.7

78.2

77.5

87.1

I

Esp

Sw

UK

75.1

78.4

74.6

88.7

**The large shifts in exchange rates**
**led** **to** **substantial** **changes** **in**
**relative** **price** **and** **cost**
**competitiveness. As was also the**
**case following the exchange rate**
**movements in September** **1992** **f**
**this** **had** **a** **marked,** **if** **not**
**unequivocal, impact on the relative**
**export performances of the Member**
**States.** **Following September** **1992,**
**the exports of Italy and the UK**

**Export volumes in the four major EC countries**

**M e x 1H2Q3** **« 100**

**improved relative to** **those** **of**
**Germany and France by almost 10**
per cent within two to three quarters
**(see** **chart).** **Export growth was then broadly similar until late** **1994,** **when the stronger DM caused**
**German exports to grow at a stower pace and the weaker lira helped Italian exports leap forward.**
**The less pronounced changes in the nominal effective exchange rates of France and the UK**

**6.3.96**

**6-**

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

Exchange rate movements in early 1995 affected macroeconomic developments in the
Community in a number of ways. Firstly, on average the European currencies appreciated
relative to the Community's international competitors, implying a loss of price competitiveness on
world markets. Secondly, in countries whose currencies depreciated significantly, the short-term
boost to export market shares was to some extent off-set by lower growth on export markets, and
by rising interest rates and the erosion of consumer purchasing power from higher inflation on the
home market. Thirdly, in countries whose currencies appreciated significantly, the negative
impact on exports and squeezed profit margins had knock-on effects on investment which
expanded by less than it might otherwise have done. Fourthly, for all these reasons, the
exchange rate turbulence had a negative impact on industrial as well as consumer confidence,
which precipitated a decline in the willingness to spend.

A quantitative assessment of the overall impact on economic activity is possible only under
specific assumptions. An indication of the magnitude may be given by simulations using the
Commission services' Quest model. These simulations assume unchanged real interest rates
(disregarding any tightening of monetary policy in depreciating countries over and above the
increase in inflation) and do not take into account any autonomous blow to confidence which the

Table B1.2

Simulated impact on GDP growth

(Percentage points)

Spring currency

turmojl
(Dec. 94 - April 95)

1996

-0.4

-0.1

0.2

0.0

-0.2

Subsequent
partial reversal

(April - Dec.95)

1995 1996

0.1

0.0

-0.1

0.0

0.0

turbulence may have caused. Table B1.2 shows
the simulated impact on growth in 1995 and
1996 of, first, the exchange rate changes
between December 1994 and April 1995, and
second, the partial reversal between April and
December 1995. The simulated impact on
growth in Germany of the initial appreciation
(and in general in countries whose currencies
closely followed the DM) is of the order of 1
percentage point in the first year and about half
as much in the second year. Conversely, Italian
output would be boosted by about _Vi_ per cent
with most of it taking place in the first year.

D

F

I

UK

EUR

1995

-1.1

-0.3

0.4

0.1

_-DA_

0.3

0.1

-0.3

0.0

0.2

For the EC as a whole, the model simulations indicate that the currency turmoil may have led to a
reduction in output by almost Vz percentage points in 1995. However, it is likely that the knock-on
effects which the turmoil had on confidence and on interest rate differentials relative to the DM

did in fact lead to a larger negative impact on growth. The partial reversal of the exchange rate
overshooting which took place during the remainder of 1995 is likely to have positive effects on
growth in 1996 in appreciating countries as well as for the Community as a whole, thus off-setting
the second-year effects of the spring turmoil. Again, through confidence effects and reduced
interest rate premia, the positive impact is likely to be larger than indicated by the model
simulation.

6.3.96

**-7**

**1.2. Rebound in activity expected during 1996**

Due to the deterioration in economic conditions since the finalisation of the Commission

services' November 1995 forecasts, the growth outlook for 1996 has become less

favourable than previously anticipated. Whereas output in the Community as a whole had

been forecast to expand by 2.6 per cent in 1996, it now seems likely that growth will be

below 2 per cent. This downward adjustment of expectations essentially reflects the impact

of the weaker starting point and the anticipated continuation of weakness in activity into

the first months of 1996.

In qualitative terms, however, the reasoning behind the November 1995 forecasts remains

valid. Provided that the credibility of economic policies is not weakened, the main forces

determining the growth outlook for the European economy are favourable to a renewed

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

circumstances, output growth is likely to accelerate from a subdued pace in the beginning

of the year to an annualized rate of around 3 per cent in the latter half of the year.

Although the average figure for the year is likely to be lower than that of 1995, the

underlying tendency would, in contrast, be positive.

The expansion of economic activity would likely be led by rising investment in equipment,

underpinned by sustained growth in Community exports and a gradual revival in

consumption, enhanced by positive, albeit moderate increases in real wages and

employment. Residential and non-residential construction should see a renewed pick-up,

and the drag from destocking will come to an end as inventory overhangs are brought

down, after which the stock cycle might again provide a boost to growth.

**1.2.1. Underlying economic fundamentals are favourable**

The main positive growth forces include:

i. The world economy outside the EC is set to continue to expand at a healthy pace;

ii. The fundamentals of the European economy in terms of low inflation, moderate wage

pressures and sound investment profitability are favourable;

iii. Monetary policies have been eased, long-term interest rates have fallen back, and the

spring 1995 exchange rate misalignment.has been partially reversed.

**6.3.96**

_**World economy continues**_ _**to**_ _**expand**_ _**at a**_ _**healthy pace**_

Economic activity outside the

Community has expanded at a strong

pace since 1992 and world trade has

been growing at a rate well above the

average of the last two decades (chart

4). The growth in non-EC countries'

imports in 1993-95 was even faster than

might have been expected on the basis

of the observed output growth. This is

partly explained by the composition of

world demand growth in recent years,

not least in the US, which has been

skewed towards investment and stocks

both of which typically have a large

import content. In addition, the

renewed dynamism of world trade owes

to the rapid integration of emerging

Chart 4

**World*** **GDP growth excluding the EC**

Real % p a .

        - i-KYKvM-i-KliYi-ifv

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

```

**World imports* growth excluding the EC**

**Real** % **p.a.**

70 72 **74** 76 78 80 82 **84** 86

excluding CEEC

90 92 94

markets in Asia and Central and Eastern Europe into the world economy, as well as to the

trade-liberalising measures agreed in the GATT Uruguay round.

Table 3

International economic environment

(real annual percentage change)

        

World excl. EC

USA

Japan
DAE [a] )
CEEC and FSU [ b] )

World excl. EC

USA

Japan
DAE [a] )
CEEC and FSU [ b] )

Extra-EC markets

Extra-EC exports

1993 1994 1995 1996

Real GDP

3.0

3.4

-0.2

6.8

-8.4

10.1

11.9

7.0

13.4

4.6

6.8

97 2

3.8

4.1

0.5

7.9

-7.4

3.6

2.1

0.4

7.9

-4.3

In addition to strong export market growth, the

Community has benefitted from a large

improvement in its competitive position

between 1992 and 1994 due to subdued unit

labour cost increases and a substantial fall in the

EC's trade-weighted exchange rate. As a

consequence of these factors, extra-EC exports

expanded strongly in 1993-95 at an average

annual rate of _9Vz_ percent (table 3). Community

exports grew rapidly on most major markets,

including the US, Japan, South-East Asia and

countries in Central and Eastern Europe.

The rapid pace of export market growth

appears to have slowed down somewhat and the

gain in export market shares is likely to have

6.3.96

Imports

11.4

15.0

13.3

15.8

7.0

10.2

10%

10.8

12.3

11.4

14.4

7.3

9.2

9

4.4

2.3

2.3

7.4

4.0

9.2

7.7

10.5

12.4

9.0

8.5

6 [1] / 2

_a_ _'_ Dynamic Asian Economies.

_'_ Central and Eastern Europe and former Soviet Union

Source: Commission services estimates and forecasts

come to an end following the strengthening of the Community's currencies on a trade
weighted basis during 1995. Nevertheless, the outlook for the external environment

remains relatively favourable. The expansion of economic activity in the United States

moderated to less than 3 per cent during 1995. In the absence of inflationary tensions,

output is expected to expand at close to its potential rate in 1996 (table 3). In Japan, the

depreciation of the yen in combination with substantial monetary and fiscal policy stimulus

is expected to produce the long-awaited recovery during this year. The rate of expansion

in _non-OECD countries_ is also expected to firm slightly in 1996-97 as continued high

output growth in Asia, Latin America and Eastern Europe combines with an end to recent

years' severe output drop in the former Soviet Union. Notwithstanding the firming of

economic activity outside the Community, world import growth is assumed to moderate

slightly in 1996 as recent years' high import elasticity is not expected to continue unabated.

The growth of extra-EC export markets (i.e. the weighted import growth of the

Community's trading partners) is expected to remain high by historical standards in 1996.

Therefore, although Community exporters have on average lost price competitiveness as a

result of exchange rate changes, Community exports to third countries are expected to

continue expanding at a rather healthy pace.

_**Healthy supply-side**_ _**fundamentals**_

Favourable conditions on the supply
side of the Community economy, in

terms of subdued inflation, available

resources and strong and increasing

profitability levels, are in place to

accommodate a sustained renewed

strengthening of demand. _Inflation_

in the Community, as measured by the

private consumption deflator,

subsided further to a level of around 3

per cent in 1995. Currently, inflation

**Charts**

**%** **p.a**

**Inflation and wages in the EC**

**90 92 94**

is either below 3 per cent or on a downward trend in all Member States. Overall, the

Community's inflation performance matches even the best results of the 1960's (chart 5).

Furthermore, although wage settlements in some countries were concluded at

disappointingly high levels in early 1995, recent developments indicate that wage increases

will remain relatively moderate in the near future. It thus seems that the price stability

gains in the Community are being safeguarded and continue to provide a positive

background for the conduct of monetary policies.

**6.3.96**

_**Capital profitability**_ **in the**

Community remains strong on

average and is almost back at

the level prevailing in the

1960's, after having suffered a

severe and prolonged

deterioration during the 1970's

and the early 1980's. If

profitability in the 1961-73

period is set to an index of

**Chart6**

**10-**

**Investment profitability in the EC**

(Net returns on net capital stock)

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

```

100, investment profitability now stands at an index of 96 (for EUR15 in 1995) after having

touched a minimum of index 65 in 1981. Return on capital is higher today than during the

strong economic upturn in 1986-90, when investment in equipment expanded at rates about

twice as high as the rate of GDP growth. The sound profitabiUty levels are likely to sustain

increased investment, not only by raising expected returns on capital but also by exerting a

beneficial impact on the balance sheet position and thus the financing means of companies.

_**Improved monetary**_ _**and**_ _**financial conditions**_

Following the exchange rate turmoil in spring 1995, many governments have taken steps to

sustain and in some cases reinforce the pace of fiscal consolidation in 1996. This has

carried with it important benefits.

First, helped by a moderate recovery of the US-dollar, there has been _à_ _**partial reversal**_ _of_

_the exchange rate overshooting_ which occurred in spring 1995. The D-Mark and

currencies closely linked to the DM have receded somewhat in trade-weighted terms and

the currencies of several countries which achieved an improvement in the credibility of their

budgetary policies, notably Italy and Sweden, strengthened significantly relative to their

most undervalued levels in April 1995. Second, _**long-term interest**_ _rates_ _**in**_ _the_

_Community have fallen back_ considerably during 1995, assisted by a coincident decrease

in US long-term yields. Just as higher long-term interest rates during 1994 played a

significant role in restraining economic activity in the Community in 1995, the subsequent

fall in rates should be an important stimulus to economic activity in 1996.

In addition to these factors, the conduct of _**monetary**_ _policy in_ _**the**_ _Community in the_

_**second half of 1995 is likely to have a positive influence**_ **on economic activity in 1996.**

As described in detail in chapter 2, short-term interest rates were reduced in Germany and

**6.3.96**

-11

countries whose currencies are closely linked to the DM (in France, this only took place

following the introduction of consolidation measures in November 1995) as well as in

countries which had been forced to raise interest rates during the spring currency turmoil to

defend their exchange rate and to head off inflationary consequences of currency

depreciations.

Although monetary policy is far from

the only factor affecting economic

activity, there has been a close

relationship between short-term

interest rates and subsequent growth

in output (over the following 4

quarters) in the Community over the

last two decades (chart 7, top half).

The level of nominal interest rates is

only one indicator of the stance of

**Chart 7**

**Monetary conditions and output, EUR4**

**15**

io _m_

**5 «**

**~$^~rttentnfifërê£r**
**rates**

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

```

monetary policies. In a detailed

**15**

assessment, other indicators such as **Yield curw**

real short-term interest rates, the term

structure, the growth of money supply

and credits etc. should also be taken

into account (see chapter 2). The

lower half of chart 7 illustrates the

**JYwircKtywrj**

relationship between the yield slope
(the difference between long-term and `70 72 74 76 78 80 82 84 86 88 90 92 94 96`

short-term interest rates) for the

Community and subsequent output growth. The yield slope is partly a reflection of the

current monetary stance and partly of the financial markets' expectations concerning

growth, inflation and the future stance of economic policies.

**15**

**Yield curw**

**JYwircKtywrj**

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

```

In view of recent interest rate reductions, the current monetary policy stance seems geared

towards a renewed, but moderate strengthening of growth for the Community as a whole in

1996. In addition, provided that the credibility of the overall policy framework is

reinforced, subdued inflationary pressures and intensified fiscal consolidation efforts in a

number of countries imply that the conditions are increasingly in place under which central

banks are likely to find themselves in a position to be able to lower interest rates further

and/or keep them low without jeopardizing the stability objective.

**6.3.96**

**12**

_**Box 2: Current outlook in a historical**_ _**perspective**_
This box reviews three episodes which have specific features in common with the current
situation and which may help to shed light on the forecast of renewed strengthening in 1996.

_Recovery in early_ _1980's_ - A comparison of the current situation with the recovery in the early
1980's reveals a number of similarities as well as important differences. Also then there was, a
clear pause in the recovery when the initiât stock-building effect faded. Output growth even
turned temporarily negative in the third quarter of 1982. Furthermore, the recovery in the early
1980's also took place against a background of high budget deficits and fiscal policy was
tightened almost to the same degree as now t as measured by the annual reductions in the
cyclically-adjusted budget deficit. Nevertheless, there are three fundamental differences which
bode well for the present economic outlook. First while world trade growth was very subdued in
1980-83, the external environment has been favourable in 1993-95 and is expected to continue to
be so in 1996. Second, investment profitability suffered less during the recent recession and
starts improving from a relatively high level. Third, inflation is running at a much slower pace now
(3 per cent) than it did in the early 1980's (still above 10 percent in 1982). This provides a much
more favourable background for the setting of monetary and financial conditions.

_US-dollar fall in 1985-86 -_ The plunge of the dollar from its severely overvalued level of 3.3 DM
in February 1985 initially had little impact on industrial confidence in the Community since it was
not wholly unexpected and the dollar level remained relatively favourable. But the continued
decline of the dollar into 1986 led to a noticeable drop in industrial confidence in the first half of
that year and had an immediate and significant adverse impact on investment. However, the
impact of this deterioration on the real economy was short-lived, and recovery in investment was
rapid thanks partly to an easing of monetary conditions. At the time, the economy also benefitted
importantly from the sharp fall in oil prices and stronger consumer confidence. Nevertheless,
most of _ihe_ factors making for a rapid revival then would appear also to be in place in the current
situation.

_Stock market crash in 1987 -•_ Stock prices tumbled on world financial markets by roughly one
third within the span of a few days in September 1987, and business confidence suffered a severe
blow. Partly due to the initial caution of economic operators, output growth in the. Community
faltered in late 1987. However, the monetary authorities took fast and significant action in
reducing interest rates in the wake of the stock market crash. This easing of monetary policy was
instrumental in overcoming the shock of the financial turbulence and to turn around the economy
one or two quarters later. With hindsight, however, the combination of this monetary easing with
an excessively lax fiscal stance proved too expansionary. As growth rebounded quickly and
strongly, output in the Community expanded by 4*2 percent in 1988 after 2.9 per cent per year in
1986-87. The subsequent overheating of the Community economy, exacerbated by the effects
of German unification, led to a build-up of inflationary pressures which in turn forced a prolonged
and painful economic downturn to re-establish price stability.

**6.3.96**

**- 13**

**1.2.2.** **Important** **short-term risks and uncertainties**

While expectations centre on a renewed strengthening of activity no later than the second

half of 1996, the worsening economic climate over the latest months has raised the risks of

a more extended period of subdued growth.

The most pertinent risk in the period immediately ahead is that the self-reinforcing

downward spiral in confidence and spending intensifies. In the near future, output is likely

to grow at a slower rate than final demand (until the inventory adjustment has come to an

end) raising the risk that job creation will come to a virtual halt or, in certain countries or

industries, even be reversed. Particularly in an environment where companies are faced

with fierce global competition as well as rapid technological and structural changes, they

are likely to want to see more solid demand prospects before they again become willing to

hire additional labour. Consumers have to gauge uncertain employment and income

prospects in the short run as well as the effects of necessary social and pension reforms in

some countries in the longer run. This might prompt households to raise their saving ratio

out of precautionary motives, thus leading to a further moderation in the pace of consumer

spending. If this risk materializes, the slowdown could ~ in spite of improved monetary

and financial conditions ~ be more severe and possibly more protracted than currently

anticipated.

The growth slowdown has cast doubts among some observers as to whether a suffcienr

number of Member States would be ready to participate in EMU at the starting date of 1

January 1999 laid down in the Maastricht Treaty given that weaker economic activity

hampers the necessary progress towards sounder budgetary positions. An extended period

of subdued growth would likely intensify these uncertainties. This might in turn lead to

renewed instability on financial markets, dimming further the growth prospects in the

Community.

A different but related set of risks applies to the conduct of economic policies. Impatience

with the pace of recovery along with fears of social unrest might weaken or even paralyze

governments' efforts to carry out the necessary budgetary and structural reforms.

However, any hoped-for short-term benefits of reduced fiscal rigour would most likely

prove illusory. If uncertainties were to arise about the resolve and ability of governments

to implement fiscal consolidation plans, this would be reflected in higher long-term interest

rate risk premia in the countries concerned, and would presumably force central banks to

raise short-term interest rates in order to underpin the currency on foreign exchange

markets, and in an attempt to preserve overall policy credibility. Indeed, a relaxation of the

**6.3.96**

                        - 14

fiscal consolidation efforts within the Community would risk leading to renewed and

possibly wide-spread tensions in foreign exchange markets. The combined impact of such

unfavourable interest and exchange rate developments would have severe, detrimental

effects on private sector confidence and thus on the chances of renewed and sustained

recovery.

It is equally important to maintain the current policy consensus within the Community

concerning the desirability of moderate wage developments. Any attempt to stimulate

consumer demand by encouraging higher wages would most likely backfire. Such a policy

would serve only to add to Europe's long-standing problems of insufficient international

competitiveness, underinvestment and excessive labour costs relative to the costs of other

production factors. Even in the short run, the negative effects of these factors would assert

themselves. Reduced competitiveness, diminished attractiveness as a production location

and lower capital profitability would have a negative impact on exports and investment.

For consumers, higher wage income per worker would be partly off-set by higher prices, by

companies' reduced ability to profitably employ labour, by reduced income for self
employed and by reduced capital income. Perhaps most importantly, if wages were

increased at a rate incompatible with the stability objectives of the monetary authorities, the

ensuing tightening of monetary and financial conditions would ensure a negative overall

impact on demand and employment.

However, some of the uncertainties surrounding the outlook may also point in a positive

direction. As the Community is enjoying the most favourable underlying economic

conditions since the 1960s, the revival in economic activity could surprise in a positive

manner once confidence is restored. This requires _inter alia_ that governments take all

possible steps to persuade economic agents of their determination to realise their stated

objectives.

**1.3. Continued progress towards nominal convergence**

Further progress towards meeting the convergence criteria was achieved in 1995, although

not in all cases at a sufficient pace. Convergence on the inflation and interest rate fronts

made largely satisfactory advances; progress was also made in relation to the consolidation

of public budgets although the fiscal outcome was less than satisfactory in several Member

**6.3.96**

15

states; and the situation on the foreign exchange markets stabilised after being marred by
marked fluctuations in the spring of the year [1] .

**1.3.1. Historically low and converging price increases**

In 1995, the average rate of inflation in the

Community, as measured by the private

consumption deflator, eased marginally to 3.1

percent. Price convergence strengthened and

eleven Member countries had rates of inflation at

or below the reference value for compliance with

the Maastricht inflation criterion. Inflation

convergence was maintained among the Member

States which have long participated in the ERM

and were in the narrow band prior to the widening

of the fluctuation margins in August 1993

(Belgium, Denmark, Germany, France, Ireland and

the Netherlands). In addition, the United Kingdom

and the three new Member States (Austria, Finland

and Sweden) all had inflation rates below the

reference value. Austria has long maintained a

stable exchange rate vis-à-vis the German mark,

and in the UK, Sweden and Finland, central bank

policy is conducted with respect to an inflation

target. Of the remaining countries, Italy witnessed

an acceleration in its inflation rate to 5 _Vz_ percent,

mainly as a result of the depreciation of the lira.

Spanish inflation remained at around 5 percent,

Portugal showed a strong deceleration to

4 _VA_ percent and Greece experienced a significant

deceleration of over 1 _Vz_ percentage points,

although the rate of inflation remained above the

Community average.

_Source:_ Commission's November 1995 forecasts
"Reference value" is calculated as the average of the 3
best performers plus _VA_ percentage point.
a) Taking into account latest information.

**Chart 8**

**Inflation convergence in Greece,**
**Spain and Italy***

***** **Private consumption delator,** **r** **eference value** **is** **average** **of 3** **best**
**performers** **•** **1.5** **%**

Table 4

**Inflation developments**
(percentage change, private consumption deflator

1994

**3.0**

**1.0**

**2.7**

**10.8**

**4.9**

**1.8**

2.7

4.8

2.6

2.4

3.0

5.5

**1.3**

**3.0**

**2.4**

3.2

2.9

1995

1.5

2.0
2.0 [a ]

9.2

4.9

1.9

**2.5**

**5.6**

**1.9**

1.6

2.4
4.1 [a ]

1.1 [a ]

2.8

3.0

3.1

3.0

1993

**3.1**

**1.0**

**3.9**

13.6

5.5

2.2

1.7

5.1

4.4

2.3

3.4

7.1

4.2

5.8

3.5

4.0

3.1

B

DK

D

GR

E

F

IRL

I

L

**NL**

A

P

FIN

S

UK

EUR15

Reference
Value

1992

2.0

1.8

4.8

15.1

6.4

2.4

**2.5**

**5.4**

**0.1**

3.1

3.9

11.1

4.1

2.2

4.7

4.6

2.8

1 For a detailed analysis, see the European Commission's "Report on Convergence in the European Union
in 1995", November 1995. The present report only reviews convergence with respect to price stability
and sound public finances.

**6.3.96**

16

The generally favourable inflation performance had its origins in a number of factors:

the establishment of central bank independence in several countries has raised the

credibility of price stability objectives, and low inflation is increasingly built into

expectations;

central bank actions, particularly in countries whose currencies had depreciated

significantly or where wage settlements had been concluded at relatively high levels,

reinforced the firmness and credibility of the anti-inflationary stance;

moderating GDP growth meant that output remained below its full capacity level;

notwithstanding higher-than-expected wage settlements in some countries at the

beginning of the year, nominal compensation per employee increased by a relatively

moderate 3 _VA_ percent last year in the Community as a whole; together with

productivity growth of 2 percent this led to a relatively modest 1 _VA_ percent increase in

nominal unit labour costs;

raw material prices decelerated in the first half of 1995 and remained subdued

thereafter.

Given the expected continuation of these factors, and in particular the strengthened

credibility of the anti-inflation objective throughout the Community, the outlook for price

convergence in 1996 is relatively benign. The recent strengthening of the currencies of

some of the countries with comparatively high inflation rates should further help this

process. Nevertheless, continuing vigilance will have to be exercised if inflationary

pressures should reemerge. This is particularly the case for countries which have

experienced significant currency depreciations in the not-too-distant past because of the

variable lags which exist in the pass-through from such currency movements to domestic

inflation.

**1.3.2. Insufficient progress in reducing budget deficits**

The budgetary position of the Member States in general improved in 1995. Government

deficits were reduced in the large majority of Member States, but there were important

exceptions to this rule. Government debt continued to increase as a share of GDP in a

majority of Member states, but with few exceptions the deterioration occurred at a

significantly slower pace than in previous years.

The latest available Commission services estimates of budgetary developments in the

Community date from the economic forecasts of Autumn 1995 (table 5). The unexpectedly

**6.3.96**

17

sharp cyclical slowdown in some countries towards the end of 1995, in conjunction with

budgetary slippages in at least a couple of Member States, imply that the budget deficits in

several countries are likely to be somewhat higher than indicated in these forecasts. It is

particularly disappointing that the government deficit turned out to be significantly higher

than anticipated in Germany (3.6 per cent of GDP against a forecast of 2.9 per cent) thus

overshooting the Maastricht reference value.

Table 5

General government deficit

(per cent of GDP)

1993

-6.7

-4.5

-3.5

-12.1

-7.5

-6.1

-2.4

-9.6

1.8

-3.2

-4.3

-7.1

-8.0

-13.4

-7.8

-6.3

1994

-5.3

-3.8

-2.6

-11.4

-6.6

-6.0

-2.1

-9.0

2.2

-3.2

-4.4

-5.7*

-5.8

-10.4

-6.8

-5.5

1995

-4.5

-2.0
-3.6 [b ]

-9.3

-5.9

-5.0

-2.5 [a ]

-7.2 [b ]

0.4

-3.1

-5.5

-5.2*

-5.6*»

-7.0

-5.1

-4.7

Consequently, the general government deficit in

the Community as a whole in 1995 will almost

certainly turn out to be above the 4.7 percent of

GDP estimated in the latest forecasts, but most

likely remain at about 5 per cent of GDP.

Compared to 1993, when the recession had

strongly deteriorated the public finance positions

of most countries, the overall public deficit has

nevertheless been cut by around 1 _Vz_ percentage

points of GDP. Discretionary policy actions

contributed to more than half of this improvement

with the remainder owing to the positive effects of

recovery in 1994 and early 1995.

B

DK

D

GR

E

F

IRL

1

L

NL

A

P

FIN

S

UK

EUR

1992

-7.1

-2.9

-2.8

-11.7

-4.2

-4.0

-2.4

-9.5

0.8

-3.9

-2.1

-3.3

-5.9

-7.8

-6.3

-5.2

_Source:_ Commission's Nov. 1995 forecasts

a) This figure includes the payment of arrears of
social welfare payments due under the Equal Notwithstanding the worse-than-expected
Treatment Directive and incorporates the
more recent information presented in the Irish budgetary outcome in some countries, most
budget.
b) Taking into account most recent information. Member States succeeded in reducing their budget

deficit in 1995. The strongest improvement is

expected in Sweden (more than 3 percent of GDP) while Denmark, Greece, France, Italy

and the United Kingdom are expected to reduce their deficits by 1-2 percentage points.

Other countries see declines of less than 1 percent of GDP. However, in Germany, Ireland

and Austria, the deficit-to-GDP ratio has deteriorated, partly as a result of lower-than
expected economic growth (Germany and Austria), and partly due to a relaxation of

budgetary stringency.

The average debt-to-GDP ratio for the Community increased in 1995 by about three

percentage points to 71 percent. This was largely due to the unification-related debt

assumptions by the German federal government (especially the Treuhandanstalt) but even

in the absence of this factor the debt ratio would have increased. In fact, the debt-to-GDP

ratio deteriorated in 11 of the Member States. On a more positive note, the fall in the ratio

in the other Member States ranged from a _Vz_ of a percentage point in the case of Italy to

**6.3.96**

Table 6

General government gross debt

(percent of GDP)

Change

Level

1994

136.0 [a ]

75.6

50.2

113.0

63.0

48.4

91.1

125.4

5.9

78.0

65.2

69.4

59.8

79.3

50.3

68.1

1995

133.8 [a ]

73.6

58.8

114.4

64.8

51.5

85.9

124.9

6.3

78.4

68.0

70.5

60.3 [a ]

81.4

52.5

71.1

95/94

-2.2 [a ]

-2.0

8.6

1.4

1.8

3.1

-5.2

-0.5

0.4

0.4

2.8

1.1

0.5 [a ]

2.1

2.2

3.0

95/93

-3.7 [a ]

-6.7

10.6

-0.1

4.4

6.2

-11.5

5.5

0.0

-2.9

5.2

3.3

3.0 [a ]

5.2

4.0

4.9

- 1!

over 5 percentage points in Ireland. The

continued increase in the debt ratios in a

majority of the Member States during the

recovery demonstrates the urgent need for

fiscal retrenchment in many countries.

With regard to the short-term outlook, the

less favourable output growth in 1996 will, in

itself, render more difficult progress towards

lower budget deficits. On the other hand, a

number of governments have recently taken

significant, and sometimes courageous, steps

to place public finances on a more sound

footing. Irrespective of the current

slowdown, the progress which is being made

in reducing structural deficits will remain

intact and thus reinforce the basis for meeting

EMU objectives independent of cyclical

conditions.

B

DK [1 ]

D

GR

E

F

IRL

I

L

NL

A

P

FIN

S

UK

EUR

1993

137.5

80.3

48.2

114.5

60.4

45.3

97.4

119.4

6.3

81.3

62.8

67.2

57.3

76.2

48.5

66.2

_Source:_ Commission's Novermber 1995 forecasts

1) Government deposits with the central bank, government
holdings of non-governmental bonds and public enterprises
related debt amounted to 20 % of GDP in 1995.

a) Taking into account latest information.

It is essential that governments do not allow cyclical weakness to become an excuse for

relaxing structural fiscal consolidation efforts. Only a strict fiscal discipline can provide the

restoration of confidence and the lower interest rates which are necessary for a renewed

strengthening of economic activity. While it is evident that a number of countries have yet

to achieve considerable reductions in their deficits in order to respect EMU commitments,

the degree of progress to be achieved is not so great as to be regarded as unrealistic.

Several Member States are expected to introduce additional retrenchment measures

between now and 1997, which would further improve convergence in the budgetary field.

**6.3.96**

**-** 19

**1.4. Faltering improvement in labour market conditions**

**1.4.1. Recent developments**

_**Employment**_

The initial strength of the current recovery

led to some improvement in labour market

conditions and employment started rising

gently during 1994, for the first time since

1991. During the first three quarters of

**Chart** **9**

**Employment and unemployment in the EC***

**%tfcMfemtabourforu**

1995, total employment increased slightly

further but under the impact of slowing **ViUlrtHrtft.tlt3HMtJUtt>>fattM>feltttt{rfoy!iMfe:**

{right &eate}

economic activity the positive trend was **_t** **78 79 80 81 82 83 84 85 86 87 88 89 90 91** _**t**_ _**i**_ **1** _**L^-t**_ **»** **•••<•** **•»•** **•** **<** **+** _**'**_ _**••**_ **<** **>** **91 92 93 94 95**

*** Including the** **5** **new German** **Ldnder** **since 1991**

reversed in the latter part of the year.

Consequently, employment is likely to have risen by considerably less than the _VA_ per cent

anticipated in the November 1995 forecasts and, correspondingly, net job creation did not

attain the 1.1 million jobs hoped for earlier.

**ViUlrtHrtft.tlt3HMtJUtt>>fattM>feltttt{rfoy!iMfe:**

{right &eate}
**_t** _**t**_ _**i**_ **1** _**L^-t**_ **»** **•••<•** **•»•** **•** **<** **+** _**'**_ _**••**_ **<** **>**
**78 79 80 81 82 83 84 85 86 87 88 89 90 91**

*** Including the** **5** **new German** **Ldnder** **since 1991**

**91 92 93 94 95**

Notwithstanding fast productivity gains, employment

Table 7

growth for 1995 as a whole was strongest in Ireland Employment growth

(%pa.)

(previously forecast at _3Vi_ per cent), driven by a 1992 1993 1994 1995

buoyant expansion of economic activity of around 7 B -0.4 -1.4 -0.7 0.4 [a ]

DK 0.1 -2.3 -0.2 2.1

per cent. The growth of employment was strong also D -1.9 -1.8 -0.7 -0.2 [a ]
in Denmark, Luxembourg, Sweden and Finland (in GR E -2.1 1.5 -4.4 0.9 -0.9 1.9 2.7 1.0 [a ]
the likely -range of 1 _Vz_ to 3 per cent) due to above- F IRL -0.7 0.4 -1.0 0.6 0.1 2.6 3.5 1.1
average economic growth as well as a catching-up of 1 -0.6 -6.8 -1.6 0.1

L 2.5 1.8 1.3 2.5

hiring following the increase in the number of hours NL 2.0 -0.1 0.1 1.2

A 1.8 0.6 0.3 0.2

worked per person during the economic upturn in P -1.8 -1.9 -0.2 -0.6
1994. In Spain, measures aiming at a more flexible FIN S -7.1 -4.3 -6.1 -5.5 -1.3 -1.0 2.2 1.7 [a ]
organisation of work may have helped to lower the UK -2.0 -1.5 0.7 0.8

EUR -1.3 -2.5 -0.4 0.7

employment threshold of growth. The number of

a) Taking into account latest information.

employed people increased by _2V*_ per cent against a Source/Commission's November 1995 forecasts
background of output growth of around 3 per cent.

In contrast, employment continued falling or, at best, remained stagnant in 1995 in

Belgium, Germany, Italy, Austria and Portugal. In several of these countries the most

recent trends have continued to point downward. In the remaining Member States, the rate

of improvement slowed down towards the end of the year.

Table 7

Employment growth

(%pa.)

1.7

0.8

0.7

1993

-1.4

-2.3

-1.8

0.9

-4.4

-1.0

0.6

-6.8

1.8

-0.1

0.6

-1.9

-6.1

-5.5

-1.5

-2.5

B

DK

D

GR

E

F

IRL

1

L

NL

A

1994

-0.7

-0.2

-0.7

1.9

-0.9

0.1

2.6

-1.6

1.3

0.1

0.3

-0.2

-1.3

-1.0

0.7

-0.4

1995

0.4 [a ]

2.1

P

FIN

S

UK

1992

-0.4

0.1

-1.9

1.5

-2.1

-0.7

0.4

-0.6

2.5

2.0

1.8

-1.8

-7.1

-4.3

-2.0

-0.2 [a ]

1.0

2.7 [a ]

1.1

3.5

0.1

2.5

1.2

0.2

-0.6

2.2 [a ]

EUR

-1.3

a) Taking into account latest information.

Source/Commission's November 1995 forecasts

**6.3.96**

**-20**

_**Unemployment**_

The resumption in job creation in 1994 originally led

to a fall in the unemployment rate from its peak of

11.3 percent of the labour force in the spring of that

year to 10.6 per cent in September 1995. But due to

the slowing of employment growth in the course of

1995, the improvement subsequently reversed course

and the unemployment rate rose to 10.9 per cent in

December 1995. The rate of joblessness continued

falling in Denmark, Spain, Finland and the United

Kingdom. In Ireland and Greece significant

employment gains were not translated into substantial

progress in reducing the jobless rate due to high

labour force growth. In the closing months of 1995,

the unemployment rate edged up in Germany, France,

Italy and Sweden.

Table 8

B

DK

D

GR

E

F

IRL

1

L

NL

A

P

FIN

s

UK

EUR

1992

7.3

9.2

6.6

7.9

18.5

10.4

15.4

9.0

2.1

5.6

3.6

4.2

13.1

5.8

10.1

9.3

Unemployment rate

(% of civilian labour force)

1994

10.0

8.2

8.4

8.9

24.1

12.3

15.1

11.4

3.5

7.0

4.4

7.0

18.4

9.8

9.6

11.3

1995

10.2

6.9

8.3

8.9

22.5

11.5

14.9

11.7

3.8

6.7

4.5

7.2

17.2

9.1

8.5

10.7

1993

8.9

10.1

7.9

8.6

22.8

11.7

15.7

10.3

2.7

6.6

4.2

5.7

17.9

9.5

10.4

10.9

Source: Commission's November 1995 forecasts

If the latest assessment of weaker economic activity in early 1996 is borne out, the short
term outlook for the labour market is less favourable than previously expected. With

practically no further gains in employment for the Community as a whole, unemployment

would rise further over the very short term. However, provided that the economy picks up

again, unemployment should resume its downward trends in the latter part of the year.

**1.4.2. Longer-term trends in employment creation in the Community**

The Community suffered large job Table 9

losses during the economic Job creation in the EC

(ESA basis; million jobs)

downturn of the early 1980's.

1976- 1981 1984- 1992- 1995

However, the subsequent 1980 1991 1994

1983

strengthening of economic growth Total economy, EUR15- 2,9 -3.0 10.4 -4.4 U [b] to an average rate of 2.8 per cent Total economy, EUR13- [a] - 2,8 -3,1 10,0 -4.4 l.l [b] 
                            - of which: private 0,0 -4,1 7.4 -3.4 1.2 [b]                            
per year during the period 1984-91 - of which: public 2,8 1,0 2.6 -1.0 -0.1 [b] 
led to the net creation of IOV2 a ) EUR15 except Portugal and Greece.

_'_ November 1995 forecasts; including the new German Lander.

million jobs in the Community. _Source:_ National accounts and Commission services estimates.

Whereas private sector employment

had stagnated and then declined markedly during the period 1975-83, coinciding with

rising employment in the public sector, the net creation of jobs in the 1984-91 period took

place predominantly in the private sector. In this regard, the contribution of SMEs was

Table 9

Job creation in the EC

(ESA basis; million jobs)

1992
1994

1976
1980

1981

1984
1991

1995

-4.4

-4.4

-3.4

-1.0

-0.1 [b] 

U [b] 

l.l [b] 
1.2 [b] 

Total economy, EUR15Total economy, EUR13- [a] 

2,9

2,8

0,0

2,8

1983

-3.0

-3,1

-4,1
1,0

10.4

10,0

7.4

2.6

 - of which: private

 - of which: public

a ) EUR15 except Portugal and Greece.

_'_ November 1995 forecasts; including the new German Lander.

_Source:_ National accounts and Commission services estimates.

**6.3.96**

21

significant. In 1988-90, employment in SMEs grew by _2Vi_ per cent per year whereas

employment in larger companies grew by _VA_ per cent per year. The 1984-91 period clearly

demonstrated the capacity of the European economy to create new employment as long as

robust, non-inflationary growth could be maintained. However, during the subsequent
economic downturn _4Vz_ million jobs were lost in 1992-94 [2] . While the downturn affected

both SMEs and large entreprises, the employment decline was less pronounced in SMEs.

The performance of employment in the

current recovery does not appear to

confirm often-stated fears of "jobless

growth". Despite the intensely

competitive environment in the industrial

sector and consequent efforts to cut

costs, the EC economy was able to

sustain a positive net creation of jobs in

the first three quarters of 1995, and the

employment threshold of growth ~ i.e.

the level of output growth above which

total employment-will expand — was the

same as^ the average over the last two

decades for the Community as a whole.

However, the employment threshold has

tended to vary between Member States

as well as fluctuate over time in

individual countries.

Slow job creation or even job losses in

certain sectors with fast productivity

growth may indirectly help generate

employment in other sectors of the

economy via a reduction in the relative

price of the products of the former,

which helps raising the purchasing power

of all consumers and boosting the overall

demand for products and services,

including those produced in employment

**chart** **10**
**GDP growth in the EC**

_**mm.**_

```
    75 77 79 81 83 85 87 89 91 93 95
```

**Employment growth in the EC**

**•wXj^ftHflSMfcBw^cJ**

**75** **77** **79** **81** **83** **85** **87** **89** **91** **93** **95**

**Labour productivity growth in the EC**

**75** **77** **79** **81** **83** **85** **87** **91** **93** **95**

**Chart 11**

**Sectoral employment trends**

**Index 1970=100**

**70** **72** **74** **76** **78** **80** **82** **84** **86**

**Source** **:** **OECO** **(1994** **data based upon Eurostat Estimate)**

2 In addition, around 1 million jobs were lost in the new German Lander as a result of restructuring.

**6.3.96**

**22**

intensive sectors with low productivity growth. SMEs, which tend to make a relatively

greater contribution to employment in less capital-intensive sectors, play a key role in

generating employment opportunities. Over the last 25 years, employment has been on a

downward trend in the sectors of the economy with high productivity growth, namely

agriculture and manufacturing industries (chart 11). However, in the manufacturing sector,

where cyclical movements of employment are more pronounced, there have been periods of

strong employment creation, notably during the high-growth period in the late 1980's. The

long-term downward trend in manufacturing and agriculture, however, is a structural

phenomenon which has been compensated by increased employment in the services sector

of the economy. This upward trend was temporarily interrupted during the latest recession,

when employment in the service sector began to shrink, partly under the impact of a more

competitive environment, for instance in financial services, and due to the vulnerability of

many small and medium sized service entreprises which had been founded during the

preceding period of high growth.

The Community's record during the 1980s and again the improvement in employment from

mid-1994 to mid-1995 suggest that the failure to reduce unemployment significantly has

not primarily been due to an incapacity to create jobs under the right conditions, but rather

to an inability to~ sustain job-creating growth for sufficiently long without encountering

macroeconomic hindrances or structural barriers on the labour market.

**1.4.3. Incidence of unemployment in the EC**

The gravity of the structural unemployment problems in Europe is underlined by the extent

to which unemployment affects certain groups of labour, in particular low-skilled and

inexperienced workers, and often turns into long-term unemployment.

With respect to skills, the rapid transformation which the European economy is undergoing

under the impact of technological developments, new organisational structures, increased

competition and globalisation, have tended to reduce the demand for unskilled labour in

Europe. However, these rapid changes on the demand side have not been met with equally

rapid progress on the supply side of the labour market in terms of new skills, competences

and occupational and geographical mobility.

In addition, low-skilled and inexperienced labour is often priced out of the market since the

productivity of such labour is not considered to correspond to the total labour costs

including taxes. Non-wage labour costs represent, in many European countries, a

substantial share of total wage costs, and generally weigh most heavily on the lower paid.

**6.3.96**

**-23**

Furthermore, the degree of protection

provided through income support schemes

in some cases generate very small

differences in net disposable incomes

between being in and out of work. In this

way, the functioning of the social benefits

system may, despite its overall merits, put a

floor under the wages for unskilled and

inexperienced labour which contributes to

pricing such labour out of work.

These mechanisms reinforce the difficulties

which young, inexperienced people and

long-term unemployed whose skill levels

have deteriorated, have in finding and

retaining a foothold on the active labour

market.

Young people continue to be particularly

affected by joblessness, and they appear to

have borne a disproportionately large part

of the increased unemployment risk during

the recent economic downturn.

Furthermore, unemployment remains

significantly higher among women than

among men, even if the incidence of

unemployment has become less imbalanced

in recent years. During the economic

downturn, the rate of unemployment

increased more among men than among

women, in part reflecting the larger share of

the male working force employed in

cyclically sensitive sectors.

Table 10

Unemployment features, 1994

**Chart 12**

**Unemployment Rate in the EC***
**(by age)**

iiiiHiiiii

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

```

**(by sex)**

**83** **84** **85** **86** **87** **88** **90** **91** **92** **93** **94**

**•EUR** **12**
**Source :** **Eurostat** **Harmonized Unemployment Rates**

**6.3.96**

Low
skilled

unemployed [ 3] )

Unem
ploy
ment rate

Youth

unem
ployment

rate

Long-term

unemployed [ 2] )

Percent

B

DK

D

GR

E

F

IRL

I

L

NL

P

UK

A

S

FIN

EUR

10.0

8.2

8.4

8.9

24.3

12.3

14.7

11.4

3.5

7.0

7.0

9.6

9.8

18.4

24.1

10.7

8.6

27.7

45.3

29.1

23.3

32.3

7.7

10.7

15.1

17.0

22.6

33.6

Share of total
unemployment
58 52

32 31

44 22

51

53

38

59 [1] )
62

30

49

43

45

10D

21

40

68

46

64

59

63

32

79

58

EUR 11.2 21.8 48 50

1) 1993 2) Unemployed for more than 12 months 3) Educational level lower than upper secondary; share calculated
for the persons aged 15 to 59 years.
_Source_ : EUROSTAT Labour Force Survey 1994 and
National Statistical Institutes for S, FIN

11.2

21.8

48

**-24**

_**Box 3: The**_ _**economic composition**_ _**of unemployment**_

From an economic perspective, unemployment may be disaggregated into a cyclical and a noncyclical component [3] . The _cyclical_ component results from a lack of total demand relative to the
available productive capacity. Since a part of the unemployed labour force is directly
"employable", cyclical unemployment can be absorbed by an increase in demand during the first
stages of a recovery corresponding to the return to normal use of the existing capacity. However,
since the cyclical component of unemployment has been estimated to represent little more than 2
percent of the labour force in 1994, eliminating it will not be enough to bring unemployment down
to acceptable levels.

Thé _non-cyclical_ component is linked in

Economic composition of unemployment in the EC the first instance to the lack of employment

(% of civilian labour force) posts at given real labour costs, i.e.
**12**

ultimately to a lack of capacity which can

: p j ^ t 3 ^

be profitably employed at given wage and
price levels» In such circumstances, higher
demand would lead to inflation rather than
a durable expansion of employment. Part
of the non-cyclical unemployment can be
absorbed by a strong, investment-based
growth process Involving an expansion of

Sttbèm^tirtèiYp6yrtie«t the productive capacity facilitated by an

**:K-.::C:::<** **:::>::::<:::+:::O:::-:J** **:•:•:•>:•:•:•:!•:** **:•:<** **:•:•:•».** **:** **:•:<••** **:** _**.*:••**_ **••>••:•:•:€•:•:•:+:•:••** **J:-:** **:••<•:••** **:>::::c** **: : H** **:•:•:•>:.** increase in investment profitability. The
7273747576777879808182838485868788899091929394 working posts thus made available could be
*EUR 12 filled by those who continue to be in the

turnover on the labour market and who are quickly "employable" with limited retraining.

Economic composition of unemployment in the EC

(% of civilian labour force)
**12**

: p j ^ t 3 ^

Sttbèm^tirtèiYp6yrtie«t

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

7273747576777879808182838485868788899091929394

*EUR 12

Howevetv part of the non-cyclical unemployment corresponds to a part of the labour force which is
not easily able to fill the kind of jobs that will become available through the growth process. This
overlap represents _structural unemployment stricto_ _sensu._ The size of this overlap is difficult
to assess but according to estimates of the Commission services, ft amounts to at least 4 per cent
of the labour force [3] . The proportion of long term unemployment (about _SVz_ per cent of the active
population) may also be used as a rough indicator. This structural unemployment _stricto sensu_
must be reduced by active labour market policies especially geared to problem groups and longterm unemployed. Such policies have an important social objective and contribute to reduce
social exclusion. But without the creation of adequate working posts, the full return of these
policies would not be reaped and such measures would risk becoming a source of disillusion for
the intended beneficiaries if, as before, they were unable to find a job.

In a different perspective, tensions in the labour market may appear even before the level of
structural unemployment _stricto sensu_ is reached. A marked rise in employment might be
constrained by the appearance of a NAIRU (Non Accelerating Inflation Rate of Unemployment)
limit in the form of an acceleration of wage inflation before unemployment has been sufficiently
brought down. When unemployment falls, the increasing bargaining power of "insiders" or
regional and occupational bottlenecks in combination with rigid wage structures may lead to an
acceleration of wages. However, the empirical estimation of the NAIRU is fragile, partly because
the NAIRU is not a universal constant but a structural, endogenous parameter of the economic
and the wage formation system. One recent estimate [5] put the NAIRU in the EC as a whole at just
above 6 per cent in 1994, but the uncertainty is very considerable. The risk of renewed wage
inflation putting a brake on employment creation can be reduced by carrying out structural
reforms of the labour market as proposed in the priorities of the European Councils in Essen and
Madrid.

"The composition of unemployment from an economic perspective" European economy no. 59, 1995.

**6.3.96**

**-25**

**1.5. White Paper medium-term objectives put at risk**

Since the publication of the Commission's 1993 White Paper on growth, competitiveness

and employment, there has been widespread consensus in the Community on the need for

solid medium-term growth as a prerequisite for a significant reduction in the level of

unemployment. The current economic slowdown has raised doubts about the possibility of

achieving such strong growth and employment creation in the Community in the coming

four to five years and, in particular, about the feasibility of cutting unemployment by half

between 1994 and the year 2000.

The White Paper was accompagnied by medium-term projections for a number of scenarios

for the period 1994-2000. The "reference scenario" illustrated the possible outcome if the

Member States maintained, as soon as their economies had recovered, budgetary policies in

line with the desired convergence path and if wage trends would be kept appropriate.

These conditions would allow monetary policies to be less restrictive than otherwise, and

exchange rate stability would be restored.

The growth profile in this scenario

implied a rather slow recovery in 1994
95 followed by a further acceleration in

1996-97 and a stabilisation of the

average growth rate in the Community at

around _3Vz_ per cent per year in the

following years. The average growth

rate in the years 1994-2000 would be 2.9

per cent, just below the 3 per cent per

year observed in 1984-1990. In this

scenario, the expansion would be led by

a strong expansion of investment thanks

to a satisfactory evolution of final

demand combined with high and rising

levels of profitability. Thus, the

expansion of productive capacity would

keep in step with output, and the

scenario would not imply a repetition of

the overheating problems of the 1988-90

period (chart 13).

**Chart 13**

**Actual and potential output in the EC,**
**1983-2000** **(WP scenario)**

**GDP and Production Capacity**

```
1983

 % pa

```

```
1986 1989 1992 1995 1998
```

**GOP** **and Production Capacity**

**ÏI11 llïl I Mill 111** **l.l** **it 11111** **l.l.l.l** **1111** **l.l** **1111111111 ill 11Al ill** **1.1.11.I.I.I.I.I.1.1** **MM III 11 ill 11111111.111111**

```
                              a -1

```

```
1983 1986 1989 1992 1995

          Output gap (*)

```

```
1998

```

**.1983** **1986** **1989** **1992**
**(*) Ratio of** **actual** **to potential GDP**

**1995** 1998

**6.3.96**

26

Chart 14

**November 1995 Forecasts versus**
**White Paper reference scenario**

(Average annual rate of growth, in percent)
**a. Real GOP growth**

```
                              il'l/l'/! : l : l : l : l : l : !'i. : l : !v! i l : l : l : l : l : l : ! : l

      1993 1994 1995 1996 1997 1998 1999 2000
```

**b. Private investment**
```
 10

     forecast

  5 t „,.,.„.„ ;v

      1993 1994 1995 1996 1997 1998 1999 2000
```

**c. Employment**

```
      1993 1994 1995 1996 1997 1998 1999 2000

```

In actual fact, however, the

recovery was much stronger in 1994

and, despite the intensifying

slowdown during the year, also

better than expected for 1995 on

average (chart 14). Thus, at the

time of elaboration of the

Commission's November 1995

forecasts, the achievement of the

White Paper growth scenario still

appeared feasible. However, the

subsequent deterioration in the

outlook for 1996 will render the

achievement of the White Paper

scenario more difficult, even if it is

not yet excluded.

If, andjonly if, confidence is restored quickly there may be a strong rebound in the

Community as a whole on the basis of healthy growth fundamentals. Indeed, growth in the

second half of 1996 and in 1997 could well be as strong as 3 per cent or more. This would

provide the basis for a strong, investment-led and sustainable growth pattern in 1998-2000.

However, too buoyant growth from 1997 onwards would imply a renewed risk of tensions

on the use of productive capacities. Policy-makers would have to remain vigilant in order

to avoid a repetition of the overheating phenomenon which occurred in not so dissimilar

circumstances in 1988/89.

**6.3.96**

**-27**

White Paper scenario and If growth were to revive strongly by
growth assumptions for 1997

1997, a return to the White Paper growth

scenario would become possible (chart

15) and this could lead to a substantial

reduction of unemployment. A stronger

growth path would hardly appear feasible

without tensions arising. But a return to

the White Paper growth scenario,

`1993` `1994` `1995` `1996` `1997` `1998` `1999` `2000` combined with structural policies aimed at

securing a tension-free growth process,

increasing the employability of the labour force and making economic growth more

employment-creating, are necessary in order to make progress towards the White Paper

ambition in terms of unemployment.

White Paper scenario and
growth assumptions for 1997

```
1993 1994 1995 1996 1997 1998 1999 2000

```

The Report of the Commission to the Madrid European Council on the mutually

reinforcing effects of increased co-ordination of macroeconomic and structural policies

concluded that: " _no process of strong growth and no substantial reduction in_

_unemployment is possible in the European Union unless the Broad Economic Policy_

_Guidelines are applied in a determined and properly co-ordinated fashion._ _The most_

_important_ _risk - which was felt through the monetary turbulence of Spring 1995 - is a lack_

_of credibility in the application of the common strategy by a number of Member States,_

_which has negative consequences for everybody. In that case, the result would be sub-_

_optimal for all._ _This is why the Broad Economic Policy Guidelines should be_

_implemented with determination_ _by_ _policy makers and social partners in all countries_ ".

This should be done along the lines set out in the remainder of this report.

**6.3.96**

28

**Chapter** **2:** **Economic policies for growth and employment**

2.1. Desired policy mix

The macroeconomic policy-mix is largely determined by a triangle of forces ~ namely

monetary policy, budgetary policy and wage trends --, responsibility for which is assumed

by three different groups of actors. The conduct of monetary policy is exercised by

increasingly independent central banks whose primary objective is to achieve and maintain

price stability. The responsibility for budgetary policy resides with sovereign governments

and parliaments, but whose freedom of action is constrained by Treaty provisions and by

the pressing need for fiscal consolidation. The conduct of wage negotiations is generally

under the responsibility of the social partners with the wage formation process varying

importantly across Member States. Wage developments should respect the conditions for

price stability and contribute to the required profitability of employment-creating

investment. Efficient co-ordination between the various policy actors is essential to ensure

the avoidance of policy conflicts of the type seen during the late 1980s/early 1990s which

was one of the key factors behind the 1992/93 recession.

The most important contribution that this triangle of forces can make to relaunch the

recovery process, to achieve a high degree of sustainable convergence and to significantly

and durably reduce an alarming unemployment total consists in bringing about a further

_détente_ in the macroeconomic policy mix. In the Community there exists a potential for a

further easing of monetary conditions. A healthy and efficient use of this potential requires,

however, that the other two forces are consistent with the objective of price stability.

Indeed, more decisive and credible fiscal adjustments efforts in a number of Member States

and continuing adequate wage developments will enable further, soundly-based reductions

in short and long-term interest rates.

In order to overcome the current growth pause and to place the Community's economy on

a strong, non-inflationary and employment-creating medium-term growth path, a

rebalancing of the macroeconomic policy, thus generated, must be reinforced and co
ordinated by a broad range of structural policies. The latter contribute to the overall

strategy through essentially three channels : (i) to ensure a tension-free macroeconomic

growth process by measures aimed at a better functioning of goods and services markets

and a greater, positive flexibility of the labour market; (ii) to enhance the endogenous

growth factors by actions geared towards promoting innovation, competition and

**6.3.96**

-29

improving human capital and (iii) to increase the employment-intensity of growth through a

widening of the wage cost scale, especially by reducing indirect labour costs at the lower

end, reorganising working conditions, etc.

**2.2.** **Monetary policy**

**2.2.1.** **Inflation and monetary policies in the medium term**

Since the early 1980s monetary policy in the Community has been increasingly geared

towards the objective of price stability. This strategic reorientation of monetary policies

was driven by disappointment with the macro-economic performance of the Community in

the 1970s which made it clear that low unemployment could not simply be achieved at the

cost of accepting higher inflation and that, in fact, there was no lasting trade-off between

low unemployment and low inflation. In addition, governments and economic operators

were becoming more and more convinced of the drawbacks of high inflation and adapted

their behaviour accordingly.

High inflation is typically accompanied by a greater degree of price uncertainty. This tends

to be reflected in higher real long-term interest rates than otherwise (through the

incorporation of a risk premium) and makes long-term investment and savings decisions

more uncertain since the real value of income and wealth is more difficult to maintain when

the future price level is uncertain. These factors lead to a sub-optimal level of investment

and savings and thus to a lower production potential than otherwise. High and variable

inflation also distorts price signals and may contribute to a misallocation of resources.

Moreover, high inflation has negative distributional effects since households in the lower

income brackets have less access to durable consumption goods or financial investments

with good real value characteristics. Finally, unanticipated inflation represents a shift in

resources from creditors to debtors. In the 1970s, the government sector became an

important borrower, spending too often on present consumption rather than on investment.

An easy monetary policy facilitated this channelling of funds to the government. In the

1980s, disinflation and high real interest rates added to the governments' debt burden which

increased drastically as a share of GDP.

The realisation that a sustainable growth path is better served with price stability led to the

formulation, with increasing success, of monetary policy in terms of that objective. The

rate of inflation in the Member States decelerated markedly during the first half of the

1980s and since then have remained markedly lower than during the 1970s. The average

**6.3.96**

**30-**

inflation in the Community (based on the
Inflation and unit labour costs in the EC
consumption price deflator) declined from

over 12 per cent in the early eighties to 3.6

per cent in 1987 (chart 16). While the

endeavour to improve price stability in the

wake of the second oil price shock in

conjunction with the recession among the

Community's trading partners was a main

factor behind the economic downturn in the

early 1980's, the further reduction in inflation from 1983-87 was achieved alongside

renewed employment-creation and accelerating economic growth. The credibility of the

ERM based on a stable nominal anchor contributed strongly to this favourable evolution.

The disinflation process was temporarily interrupted in the late 1980s when a too

expansionary monetary-fiscal policy mix engendered an overheating of the Community

economy. The accompanying acceleration in inflation and inflationary expectations was

compounded by German unification and the hike in oil prices resulting from the Gulf war.

Monetary policy returned to a firm anti-inflationary stance in late 1990 and inflation, after
having peaked atpver 5 [!] /2 per cent in 1991, fell gradually back to just over 3 per cent in

1995. Meanwhile, the severe tightening of monetary policy in Germany and the rest of the

Community in the aftermath of German unification contributed to the exchange rate

turbulence in the ERM because in a number of Member States the deterioration of the

economic situation called, in the opinion of markets, for a differentiated policy response.

The recession in 1993, when real GDP in the Community declined by 0.6 per cent, was

then also particularly severe.

The considerable progress towards price stability can be attributed to a combination of

factors.

**Chart 17**
**Demand pressures and inflation in the EC**

```
   1980 1982 1984 1986 1988 1990 1992 1994

```

First, as the monetary authorities became

increasingly conscious of the importance

of low inflation they took action

accordingly. While nominal short-term

interest rates declined regularly

throughout the 1980's on average in the

Community, compatible with the trend

decline in the Community-wide money

supply growth, real short rates followed

**6.3.96**

-31 

an upward course until 1986-87. In late 1987, interest rates were lowered in the wake of

the world-wide drastic fall in stock market prices, which created fears of an impending

slowdown. Instead, the economy overheated and from 1989 to 1992, interest rates were

increased considerably. Both nominal and real rates peaked in August/September 1992 at

12.4 per cent and around _TA_ per cent, respectively. Already by 1989, money supply

growth was decelerating more rapidly and, by 1991, also inflation. In a number of Member

States, however, money supply targets in the early nineties were overshot, so it was only

from 1993 onwards, in the context of subdued economic growth, that central banks were

able to ease monetary conditions significantly. In late 1995, the average nominal short rate

in the Community, at 6.4 per cent, was lower than at any time in the 1980's and the real

rate, at _V/z_ per cent, was down to levels last prevailing in 1983. Despite the lowering of

interest rates, money supply growth plunged in 1994-95 and targets were undershot (table

11), suggesting that monetary policy could have eased earlier without jeopardising price

stability. The overshooting of money supply targets in some Member States and exchange

rate unrest in others prevented this from happening.

Secondly, and related to the first factor, the rate of wage increases declined markedly. Unit

labour costs — which are a prime determinant of inflation together with profit margins,

import prices and indirect taxes — decelerated strongly in the first half of the 1980's and

rose at_a rate generally below inflation. Following a sharp upturn in 1989-90, unit labour

costs decelerated again between 1991 and 1994 (chart 16). The evolution of unit labour

costs can be compared with the evolution of the ratio of M2 over real GDP. This ratio ~

with an appropriate assumption on the velocity of money ~ gives an indication of the

increase in. the money supply in excess of what is needed to finance real transactions. The

decline in the M2/real GDP-ratio over the 1980's reflects the lower availability of liquidity

to finance nominal developments. A widening in the difference between the change in the

M2/real GDP ratio and the change in unit labour costs suggests that monetary policy

accommodates wages pressures, while a narrowing suggests that monetary policy is

relatively tight as in the late eighties/beginning of the nineties. The difference narrowed

again in 1994-95. This may suggest either an increase in the velocity of money or that

monetary policy was relatively strict in 1995 with respect to the moderate wage pressures.

Finally, from the mid-1980's onwards, the creation of the single market (including the

liberalisation of capital movements) in combination with a generalised move towards

market deregulation, led to a strengthening.of competition and an improvement in the

allocation of resources. These effects contributed to the moderation of price rises.

**6.3.96**

Whilst all Member

States pursue the

objective of price

stability, the monetary

policy frameworks in

individual Member

States target different

variables. These

frameworks have

become more diverse

in the Community

over recent years

(table 11) in an

attempt to formulate

the most appropriate

and credible response

to the changing

economic and

financial circumstan
ces. Inside the ERM

**32**

iTable 11 I
Money, credit and inflation targets and outcomes

(per cent per year)

II 1994 I 1995

Target Target Outcome Target Outcome
variable [3] (medium (medium
term) term)

Germany M3 4 - 6 4.9 4 - 6 2.5 (Dec)
France M3 (around 5) 1.1 (around 5) 3.9 (Nov)
EIT [a] 4.2 4.8 (Oct)
Spain M3 - 8.2 10.7 (Nov)
ALP+CP      - 7.6 9.2 (Nov)
ALP 4.5-7.5 8.2 9.7 (Nov)
CPI [b] 4.7 (<3) 4.3 (Dec)
Italy M2 5-7 1.6 5 2.2 (Dec)
UK M4 3-9 4.5 9.3 (Dec)
MO 0-4 6.7 5.6 (Dec)
RPIX* [5] 1-4 2.4 1-4 3.0 (Dec)
(<2.5)
Finland CPIY [b] - 1.3 2 -0.6 (Nov)

b ' <*>
Sweden CPI [b] -(2) 2.4 2 ± 1 2.6 (Dec)
I 1 (2±D
a Money supply targets: MO, M2, M3, M4; ALP; credit targets: EIT
b Inflation targets: CPI, CPIY (CPI minus indirect taxes, subsidies and
capital expenditure on housing, RPIX (retail price index minus mortgage
interest payments)

the focus is on the exchange rate, but to a variable degree. Hitherto, the exchange rate

target has been most narrowly binding in Belgium, the Netherlands and Austria while, on

the other hand, in Spain and Portugal, exchange rate fixity has been less pronounced.

Furthermore, in Spain and France the exchange rate target is complemented by an inflation

and money supply target, respectively. Germany is the only country which continues to

give considerable weight to the control of the money supply. Outside the ERM, an

inflation target represents the focus of attention of the policy makers in Finland, Sweden

and the United Kingdom.

**6.3.96**

**-33**

**2.2.2.** **Monetary stability affected by internal and external factors in 1995**

After the exchange rate turbulence of 1992 and 1993, exchange rates in the EU countries

went through a period of calm that lasted until the end of 1994. Subsequently, the

currencies of the Member States once more displayed pronounced volatility, particularly in

March and April 1995. Despite interruptions, calm had returned to the markets by the end

of 1995 (chart 18). Similarly, short- and long-term interest rates displayed considerable

volatility in 1995 with diverging trends (chart 19) reflecting, to some extent, the tensions in

the exchange markets but also responding to developments and prospects for inflation and

economic activity. Internal and external factors prevented monetary policy from being

more balanced at the beginning of 1995 and delayed the necessary easing of monetary

conditions.

Exchange rate tensions at the international

level, related to the financial crisis in Mexico

affecting especially the dollar exchange

markets, were at the origin of pressures on

several European currencies at the beginning

of the year (see box 4). The Italian lira

suffered most during the currency turbulence,

losing over 16 % of its DM value between the

end of 1994 and April 1995. Political

uncertainty and doubts about the commitment

to budgetary consolidation played a major

role in the currency's weakness. Similar

problems affected the Swedish krona, and

inside the ERM, the Spanish peseta, which

devalued on 6 March by 7 % and with it the

Portuguese escudo by 3.5 %. The strong

**JAN MAR JUN** **SEP DEC** **FEB MAY AUG NOV** **JAN**
**1994** **I** **1995** **11996**

**Chart 18**

**The evolution of some** **EU** **currencies**

**against** **the DM**
**Index primo** **January 1994** **=100**

**JAN MAR** **JUN** **SEP DEC** **FEB MAY AUG NOV**
**1994** **|** **1995** **j**
**110**
#### **^V**

**75**

**JAN**
**1996**

appreciation of some Community currencies

and the simultaneous increase in interest rates in countries whose currencies had come

under pressure amounted to a significant tightening of the monetary stance in Europe.

Slow money supply growth in Germany and better inflation prospects led the Bundesbank

to reduce official rates at the end of March; two more cuts were to follow (in August and

December). This provided the other Member States with the necessary room to ease

monetary policy as well. This was done in a differentiated way and at a different pace,

determined by recent inflationary developments and the situation in the exchange markets,

**6.3.96**

**34-**

reflecting _inter alia_ the credibility of governments to stick to a stability oriented economic

policy.

Almost all ERM participants were in a

position to lower rates substantially. Dutch

and Austrian money market rates followed

closely developments in Germany, although

the short-term differential in the latter

widened. In Belgium, the differential with

DM rates widened temporarily to close to

2% in March, but it subsequently

disappeared and Belgian rates were able to

track short-term interest rate developments

in Germany. In Denmark, France and

Ireland; considerable progress was likewise

made in the second half of the year when

exchange rate tensions subsided. There

was a brief interruption for France in the

Autumn, but following the introduction of

credible fiscal consohdation efforts, the

**Chart 19**

**Short-term interest rate differentials**
**against the DM**

**JAN** **MAR** **JUN** **SEP** **DEC** **FEB** **MAY AUG NOV** **JAN**
**1994** **|** **1995** **|** **1996**

**JAN** **MAR** **JUN** **SEP** **DEC** **FEB** **MAY** **AUG** **NOV** **JAN**

differential narrowed significantly. **1994** **"I** **1995** **|** **1996**

However, short differentials with Germany

remained higher compared to the beginning of the year in France and Ireland. Spain was

not in a position to lower rates substantially because of doubts in the markets on the

political stability and the budgetary situation, while in Portugal interest rates continue to be

more than 5 % higher than in Germany.

Outside the ERM, where central bank action is geared more directly to developments in

domestic inflation, monetary policy was progressively tightened in Sweden and Italy

because the inflation outlook deteriorated. Money market rates remained relatively stable

in the United Kingdom, fluctuating between 6.50 per cent and 6.75 per cent. In Greece

better inflation prospects allowed interest rates to be reduced considerably, while in

Finland, after an initial hike in March, interest rates were cut in several steps from the

Autumn onwards and short-term differentials narrowed again to 70 basis points.

At the end of 1995 the monetary situation compares favourably to the Broad Economic

Policy Guidelines. Exchange rate stability was returning (chart 18) and 11 Member States

realised the objective of an inflation rate between 2 and 3 per cent as a step towards

**6.3.96**

35

stability. These developments are encouraging for keeping the inflation rate low in a

durable way. Progress was strongest in the Member States already experiencing a low

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

accelerated by 2 percentage points to 6.0 per cent while in Spain inflation remained

broadly unchanged. Monetary policy made an important contribution to the overall

positive developments, but occasionally led to tensions when there was a perceived lack of

fiscal discipline or when inflationary expectations were fuelled by excessive wage claims.

_**Box**_ _**4:**_ _**The dollar and the ERM**_

Although domestic reasons, related to political uncertainty or to the commitment to
budgetary consolidation, explain part of the exchange rate volatility in the ERM, external
factors had an important influence. The sensitivity of the ERM to external developments
is illustrated in the graph below, showing the influence of the USD/DM exchange rate on
tensions in the ERM, represented by the spread between the strongest and weakest
currency in the grid. One observes that an appreciation of the German mark vis-à-vîs the
dollar tends to widen the spread. A clear shift in the relation after the realignment on 6
March is also visible.

The transmission mechanism explaining this phenomenon is as follows. When the US
dollar weakens, capital flows into the German mark more than into other European
currencies because the markets think that certain countries have relatively more
difficulties to accept a higher dollar. This puts upward pressure on the German mark in
the ERM and the spread widens. This sort of intra-European volatility will naturally vanish
among members of EMU. While the US dollar appears to be an important trigger at
certain moments for ERM turbulence, it can not be considered as its only cause; in fact,
for several other currencies, the bilateral exchange rate spread does not widen after a
dollar fall against the DM.

The evolution of the USD and the spread between the!
strongest and the weakest ERM currency in 1995

OWUSD (left-hand scale)

J ' F ' M ' A ' M ' J ' J " A [1] S " O " N " D

T [14 ]

The inpact cf the IJEDcn the SWin 1939

»_ srœ6Mïch

**H** **1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1**

1.36 1.40 1.44 1.48 1.52 1.33

ExchEnaeiateDVmSD

6.3.96

**36**

2.2.3. **Room for further easing of monetary conditions**

In early 1995, Member States in the ERM took a cautious approach to the easing of

monetary conditions in order to preserve stability. This policy was successful in terms of

the chosen objective (low inflation, low growth of money supply or stable exchange rate)

but against the background of the more restrictive fiscal stance and the low level of the

dollar it appears to have been relatively tight in the first half of 1995. Later in the year,

when it became clear that the economy was hit by a marked slowdown, Member States

were, to varying degrees, able to relax monetary policy. This led to a more balanced

policy mix. After the sharp rise of long rates in 1994 ~ because of better growth

prospects, international arbitrage flows and a less certain inflation outlook, but also

because monetary policy was prevented to be sufficiently loose due to the budgetary

situation — long rates almost completely reversed the evolution in 1995. As long-term

interest rates declined more rapidly during the year than short-term interest rates, the term

structure of interest rates became flatter (chart 20). While the difference between the 3
month interest rate and the 10-year bond yield was 2.5 per cent in January for the

Community average, it decreased to 1.2 per cent in December 1995. As the slope of the

yield curve partly reflects market expectations about future inflationary pressures, this

flattening suggests that inflationary expectations were abating. It also implies that the

official interest rate reductions have, on average, been credible. However, these cuts in

interest rates have yet not been fully transmitted to the economy as bank lending rates

remain high (chart 20), suggesting that credit institutions did not fully pass the advantage

to their customers but also increased their profit margins. This is of particular importance

for small and medium-sized entreprises which have less easily access to capital and money

markets — where interest rates declined markedly — but rely more on bank credit. The

same applies to the household sector and this may restrain consumer spending. A smooth

and competitive transmission mechanism forms an essential element in reaping the full

benefits of lower interest rates.

Outside the ERM monetary policy generally remained tight, on the whole, in response to

emerging inflationary pressures. In Italy, short rates rose by about 1.5 per cent in the first

quarter of 1995 and stayed high. Measured by the reaction of the exchange rate, this

policy enjoyed particularly high credibility in Sweden and Finland. In the latter country

short-term differentials against the DM could already be reduced substantially (chart 19).

Inflation seems to be currently firmly under control in the majority of the Member States

while the appropriate action was taken where this was less the case, mainly in countries

with a weaker exchange rate. The risks for an interruption of the favourable trend also

appear small. Such risks could be linked to the future emergence of a-positive output gap

**6.3.96**

**37**

and/or a stronger growth of unit labour costs. Long-term interest rates adjusted for

(current) inflation remained substantial in 1995. This could reflect a general increase of

real rates of return on investment which would be a positive development. The

liberalisation of capital movements and financial deregulation from administered interest

rates towards market behaviour contributed to the emergence of higher real interest rates

already during the 1980s. On the other hand, the current high real long rates may to some

extent also reflect a risk premium for a higher level, and/or higher volatility, of inflation in

the future. This kind of price uncertainty appears to stem more from occasional doubts in

the markets on the commitment for budgetary consolidation and, linked to that, the

commitment to meeting the EMU objectives, rather than to excessive wage demands.

These risks make the monetary stance more restrictive than it would otherwise need to be

to preserve stability.

In this context market analysts often refer to the existence of a risk premium on German

long-term bonds because they presume that monetary policy in EMU would be less

Chart 20

**INTEREST RATES AND EXPECTED INTEREST RATES IN THE** EU

The evolution of the average interest rates in EU 15

**1** **• ***
Feb Apr Jun Aug Oct Doc Feb Apr Jun Aug Oct Dec
**94** **|** **95**

Three-month futures contracts in Dec 95 and Jan 96

**p*q**

rigorous than current German

monetary policy. This is an

interpretation based on the

steep slope of the yield curve

compared to the relatively flat

slope in the USA and a higher

long-term interest rate in

Germany than in the US.

However, another interpretation

is equally valid. Indeed, the

present constellation of interest

rates is consistent with an

expectation of a strengthening

of the US dollar against the

German mark relative to its

currently low level.

Given the current growth

outlook, and in the light of the

successful easing of monetary

policy and the gradual reversal

of exchange rate misalignments

since March 1995, the objective

**6.3.96**

**38-**

of low inflation would appear to be compatible with an additional easing of monetary

conditions. This presupposes that wage pressures and exchange rate tensions can be

avoided and budgetary consolidation remains credible. The potential for easing remains

intact even though short-term interest rates in Germany and some other countries are

approaching low levels. Even lower interest rates have been observed in the past. In

Germany, the level of the discount rate was lower in 1959 and at the end of

1987/beginning of 1988, the period following the October 1987 stock exchange crash

(2.75 per cent and 2.50 per cent respectively). Futures contracts provide an indicator of

the general orientation of market expectations about future interest rates (chart 20).

Interest rate expectations have been adjusted downward as illustrated by the decline in the

interest rates implied by futures contracts, suggesting that market expectations are

consistent with a further easing of monetary policy. In France and Italy the expected drop

in short-term interest rates is larger than in Germany, so that the short-term interest rate

differentials could narrow, which is an indication of stability in the exchange markets. In

Germany and the UK the implied interest rate by the December-96 contract is higher than

on some previous contracts, suggesting that short-term interest rates could be bottoming
out in the course of 1996. The expected interest rate at the end of 1996 remains, however,

lower than the one observed on average in January.

Continued wage moderation and enhanced credibility for fiscal consolidation should create

the conditions for a durable relaxation of monetary policy in Europe.

**6.3.96**

39

**2.3.** **Budgetary policy**

**2.3.1.** **Recent developments and short-term prospects**

_**Recent origins of budgetary imbalances**_

In general terms, the worrying budgetary positions confronting the Community as a whole

and the majority of member countries result from the combined influence of three main

factors: first, the failure of Member States in general to exploit the strong economic

expansion of the second half of the 1980s to curb existing large structural imbalances;

second, the exacerbation of these imbalances in the early 1990s by underlying

deteriorations in Germany (related to unification) and also in a large number of the other

Member States; and finally, the sharp cyclical deterioration linked to the recession of

1992/93.

At the trough of the downturn in the early 1980s, the Community's overall budget deficit

widened to a hitherto unseen high of around 5 per cent of GDP. Despite a growing

consensus among policy-makers that budgetary policies needed to be oriented towards the

objective of medium-term consolidation, efforts made to reduce structural imbalances in the

course of the 198.0s proved insufficient. The Community's overall budget deficit declined

to a low of 2V2 percent of GDP at the end of the decade but the improvement was mainly

due to better cyclical conditions. Indeed, the structural deficit remained unchanged at the

high level of some 3!/2 per cent of GDP during the prolonged and healthy economic

expansion of the 1980s (chart 21).

The early 1990s witnessed a **Chart 21**

**Output gap and trends in budget deficit, EUR**

substantial and rapid deterioration

_**%**_ **ofCOP**

in the budgetary performance due to

both discretionary policies and

cyclical factors. In the space of

only 4 years, the Community's

budget deficit increased by nearly 4

percentage points to a record high

of 6.3 percent of GDP in 1993.
```
                              80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95
```

Initially, there was a strong

deterioration in the cyclically
adjusted budget deficit for the Community as a whole. This stemmed to a large extent

from the impact of unification on German public finances. But it also reflected a move

towards an expansionary fiscal stance in some Member States (table 12), in part reflecting

**Chart 21**

**Output gap and trends in budget deficit, EUR**

_**%**_ **ofCOP**

```
80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95

```

```
6.3.96

```

**40**

endeavours to offset the growth impact of the coinciding tightening of monetary

conditions.

Following the onset of recession in the second half

of 1992, the further sharp deterioration in the

Community's overall budgetary position entirely

reflected the consequences of the cyclical downturn.

This was partly offset by a small, but in the

circumstances necessary, attempt at redressing the

structural imbalances.

Countries reacted very differently to the deepening

downturn. In Germany, the process of correcting

the unification-induced build-up in imbalances firmly

commenced in 1992-93. Likewise, budgetary policy

was tightened significantly in Belgium, Ireland, Italy

and the Netherlands, broadly off-setting the negative

budgetary impact of the recession. All of these

countries were confronted with high budgetary

imbalances at the beginning of the 1990s. In

Table 12

C y c l i c a l l y - a d j u s t e d d e f i c i t s 1985-95

(per cent of GDP)

1989

-7.2

-0.5

0.5

-15.5

-4.9

-2.4

-1.4

-10.9

-5.2

-2.9

-3.6

1.2

2.2

-3.3

-3.7

1993

-5.9

-2.4

-3.3

-11.7

-6.4

-5.0

-1.1

-8.3

2.8

-2.7

-3.6

-6.7

-2.4

-9.3

-5.8

-5.1

1991

-8.2

-1.4

-5.2

-12.0

-7.3

-3.1

-2.3

-10.9

-4.5

-3.4

-8.3

-0.7

-2.4

-2.6

-5.4

1995 [a ]

-4.0

-2.2

-3.2

-8.9

-4.9

-4.5

-3.3

-6.8

0.6

-3.0

-5.4

-4.6

-3.5

-5.4

-4.5

-4.2

B

DK

D

GR

E

F

IRL

I

L

NL

A

P

FIN

S

UK

EUR

1985

-7.6

-3.4

-0.3

-13.7

-4.8

-1.8

-10.3

-11.9

7.7

-2.4

-1.9

-4.8

2.9

-3.7

-1.7

-3.5

a) November 1995 Forecasts; EUR including five
new German Lander from1991 onwards

_Note:_ Commission services' estimates. The methodology is explained in _European Economy,_ n" 60,
1995. p. 35-90.

contrast, several countries (Denmark, France,

Finland, Sweden and the UK) attempted to alleviate the economic slowdown through a

fiscal stimulus. In these countries, structural deficits widened by at least 1 percentage point

during 1992/93.

In retrospect, the attempt to use budgetary policy to counteract monetary tightening

proved neither viable nor successful in most Member States. In addition, as the

Community had failed to cure its fiscal imbalances during the previous boom period, it had

lost control over a potentially important policy instrument during the recession in 1992-93.

_**Insufficient consolidation efforts**_ _**In**_ _**1994-95**_

Consequently, most Member States committed themselves to ambitious medium-term fiscal

consolidation plans once the recovery took hold. In overall terms, the net borrowing of the

general government was estimated in the November 1995 forecasts to have fallen to 4.7 per

cent of GDP in 1995 from its peak of 6.3 per cent of GDP in 1993, as a result of better

cyclical conditions as well as retrenchment efforts. Despite this improvement, the

government debt/GDP ratio in the Community as a whole posted a marked rise of nearly

6.3.96

41

five percentage points in the years 1994-95. Although partly due to exceptional factors,

this development underscores the insufficient adjustment in the primary balance.

The estimated discretionary tightening in the Community over the two years 1994-95

amounts to just below 1 percent of GDP. During the last two years, considerable

consolidation measures — leading to reductions in structural deficits of one percentage

point of GDP or more — were undertaken in about half of the Member States, including

those where budgetary situations were most preoccupying. Nevertheless, the structural

deficits in the vast majority of Member States are still in excess of 3 per cent of GDP going

into 1996.

Two countries (Ireland and Austria) are estimated to have shown a noticeable structural

deterioration over the period under review. In Ireland, the budgetary relaxation (over 2
percentage points of GDP during 1994-95 [4] ), albeit from a low level, give some cause for

concern. With regard to Austria, the underlying budgetary position worsened markedly

_(WA_ percentage points), with the additional costs of EU membership in 1995 accounting for

only a limited part of this deterioration.

Evidently, many countries did not exploit to the full the possibilities of implementing fiscal

consolidation measures in the context of the relatively good economic conditions pertaining

in 1994 and early 1995. Consequently, the differentiated increase in long-term interest

rates during 1994, the currency turmoil in the early part of 1995 and the associated

tightening of monetary conditions in several countries, were in part related to a belief in

financial markets that consolidation efforts had been smaller, and less rapid, than hoped for.

In this way, insufficient credibility of fiscal policies played a significant catalysing role in the

slowdown of the Community economy in the course of 1995.

_**1996:**_ _**Reinforced**_ _**fiscal consolidation efforts**_

Several Member States have taken substantial, and sometimes courageous, efforts to

reduce budget deficits in 1996. According to the Commission services' estimates of

cyclically-adjusted deficits, the discretionary consolidation measures to be implemented in

the Community in 1996 will result in a reduction in the overall structural deficit from 4.2

per cent of GDP in 1995 to 3.4 per cent in 1996. The size of this discretionary tightening

is roughly twice as large as the efforts undertaken in 1995. All fifteen Member States are

4 Around _V%_ percentage point of GDP is due to exceptional factors (see note to table 5 in chapter 1).

**6.3.96**

**42**

expected to reduce their structural deficits this year. Particularly important efforts are

being taken in countries with currently high deficits or debt problems.

Whilst the improvement in structural budget balances will _in se_ not be affected by the

worsening growth outlook in 1996, actual budget deficits risk widening under the influence

of adverse cyclical conditions. However, it would be unwise to allow slippage from

announced targets. Any market doubts about the resolve of governments to stick to fiscal

adjustment programmes would risk resulting in an instant reversal of the favourable trends

in short- and long-term interest rates currently being experienced in many Member States.

Furthermore, in these countries the negative effects on budgetary positions emanating from

a lower-than-expected level of economic activity in 1996 will be compensated by

diminishing debt service costs resulting from lower interest rates. This impact depends

_inter alia_ on the size of the outstanding debt and its maturity structure. For instance in

Belgium and Italy, countries with a high public debt, the effect is important: a 1 percentage

point decrease in the interest rate is estimated to lower the budget deficit by 0.3 to 0.4 per

cent of GDP in the first year and by 0.5 and 0.8 per cent of GDP (cumulative), respectively,

in the second year.

Encouragingly, there is a general recognition in the Community of the need to prevent any

slippagfiL from the announced consolidation paths. While continuing fiscal consolidation

efforts are clearly needed, the stated targets remain within reach, provided that there is a

relatively strong growth revival in the course of 1996, strengthening into 1997.

**2.3.2.** **Medium-term benefits of continuing and enhanced consolidation**

Bringing order to the Community's public finances can be expected to yield a high medium

and long-term dividend. Indeed, in most Member States credible fiscal consolidation

efforts are a prerequisite:

i. to place public finances on a sustainable footing, increase economic efficiency and

contribute to the achievement of a sustained medium-term growth process;

ii. to unburden monetary policy and restore the potential for counter-cyclical fiscal

action;

iii. to participate in EMU.

_**Placing public finances on a sound footing**_

The persistence of sizeable budget deficits (exceeding 3 per cent of GDP for most of the

period since the first oil shock) has resulted in a steep upward trend in the government debt

**6.3.96**

Chart 22

General government consolidated gross debt, EUR*

% 01 GUP

" 73 75 77 79 81 83 85 87 89 91 93 95

 - 1970-1977: EUR11 (OK, F, NL **and** P **excluded).**

General **government** **net borrowing, EUR***

`% of` _COP_

```
     '1 73 75 77 79 61 83 85 87 89 91 93 95

```

'1970-1978: EUR11 (CR, L, P **and** 8 **excluded).**

**43**

to GDP ratio, reaching over 70 percent of GDP in

1995 in the Community (chart 22). The steady

ascent in the government debt ratio has been

accompanied by a sharp increase in the debt

servicing cost, with interest payments on the existing

debt climbing from 1.8 per cent of GDP in 1973 to a
daunting _5_ _[X]_ _A_ percent of GDP now. This evolution

carries the risk of keeping the government finances

on an unsustainable track and leads to the crowding
out of more productive government expenditure.

While a secular rise in public debt is a common

feature in most Member countries, the increase was

particularly spectacular in Belgium (in the 1980s), in

Greece, Spain and Italy (in the 1980s and 1990s) and

Finland and Sweden (in the 1990s). These developments have been accompanied by a

rapid rise in interest payments on debt, approximating or exceeding 10 per cent of GDP in

the three most indebted member countries (Belgium, Greece and Italy).

The primary deficit is the key policy
variable determining the change in the debt

ratio. The improvement in the primary

balance over the period 1982 to 1989 (from

a deficit of 1.3 per cent of GDP to a surplus

of 2.2 percent of GDP) was too slow to halt

the increase in the debt ratio because real

interest rates in excess of real output

growth added to an adverse "snowball

effect" (chart 23). In the early 1990s, a

sharp increase in the debt ratio (the ratio

grew from 55 percent of GDP in 1990 to 68

percent in 1994) occurred essentially

because of a relaxation of budgetary

stringency which led to a deterioration in

the primary balance. Given that a primary
surplus of [ 3] A per cent of GDP in 1995 was

insufficient to stabilise the debt ratio in the

**Chart 23**

**Government gross debt dynamics, EUR***
**%** **of** GDP **A** **"** **Annual change in gross debt ratio**

Contributions to the change in the gross debt ratio

% of GDP B " Primary deficit

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

***1970-1978:EUR11 (DK,** **F,** **NL and** **P** **«xchided).**

**6.3.96**

44

Community on average, there is an urgent need to pursue with determination the

achievement of larger surpluses on primary balances.

_**Increasing economic efficiency**_

The development of budgetary imbalances has generally taken place in conjunction with an

increase in the governments' share in overall GDP. General government receipts and

expenditure, which represented 34 per cent of Community GDP in 1961, rose to 46 per

cent and 51 per cent of GDP, respectively, in 1995. Asymmetric policy behaviour over the

course of the business cycle is at the root of the trend increase in the ratio of government

spending to GDP. Whereas expenditures climbed markedly in every economic downturn,

only limited corrections took place in subsequent periods of recovery. The revenue ratio

typically adjusted to the new expenditure situation albeit partially and with a certain time

lag.

Table 13

Receipts and **expenditures of general government -** **EUR** **[a ]**

**(in** **%** **of GDP)**

```
                            Levels Changes

```

**`1961`** **`1973`** **`1985`** **`1989`** **`1993`** **1995** **1961-73** 1973-85 1985-89 1989-93 1993-95

Current receipts

of which

1. Indirect taxes

2. Direct taxes
3. Social security contributions
4. Other current receipts

Total expenditure
of which

5. Current transfers

5bis. of which to households
6. Actual interest payments
7. Public consumption
8. Net capital transfers
9. Gross capital formation
Pro memory
10. Gross saving
11. Net lending(+) / borrowing(-)
12. Gross public debt [b ]

**44.8**

13.4

13.3

14.6

3.4

**46.8**

20.7

17.1

4.6

18.2

0.9

2.8

1.2

-2.4

54.1

**46.2**

13.6

12.9

15.9

3.7

**52.5**

23.7

20.0

5.5

19.5

1.0

2.8

**-2.5**

**-6.3**

**66.2**

**46.2**

13.9

12.8

16.0

3.4

**50.9**

23.4

19.8

5.4

18.9

**0.6**

**2.6**

**-1.6**

**-4.7**

**71.0**

**3.3**

**-1.2**

1.5

1.8

1.2

**4.9**

4.6

**-1.3**

**2.4**

**0.1**

-0.9

**-2.3**

**-1.6**

**-28.4**

-0.4

-0.1

0.4

-0.3

-0.7

**-2.6**

-1.1

-0.8

-0.4

-1.0

-0.1

-0.1

1.8

2.1

0.2

1.4

0.2

-0.4

1.3

0.3

5.7

3.0

2.9

0.9

1.3

0.1

0.0

-3.7

-3.9

12.1

**7.6**

0.8

2.7

2.9

1.4

**10.9**

5.7

4.8

3.2

3.1

0.1

-0.7

-4.3

-3.6

17.1

34.3

13.9

**8.7**

10.2

1.5

33.6

11.5

3.1

13.7

0.8

4.5

6.0

0.7

65.2

37.6

12.7

10.2

12.0

2.7

38.5

16.1

13.1

**1.8**

16.1

0.9

3.6

3.7

-0.9

36.8

**45.2**

13.5

12.9

14.9

**4.1**

**49.4**

21.8

17.9

5.0

19.2

1.0

**2.9**

**-0.6**

**-4.5**

53.9

0.0

**0.3**

**-0.1**

0.1

-0.3

**-1.6**

**-0.3**

**-0.2**

**-0.1**

**-0.6**

**-0.4**

**-0.2**

0.9

1.6

4.8

1961 and 1973 : EUR 15 excluding Greece, Portugal, Austria, Sweden and Finland.

1961 and 1973 : EUR 15 excluding France, Netherlands, Greece, Portugal, Austria, Sweden and Finland

On the expenditure side the main contribution to the progression in the government's share

of GDP has stemmed from rising transfers to households, which has risen from 12 percent

of GDP in 1973 to 20 percent in 1995, linked essentially to growing rates of unemployment

and increased old age pension provisions, and greater levels of interest payments on

government debt _{3Vz_ percentage points increase). The strong growth in transfers to

households was only partly matched by an increase in social security contributions,

implying that a growing proportion of these transfers (about 3 per cent of GDP at present)

has to be financed through fiscal resources. Whilst the share pf indirect taxes remained

**6.3.96**

**45**

broadly unchanged over the last two decades, the direct tax pressure increased by 4

percentage points in the Community on average.

There are growing signs that the present

share and structure of government revenues

and expenditures is impairing the efficiency

and flexibility of the Community economy in

terms of crowding-out of private sector

activities, higher tax burdens, an increasing

wedge between labour costs and take-home

pay, and reduced labour market flexibility.

Greater awareness of these detrimental

effects has contributed to make a downsizing

of the government's share in the economy an

important goal for budgetary policy in the

Community.

**Chart 24**

**Transfers to households and**
**unemployment rate, EUR**

```
    71 73 75 77 79 81 83 85 87 89 91 93 95

```

_**Contributing to the achievement of a sustained, strong medium-term growth path**_

In the context of the need to move to a sustainable, healthy medium-term growth path,

action towards sounder public finances is crucial to excite a rise in national saving, a

reduction in real interest rates and a crowding-in of private investment. Although a high

investment level may be realised by drawing upon foreign savings, such a situation is not

sustainable over a longer period of time, and would be inappropriate for the Community as

a whole given its size in the world economy and its degree of economic development.

Recent empirical analyses concur that persistent fiscal imbalances and declining national

saving (in the Community and elsewhere) have contributed importantly to the high level of

real long-term interest rates experienced in the Community and world-wide since the 1980s

and to the declining trend in investment.

A high level of national savings must

therefore go hand in hand with the

Community's ambitions to generate the

higher investment levels which are vital to

underpin a satisfactory medium-term

growth performance. Given the observed

long-term stability in private savings,

there is widespread agreement that the

**National,** **private and government** saving, **EUR**

_%_ of GDP

PftetMSawng

**I** **, 1** **r <, l** **>** **.** **>** **•** **t** **.** **I-** **•** **•** **•** **•!** **•** **-I** **• < • < . <**
```
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94

                          6.3.96

```

46

most direct and desirable way to increase national savings is through an increase in

government saving. Restoration of positive government savings must consequently form

an integral part of the budgetary strategy.

_**Unburdening monetary policy**_

By fostering low and stable inflationary expectations, a low budget deficit and government

debt facilitate the primary task of monetary policy to achieve and maintain nominal stability.

Especially in countries where short-term interest rates are to a large extent determined by

exchange rate considerations, the credibility of fiscal policy plays a decisive role in the

degree of restrictiveness of a stability-oriented monetary policy. This was amply

demonstrated by recurrent currency turbulences during recent years. Financial market

concern about the firmness of the commitment of some governments to achieve a sustained

reduction of budget deficits led to pressures on currencies, forcing bouts of interest rate

tightening in the countries concerned. In addition, risk premiums on long-term interest

rates are substantial in several countries, despite marked progress towards low inflation and

relatively large margins of slack. Whilst to some degree this reflects perceived risks to

stability associated with the considerable depreciation of these currencies in recent years,

large fiscal imbalances also appear to have affected expectations about future inflation in

some member countries. Finally, sound public finances will also reduce the likelihood of,

or the economic costs of, a possible market testing of the anti-inflationary credibility of the

newly independent central banks.

As a consequence, the combination of sound fiscal policy with less restrictive monetary

policy is likely to result in a composition of growth which provides stronger investment and

thus a faster and sustained expansion of potential output, than a combination of lax fiscal

policies with higher real interest rates.

_**Restoring the margin of manoeuvre for counter-cyclical fiscal action**_

Large budgetary imbalances reduce the scope for counter-cyclical fiscal action. When the

underlying budgetary position is sound, the free play of the automatic stabilisers tends to

cushion cyclical variations in economic activity and the potential availability of fiscal action

may be an important insurance in case of severe adverse shocks. In the case of severely

unbalanced budgetary positions, however, the counter-cyclical use of budgetary policy may

well de-stabilise rather than stabilise the economy if financial markets fear sustainability

problems, leading to a rise in long-term interest rates or currency instability. Consequently,

the stabilisation function cannot be considered in isolation.

**6.3.96**

**47-**

**Cyclical component of general government deficit**

In the Community, the size of the

cyclical component of the budget

deficit is quite important but it

varies in a substantial manner over

time and across Member States.

The adverse impact of the

automatic stabilisers was equal to

or exceeded 2 per cent of GDP in

at least one Member States during

Chart 26

about half of the time over the last - 70 For each year, the Maximum (Minimum) relates to the Member state with the 72 74 76 78 80 82 84 86 88 90 92 94
two decades (chart 26). highest (lowest) rate among the 15.

Furthermore, there appears to be a quite clear relationship between the magnitude of the

cyclical component and the size of the country: small, open economies, which are relatively

more vulnerable to external developments and usually less diversified, tend to need more

room for manoeuvre. Other factors which influence the size of the automatic stabilisers are

the overall size of the government sector, the progressivity of the tax system, the

generosity of unemployment benefit schemes and the sensitivity of unemployment to

fluctuations in output.

In the Community on average, the cyclical component of the budget deficit fluctuated

within a margin of slightly less than ± 2 per cent of GDP during the last two decades.

Consequently, in order to keep the actual budget deficit below 3 per cent of GDP in the

Community as a whole during economic downturns, it is essential to bring the structural

deficit down to close to balance (compared to an estimated level of above 4 per cent of

GDP in 1995).

_**Participating**_ _**in EMU**_

The budgetary convergence criteria of the Maastricht Treaty provide an effective support

framework for Member State efforts by exerting a useful disciplinary role in terms of the

correction of existing excessive deficit and debt ratios. The correction of these imbalances

will ensure the necessary degree of fiscal discipline in Stage 3 and support the anti
inflationary commitment of the future European Central Bank which is essential for

ensuring an optimal policy mix in the third stage.

The Community's budgetary policies must therefore encompass the convergence

requirements of the Maastricht Treaty within the overall medium-term budgetary goal of

close to balance, as stated in the Broad Policy Guidelines approved by the Council in July

**6.3.96**

48

1995. The appropriate reference benchmark in this perspective should be broad

equilibrium in the "structural" budget balance while at the same time allowing the actual

balance to fluctuate around this value in accordance with the economic cycle. Thus,

budgetary policy would be in a position to play a symmetric stabilisation role in periods of

economic expansion and downturn, without endangering the restored sustainability. This

shock-absorbing role for budgetary policy will be particularly important once the single

currency is in place in terms of its role in helping to accommodate country-specific

economic disturbances.

_**2.**_ _**3.3.**_ _**Fiscal consolidation**_ _**and**_ _**short-term**_ _**growth prospects**_

Governments acknowledge that the medium-term benefits of fiscal consolidation efforts are

potentially large. That is why all Member States are committed to the objective of sound

public finances. Nevertheless, governments often hesitate to implement planned

retrenchment measures because of the perception that in the _short run_ these will restrict

economic activity and worsen the labour market situation. Clearly, the _direct_ impact of

fiscal consolidation tends to restrain demand and growth via a reduction in government

purchases or in private sector disposable incomes. It is thus understandable, given the

present pause in the growth process, that some Member States may be anxious about any

negative growth impact from adhering to their existing consohdation plans.

However, this demand-restraining impact may be offset by a number of _indirect_ effects.

Budget deficit reductions are likely to make it easier for a stability-oriented monetary

policy to contribute to a better policy mix. Furthermore, fiscal consolidation may limit the

adverse demand impact via a reduction in long-term interest rates. In an environment of

forward-looking financial markets which increasingly focus on the sustainability of

budgetary policies, high and rising public debt ratios are contributing to high risk premiums

on interest rates. Provided that the announced adjustment measures are judged credible by

financial markets ~ i. e. they dispel fears of future monétisation of the public debt and,

thus, rising inflation --, fiscal consolidation, especially in highly indebted countries saddled

with high risk premiums, may entail a sizeable fall in long-term interest rates, which in turn

stimulate investment and alleviate the debt service burden. Less restricitive monetary

conditions and lower long-term interest rates will have a beneficial impact on investment

and attenuate the impact on private consumption. This may well offset the direct impact of

withdrawing the fiscal stimulus, even in the short run.

**6.3.96**

49

The "crowding-in" of investment is more likely to be encouraged, as is the case at present,

by high levels of profitability and a progressive return to positive public savings contributes

soundly to its financing. A rapid and substantial crowding-in of investment is essential not

only in terms of expanding future productive capacities but also in terms of anchoring non
inflationary expectations.

Furthermore, through expectational effects, credible fiscal restraint may also exert a

favourable impact on consumer behaviour. There is ample theoretical and empirical

evidence that if budget retrenchment signals a permanent cut in government spending and

taxes over the medium term, consumers tend to respond rapidly by decreasing their

savings.

In broad terms therefore a credible package of consolidation measures may not have

significant adverse short-term effects provided a number of factors are adequately taken

into consideration. The consolidation process must be correctly timed, be non-piecemeal in

its implementation with the order of priorities firmly oriented towards the expenditure side.

In addition to these basic requirements, it is important that budgetary consolidation is

perceived to constitute an element in an overall economic approach which is balanced and

consistent. Under these circumstances the application of the overall economic approach

would represent a type of "regime" change (see box 5).

_**2.3.4.**_ _**Priority**_ _**areas for**_ _**consolidation**_

It is clear that trenchant medium-term fiscal consolidation efforts will require fundamental

budgetary reforms which may provoke adverse political reactions. It is therefore crucial

that the distribution of the necessary efforts is even-handed to ensure the required degree of

social acceptability which is vital to the success of the overall adjustment exercise.

Although specific measures to be taken need to be tailored to situations in individual

member countries, the primary task in virtually all member countries is, as stated in the

1995 Broad Economic Policy Guidelines, to promote fiscal consolidation by reducing

structural deficits. Whilst in terms of actual budget deficits, the less favourable economic

environment may hide the extent of the fiscal adjustment being undertaken, significant

consolidation results should become apparent over the medium term as cyclical conditions

improve.

**6.3.96**

-50

It is widely recognised that controlling the growth of government expenditure is the

preferred approach. The overall tax burden in the Community is already high, especially

relative to its major partner countries, and tax increases would imply raising their

distortionary effects. Furthermore, there is widespread and strong political resistance to

higher taxation. Conversely, actions aimed at containing the increase in government

expenditure, and also at restructuring the latter, could be accompanied by increased

efficiency of the public sector. In a medium-term perspective, they would open the door

for new and more productive initiatives, such as additional expenditure to combat long
term unemployment, to improve education or to reverse the downward trend in public

investment. It will also increase the degree of preparedness to meet longer-term challenges

linked to the ageing of the population which will inevitably put additional strains on an

already stretched social spending budget. Finally, curtailing the share of government

expenditure would create scope for a reduction in the overall tax burden once budget

deficits are on a firmly declining path and close to balance.

Following several years of attempts at controlling government spending, but whose impact

was offset by continuing 'snowball effects' and high and rising unemployment, little if any

scope exists for easy and painless actions in most Member States. These countries face the

more daunting task of fundamental reform of basic government expenditure programmes.

Amongjhe issues which need to be addressed are the need to place pension provisions on a

sustainable footing, to curb the rise in health care costs, to reduce distortionary and costly

subsidies, to increase the effectiveness of social transfers and to improve the functioning

and efficiency of public services.

Finally, in countries with high budgetary imbalances, a drastic reduction in budget deficits

without a certain rise in the tax burden appears unachievable. In this context, increasing

indirect taxes may be preferable to direct taxes, as the distortionary effects are likely to be

lower. Furthermore, member countries would also stand to gain from a broadening of the

tax base, a reduction of excessively high marginal tax rates, modification of tax structures

in ways which are likely to be conducive to growth and employment and introduction of

measures designed to improve tax administration. Member countries should give particular

attention to a reduction in employers' social contributions at the lower end of the wage

scale and provide for alternative financing means or increased expenditure restraint in order

not to endanger the overall goal of greater budgetary discipline.

**6.3.96**

**51 -**

_**Box 5: Examples of successful fiscal**_ _**consolidation**_ _**efforts**_

There is broad consensus within the Community on the need for fiscal consolidation and all
governments have committed themselves to policies of medium-term fiscal consolidation. While
subscribing to the unambiguously positive, medium-term macroeconomic effects of credible
efforts to reduce excessive budget deficits, many policy-makers fear that far-reaching fiscal
retrenchment efforts will, in the short run, adversely impact on aggregate demand and thus
jeopardise output growth and add to unemployment

Recent economic analysis and historical evidence shows that this concern is not always justified,
especially not tn countries with excessively high budget deficits, indeed, experience in a number
of Member Countries during the 1980s suggests that major fiscal contraction can go hand in hand
with high growth and strong job creation. The 1933 Danish fiscal adjustment program and the
1957 Irish deficit reduction program are two Illustrative cases. Against a backdrop of poor
economic performance, both countries implemented very demanding measures which proved to
be very successful in reversing a steady trend of rapidly worsening budgetary positions while
enjoying a substantial improvement in economic performance in the short run.

Over the period 1982-1986 Denmark

Denmark

transformed a deficit of 9.1 per cent of
GDP into a surplus of 3.4 per cent of **1982** **1983** **1984** 1985 1986
GDP T i.e. _&n_ improvement of 12.5 per
cent of GDP, The credibility of the Budget balance (% GDP) -9.1 -7.2 -4.1 -2.0 3.4
policy shift was reflected in a halving Primary balance (% of GDP) -3.1 0.9 5.5 7.8 12.2
of the léyej of long-term interest rates Government debt (% of GDP) 63.9 73.4 75.1 72.0 63.7
and a marked fall in inflation. Rather GDP (real % p.a.) 3.0 2.5 4.4 4.3 3.6
than plunging the economy into Domestic demand (real % p.a.) 3.5 1.4 5.1 5.4 6.1
recession, the fiscal adjustment was -of which Investment (% p.a.) 7.1 1.9 12.9 12.6 17.1
accompanied by a strong economic Long term interest rate (% ) 20.5 14.4 14.0 11.6 10.6

Inflation (% p.a.) 10.2 6.8 6.4 4.3 2.9

expansion, „ despite an unfavourable
international environment in the initial Employment(% p.a.) 0.2 0.7 2.9 2.6 4.3
phase. Over the period, real GDP Unemployment (%) 89 9.0 8.5 7.1 5.4
growth averaged 3% per cent, almost
double the Community average. Growth
was predominantly driven by the **Public debt** **(%** **of GDP)** **Denmark**
crowding-in of private spending; private
consumption and, especially, investment
expanded vigorously. As a result of
buoyant economic activity, the rate of
**unemployment fell from 8.9 per cent in**
1982 to 5.4 per cent in 1986. This
prosperous episode came to a sudden
end in the second half of the 1980s.
Overheating and high pay rises, **0** **Cyclically-adjusted1** **2** **budget deficit3** **4** **(%** **of GDP) 5** **6**
reflecting strained labour market
conditions, led to a tightening of monetary policy and a relapse of expectations. This, in turn,
resulted in a prolonged period of subdued growth, deteriorating public finances and rising
**unemployment**

Denmark

**1982**

**1983**

**1984**

1985

1986

-7.2

0.9

-2.0

7.8

12.2

63.7

Budget balance (% GDP)

-4.1

5.5

3.4

Primary balance (% of GDP)

-9.1

-3.1

73.4

Government debt (% of GDP)

63.9

75.1

72.0

1.4

1.9

GDP (real % p.a.)

2.5

3.6

6.1

4.3

5.4

Domestic demand (real % p.a.)

12.9

14.0

4.4

5.1

-of which Investment (% p.a.)

3.0

3.5

7.1

12.6

11.6

17.1

10.6

Long term interest rate (% )

20.5

10.2

14.4

Inflation (% p.a.)

4.3

2.6

7.1

2.9

4.3

5.4

6.8

0.7

9.0

Employment(% p.a.)

0.2

89

Unemployment (%)

6.4

2.9

8.5

**Public debt** **(%** **of GDP)** **Denmark**

**0** **1** **2** **3** **4** **5** **6**

**Cyclically-adjusted** **budget deficit** **(%** **of GDP)**

**6.3.96**

**52**

Ireland

**In** **Ireland,** **the** **1987** **budgetary**
**adjustment plan led to a marked**

**1986** **1987** **1988** 1989 1990

**reduction in general government net**
**borrowing from 1034 per cent of GDP** Budget balance (% GDP) -10.6 -8.5 -4.4 -1.8 -2.3
**in 1987 to** **1.8** **per cent of GDP in** Primary balance (% of GDP) -1.4 0.8 4.2 6.0 5.5
**1989,** **reflected** **In** **a** **15** **points large** Government debt (% of GDP) 114.9 116.0 111.6 101.7 96.5
**drop in the public** **debt-to-GDP** **ratio** GDP (real % p.a.) 0.3 4.7 4.3 6.1 7-8.
**over the same period.** **The fiscal** Domestic demand (real % p.a.) 2.1 0.3 1.3 7.6 5.7
**consolidatiori did net hamper high** -of which Investment (% p.a.) 0.0 -2.3 -1.6 13.8 11.1
**economic** **growth,** **as real GDP growth** Long term interest rate (% ) 11.1 11.3 9.4 89 10.1
**accelerated from virtual stagnation** _**\n**_ Inflation (% p.a.) 3.7 2.4 4.0 40 2.0
**1986** **to growth of** **6** **per cent in** **1989.** Employments p.a.) 0.2 0.8 0.0 -0.2 4.2
**While improved competitiveness and** Unemployment (%) 16.8 16.6 16.1 14.7 13.4
**positive external** **developments** **proved**
**instrumental in spurring the marked**
**turnaround both in terms of output and** **Pubic** **debt** **(%** **of OOP)** **Ireland**
**budgetary** **performance»** **the domestic**
**economy also responded favourably to**
**the policy shift with the preceding phase**
**of deeply depressed domestic demand**
**giving way to a substantial pick-up in**
**investment and** **consumption.** **Further-**
**more,** **unemployment** **fell,** **albeit** **less**
**significantly,** **from** **16*6** **per cent** **in 1987**
**to 14.7 per cent** **in*** **1989,** **A key feature** **3** **CycMcaJly-adJustad** **4** **5** **6** **7** **budget8** **dele*** **S** **10** **(%** **11 of OOP) 12** **13** **14** **15** **16**
**of the Irish** **approach** **was thai fiscal**
**consolidation** **was** **assisted by an agreement with the social** **partners on** **a comprehensive**
**adjustment** **plan in which** **the adherence to moderate wage Increases** **was** **a** **crucial** **element,** **in**
**contrast to the Danish** **experience,** **output growth remained** **buoyant lit** **the subsequent period** _**dn^**_
**the public debt ratio declined steadily, despite slowing fiscal consolidation efforts.**

1990

**1988**

1989

**1986**

**1987**

-4.4

4.2

-1.8

6.0

-2.3

5.5

Budget balance (% GDP)

-10.6

-8.5

0.8

Primary balance (% of GDP)

-1.4

111.6

101.7

116.0

96.5

Government debt (% of GDP)

114.9

4.3

1.3

7.6

7-8.

GDP (real % p.a.)

-2.3

11.3

4.7

0.3

6.1

5.7

Domestic demand (real % p.a.)

-of which Investment (% p.a.)

0.3

2.1

0.0

-1.6

9.4

13.8

Long term interest rate (% )

11.1

11.1

10.1

2.0

4.2

89

40

Inflation (% p.a.)

3.7

2.4

0.8

0.0

16.1

4.0

-0.2

14.7

Employments p.a.)

0.2

13.4

Unemployment (%)

16.8

16.6

**Ireland**
**Pubic** **debt** **(%** **of OOP)**

**3** **4** **5** **6** **7** **8** **S** **10** **11** **12** **13** **14** **15** **16**

**CycMcaJly-adJustad** **budget** **dele*** **(%** **of OOP)**

**However, success of fiscal consolidation efforts in Denmark** _**m6**_ **Ireland contrast with the**
**experience of many other** **countries.** **Important** **features of both the Danish and Irish experiences,**
**differentiating them from less successful** **ones,** **are:**
**-** **In** **both countries, fiscal retrenchment was part of a** **credible-change In** **the economic policy**
**regime*** **The regime change implied a renewed commitment to stable exchange rates and**
**low inflation supported by budget consolidation and appropriate wage** **behaviour.** **Other**
**factors were also at work {improved competitiveness position; liberalisation of capital**
**movements) but undoubtedly the positive expectations effect of the policy shift enabled the**
**economy** **to** **reap the benefits of** **these** **developments.**
**Although** **the direct impact of slower public expenditure growth was clearly negative,**
**important indirect effects, linked to the improvement** **In** **expectations, were evident in the**
**substantial falls** **In long-term** **interest rates and a surge** **In** **private sector confidence.**

**-** **The distinction between the Danish and** **Irish** **experiences and other less successful**
**retrenchment efforts is not simply the scale of adjustment undertaken but also the positive**
**effects on private sector expectations attributable to a credible commitment to sustaining the**
**budgetary adjustment into the** **medium-term.** **While there was some rise in the tax burden,**
**the bulk of the adjustment was on controlling growth of public expending, which yielded**
**positive expectations about a permanent decline** **in** **the share of government in the economy.**

**6.3.96**

**53 -**

**2.4.** **Wage developments**

**2.4.1.** **The appropriate wage trends**

Whereas monetary policy is conducted by increasingly independent central banks and

budgetary policy is determined by sovereign governments, the development of wages

generally represents the outcome of negotiations between social partners. Nevertheless,

wage trends are a key ingredient of macroeconomic and structural policies. The

macroeconomic wage bill (including all social security contributions) is equivalent to about

50 per cent of Community GDP, broadly equalling the share of total government spending

in the economy. Consequently, the evolution of aggregate wages and wage differentials

has substantial implications for inflation, growth, employment and the employment-content

of growth. In view of their economic importance, it is warranted that policy-makers, whilst

fully respecting the autonomy of the social partners in this area, closely monitor wage

developments and set the stage by concluding appropriate wage agreements in the public

sector.

To help assess the appropriateness of wage developments, some broad signposts have been

developed at the Community level in the framework of the surveillance of economic

performance and policy. At the macroeconomic level, two issues are of particular concern.

Firstly, it is of crucial importance that the perception of the expected rate of inflation which

is embodied in wage settlements is, as much as possible, compatible with the price-stability

objective of the central bank. If this is the case, wage developments _de facto_ do not place

an undue burden on the conduct of monetary policy. Conversely, if wages increase in a

manner which is inconsistent with achieving and/or maintaining low inflation, a stability

conflict arises of the type experienced during the early 1990s.

Secondly, as regards real wages, it is important that their evolution at the macroeconomic

level takes into account the need for safeguarding, and if necessary improving, the

profitability of investment. In this respect, the Commission, in its 1993 White Paper, put

forward a rule of thumb: over the next few years, real wages should increase by about one

percentage point less than overall labour productivity. The validity of such a rule is now

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

conclusions of the Essen European Council. This rule is based on both past experience and

the realisation of the significance of enhanced investment profitability to the Community's

medium-term conditions to foster a strong expansion of productive capacity and

employment-creating growth. During the period 1982-89, which saw a steady restoration

**6.3.96**

**54-**

in investment profitability, real wages increased on average by 1 percentage point per year

less than productivity growth. This marked improvement in profitability contributed to the

brisk expansion of investment, especially in equipment, and to the acceleration of actual

and potential rates of growth during the second half of the 1980s.

Respecting this rule, in combination with employment growth, also allows for a sufficient

increase in consumption and overall demand which is necessary for investment and to

favour an appropriate balance between capital-widening and capital-deepening investment.

Furthermore, adequate wage trends will contribute to the external cost competitiveness of

the economy and positively affect entrepreneurial location decisions.

In this context, it is noteworthy that in the Community on average, the profit share already

exceeds the level registered in the 1960s. However, this is necessary in order to

compensate for the comparatively higher capital/output ratio. In the next few years,

profitability may approximate the level reached during the quasi-full-employment period.

But in view of huge capital needs and to offset the relatively higher level of real interest

rates (compared to the levels prevailing during the 1960s), a further improvement in

profitability is called for. Since average labour productivity is enhanced by the employment

of a larger capital- stock, the standard of living of workers will be positively affected over

the medium term.

Obviously, for the development of employment, an adequate degree of wage differentiation

is also highly relevant. However, policies should aim at lowering total wage costs at the

lower end of the scale without reducing the _disposable_ income of low-wage earners. In the

pursuit of a higher level of employment, the results of wage settlements should provide for

an appropriate differentiation across qualifications as well as geographical areas and sectors

and firms. Market forces are pushing into this direction. But the interaction between tax

and social benefit systems in many countries create an 'implicit wage floor', preventing a

substantial downward adjustment of wages relative to productivity. A widening of the

distribution at the lower end of the wage scale would increase the employment-content of

growth but the scope for such action is limited by the social/political exigency to preserve

the foundations of the European social model. The closer the link between wage and

productivity levels of the particular working post, the more activities with below-average

productivity could be (re-)introduced in the production process. It would make low
productivity activities profitable that were formerly either priced out of the official market

or "transferred" to foreign low-wage producers. Similarly, it would help limit the process

of substitution of parts of the workforce by capital investment.

6.3.96

**55-**

Such a downward widening can be obtained in two manners. Market forces can be allowed

to substantially lower the wages of low-skilled workers as has happened in the US. Taken

to extremes, this option entails serious economic and social consequences ("working poor

syndrome"). There are, however, possibilities for some widening in keeping with a reform

of the European social model. Gross labour costs can be reduced by lowering employers'

social contributions or by simultaneously lowering wages and taxes on low incomes

without affecting net income. The first approach is currently being pursued in several

Member Countries (including France, Belgium, Netherlands, Ireland and the UK). While

some positive results are emerging at the national level, their size appears yet to be

insufficient to perceive a noticeable macroeconomic influence at the Community level. To

neutralize the impact on budget deficits and to avoid adverse economic side-effects, it is

essential to carefully design such measures and to target them at the low end of the wage

scale.

The requirement for an appropriate degree of wage flexibility has also significant **regional**

aspects. In the Community, intense intra-regional trade links have been accompanied by a

narrowing of regional divergences in wage and productivity _levels._ Nevertheless, wide

discrepancies remain between Member States and regions in the levels of overall

compensation per employee and disparities of broadly identical magnitudes exist in the

levels of overall labour productivity. As a result, the levels of unit labour costs are similar

across Member States. For the less-favoured regions in the Community to exploit fully

their competitive advantage in terms of wages and non-wage labour costs, it is essential

that increases in real wages relative to changes in productivity remain adequate. This

should enable these regions to post a relatively more dynamic growth, productivity and

employment path and would eventually enable relatively stronger increases in real wages,

thereby advancing the catching-up process.

In the wage-profitability-investment-employment nexus, there is also a role for wages

having a larger flexible and profit-related component. Such a flexibility is especially

desirable at the **sector/firm** level in order to respond adequately to sectoral/firm specific

changes in economic conditions. In this context, experience has indicated that in the

absence of such flexibility, the adjustment to adverse shocks occurs through

disproportionate losses in working posts.

These considerations stressing the need for appropriate wage behaviour are all the more

pertinent in view of the ongoing deepening of European economic integration. Following

**6.3.96**

56

the full liberalisation of capital movements, investments are taking place in those

geographical areas where the expected rate of return is highest. Although the latter is

determined by several structural and microeconomic factors, wage developments are an

important element. In EMU, with single monetary and exchange rate policies and overall

reduced freedom in budgetary policy, the role of wages in response to changed economic

situations will gain prominence. As a result, it will be essential that the social partners

exhibit the necessary degree of flexibility in wage negotiations. All these issues constitute

important topics for the dialogue between the social partners.

**2.4.2.** **Wage adjustment in the EC since 1980**

Over the past 15 years, the evolution of

nominal wages in the Community has

generally not only accompanied but also

facilitated the remarkable disinflation

process. As shown in chart 27,

significant wage adjustments contributed

quite strongly to the noticeable fall in

inflation achieved during the protracted

expansion phase of the 1980s. The rate

of increase in nominal unit labour costs

**Chart 27**

**Nominal wages and inflation - EUR**

**%** **change** **p.a.**

decelerated strongly from the beginning of the decade and was actually faster than the rate

of inflation. The success in adjusting wage trends during the period 1980-89 was all the

more spectacular in the initial years as it occurred against an unfavourable background of

strongly rising import prices.

It is only towards the end of the 1980s that the promising trend of moderating wage

increases came to a halt and wage behaviour became clearly incompatible with the

monetary authorities' stability objective in the period 1990-92. The policy-induced

overheating of the Community economy in 1988-89 led to a marked pick-up in inflation

and inflation expectations. Wage trends reacted to the accelerating rate of inflation, albeit

with a certain lag: nominal wages per head accelerated to 7.4 per cent in 1990 against 5.4

per cent in 1987. In the light of these developments, monetary policy was tightened as

from late 1988 and became very tight in 1991-92. The stability conflict was exacerbated by

the post-unification boom in West Germany which generated bottlenecks in the labour

market and entailed steep wage increases. The period since 1993 has generally seen a

substantial improvement in wage behaviour. Nominal wage increases decelerated

6.3.96

**57-**

considerably and assisted the resumption of the trend towards price stability in the

Community.

The long-term macroeconomic

evolution of real wages in relation

to labour productivity and

investment profitability shows a

similar pattern as the nominal

indicators. During the 1980s,

increases in real wages, while

remaining positive, fell clearly short

of labour productivity growth,

resulting in a substantial decline in

real unit labour costs. This

**Chart 28**

Real wages and labour productivity - EUR

**annual** **% changes**

`3` _**•**_ _**7**_ _**^Ubfmff9ik**_ _**f**_ _**fMfy0fMi9h-**_

```
2

1

o i

-1

1

o

-1

-2

-3
    80 81 82 83 84 85 86 87 89 90 81 92 93 94 95

```

conspicuous wage development was a key factor behind the boost in investment

profitability which rose steadily from the low point reached in 1980 of about 65 per cent of

the average over the period 1961-73 to close to 90 per cent in 1989 (see chart 6 in chapter

1). This improvement was interrupted during the slowdown of the early 1990s as real

wages reacted with a certain time-lag to the cyclical deceleration in labour productivity

growth^ Nevertheless, due to the greater responsiveness of employment to economic

trends, the deterioration was markedly smaller than in previous recessions. Noteworthy in

this respect were developments in 1992 when growth in labour productivity exceeded its

long-term trend because of strong labour shedding. Productivity gains thus obtained

should not be distributed to those who keep their employment. Over the last two years,

wage trends were again generally in line with the Council's recommendation in the Broad

Economic Policy Guidelines. The rapid expansion of output and the impact of

restructuring measures have resulted in labour productivity growth in excess of real wages,

albeit also accelerating. This laid the grounds for a renewed recovery in investment

profitability from 1994 onwards.

With respect to an increased flexibility of the labour market in relation to unemployment,

empirical evidence seems to suggest that in the first half of the 1980s wage flexibility in the

Community deteriorated, but stabilised thereafter. In terms of the differentiation of wages,

there is no clear picture for the Community. While in France and the UK there is a clear

trend towards an increased earnings dispersion in the 1980s, the latter stayed almost
unchanged in Italy and decreased somewhat in Germany [5] .

Based on figures published in "The OECD jobs study, Implementing the strategy", 1995, p. 14

**6.3.96**

58

2.4.3. Expected wage developments

Following a slight acceleration last year from the low rate registered in 1994, nominal

wages are assumed, according to the Commission's November 1995 forecast, to increase

by about 3% per cent this year and next in the Community on average. Real wages might

pick up to 1 per cent following two years of virtual stagnation whereas labour productivity

growth is expected to return to its long-term trend of around 2 per cent. These recent and

prospective developments suggest that from a macroeconomic perspective wage behaviour

in the Community on average is appropriate and set to contribute positively to the

achievement and maintenance of price stability, to the generation of a high, employment
creating growth path and to the improvement in the Community's external competitive

position. Given a long-term trend in annual productivity growth of 2 per cent in the

Commumty on average, the Broad Guidelines in effect suggest that growth in nominal

compensation of employees per head of the order of 3/4 per cent in the Community on

average may be considered compatible with the intermediate price inflation target of 2-3

per cent, as a step towards stability, with the need for a continuing improvement in

investment profitability and with the necessity to ensure an adequate expansion of domestic

demand.

Although in most Member Countries wage developments are in keeping with the objectives

of price stability and a further restoration of investment profitabiUty, some important,

country-specific, trends are discernible. In some countries where inflation is already low,

relatively subdued demand and, more importantly, the competitiveness losses associated

with currency appreciation, have limited the extent to which wage and unit labour costs can

be passed on to prices. This is particularly the case in Germany where the relatively high

pay settlements at the beginning of last year and the strong effective appreciation of the

DM led to a significant squeeze of profit margins in export sectors. Obviously, wage

trends cannot adjust instantaneously to movements in exchange rates and in case of a clear

overshooting, a market-mduced correction of exchange rates is certainly the most desirable

option. Still, in order to safeguard the country's competitive position and its attractiveness

for private sector investment decisions, it is essential in Germany, but also in some other

countries, to contain pay settlements whilst at the same time implementing measures to

enhance productivity and employment. Proposals of this type are currently being discussed

in some countries by the social partners, sometimes in concertation with the government.

Conversely, in some depreciating countries, like Spain and Italy, the actual rate of inflation

turned out to be higher than the targeted rate of inflation incorporated in the pay

**6.3.96**

-59

settlements last year. This resulted in a fall in real wages for the second consecutive year.

According to the forecasts, nominal wage increases might accelerate somewhat to the 4V£

to 5 per cent range. In both countries, it is essential that workers do not seek to catch up

on previous years' losses in purchasing power through higher pay claims as this would risk

fuelling a price/wage spiral. Instead, continuing adequate wage behaviour in combination

with credible fiscal rectitude should engender an appreciation of these currencies, thereby

lessening (imported) inflationary pressures. Such an evolution seems to take place in Spain

and Italy and such a policy mix was successfully implemented in Sweden last year. In the

latter country, however, forecasted wage settlements for this year seem to embody a

marked acceleration in the rate of increase of nominal wages which risks being in conflict

with the stability objective and which allied with the considerable appreciation of the Krona

may threaten its external competitive position. Finally, in a few other Member Countries,

for instance Greece, the disinflation process is far from being completed.

**2.5. Structural policies**

**2.5.1.** **Vital complement to macroeconomic policy-mix**

The objective of setting in place the desired macroeconomic policy mix, described in

previous sections, is essentially twofold: firstly, to overcome the present pause in the

recovery and secondly to firmly re-establish the Community's economy on a robust

medium-term growth path. With regard to the latter objective, macroeconomic policies

provide the essential framework within which such a strong traditional growth process

underpinned by capacity and employment-creating investment can develop. This is needed

to ensure a significant increase in both the effective and potential rates of growth in the

Community. Assuming the maintenance of trend productivity growth of the order of 2 per

cent, this would allow for strong employment creation. However, for such a growth

process to be sustained and thus to allow for strong employment creation, macroeconomic

policies must be accompanied and supported by structural measures in both the goods and

services markets and in the area of labour market reform.

Structural policies are crucial to the success of the Community's growth and employment

strategy for essentially three reasons. Firstly, structural policies create the conditions

necessary for a higher rate of economic expansion without the early appearance of adverse

inflationary pressures. Secondly, they help to increase the endogenous growth forces by

ameliorating the efficiency and overall competitiveness of the economy. Thirdly, they play

a crucial role in improving the employment content of growth and reducing structural

**6.3.96**

60

unemployment. Furthermore, structural policies must also take into account the need to

preserve a healthy environment.

(i) _**To ensure a tension-free macroeconomic growth process**_ ~ Well functioning

product and service markets contribute to achieving higher growth and employment by

allowing relative prices to adjust swiftly to changing economic conditions.

Furthermore, the economic merit of actions geared towards increasing the flexibility of

labour markets is related to their contribution to avoiding labour market bottlenecks

and a resumption of wage inflation as unemployment comes down. As such, they are

crucial to help reduce the NAIRU. Indeed, measures aimed at improving the

transparency of labour markets, at enhancing flexibility in the areas of professional and

geographical mobility or at retraining target groups hit by exclusion or industrial

restructuring facilitate the re-absorption of unemployed workers when the demand for

labour resumes. Some measures have already been introduced in these areas at the

national level, backed up by Community programmes in the context of the Structural

Funds. Such measures, however, do not in themselves engender new jobs.

**(ii)** _**To reinforce the Community's endogenous growth forces**_ _—_ Specific measures

directed towards enhancing competitiveness and innovation will underpin strong

advancements in terms of productivity and consequently real standards of living and

wealth. Indeed, policies aimed at fully exploiting the potential of the internal market,

reinforcing competition, fostering investment in new technologies, accelerating the

realisation of trans-European infrastructure networks, stimulating SMEs, raising the

quality of human capital, and furthering investment in weaker regions, all have in

common the objective of reinforcing the endogenous growth forces of the

Community's economy via increases in overall productivity. Taken as a whole, these

policies could, according to the new growth theories, lead to an acceleration in the

Community's rate of growth through an enhancement of the overall productivity of its

economic structure.

The _net_ employment effects of these policies will ultimately depend on the smoothness

of the inter-sectoral redistribution of productivity gains and developments in terms of

labour demand (see box 6). For this process to operate effectively, relative price

movements must be permitted to operate flexibly, the sectoral changes implied by this

process must command a large degree of economic and social acceptability and finally

growth must be sufficiently high as to ensure a positive net balance in terms of job

creation across the sectors. Therefore, to bear fruit in terms of _net_ employment, the

**6.3.96**

-61 

_**Box 6: Productivity and employment growth**_

As stressed in the White Paper on "Growth, competitiveness and employment" and by the Social
Partners, there is no contradiction between initiatives to enhance productivity growth and _net_
employment creation provided that the wealth created by the sectors with high-productivity
increases is adequately redistributed within the economy, enabling sectors with low productivity
growth to create new jobs. One important channel of redistribution of productivity gains is
decreasing relative prices in sectors with high productivity growth, increasing the purchasing
power for all consumers, and thus demand for products and services in general, and especially in
employment-intensive sectors with low productivity growth and increasing relative prices. As is
shown in the table below, such a mechanism has worked well during the 1960s and in 1986-90 in
the Community.

Employment, productivity and relative prices in main sectors

(EUR5, in % per year) [3 ]

Total

Agriculture

Industry

Market

services

Non-market

services

Indicator

Period

5.5

1.0

2.4

0.5

-1.4

0.3

5.0

2.4

2.1

-1.0

-0.4

-0.4

1.8

1.7

1.7

-4.6

-2.9

-3.1

6.5

4.7

4.9

-0.4

-2.5

-2.0

5.6

3.5

4.0

1.6

1.7

2.4

4.0

1.5

1.6

0.7

0.5

0.4

Value added

Value added 1961-73 4.9 1.8 5.5 5.6 3.7

1974-85 2.1 1.7 1.0 3.5 2.3
1986-90 3.1 1.7 2.4 4.0 1.4

Employment 1961-73 0.3 -4.6 0.5 1.6 2.2

1974-85 0.2 -2.9 -1.4 1.7 2.0

1986-90 1.0 -3.1 0.3 2.4 1.0

Productivity 1961-73 4.6 6.5 5.0 4.0 1.5

1974-85 1.9 4.7 2.4 1.5 0.3
1986-90 2.1 4.9 2.1 1.6 0.4

Relative price 1961-73 -0.4 -1.0 0.7 3.4

1974-85          - -2.5 -0.4 0.5 3.5
1986-90 -2.0 -0.4 0.4 2.9

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

4.9

2.1

3.1

0.3

0.2

1.0

4.6

1.9

2.1

Employment

Productivity

Relative price

1961-73

1974-85

1986-90

1961-73

1974-85

1986-90

1961-73

1974-85

1986-90

1961-73

1974-85

1986-90

For such a process to work effectively, three essential conditions must be met simultaneously:

- _relative product prices_ between sector must be allowed to change in the right direction without
artificial rigidities. The full working of the internal market and the achievement of convergence
together with the pressure of international competition in a more open world economy are
ensuring that the required flexibility of markets is maintained and strengthened throughout the
Union. There is statistical evidence that this process has been and continues to be at work;

- _sectoral changes_ need to be economically justified and socially acceptable. Also concerning
the process of sectoral change there is clear evidence that it is going on strongly. Progress in
the five key areas identified by the Essen European Council, especially the re-direction of
labour market policies from passive income support to more active measures, such as reforms
and strengthening of education and training systems, are underway and will be instrumental in
supporting such processes of change, while cushioning the possible adverse social costs;

 - and, above all, the rare _of growth_ must be high enough to maintain a positive balance between
job creation and job destruction across sectors. If this is the case, this process will give an
important contribution to the achievement of the employment targets of the Union. At present
the growth condition is not fulfilled, underlining the need for a firm and credible implementation
of the policies agreed upon in the Broad Economic Policy Guidelines.

**6.3.96**

62

newly created competitive and productivity potential must be exploited by effective

high rates of growth. If the latter is not the case, efforts targeted at the labour market

will lead to frustration amongst the higher skilled groups while human capital

continues to be destroyed by long-term unemployment.

**(iii)** _**To increase the employment-content of growth —**_ **The achievement of a higher**

labour content of growth essentially means that more jobs will be created for a given

growth rate of GDP. Such an outcome implies, in statistical terms, that the growth of

the overall apparent productivity of labour will become slower. It is self-evident, of

course, that this outcome should not be achieved by negatively influencing productivity

at the firm or sector level. Theoretically, the employment-content of growth may be

increased by a macroeconomic evolution of _relative factor prices_ which favours the

use of labour with respect to capital. Such a development of relative factor prices

stimulates in the first place, via increased profitability, the traditional growth process

driven by capacity-enhancing and employment-creating investment. Yet, this is likely

to take a considerable time to have a noticeable impact on the employment-content of

growth.

Apart from this macroeconomic substitution process, increasing the employment
content of growth rests essentially on a widening of the wage scale and changes in the

field of working time and work organisation. In the European social model the first

option can only be realised to a limited extent by reducing net wage income at the

lower end of the wage scale (see above). A more promising way is by lowering non
wage labour costs for this category. The second approach of a higher flexibility in

working time arrangements — which can be combined in- some cases with a reduction

in working time ~ if tailored to the specific needs of enterprises and individuals, will

achieve a better utilisation of fixed capital and stimulate both new jobs and higher

participation in the labour market. In addition to these two approaches, the promotion

of local and regional initiatives, for example in the fields of social services could

contribute considerably to an increase in the labour-content of growth. This also

applies to environmental protection industries and services, where job creation has

been much higher than in the rest of the economy.

There are thus ways to achieve a higher labour content of growth without calling into

question fundamental social values. In implementing these measures, caution must be

exercised to ensure that they are neutral in terms of costs and government budgets.

Under these assumptions, it is clear that the introduction of these measures has

substantial employment potential. They are used to varying degrees in the Member

States. However, the scale of the measures currently taken is still too small to ensure

significant results at the Community level.

**6.3.96**

**-63**

_**Box 7 : The Community in the world economy**_

The world economy is becoming increasingly "globalised". Trade integration among industrialised
countries continues to rise and emerging economies in Asia and in Central and Eastern Europe
are becoming increasingly important trading partners. In addition, international capital flows have
become more mobile and both financial and foreign direct investment flows have risen markedly
(although gross flows have risen strongly, this does not in general apply to _net_ capital flows, as
mirrored in current account balances). The globalisation of markets has been driven by progress
in transportation and communication technology, libéralisation of trade and investment, and by
changes in enterprise organization and strategy [6] .

Table B7.1 These developments play an important

Growth of trade and GDP role for the Community economy.

(annual percentage change) Currently, extra-EC exports of goods and

1970-79 1980-89 1990-95 services account for about 10 per cent of

World Trade [3] ) 7 4 [1] / 2 6 Community output (EUR15). The share in

World GDP 4 3 [1] / 2 _TA_ GDP has increased only modestly over

EC GDP 3.4 2.2 1.7 the last two decades, but since prices on

a) Average of exports and imports of goods internationally traded products bave risen

slower than the overall price level, this
masks the fact that international trade has expanded at a considerably higher pace in volume
terms than overall output growth.

Table B7.1

Growth of trade and GDP

(annual percentage change)

1990-95

1970-79

1980-89

World Trade [3] )

7

4 [1] / 2
3 [1] / 2

2.2

6

World GDP

4

_TA_

EC GDP 3.4 2.2 1.7

a) Average of exports and imports of goods

EC GDP

3.4

The Community is a major participant in world trade. Table B7.2 shows that the Community's
share in world merchandise exports (excluding intra-EC trade) remains high at 23 per cent, but

Table B7.2 since the early 1970s, this share has

declined somewhat. This fall is to some

Shares in world trade (goods) [3] )

(per cent) extent explained by a comparatively low

share of Community exports in strong
1972-74 1982-84 1992-94

demand, high-technology sectors relative

EUR12 25.3 23.2 23.5

to the US and Japan (26 per cent of total

US 19.0 17.6 18.4

exports in the EC versus 30 per cent in the

Japan 10.6 12.5 14.2

US and 35 per cent in Japan [7] ). In

DAE [b] ) 5.6 10.9 15.1

addition, the Community has a

World 100.0 100.0 100.0

comparatively low share of exports

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

directed towards markets which have been

b) Dynamic Asian Economies

growing fast, partly due to geographical
factors. For example, exports to Japan, the NICs and China, where import growth rates would
appear to be particularly promising over the medium term, represent only 14 per cent of extra-EC
exports, against 23 per cent in the US and 27 per cent in Japan [7] . However, the Community is
well placed to benefit from the expected strong growth of trade with Central and Eastern
European countries (CEEC) in coming years. In 1994, around 9 per cent of extra-EC exports
(EUR12) were directed towards CEEC and the former Soviet Union, and such exports expanded
by around 15 to 20 per cent per year in 1994-95 {in value terms).

Table B7.2

Shares in world trade (goods) [3] )

(per cent)

1972-74

1982-84

1992-94

EUR12

25.3

19.0

10.6

23.5

18.4

14.2

15.1

US

Japan

DAE [b] )

World

5.6

23.2

17.6

12.5

10.9

100.0

100.0

World 100.0 100.0 100.0

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

b) Dynamic Asian Economies

6 It is worth recalling that internationalisation of the economies, as measured by the share of trade in overall
GDP, for many countries is no greater today than before 1914 during the period of liberal trade and fixed
exchange rates under the gold standard. In a similar vein, capital mobility, in terms of net flows, do not
appear to be higher today than it was at that time.
7 "European Competitiveness in the Triad", Note for the attention of the EPC, Commission services 1995.

**6.3.96**

**64-**

Table B6.3

Foreign direct investment flows, EUR12
(billion ECU)

1993

21.0

16.0

9.0

1.7

21.9

13.4

10.2

-1.2

1.8

2.4

Increased trade has been paralleled by
increased foreign direct investment, in the
second half of the 1980's there was a

marked rise in both inward and outgoing
FDl for the Community. Foreign
investment in the EC rose vigorously as
foreign investors sought to prepare for the
internal market, and the Community's net
outflow of FDl was substantially reduced.
From 1989 to 1993, the latest year for
which data are available, both inward and
outgoing FDl flows fell back somewhat
under the impact of the economic
slowdown, but the level remained
relatively high in a historical perspective.
FDl flows were largely _m_ balance for the
Community (EUR12) as a whole in 1993.

1989

27.9

23.0

9.8

4.4

33.3

26.8

24.1

0.7

n.a.

n.a.

-5.4

Inward FDl

 - _from OECD_

_- from US_

_- from Japan_

Outward FDl

 - _to OECD_

_-to_ _US_

_- to Japan_

_-to rest of Asia_

_- to CEEC_

1984

6.2

5.0

3.0

0.4

17.4

13.0

11.5

0.3

n.a.

n.a.

-11.2

Net inflow

Net inflow -11.2 -5.4 -0.8

Source: Eurostat. FDl excluding reinvested earnings.

At least until recently, most outward investment flows have been directed towards other
industrialised countries with a secondary role played by investment in low-wage countries. In most
sectors outward FDl takes place mainly to gain access to local markets for goods and services.
Services sectors - in many of which firms are required to have a physical presence in the local
market — account for a share of outward FDl almost as large as the manufacturing sector.
Outward FDl in low-wage countries represent only a marginal, though growing fraction of
domestic investment in the EC.

While there is broad agreement that the Community economy, as well as its partners, stand to
gain in overall terms from increased international integration, there remains a concern that
particular groups within the Community may loose out (unless they are, in one way or another
being compensated). In particular, the downward pressure on low-skilled wages and/or the rising
unemployment among low-skilled labour in most European countries has been attributed to the
increased competition from low-wage countries. However, it is very difficult to separate the
effects of increased international trade from the effects of technological changes which also
appears to have reduced demand for unskilled labour. Recent studies have not been able to offer
conclusive evidence on the magnitude of these effects. One recent review of the available
evidence has concluded that competition from low-wage economies has had a negative impact on
EC employment in some sectors, but that it is not particularly large. It may well be off-set by
rising employment in other sectors. Trade with developed economies has in general had larger
positive and/or negative effects. In the EU, with the exception of the UK, rising import penetration
from low-wage competitors has resulted in falling employment among low-skilled labour, whereas
in the US and the UK, it has resulted in lower wages for manual labour.

For the Community, active participation in the globalisation process is an essential means of
achieving a continued improvement in living standards as well as better overall job opportunities.
However, in order to reap the full benefits of such international integration, rigorous and extensive
action is called for in the Community to facilitate structural adjustments as well as retraining
efforts.

6.3.96

-65

**(iv)** _**To generate environmentally sustainable economic growth**_ **~** **It is, by now,**

increasingly recognized that there is no simple linear relationship between economic

growth and pressures on the environment. Although an increase in the production of

goods and services would _a priori_ lead to an increase in resource use and pollution,

countervailing forces - like technical progress, structural change and increasing

preferences for a clean environment - frequently tend to compensate for this increase.

One can therefore say, provided that an appropriate policy framework is put in place,

that there is no inherent conflict between economic development and the environment.

In fact, in the long run, economic prosperity is likely to depend on a healthy

environment.

One of the main conditions for a harmonious development of economic activity and the

environment is, in line with the polluter pays principle, that market participants receive

the right price signals. Only if market prices reflect not only private but also

environmental costs will it be possible to reach a path of environmentally sustainable

economic growth.

Although it has to be stressed that environmental policies should be pursued in their

own right, environmental policies can make a positive contribution to employment

creation. The main channel for employment gains to occur from environmental

policies involves the use of revenues from taxes, which are introduced for

environmental purposes, to* compensate for reductions in social charges levied on

essentially low-paid labour. Caution has to be applied both with respect to the size of

these potential employment gains from such tax reform and with respect to the specific

conditions that have to be fulfilled for reaping any such benefits. Overall, most of the

available evidence suggests that well devised environmental policies could have

positive employment effects, but that these are likely to be very moderate and will

certainly not offer a complete solution to the present European unemployment

problem. The energy sector can also assist economic growth and employment by

becoming more competitive. The achievement of a single energy market through the

integration of the gas and electricity sectors is the primary requirement in this respect.

Active labour market and education policies can improve the efficiency of the labour

market by matching demand with supply of labour. In addition, by concentrating efforts in

terms of enhancing the employability of workers, in particular for those groups trapped in

the hard core of structural unemployment, structural reforms act to address some of the

key factors contributing to social exclusion. These policies have therefore an important

social dimension as they contribute to maintaining and reinforcing cohesion and social

consensus in the Union.

**6.3.96**

66

An unprecedented pace of technological change, the emergence of new producers of

traditional products and an acceleration in the process of globalisation are leading to fiercer

competition in world-wide as well as domestic markets. This is, in turn, provoking

fundamental sectoral, enterprise and skills-based changes in economies. The latter are

moving swiftly towards a diversified, knowledge-based, pattern of production of goods and

services with companies being organised in a less hierarchical and more decentralised

manner leading to the generation of increasing opportunities for high-skilled jobs linked to

the greater complexity of operations. While new opportunities are undoubtedly flowing

from this process of structural change, the side-effect is that it also demands deep-seated

changes not only in the work organisation but also in the skill levels needed.

This process of globalisation should not, however, be seen as a negative phenomenon since

it ultimately generates a more efficient, world-wide, allocation of resources. It should also

be stressed that the increased competition that globalisation inevitably brings should not be

met by inappropriate calls for protectionist measures or for drastic cuts in wage levels. It

should however be confronted by policies aimed at enhancing the Community's natural

comparative advantages particularly in terms of having a highly skilled, highly educated,

workforce. There is a clear link extending from multilateral trade liberalisation and

increased market access for Community producers in third countries to better growth and

employment opportunities in the Community. The Commission has recently set out a
strategy for ensuring improved market access [8], using to the full the WTO trade disciplines

and rights while pursuing additional liberalisation efforts.

In conclusion therefore, it is clear that macroeconomic and structural policies should be

applied in parallel in a climate of enhanced confidence and increased social consensus. This
view is shared by the European Social Partners [9] . Without growth, structural policies are

more difficult to implement and may even have undesired effects. Thus the policies

designed to improve the operation of the markets in goods and services could result in

increases in overall productivity without net job creation. Similarly, labour market policies

can, for the most part, reach their objectives only if growth ensures that a sufficient number

of actual jobs is created and provides the necessary financing capacity. At the same time,

improvements in competitiveness and in the operation of the labour market are necessary to

8 "The Global Challenge of International Trade: A Market Access Strategy for the European Union",

Communication from the Commission 1996, COM(96) 53.
9 "The Social Partners guidelines for turning recovery into a sustained and job-creating growth process".

Joint Opinion elaborated by the Macroeconomic Group of the Social Dialogue, 16 May 1995.

**6.3.96**

67

maintain sustained growth in the medium term by limiting the risks of inflationary strains in

producer prices and wages.

**2.5.2.** **Initiatives taken in 1995 to improve the functioning of product**
**markets**

Implementing reforms aimed at strengthening the forces contributing to endogenous

growth and at enhancing the dynamism and competitiveness of the Community economies

has been reiterated with good reason in Community documents over the years. In this

regard, the importance of _**fully exploiting the opportunities provided by the internal**_

_market_ has been particularly stressed. The Madrid European Council of December 1995,

reaffirmed the importance it attaches to the completion of this, already highly successful,

initiative by highlighting the need to introduce greater competition in many sectors in order

to improve competitiveness with a view to job creation. With regard to Member States'

implementation of Internal Market directives in this area, the global rate of transposition of

such directives, as of 21 November 1995, was 93.2 percent with national performances

ranging from rates of transposition of 87.8 percent to 99.1 percent. Problems in relation

to transposition (i.e. delays in transposition, partial transposition, non-conformity) are

being experienced in the following sectors: public procurement, insurance, free movement

of people, new technologies and services/audio-visual, and intellectual and industrial

property rights.

Efforts to ensure better conditions for the effective operation and _competitiveness of_

_**European ^enterprises**_ continued in 1995. In July 1995 the _**independent expert group on**_

_**legislative and administrative simplification**_ submitted its final report and the Commission

agreed to present concrete measures to ensure that such a simplification process occurs. In

this regard, the Madrid European Council referred to the Commission report on the

independent experts group study and called upon the Commission to table its new

proposals for the consolidation of Community law and asked the Council to act as soon as

possible in this area. The Commission's action programme for industrial competitiveness

was given Council support and the Commission nominated the _Competitiveness Advisory_

_Group,_ presided over by Mr. Ciampi, and consisting of high-level experts and industrialists.

This latter group presented its report on competitiveness to the Madrid European Council

with the latter instructing the Council to examine its recommendations.

As regards the _Information_ _Society,_ the Commission presented important initiatives in the

area of telecommunications in 1995. The objective of these initiatives, which essentially

**6.3.96**

68

concerned infrastructures and the provision of universal services, was to ensure a greater

liberalisation of the regulatory framework.

In relation to the key area of _SMEs,_ the Madrid European Council took note of the

Commission report on the role played by the latter as a source of jobs, growth and

competitiveness. The Commission report stressed the need to simplify the administrative

formalities impacting on SMEs, to remove obstacles affecting their operation in the internal

market, to improve their financial environment and to ensure better access for SMEs to

information, training and research. The European Council urged the Commission to act on

their report as quickly as possible in order to put into practice its recommendations. In

response to this request, the Commission expects to approve a new multi-annual

programme for SMEs in March and submit it to the Council. Also the next integrated

programme for SMEs is under preparation.

With regard to the _**Trans-European networks**_ _(TENs)_ some progress was made in 1995.

In all areas ~ transport, telecommunications and energy ~ examination of the various

proposals progressed. As regards the energy sector, a common position on the guidelines

was adopted by the Council in June. The aim was twofold: to advance the development of

the networks in general and to facilitate the realisation of the priority projects identified by

the Essen European Council in December 1994. In the autumn, the Council formally

adopted the Financial Regulation in relation to the financing of the TENs and under its

provisions the Commission was able to decide, in December, on the co-financing of a

number of feasibility studies in the area of energy. The Madrid European Council

confirmed, the essential role of TENs in enhancing competitiveness, job creation and the

cohesion of the Union. It welcomed the progress recently achieved in this area and called

upon the Council and the Parliament to complete the legislative framework rapidly. It

urged Member States to give top priority to the effective implementation of projects and

especially those identified as being of special importance. Lastly, the European Council

requested the EcoFin Council to adopt, on a proposal from the Commission, the necessary

decisions to complement the financial resources currently available for these networks.

This proposal is expected to be submitted to the Council soon.

The _Structural_ _**and**_ _Cohesion Funds_ continued to make an important contribution to the

balanced development of the EU. In fact, ECU 22 billion was spent in the weaker regions

under the _Structural Funds,_ which concentrated on investment in productive capacity,

physical infrastructure and human capital. Over ECU 2 billion was spent in the poorer

**6.3.96**

-69

countries under the _Cohesion Funds,_ divided between transport and environmental

measures.

Finally, on the subject of the _**environment,**_ the clear and decisive role which the

Community is playing on the international stage in terms of environmental protection was

welcomed by the Madrid European Council. With a view to putting economically efficient

measures in place to help the Community fulfil its international commitments to stabilise

emissions of greenhouse gases, the Commission presented a revised C02/energy tax draft

Directive in May 1995. This draft Directive contained guidelines that will enable Member

States to introduce C02/energy taxes at the national level which are compatible with

Community legislation. Fair and efficient pricing approaches, also in other areas, are

necessary to bring the Community on a sustaninable development path. In December 1995,

the Commission published a Green Paper aimed at launching a broad discussion on policy

options for internalising the external costs of transport. In addition, financial incentives for

demonstration projects promoting sustainable production techniques, land use development

and other measures will be made available once the Council Regulation for LIFE II is

adopted. Furthermore, the Commission announced in 1995 a pilot project on "Growth and

Environment" to offer financial support, in the form of loan guarantees, to small firms

carrying out investments that either contribute to energy savings or otherwise bring

environmental improvements. Finally, the Commission issued, in December 1995, a White

Paper on an _**Energy Policy for the European Union,**_ highlighting market integration as the

central, determining factor in the Community energy policy. The contribution that the

energy sector can make towards enhancing the competitiveness of the European economy

is to seek, greater efficiency in the organisation of energy systems and more effective

delivery of energy services. The White Paper proposes the building up of a cooperative

approach by establishing a framework which supports dialogue, transparency and shared

analysis of energy policy issues leading to the identification of common energy policy

objectives.

**2.5.3.** **Labour market reforms: More needs to be done**

The creation of jobs and the fight against unemployment constitutes the primary economic

and social goal of the European Community. In this regard, it is encouraging that, for the

first time, the Community has a common employment strategy, based on a combination of a

stability oriented macroeconomic policy, aimed at engendering higher rates of economic

growth, and structural adjustment. Structural adjustment initiatives involve both

continuing improvements in the functioning of product and service markets, along the lines

**6.3.96**

**-70**

covered in 2.5.2., and labour market policies aimed at improving skills and competencies as

well as promoting a higher degree of overall flexibility which is crucial for strengthening the

economy's growth capacity.

While ascertaining the nature of the problem and outlining the correct policy approach to

be adopted is an important element in terms of the overall solution, the greatest challenge is

at the implementation phase. Following the broad employment strategy agreed by the

_European Council in Essen_ in December 1994, Member States have started to renew and

enhance their existing employment policies along the lines of the five broad objectives

agreed at the latter summit and fleshed out at Cannes in June 1995.

Since the launching of the Essen strategy a wide range of measures aimed at upgrading the

skills of low-skilled workers, at reducing the overall costs of labour, at improving the

efficiency of active labour market policies and at facilitating higher labour mobility have

been introduced, to varying degrees, in a large number of Member States. A first

assessment of the efforts undertaken was made by the Commission, the EcoFin Council,

the Labour and Social Affairs Council and the Social Partners in preparation for the Madrid

European Council in December 1995. These various reports highlighted that efforts made

so far needed to be commended and recognised. Nevertheless, they stressed that labour

market ^reforms would have to be pushed forward if a decisive improvement in the

Community's employment situation was to be realised. With this in mind a number of areas

for reform were singled out as needing to be pursued or strengthened at national level.

These recommendations were taken on board in the joint report submitted by the Council

(EcoFin and Labour and Social Affairs) and the Commission to the _Madrid European_

_Council_ which approved the report and reaffirmed its determination to give the objective

of job creation maximum priority in the European Union in the coming years. It expressed

its pleasure with the way in which the Essen-strategy, based on close co-operation between

all the interested parties, had been implemented in practice in 1995 and emphasised that this

strategy would continue to provide the framework for Member States' multiannual

programmes and for the development of their employment policy. Concretely, Member

States were urged to prioritise the following areas of action in their multiannual

employment programmes, applying the latter particularly to certain disadvantaged

categories such as first time job-seekers, the long-term unemployed and unemployed

women:

  - additional training programmes, especially for the unemployed;

**6.3.96**

71

  - making business strategies more flexible in areas such as the organisation of work

and of working time;

  - ensuring a pattern of non-wage labour costs which are appropriate to unemployment
reducing objectives;

  - continuing the current wage restraint by linking it to productivity, as an essential

element in promoting the intensive use of the factor of production labour;

  - obtaining the maximum level of efficiency in social protection systems so that, while

maintaining where possible the level attained, they never act as a disincentive to

seeking work;

  - pressing for adaptation of passive labour market policies, which act to protect the

unemployed, into active job-creation measures;

  - substantially improving the machinery for information-sharing between those

providing and those seeking employment;

  - promoting local employment initiatives.

Finally, the Madrid Council, requested the Council (EcoFin and Labour and Social Affairs)

and the Commission to continuously monitor and assess Member States' progress in

relation to the application of their multiannual employment programmes and to submit a

second joint annual report for its December 1996 meeting. In this way the European

Council reaffirmed its determination to ensure the continued success of its job creation

strategy centred on the need to ensure a more employment-creating growth pattern backed

up by structural reforms aimed at eliminating existing rigidities and achieving a more

efficient operation of national and Community labour markets.

**6.3.96**

**- 7 2 -**

**PART B**

**ECONOMIC SITUATION AND POLICY ISSUES**

**IN THE INDIVIDUAL MEMBER STATES**

6.3.1996

**73**

BELGIUM

_**Weak**_ _**consumer expenditure slows down growth**_

In 1995, economic growth in Belgium is estimated at 1.9%, approximately _VA_ of a

percentage point lower than in 1994. After strong growth in economic activity in the last

quarter of 1994 and the first of 1995, the level of economic activity decreased in the

second and third quarters of 1995. The unemployment rate (Eurostat definition) rose in

the whole year of 1995, from 10.0% in 1994 to 10.2%. In 1995, Belgium made

significant progress towards nominal convergence: ©inflation fell to 114%, remaining

amongst the lowest in the Union, and; (ii) the general government budget deficit declined

from 5.3% of GDP in 1994 to an estimated 4 [,] / 2 %.

**TaUel**

**Belgium: Macroeconomic** **performance**

**1586-90** **1991-93** **1994** **1995**

**GDP growth rate**
**(%** **change)**

**Total domestic** **demand**

_**(%**_ **change)**

**Employment** **(%** **change)**

**Unemployment** **rate** **(%)**

**Inflation** **(%** **change)**

**Balance of current account**

_**(%**_ **of GDP)**

In 1995 real GDP decelerated

from 2.2% in 1994 to 1.9%. Key

factors in this have been the

weakness in private consumption,

which grew by just 1.4% in real

terms in 1995 (virtually the same

rate as in the previous year), and

an estimated neutral contribution

of stocks to economic growth (in

1994 changes in stocks had given

a positive net contribution of

0.3%). Although the household

saving rate fell in both 1994 and

**1.9 ***

_**15**_ _*_

**04**

**102**

**1.5**

5J0

##### **_•A_**

3J0

3 ^

**1.1**

**8.7**

**23**

**14**

**0.8**

**0.8**

**-0.6**

**7J6**

_25_

**2J6**

**22**

**14**

**-0.7**

**10.0**

**3J0**

**43**

**JL**
**For definitions, see Table 2**

_Source: Commission's_ _**November**_ _**J**_ _**995 forecasts**_

*** Taking** into **account latest** **information**

1995, it remains at about 19% of disposable income, which is a relatively high level by

European standards. The lack of dynamism of private consumption mainly reflects three

factors: (i) slow growth in disposable income; (ii) unfavourable prospects for the labour

market, and; (iii) the uncertainty surrounding additional fiscal tightening measures,

together with the impact of the planned reform of the Social Security system.

Investment expenditure, particularly in the manufacturing sector, played a significant role

in fostering economic growth in 1995. Investment of enterprises grew by about 5% in

1995, reflecting high capacity utilisation rates in the manufacturing industry since 1994,

together with improved profitability. Residential construction is estimated to have

increased by about 1% in 1995. The growth rate of exports in 1995 remained at around

6.3.1996

**- 7 4 -**

the same level as in the previous year, notwithstanding the slowdown in foreign demand

and the effective real appreciation of the Belgian franc. Wage moderation resulting from

the real wage freeze in the private sector and the adoption of the so-called "health index"

to adjust wages should improve competitiveness.

_**Nominal convergence is progressing**_

The excellent monetary stability record of Belgium in recent years continued in 1995.

The inflation rate (measured by the CPI) declined from 2.4% in 1994 to about 114% in

1995, which is amongst the lowest rates in the Union. In 1996, inflation is projected to

remain at a low level.

Tabid

Belgium: Economic policy indicators

1986-90 1991-93 **1994** **1995**

Money growth

_(%_ change)

Gove rnme nt budge t balance
(% of GDP)

Gross gove rnme nt debt

(% of GDP)

Noniruri"wages per head

(% change)

Real wage s per head

(% change)

-4.8

-53 **-45**

**-72**

131.4

3.8

15

9.1

-6.8

5.7

3.1

133 D 136.0* 133.8 

_**49**_

_IX_

**2.7**

1.1

_Source:_ _Commission's_ _November_ _1995_ _forecasts_

 - Taking into account latest information

Definitions

Unemployment rate: harmonized Eurostat de finition, excluding Austria, for whic
OECD data is used.

Inflation rate : private consumption deflator.
Money growth:broad money (M2/M3).
Gove m me nt budge t balance : net lending/borrowing of **general gove** rnme **nt.**
Nominal wage s: compensation of employees per head.
Real wages: nominal wages per head deflated by private consumption prices.

In 1995, significant progress

was registered in reducing fiscal

imbalances. The budget deficit

fell from 5.3% of GDP in 1994

to an estimated 4Î4%, mainly

reflecting the reduction in real

primary spending of around

_VA%,_ together with lower

interest charges due both to

lower interest rates and

improved debt management

techniques. The general

government gross debt ratio

declined for a second

consecutive year, attaining

133.8% of GDP in 1995

(137.9% in 1993).

These two measures were adopted in the framework of the "Global Plan" in November 1993. The
"health-index" is the official CPI excluding tobacco, and alcohol products, petrol and diesel.
Effectively, the "health-index" excludes from the CPI those products which are more directly affected
by (increases in) excise taxation, thereby in practice partly severing the link between price increases
and automatic wage indexation.

6.3.1996

                             - 7 5 

Since the introduction of the convergence programme in 1992, the government has

adopted several fiscal packages. The 1996 Federal budget is the most recent set of

measures, aiming to reduce the public deficit to 3% of GDP in 1996, with total savings

amounting to BFR118 billion (or 1.4% of GDP), of which about a third are

non-recurrent measures. The general government deficit is projected to decrease from

4.5% in 1995 to nearly 3% in 1996.

Since the end of 1993, the Belgian franc has been amongst the strongest currencies of the

EMS. In the course of 1995, the short-term interest rate differential against the DM has

been progressively reduced and disappeared since the end of 1995. The long-term

interest rate differential against the DM has also narrowed substantially. Interest rate

developments reflect to a large extent an improved assessment of Belgium's economic

fundamentals, and the enhanced credibility attached to the process of fiscal consohdation.

_**Labour market imbalances remain**_

Since 1993, Belgium has registered a significant surplus on the current account of the

balance payments of over 4% of GDP. However, Belgium has lost price-competitiveness

since 1990; between 1990 and 1995, relative unit labour costs expressed in a common

currency deteriorated by nearly 13% against a group of 19 competitor countries. Given

the appreciation trend of the nominal effective exchange rate associated with the 'franc

fort" policy, Belgium needs to keep the rise in its production costs below the average of

its trading partners. This can be achieved either: (i) by having relatively lower increases

in labour costs expressed in local currency, and/or, (ii) by achieving higher productivity

gains.

Given the insufficient degree of wage moderation in the first half of the 1990s, Belgian

enterprises are forced to increase labour productivity in order to remain competitive,

adopting capital intensive techniques of production which are not conducive to job

creation.

Between 1985 and 1995, output increased by about 25%, whereas employment rose by

just 314%. There is a window of opportunity to reassess labour market policies in 1996,

given that the current real wage freeze comes to an end at the beginning of 1997, and

6.3.1996

-76

there seems to exist a wide social and political consensus on the need to revise the law

on the "safeguard of competitiveness" .

Labour market

**Chart** **1** **- Belgium**

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

**labour force** **as** **% of** **population** **1S-64** **years** **Difference between** **EUR3** **and B** **Difference in** **percentage points** relatively low in

**(right-hand «ale)** Belgium, and the

average duration of

unemployment spells

high. This suggests

that there might be a

correlation between

**1970** **1972** **1974** **1976** **1978** **1980** **1982** **1984** **1986** **1988** **1990** **1992** **1994**

*** Unified Germany from 1991 onwards** the relatively generous

_**Source:**_ **Commission services** eUgibility rules

governing the various unemployment and career interruption schemes and the low degree

of labour market participation. Measures aiming to reduce the attractiveness of

non-participation could pay out a substantial reward in the medium to long term,

reducing the imbalances in the labour market and easing the financing of Social Security .

**Chart** **1** **- Belgium**

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

**labour force** **as** **% of** **population** **1S-64** **years** **Difference in** **percentage points**

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

**1970** **1972** **1974** **1976** **1978** **1980** **1982** **1984** **1986** **1988** **1990** **1992** **1994**

*** Unified Germany from 1991 onwards**

_**Source:**_ **Commission services**

The 1"996 budget included a number of measures to stimulate employment creation,

namely measures favouring work-sharing, temporary reductions in Social Security

contributions for low-paid jobs, and measures targeted to some problem groups (e.g.

young unemployed, long-term unemployed, etc.).

Belgium has achieved significant progress in recent years as regards nominal

convergence. However, over the same period, important labour market imbalances have

been building up, which require additional corrective measures to improve the

functioning of the labour market and allow for a substantial reduction of unemployment

in the medium-term.

The law to "safeguard competitiveness" (31.1.1989) established a number of objective criteria to
assess competitiveness developments and take appropriate corrective.measures.

6.3.1996

**77-**

DENMARK

_**Strong growth, supported by a balanced economic policy**_

The recovery in Denmark started already in 1993, somewhat ahead of the other

continental Member States, and strengthened in the following year in which output

recorded a strong 4.4% rate of growth. 1995 was altogether again a year of good growth

and continued decline of unemployment. During the year, however, the cyclical pattern

became more similar to other European countries: growth was strong in the first months

of 1995, but has weakened since then.

As in the majority of the other Member States, Danish fundamentals are sound and there

is reason to believe that the current growth slowdown is a temporary one. Profitability is

good, long and short-term interest rates are low and consumer confidence remains at a

high level, all of which would point to renewed growth momentum.

Private consumption remained subdued in the second half of 1995. However, this should

be seen on the background of very strong growth in 1994, and of relatively high real

long-term interest rates which have stimulated savings.

Investment in equipment

**Tahlel**
**Denmark: Macroeconomic performance** picked up strongly in 1995,

**1986-90** **1991-93** **1994** **1995** mainly due to the high degree

GDP growth rate 1.4 1.2 4.4 of capacity utilisation in
(% change)

industry and the good

Total domestic demand 0.4 0.0 5.2 4.5
(% change) profitability in manufacturing.

Employment (% change) 0.9 -1.1 -0.2 2.1 Construction, on the other

Unemployment rate (%) 6.4 9.2 8.2 6.7 hand, increased only modestly,

Inflation (% change) 3.7 1.8 1.0 2.0

given the high level of interest

Balance of current account -2.1 2.2 2.0 **1.5**
(% of GDP) rates earlier in the year.

For definitions, see Table 2 for **Belgium** Indicators for construction in
_Source: Commission's November 1995 forecasts_ late 1995 suggest a moderate

pick-up. As previous investment has increased production capacity, and as incoming

orders appear to have been stagnating, new investment in equipment may not have

increased further in the second half of 1995.

**Tahlel**

**Denmark: Macroeconomic performance**

**1986-90** **1991-93** **1994** **1995**

GDP growth rate
(% change)

1.4

1.2

4.4

Total domestic demand

(% change)

5.2

4.5

0.4

0.0

Employment (% change)

Unemployment rate (%)

2.2

2.1

6.7

2.0

**1.5**

-1.1

9.2

Inflation (% change)

1.8

-0.2

8.2

1.0

2.0

Balance of current account

(% of GDP)

0.9

6.4

3.7

-2.1

For definitions, see Table 2 for **Belgium**

_Source: Commission's November 1995 forecasts_

**6.3.1996**

78

The weakened growth in major

Table 2
Denmark: Economic policy indicators export markets has influenced

| 1986-90 1991-93 1994 Danish exports negatively and

Money growth 6.3 6.8 -5.6 the Danish krone appreciation
(% change)

in the first half of 1995 may

Government budget balance 0.9 **-3.2** -3.8 **-2.0**
(% of GDP) have depressed exports further.

Gross government debt [: ] 60.7 71.3 75.6 73.6 Imports moderated, compared

(% of GDP)

with the double digit growth

Nominal wages per head 5.1 **3.4** **3.2** **3.3**
(% change) rate of 1994, and the current

Real wages per head 1.4 1.6 **2.2** account surplus remained solid.
(% change)
## 1 Reduced interest payments on

For definitions, see Table 2 for Belgium

foreign debt due to declining

_Source: Commission's November 1995 forecasts_

'Government deposits with the central bank, government holdings of foreign debt and lower interest
non-government bonds and public enterprise related debt amounted to rates contributed to this. The
some 23% of GDP in 1994

prospects for Danish exports

next year could be positively influenced by greater exchange rate stability while on the

other hand growth prospects for export markets have worsened recently.

Table 2
Denmark: Economic policy indicators

| 1986-90 1991-93

Money growth

(% change)

6.3

6.8

1994

-5.6

Government budget balance

(% of GDP)

**-2.0**

-3.8

0.9

**-3.2**

Gross government debt [: ]

73.6

60.7

71.3

75.6

(% of GDP)

**3.2**

**3.4**

Nominal wages per head

(% change)

5.1

Nominal wages per head 5.1 **3.4** **3.2** **3.3**

(% change)

Real wages per head 1.4 1.6 **2.2**
(% change)
## **1**

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995 forecasts_

**2.2**

Real wages per head
(% change)

1.4

1.6

'Government deposits with the central bank, government holdings of
non-government bonds and public enterprise related debt amounted to

some 23% of GDP in 1994

Despite strong growth and a sharp decrease in registered unemployment Danish inflation

remains subdued. For 1995, consumer prices increased by 2%. The favourable inflation

Chart 1 - Denmark

Discount **and repo rates in 1994 and** 1995

—Discount rate

—Repo rate

**J** **i** **i** **i** **i** **i** **i** **'** **'** **'** **'** **»** **'** **i** **i** **'** **i** **i** **i** **i** **i** **i** **i** **i**

**J** **F M A M J** **J** **`O`** **`N`** **`D`** **`J`** **`F`** **`M`** **`A`** **`.`** **`M`** **`J`** **`J`** **`A`** **`S`** **`O`** **`N`** **`D`** **`J`**
**1994** **`1995`** **`1996`**

_**Source:**_ **Commission services**

performance may in part

be explained by the

appreciation of the

Danish krone. Also, it

seems that Danish wage

settlements are adjusting

to low Danish consumer

price increases, thus

reducing the risks of

unfavourable wage/price

developments.

While fiscal policy is being tightened, short and long-term interest rates have been

decreasing, in line with those of most other countries (Chart 1). Key interest rates were

increased in the Spring of 1995, as the Danish krone came under pressure. Since then,

the krone along with the other core currencies has been appreciating against most other

currencies and the monetary authorities, following international developments, decreased

6.3.1996

-79

the discount rate and other key interest rates. Long-term rates have also been decreasing

in 1995.

Registered unemployment in Denmark had been increasing from 1987 onwards. The

situation changed in 1994, when unemployment started decreasing. The favourable

development in unemployment continued in 1995, as employment increased faster than

the labour force and as active labour market measures (leave schemes, early retirement

schemes and special job training or education) brought down registered unemployment

further. The improved employment situation has not led to any sharp wage increases

although the registered unemployment rate is now approaching the level which could

lead to some inflationary pressures.

_**Continued fiscal tightening and structural reform**_

After having fought the 1992/93 recession with a temporary fiscal expansion, the Danish

government has been tightening fiscal policy since 1995. This followed i.a. from the 1993

tax reform which is implemented over the period 19.94-98, personal income taxes being

to some extent replaced by environmental taxes. Discretionary budgetary measures

together with strong automatic stabihsers have markedly improved public finances. In

1995, general government net borrowing of about 2% of GDP is estimated and the gross

public debt ratio is likely to have continued its downward trend. The near-term outlook

is for a continued reduction of the deficit and debt.

Structural policies, not least in view of the persisting high unemployment, remain very

important. Throughout 1995, increased efforts were made to improve education and

increase labour mobility in order to prevent labour market tensions. Further structural

improvements are laid down in the 1996 budget, aiming at preventing youth

unemployment, tightening unemployment benefit eligibility rules, improving state

supported jobs and vocational training and creating jobs for elderly or handicapped

persons. Also, the maximum period for which unemployment benefits can be received is

reduced from 7 to 5 years. These highly needed structural measures will have full effect

in the coming years.

The fiscal tightening and the continued structural reforms constitute important policy

measures which go in the right direction. However, an increased effort is needed to

ensure a positive macroeconomic development over the medium term, particularly

through increased labour market flexibility and education.

6.3.1996

**80**

**GERMANY**

_**Slow-down in**_ _**the**_ _**pace of the recovery during 1995**_

In 1994, Germany came out of recession with a fairly strong recovery: GDP increased by

2.9%. The upswing was led mainly by buoyant growth in exports and investment,

particularly in construction. The pace of the recovery slowed somewhat in the second

half of 1994 and in a more pronounced way in 1995, so that economic growth reached

about 2% in the latter year, significantly below initial expectations.

One of the main factors behind the deceleration was a gradual loss of drive in investment:

while in the last quarter of 1994 fixed capital formation was still growing by almost 7%

on the year, by the third quarter of 1995 it had fallen below the previous year's levels.

Not only construction, but also equipment investment slowed, despite relatively high

capacity utilisation. Exports, too, gradually decelerated, partly because of a weaker

growth in export markets than had been the case in 1994. By contrast, domestic

consumption, while not particularly dynamic, was on a slow upward path, after having

been rather weak throughout 1994.

**Chart** **1** **- Germany**

**Confidence indicators slide and investment weakens**

% annual change Index 1985 = 100
10 130

_**w**_

Construction

Index 1985 = 100

130

**no**

Manufacturing

% **annual change**

10

_Three_ _month_

_moving_ _average_

80

_Three month moving_ _average_

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

Oequipment investment (right-hand scale)

| 1994 | 1995 |

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

E3construction investment (right-hand scale)

**80 u** **I_J** **i i i i i i i i i** **i_**

_Source :_ Statistisches Bundesamt, Commission services

The cooling down of investment was preceded, at the beginning of the year, by a

worsening of economic sentiment. Confidence in industry, which had reached high levels

6.3.1996

-81

in the preceding recovery, fell off dramatically after January 1995. In the construction

sector, a slowdown had been widely anticipated, mainly owing to the phasing out of

fiscal incentives (Chart 1).

The loss of confidence went

Table 1
Germany: Macroeconomic performance together with renewed

1986-90 1991-93 1994 1995

concern over German

GDP growth rate 2.9 1.9 *
(% change) industrial competitiveness,

Total domestic demand 2.8 1.8  - already negatively affected by
(% change)

the preceding combination of

Employment (% change) -0.7 -0.2  
Unemployment rate (%) 6.7 8.4 8.3 a strong DM and high wage

Inflation (% change) 2.7 2.0 * increases (Chart 2). Tough

Balance of current account ^1.0 -1.3 -0.8  - cost control, restructuring,
(% of GDP)

extensive payroll cuts and

For definitions, see Table 2 for Belgium
_Source: Commission's November 1995 forecasts_ wage moderation were
_*_ Taking into account latest information starting to redress the trend in

1994; but then a revaluation of the DM in the summer of that year, relatively high wage

increases at the beginning of 1995, and finally a further considerable DM appreciation in

March 1995 significantly worsened the situation. By then, the DM's nominal effective
exchange rate had risen 8.3% in twelve months [3] . On the domestic side, tax increases

negatively affected sales prospects.

Table 1

Germany: Macroeconomic performance

1986-90 1991-93 1994 1995

1.9 *

GDP growth rate
(% change)

2.9

1.8 

Total domestic demand

(% change)

2.8

Employment (% change)

Unemployment rate (%)

2.0 *

-0.8 

-0.2 

6.7

-0.7

8.4

2.7

-1.3

8.3

Inflation (% change)

Balance of current account

(% of GDP)

^1.0

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

Chart 2 - Germany

Indicators **of international price competitiveness**

**(Germany compared to 20 industrialised countries)**
**Index 1987 = 100**

**—nominal** **effective** **exchange rate**
**—real** **effective exchange** **rate** **(deflator of** **toul** **exports)**

**J** **i** **i** **i** **i** **i** **'** **•**

**1991** **|**

The deteriorating mood

induced enterprises to

be very cautious in

hiring personnel. In

west Germany,

employment continued

to slide longer after the

beginning of the

upswing than in the

previous recovery.

_**Source:**_ **Commission services**

Overall, employment in

the year 1995 did not show any improvement over 1994: job creation in East Germany,

due to rapid economic convergence, could not fully compensate for the losses in the

3 Effective rate vis-à-vis 18 industrial countries.

6.3.1996

**82**

West. Unemployment gradually increased during the year. Despite weakening consumer

confidence, the saving rate remained more or less unchanged.

By the end of the year, there were few signs of improvement, even if some sectors did

show some indications of a more positive trend in the offing. Nevertheless, the

deceleration observed during 1995 need not continue in the course of 1996. Several

negative factors are set to fall away, or to diminish in importance, so that growth

prospects should gradually improve during the year.

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

TaUe 2

Germany: Economic policy indicators

| 1986-90 1991-93 1994 1995

will stimulate the economy,

just as the increase during

1994 was a factor behind the

slow-down. Nominal short
term interest rates fell by more

than 200 basis points during

1995 and real short-term rates

are currently just above 2%.

There are chances for a further

easing in short-term rates. The

appreciation of the DM seems

to have come to an end, so

that pressure from foreign

competitors should also

subside somewhat.

**2.3**

-3.6

58.8

**3.7**

1.7 *

Money growth

(% change)

Government budget balance

(% of GDP)

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

Real wages per head
_(%_ change)

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995_ _forecasts_
_*_ Taking into account latest information

8.3

**-3.2**

44.6

1.6

-2.6

50.2

**3.2**

0.5

1 Unification Felated debt assumptions by the federal government in 1995
(Treuhand and eastern housing companies), equal to DM235 bn (6.75%
of GDP), are not included.

The Federal Government has acknowledged the current growth pause in its annual

economic report and has reduced its growth expectations for 1996 to _Wz%._ The outlook

assumes that activity will regain momentum in the course of 1996. Nevertheless, since

the weak start to the year renders a higher annual growth performance unlikely, the

government expects total employment to continue to fall and unemployment to rise

further in 1996, to about 10% of the German workforce or almost 4 million.

The labour market situation has prompted the social partners, including the Federal

government, to agree on a pact for employment. The ambitious goal to halve registered

unemployment by the end of the decade was commonly agreed upon. To achieve this

goal, decisive action is necessary to improve the supply-side conditions of the German

6.3.1996

83

economy in the medium term and in its annual economic report the government

presented a 50 point programme for this purpose.

_**East Germany: convergence**_ _**advances,**_ _**but deep-rooted problems persist**_

After having grown markedly in the years before, east German GDP advanced again

strongly by 6% in 1995. Manufacturing output continued to rise even faster, as new or

modernised plants began production, while the boom in construction, where activity had

increased by 21% in 1994, petered out. In 1995, employment increased for the second

consecutive year and unemployment fell again. Yet the latter has been edging higher

since last summer, reflecting decelerating growth and less relief from labour market

policy.

With eastern (nominal) unit labour costs still exceeding the west German level by about

one third, little progress was achieved in 1995 with respect to cost competitivenes. Wage

increases slowed, but productivity gains decelerated also. Factories are more diverse than

elsewhere: some are technologically very advanced, able to cope with western wage

rates, many are less productive, and have difficulties surviving even with lower eastern

wages. One way to tackle this would be relatively low collectively agreed wages, leaving

room Tor wage differentiation by means of a positive wage drift where circumstances

permit.

The very weak eastern competitive position is still evident in various aspects. Although

there is arising number of modern plants, and east German exports to the EU increased

by some 30% in 1995, eastern exports still account for only 2% of the German total,

compared with a share of 11% of GDP. With the current average level of profitability it

will take considerable time to converge to western patterns of distribution. Profits are

still low and enterprises vulnerable to shocks. The region will continue to rely heavily on

western transfers, which currently represent some 4V£% of German GDP.

_**Public finances: no further consolidation in 1995**_

The general government net borrowing requirement amounted to 3.5% of GDP in 1993

and fell to 2.6% in 1994. In early 1995, the deficit was expected to decline further. Since

6.3.1996

**84**

then, however, the deficit perspectives have deteriorated and the preliminary official
borrowing figure for 1995 was 3.6% [4] .

This reversal was mainly due to disappointing revenues. Over and above the

consequences of slower than expected growth in 1995, there were larger than previously

estimated shortfalls in direct taxation linked to several special, mainly temporary factors,

e.g. the impact of the 1993 recession on final tax bills settled last year. Nonetheless, the

total tax to GDP ratio remained at an all time high of 43%% of GDP, reflecting the re
introduction of the 7.5% solidarity surcharge on income taxes.

General government spending accelerated, particularly in social security. Health

expenditures turned out more dynamic than expected and a new long-term care insurance

was introduced. Yet outlays by territorial authorities fell short of initial plans. At the

outset, the execution of the federal budget was delayed, owing to the October 1994

elections, and later, when revenue shortfalls became obvious, spending was handled

restrictively on an ad hoc basis at all government levels. Given quickly rising interest

charges due to debt assumptions, primary non social security spending barely rose in real

terms.

Government debt rose to some 59%» of GDP by the end of 1995. The assumption of

Treuhand and eastern housing companies debts alone accounted for a 6% percentage

points jump in the debt ratio. By now, unification-related liabilities which have partly

been accruing off budget have by and large already been taken over by the federal

government. They have contributed heavily to the rise in the debt ratio from just 41.5%

back in 1991.

4 Figure released early in 1996 by the German authorities. It excludes debt assumptions from
Treuhand and eastern housing companies amounting to 6.75% of GDP.

6.3.1996

85

GREECE

_**Progress in macroeconomic adjustment in 1995**_

Macroeconomic trends in 1995 were marked by two key developments: progress in

disinflation and, continued efforts to redress the fiscal imbalances. At the same time, real

interest rates, while continuing to remain high, have shown some easing tendency and

actual exchange-rate depreciation has been broadly consistent with the monetary policy

objective of the Bank of Greece. In 1996, economic growth is expected to accelerate

underpinned principally by strengthening domestic demand.

Economic activity in Greece started to recover in 1994, reflecting principally the

contribution of an improving external economic environment, while domestic demand

remained weak. Growth accelerated further in 1995. Domestic demand, and particularly

gross fixed investment, began to strengthen, while private consumption remained flat.

Public investment performed quite well, largely supported by Community Structural

Funds. The recovery of domestic activity has also been accompanied by a modest

widening of the deficit in the external accounts.

Growth of private

**Tafclel** consumption spending, at
GreecM-Macroeconomic performance

1.4% in volume terms in

GDP growth rate 1995, continued to remain
(% change) weak, reflecting principally

Total dorrestic demand
| (% change) the modest growth in real

Employment (% change) incomes. Real wages grew

Unemployment rate (%) by 0.5% in 1995, after

Inflation _{%_ change) growing at 1.3% in 1994.

Balance of current account
(% of GDP) However, real disposable

income remained virtually

For definitions, see Table 2 for Belgium
_Source: Commission's November 1995 forecasts_ stagnant in 1995. Important

factors in this development have been the implementation of the 1994 tax bills, which led

to a rise in direct tax revenues, and the decline in interest rates, which limited the growth

of non-labour income. However, private consumption was supported by a fall in the

saving rate, from 18.9% of gross disposable income in 1994 to 17.9%» in 1995. This fall

in the saving rate likely reflects the combined impact of the reduction in real interest rates

and the partial resolution of tax uncertainty. Moreover, the situation in the labour market

**Tafclel**

GreecM-Macroeconomic performance

GDP growth rate
(% change)

Total dorrestic demand
| (% change)

Employment (% change)

Unemployment rate (%)

Inflation _{%_ change)

Balance of current account

(% of GDP)

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995 forecasts_

6.3.1996

-86

has started to improve; unemployment, which peaked during the recession, has stabilised

at 9.5% of the labour force.

Greece's relatively high inflation has been on a downward trend since mid-1993, and for

the first time in over twenty-two years the rate of consumer price inflation was in single

digits through most of 1995. On the basis of the private consumption deflator, inflation

averaged 9.2%) in 1995, compared with an average of close to 16% in the first three

years of the 1990s. The improving inflation performance has been supported by several

factors: first, fiscal policy over the past two years has become gradually more restrictive

than in previous years; secondly, the stance of monetary and exchange rate policy has

been restrictive since 1991; consequently, imported inflation has been limited through

successive reductions in the rate of depreciation of the drachma and the under-indexing

of the inflation differential against Greece's Community partners has led to an

appreciation of the real exchange rate; as a result, while this has contributed to shifting

relative prices in favour of imports, it has also contributed to anchoring inflation

expectations and, together with the progress in budgetary consolidation, it has imparted

a disciplining effect on domestic price-setting behaviour; and, finally, the success in

reducing actual inflation has likely restrained inflation expectations in the product and

labour markets (in recent years, nominal wage agreements now extend over a two-year

horizon and, together with clauses protecting against surprise inflation, have generally

contributed to easing cost-push pressures on prices).

TaUe2
Greece: Economic policy indicators

Money growth

(% change)

Government budget balance

(% of GDP)

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

Real wages per head
(% change)

For definitions, see Table 2for Belgium

_Source: Commission's November_ _1995_ _forecasts_

With a disinflation strategy

largely based on fiscal adjustment

and on underindexing the

depreciation of the drachma

exchange rate to Greece's

inflation differential vis-à-vis the

ECU, the exchange rate objective

has been supported by a positive

sentiment about stabilisation and

depreciation prospects.

Following the successful

response to averting an exchange

rate crisis in mid-1994, which

was unleashed by the liberalisation of the remaining capital account restrictions, Greece's

foreign currency reserves have risen to unprecedentedly high levels and large net

autonomous capital inflows are supporting the external value of the drachma. At the end

6.3.1996

87

of September 1995 Greece's reserves stood at USD 16.1 billion. The capital inflows have

been largely sterilised to prevent the swelling of domestic liquidity above the objectives

set by the Bank of Greece's monetary programme for 1995.

Real interest rates, which have displayed some easing tendency in 1995, continue to

remain high. The continuing high level of inflation, as well as uncertainty about the

durability of both the gains made on inflation and those made in budgetary consolidation,

continue to underpin risk premia in interest rate determination.

_**Policies to address imbalances and promote convergence**_

Greece's budgetary imbalances have started to improve since 1994 when the central

government budget targets were broadly realised. In 1995, the progress in reducing fiscal

imbalances and in containing the growth of indebtedness continued. The deficit of the

general government has been reduced from the peak so far this decade of 12.1% of GDP,
recorded in 1993, to 9.3% of GDP in 1995 [ 5] . Correspondingly, the primary balance has

recorded surpluses since 1992; the deficit is expected to decline further in 1996, and the

primary surplus to increase, compared to last year. However, budgetary policy continues

to be circumscribed by large interest payments which in 1995 amounted to 13.4% of

GDP and constituted almost 35% of total receipts of the general government.

The size of the interest bill reflects Greece's heavy indebtedness and the persistence of

high interest rate on government debt. In spite of stubbornly high inflation, the debt ratio

reached 114.4% of 1995 GDP, up from 82.6% in 1990. This large increase reflects

principally the takeover of debt outside the general government into its accounts. It is

clear that the primary surpluses recorded in recent years are not yet adequate to stabilise

the debt ratio but only to contribute to a slowdown in the growth of the debt ratio.

Budgetary adjustment has relied on raising revenues through combating tax evasion,

widening the tax base, and improving the efficiency of the tax mechanism, and also on

restraining the growth of primary expenditure. Total current revenues of the general

government have risen from 32% of GDP in 1990 to 36.4%) of GDP in 1995, and much

of this progress has taken place following the implementation of the April 1994 tax bills.

-> In the summer of 1995, the Greek authorities included the general government accounts items
previously omitted or not fully accounted for; the revised data, which are used presently, have
resulted in a lowering of the general government deficit dating back to 1992. The revision has not
affected the pace of fiscal adjustment between 1993 and 1995 measured by the change in the deficit
ratio, even though the level of the ratio is now lower by more than one percentage points in terms of
GDP in 1993.

6.3.1996

88

There has been less progress in restraining primary expenditure growth; primary

spending represented almost 31% of GDP in 1995, up from 29.4% in 1992.

**Chart 1 - Greece** Chart 1 presents the

**Cyclically adjusted** Fiscal adjustment (general government) **variables** **as** **%** **of trend GDP** **Cyclically adjusted variables as** **%** **of** **trend** **GDP** composition of fiscal

**—Primary** **expenditure** **(left-hand** **—Revenues** **(left-hand** **scale)**

**scale)** **ea** **Primary balance (right-hand** adjustment since the

**•Deficit (right-hand scale)** **scale)** end of the past decade

by comparing data on

revenues and primary

spending adjusted for

cyclical fluctuations

and reported as ratios

**1988** **1989** of trend GDP; thus,

_**Source:**_ **Commission services**

the data may be

thought of as representing discretionary policy. The reduction in the primary deficit has

been taking place since 1992 and it has been achieved principally through discretionary

increases in the ratio of revenues to GDP which has risen from 32.3%) of trend GDP in

1990 to 38.0%) in 1995; on the other hand, cyclically adjusted primary spending has

remained broadly stable at close to 34% of GDP.

**Chart 1 - Greece**

**Cyclically adjusted** Fiscal adjustment (general government) **variables** **as** **%** **of trend GDP** **Cyclically adjusted variables as** **%** **of** **trend** **GDP**

**—Primary** **expenditure** **(left-hand**

**—Revenues** **(left-hand** **scale)**

**ea** **Primary balance (right-hand**

**scale)**

**•Deficit (right-hand scale)**

**scale)**

**1988** **1989**

_**Source:**_ **Commission services**

The key policy issue is to secure and further the gains on inflation and on budgetary

consolidation; these are key conditions for reductions in real interest rates and for

fostering and sustaining economic growth. While progress has been made in relation to

the Treaty convergence criteria in the past two years, the distance that needs to be

covered requires that the adjustment policies must be pursued without fail.

6.3.1996

-89

SPAIN

_**Healthier economic recovery but surrounded by a number of uncertainties**_

Despite the deceleration in economic activity since the Spring, Spanish GDP rose in 1995

by 3%. Employment rose sharply in 1995 (2.7%) as a result of the economic growth,

wage moderation and a more flexible labour market. Nevertheless, the unemployment

rate fell only moderately because of an increase in the participation rate. Inflation

resumed its downward trend in May 1995 whereas the general government deficit was in

line with the convergence programme target in 1995. Although imports resumed faster

growth than exports in 1995 the external accounts remained close to balance, partly as a

result of the improvement in the terms of trade.

Economic activity in Spain, which has been growing continuously since mid-1993 began

to decelerate in the second quarter of 1995. Despite this, after having risen 2% in 1994,

GDP is estimated to have grown by 3.0% in 1995.

After two years of growth led by net exports, partly due to the peseta depreciation, in

1995 the engine of growth was domestic demand, whereas the external sector

contributed negatively to GDP growth. The marked recovery in domestic demand in

1995 was based on a strong growth of investment, both in construction and equipment,

while private consumption remained sluggish.

**TaUel**

**Spain: Macroeconomic performance**

**1986-90** **1991-93** **1994** **1995**

0.6

-0.2

-2.1

**19.2**

6.1

-2.7

2.1

**1.1**

-0.9

24.3

4.9

-1.2

**3.0**

**3.3**

2.7

22.7

4.9

-1.3

GDP growth rate
(% change)

Total domestic demand

(% change)

Employment (% change)

Unemployment rate (%)

Inflation (% change)

Balance of current account

(% of GDP)

4.5

6.6

3.2

18.9

6.6

-1.3

After a cumulative fall of 14% in

1992 and 1993, investment

began to recover in 1994 as a

result of the pick-up in final

demand, led at first by strong

export growth, the improvement

in business profitability, lower

indebtedness of the non-financial

enterprise sector and a higher

capacity utilisation rate.

However, given subdued private

consumption and some

For definitions, see **Table 2 for Belgium**
_Source: Commission's November_ _1995_ _forecasts_
_*_ Taking into account **latest information**

deceleration in external demand

growth, investment began to decelerate in mid-1995.

6.3.1996

-90

Chart 1 - Spain

**Private consumption, employment and the saving rate**

**Annual %** **change** **^**

**•Total** **employment**
**—Private consumption**
**—Households'** **raving** **rate** **(right-hand scale)**

**1986** **1987** **1988** **1989** **1990** **1991** **1992** **1993** **1994** **1995**

_**Source**_ **Commission services**

Private consumption is

assessed to have grown by

1.6% in 1995, a relatively

low rate taking into

account the sharp rise in

employment (Chart 1) and

in real gross disposable

income (3.1%). The

household saving ratio is

estimated to have picked up

to 12.8% in 1995, as a

result of growing

uncertainty as to future income developments. This could be explained by lower job

security, as a result of the 1994 labour market reform, memories of the sharp 1992-93

recession, tougher conditions for access to unemployment benefits and uncertainty as to

the future of the pension system, also reflected in a boost of private pension systems.

Hence, a major question mark as to the development of economic activity in Spain, as in

other Member States, is associated with households' readiness to spend.

Exports and imports have been slowing down after the very sharp rises recorded in 1994.

However exports have been decelerating more markedly than imports as a result of the

fading effects of the earlier

**TaMe** **2**
**Spain: Economic policy indicators**

**1** 1986-90 1991-93 1994

peseta depreciation and the

J recovery in domestic demand.

Money growth

(% change)

14.5 7.5

(% change) The Spanish external accounts

Government budget balance -3.8 -5.5 -6.6 -5.9 improved significantly in the last
(% of GDP)

few years as a consequence of

Gross government debt 44.1 51.5 63.0 64.8
(% of GDP) the peseta depreciation in

Nominal wages per head 7.7 8.2 3.1 **3.9** 1992-94 and the deeper recession
(% change)

in Spain than in the EU as a

Real wages per head 1.0 2.0 -1.7 -0.9
(% change) whole. The balance of goods and

For definitions, see Table 2 for Belgium services shifted from a deficit of

_Source: Commission's November_ _1995_ _forecasts_

3.2% of GDP in 1991 into

balance in 1994. Although in

1995 real import growth once again outpaced the growth of real exports, an

Government budget balance

(% of GDP)

-6.6

-5.9

-3.8

-5.5

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

44.1

51.5

64.8

63.0

7.7

8.2

3.1

**3.9**

Real wages per head
(% change)

1.0

2.0

-1.7

-0.9

For definitions, see Table 2 for Belgium

_Source: Commission's November_ _1995_ _forecasts_

6.3.1996

-91

improvement in the terms of trade allowed the balance of goods and services to remain in

balance.

Employment rose substantially in 1995, as a consequence of the steady economic

growth, wage moderation and a more flexible labour market, the two last factors having

led to a lowering in the threshold of employment creation and the apparent productivity

growth. However, the unemployment rate has fallen relatively moderately and has

remained clearly above 20% in 1995 given the continuous rise in the activity rate, linked

to a steady increase in women's participation in the labour market.

The general government deficit-to-GDP ratio is estimated to have been cut further to

5.9% in 1995 after 6.6% in 1994 and 7.5% in 1993. However, despite this reduction, the

general government debt ratio still increased, though at a decelerating pace, to some

64% of GDP by the end of 1995.

There has been a deceleration in the CPI inflation rate (year-on-year) since May 1995.

However, on average the inflation rate remained flat in 1995 as compared to 1994,

mainly as a result of the impact of the January 1995 indirect tax rises which pushed up

inflation in the first months of 1995. The downward trend in inflation is supported by

moderate wage increases, a stable currency, a slowdown in import price growth and the

anti-inflationary stance of the Bank of Spain.

At the end of 1994, the Bank of Spain adopted a new monetary policy strategy

incorporating a basic medium-term objective set in terms of the inflation rate, with

exchange rate stability viewed as having especial relevance for the attainment of this

objective. Indications of strong inflationary pressure led the Bank of Spain to raise

interest rates by a total of 190 basis points during the first half of 1995. Improved

inflation prospects in the second half of the year, together with the strength of the peseta,

paved the way for a 25-basis-point reduction in interest rates in December. Long-term

interest rate differentials with Germany narrowed somewhat during the year but

remained at 390 basis points in December. Currency turbulence early in 1995 led to a

sharp depreciation of the peseta culminating in a 7% devaluation of the peseta's ERM

central parity on 6 March. The currency subsequently recovered against the DM,

appreciating quickly towards its new central parity. In the last quarter of the year, the

peseta strengthened further, moving progressively upwards in the ERM grid to finish the

year as the second strongest currency in the grid.

6.3.1996

-92

The economic fundamentals now appear to provide a sounder base for steadier economic

growth in Spain than in previous upturns, in particular that of the late 1980s. The

recovery has been led by exports and investment and some room exists for stronger

private consumption without major tensions showing up in the external accounts. A more

flexible labour market which has also contributed to wage moderation has laid a better

ground for more balanced economic growth.

The main uncertainties as to the strength of the recovery now have to do with the

developments in external markets and the behaviour of consumers as reflected through

the household saving ratio.

_**High public deficit and unemployment still the two main challenges**_

Economic policy in Spain has been guided by the 1994 revised convergence programme

which aimed at complying with the EMU criteria through structural reform and a more

balanced policy mix. Of key importance is the process of fiscal adjustment which should

lead to a 3% general government deficit-to-GDP ratio in 1997.

**Chart 2 - Spain**

General government budgetary variables (as % of GDP)

QGross debt (right-hand scale)

— Primary deficit

      - Interest payments

—Tntal rififkit

1990 1991

_Source_ Commission services

The Spanish

authorities have

gained credibility by

meeting their

convergence

programme/budget

deficit targets in

1994 and in 1995.

This has been mainly

achieved through a

cut in the primary

deficit (which

excludes interest

payments) as shown in Chart 2. Reversing the previous trend, current expenditure

excluding interest payments was reduced from 39.1% of GDP in 1993 to 37.2%) in 1995,

more than compensating the fall in current receipts from 41.8% of GDP in 1993 to

40.7% in 1995.

6.3.1996

                             - 9 3 

However, fiscal adjustment was largely back-loaded to 1996 and 1997 along with the

convergence programme. The draft budget law for 1996 targeted the deficit ratio

included in the convergence programme: 4.4% of GDP, but it was voted against by

Parliament. Hence, the 1995 budget law has been carried forward into 1996 with some

fiscal adjustments, which should have a similar impact on the deficit as the draft budget

law. In 1996 the budgetary savings are expected to lead to a primary surplus for the first

time this decade. A strict compliance with the budgetary targets is essential to make it

easier for interest rates to come down further and so, while boosting the economy, to

curb the growing weight of interest payments, which already account for more than 5%

of GDP.

Employment has been evolving very favourably since early 1994. Although its growth

decelerated in 1995-Q4, total employment still rose in that quarter by 3.2%)

(year-on-year) and by 2.7% on average in the whole year. This has allowed an increase in

the traditionally very low activity and employment rates. However, despite the

improvements, the unemployment rate was still 22.8%) in 1995-Q4 and the share of

temporary jobs in total employment was 34.5%. In order to redress the large Spanish

labour market imbalances, further reforms in product and services markets are called for,

especially in sectors sheltered from competition, which can help reduce inflation and

improve efficiency, output and employment.

6.3.1996

94

FRANCE

_**Economie**_ _**growth slows as**_ _**domestic**_ _**demand weakens**_

The French economy began to slow down early in 1995 before decelerating sharply, with

GDP growth (year-on-year) falling from more than 4% in the first quarter to less than

1% in the last quarter. The very significant contribution of stocks to economic growth in

1994 had somewhat masked the lack of dynamism in the other components of domestic

demand, which failed sufficiently to take up the running in 1995.

Consumption has not regained

**TaUel**
**France:** **Microeconomic** **performance** momentum and the support

jj 1986-90 1991-93 1994 I ^ S ^ measures taken in 1994 have

**GDP growth rate** been prolonged in 1995. The
**(%** **change)**

distinct increase in the

**Total domestic demand**
**(% change)** purchasing power of personal

**Employment** **(%** **change)** disposable income, resulting

**Unemployment** **rate** **(%)**

from higher employment and

**Inflation** **(%** **change) -**

the more favourable trend of

**Balance of current account**
**(%** **of GDP)** wages per head, gave rise to a

**For definitions, see Table 2 for Belgium** modest upturn in consumption
_**Source: Commission's November 1995 forecasts**_

in 1995 since the savings ratio

rose significantly. Households' expectations regarding unemployment and incomes fell

after the" summer, which has adversely affected consumption and overall economic

activity.

**GDP growth rate**
**(%** **change)**

**Total domestic demand**

**(% change)**

**Employment** **(%** **change)**

**Unemployment** **rate** **(%)**

**Inflation** **(%** **change) -**

**Balance of current account**

**(%** **of GDP)**

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

The revival of productive investment, which started in the spring of 1994, is likely to

continue beyond 1995. Although the capacity utilization rate has decreased since

mid-1995 and the outlook for demand is less rosy, the low level of investment in

previous years means there is a hefty investment backlog. Profitability has also risen over

the last two years. Substantial financing capacity have been generated during the last

years and the constraint of high real interest rates has been partly removed at the

beginning of 1996.

Exports were exceptionally buoyant and made a major contribution to growth in 1994

and the first quarter of 1995, but a lull has been discernible since the spring. Although

firms have benefited from lower unit labour costs, an increase in the effective exchange

6.3.1996

                             - 9 5 

rate has been detrimental to price competitiveness and forced them to cut margins.

France now has a healthy current account position; following a deficit equivalent to 0.5%

of GDP in 1991, a surplus of 0.6% of GDP was recorded in 1994 and a surplus of some

1.0% of GDP is expected in 1995.

_**Inflation firmly under control but labour market situation worrying**_

The rise in consumer prices remained below 2% in 1995. In spite of the hike of two

I TaUe 2

1 France: Economic policy indicators

1986-90

-5.0

51.5

**3.0**

1.1

Money growth

(% change)

Government budget balance

(56 of GDP)

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

8.9

-1.8

33.7

4.2

1.3

1991-93

1.4

-4.1

40.2

3.6

0.9

1994

1.9

-6.0

48.4

2.1

0.3

percentage points in the

standard VAT rate on 1 August

1995, retail prices rose in 1995

at the same pace as in 1994.

Sales prices in manufacturing

have decelerated since the

beginning of 1995 and consumer

caution is likely to keep retailers'

margins under pressure.

Real wages per head _
(% change)

(% change) Unit labour costs are estimated

For definitions, see Table 2 for Belgium to have increased by about 1%
_Source: Commission's November 1995 forecasts_

in 1995 as a result of lower

growth in productivity and

rising wages. Bringing these costs under control has formed a key part in combatting

inflation. "Expressed in national currency, unit labour costs fell by some 10% in relation

to the other industrialized countries between 1987 and 1995, whereas for the Community

as a whole they increased by about 5%.

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995 forecasts_

Chart 1 - France

Value added, salaried employment and productivity in the non-agricultural
market sectors (seasonally adjusted)
**Value** **added and employment (quarterly % change)** **Productivity (1988** **Ql =100)**

Changes in

employment have been

consistent with the

standard productivity

cycle. Growth in

employment, which

was limited in the early

part of the recovery

and thus led to a sharp

increase in productivity

6.3.1996

**|** **1988** **|** **1989** **|** **1990**

_**Source:**_ **Commission services,** **INSEE**

**1991** **|** **1992** **|** **1993** **|** **1994** **|** **1995** **|**

-96

in the first half of 1994, subsequently grew at a quarterly rate of 0.4% in the non
agricultural market sectors. New jobs were created largely in the business service sector,

which includes the activities of temporary employment agencies, and in the household

service sector. Employment continued to expand up to the middle of 1995, whereas GDP

stagnated, producing a dip in productivity. However, after falling steadily since the

summer of 1994, unemployment began to rise again as from the autumn of 1995. In

1996, as in 1995, productivity gains could be slightly below their trend rate since the

employment support policy should result in a disproportionately large increase in jobs

relative to growth.

_**Cutting public**_ _**deficits,**_ _**a priority for jobs and growth**_

Fiscal consolidation is a necessary condition for a stable macroeconomic environment

conducive to growth and employment. It should enable an easing of monetary policy,

compatible with the monetary stability objective, which should offset the adverse effect

on economic activity of budgetary restraint. The Government has also launched

structural initiatives to make the labour market function more effectively.

General government net borrowing rose sharply after 1991, reaching 6% of GDP in

1994. The public deficit will probably amount to 5% of GDP in 1995 and will therefore

be in line with the Government's objective. Moves to bring public finances under control

in 1995 focused largely on the central government deficit, which was to be trimmed from

4.9%) to 4.2%» of GDP. Tax increases and spending cuts contained in the supplementary

Finance Law of August 1995 enabled new spending on employment to be funded while

adhering to the deficit target specified in the initial Finance Law. However, additional

measures were taken at the year-end to offset the shortfall in taxation.

O Chart 2 - France

The components of general government net borrowing

**•/.of** **GDP** **'**

**1987** **1988** **1989**

_**Source:**_ **Commission services,** **INSEE**

The consolidation of

central government

finances will continue

in 1996 and efforts

will be made to

remedy the recurrent

social security deficit,

which constitutes a

major obstacle to

compliance with the

6.3.1996

97

convergence criteria. The ongoing reform of the social security system aims at reducing

the deficit from 0.8%o of GDP in 1995 to 0.2% in 1996 and to achieve a surplus in 1997.

The consolidation will stem from health spending control and increases in taxes and

social security contributions.

The Government's objective is to reduce net borrowing by 1% of GDP each year so as

to bring it down to, or below, the 3% mark by 1997. However, if growth would not

increase again, additional measures could be necessary in order to achieve the

Government's fiscal policy objectives.

The twin objectives of monetary policy are to ensure domestic price stability and

maintain the franc's parity within the EMS. They were achieved in 1995. Nevertheless,

interest rates and the differential with Germany were still high in France in the course of

1995. The large public deficits and high unemployment are two of the factors

undermining the franc's credibility, with the result that interest rates still carry a risk

premium. Whereas long-term rates were headed downwards throughout the year, short
term rates rose sharply in March as the German mark gained ground against the other

European currencies. After June, as political and budgetary uncertainties were gradually

dispelled, the Bank of France was able to ease monetary policy.

Structural measures are necessary to improve the functioning of the labour market. This

year, for instance, France adopted a multiannual employment plan in response to the

request of the Essen European Council. Measures have recently been taken in the

priority areas identified by the Council. Policy in 1995 focused on reducing the cost of

unskilled labour and placing young people and the long-term unemployed in

employment. The Government decided to intensify moves -begun in July 1993 - to

reduce security contributions for the low-paid. Overall, budget efforts to reduce the cost

of unskilled labour should amount to 0.6% of GDP in 1996 and account for 9% of the

total cost of wages below 1.3 times the minimum wage level (SMIC).

A rebound in growth in the course of 1996 could be fostered by renewed household

confidence, due to a reduction in uncertainties concerning budgetary policy. Moreover

fiscal consolidation and the lack of inflationary pressures should constitute an

environment favourable to a further reduction in interest rates.

6.3.1996

**98-**

**IRELAND**

_**Continuation of broad-based growth in 1995**_

The current dynamism of the Irish economy is based on a variety of factors which

encourage both stability and growth. Consumer and business confidence remain high,

having recovered from the setback of temporarily higher interest rates in the first quarter

of 1995. The subsequent decline in nominal interest rates to relatively low levels and the

generally buoyant domestic demand provide a favourable climate for investment. The

background of nominal stability has also been encouraged by continued strict budgetary

policy and the corresponding decline in the debt burden. Price stability is also helped by

the continued adherence to the wage agreement between the social partners which allows

for cumulative pay increases in line with expected inflation, but lower than the expected

growth in productivity. The resulting improvements in competitiveness combined with

the favourable development of outlook for international trade have seen a continued

positive contribution of net exports to overall GDP growth.

TaHel

Ireland: IVfacroeconomic performance

| 1986-90 1991-93 1994 1995

GDP growth rate 4.6 3.1 6.7 6.7
(% change)

Total domestic demand 3.3 -0.2 4.2 5.9

(% change)

Employment (% change) 1.0 0.4 2.6 3.5 I

Unemploy ment rate (%) 15.5 15.3 14.7 14.4 I

Inflation (% change) 3.2 2.4 2.7 2.5

Balance of current account -1.2 3.4 5.1 6.0

(% of GDP)

For definitions, see Table 2 **for Belgium**

_Source: Commission's November 1995 forecasts_

The Irish economy grew

strongly in 1995, continuing

the broad-based growth that

emerged in 1994. As in 1994,

GDP is expected to increase by

over 6% in 1995, but unlike

the trend of earlier years, when

growth was fuelled mainly by

net exports, domestic demand

is expected to make the most

important contribution to

growth. The buoyancy of

domestic demand has had a beneficial impact on the more labour-intensive indigenous

sectors of the economy, resulting in strong employment growth of 49 000 in the year to

mid-April 1995 (+4.1%). However, this strong rise in employment has not been matched

by the decline in unemployment. The rising trend in labour force participation from a

relatively low level, particularly the substantial rise in female participation, is the main

explanation for this difference. With the expectation that this trend will continue into the

medium term combined with the projected increase in the population of working age, the

implication is that, in the absence of increased emigration, employment growth needs to

6.3.1996

99

be sustained at a high level for a number of years if unemployment is to show a more

significant decline. Nevertheless, the rising numbers in employment, along with continued

moderate increases in real wages, contributed to the growth in private consumption. In

addition, unanticipated post-budgetary contingency payments in the latter half of 1995

raised household incomes, while a confidence-induced decline in household saving is

thought to have further boosted private consumption with growth expected to have been

over 4% in 1995. The low level of interest rates, the continuing confidence of the

industrial sector, rising output, and a healthy saving ratio allowed investment growth to

improve on the recovery which began in 1994, when it rose by 7.3%. The recovery in

investment is expected to have reached about 8% in 1995, driven partly by increased

private sector activity but also reflecting some upturn in public investment. The recovery

in public investment reflects some catching up from the relatively low level of 1994 when

delays in disbursements from the Structural Funds constrained the capital programme.

The steadily improving competitiveness of the Irish economy helped export volumes rise

by about 10% in 1995, thereby continuing to make a significant contribution to growth,

albeit lower than in previous years. The state of the public finances remains healthy and

although there was some upward pressure in 1995 the deficit is expected to remain

comfortably within 3% of GDP. The recovery has thus far not been accompanied by any

significant increase in price pressures, with the consumer price index showing only a

2.4%) increase in the final quarter of 1995 compared with the previous year.

Foreign exchange market developments during the first quarter of 1995 were

dominated by _à_ weakening US dollar, a strengthening DM and a re-emergence of

tensions in the ERM. Amid these tensions, the Irish pound depreciated sharply early

in the year. The Irish central bank responded to exchange market tensions by

engaging in forex intervention to stabilize the currency. A 1 percentage point rise in

the official short-term facility rate in early March, also helped to support the

currency. In March, the Minister of Finance expressed a preference for the Irish unit

to move higher in the ERM even if it meant trading above par with sterling. The IRL

promptly broke through par, moving quickly to a range of UKL 1.02-1.03. Against

the DM, the Irish unit also entered an appreciating trend from April onwards,

although it has been subject to short-term reversals during periods of sterling

weakness. In the second half of the year, with inflation pressures remaining under

control, the Irish Central Bank followed Bundesbank official rate cuts in August and

December, reducing Irish official interest rates by a total of 75 basis points. By the

end of the year, the Irish unit had strengthened further against sterling, as well as

reducing its gap against the strongest in the ERM grid.

6.3.1996

100

_**\**_ _**Favourable prospects over the**_

_**medium term**_

The prospects for continued

non-inflationary growth remain

G overnment budget balance
(% of GDP) favourable, although some

Gross government debt moderation from the very high
(% of GDP) rates of 1994 and 1995 is

Nominal wages per head
(% change) expected. The general outlook

Real wages per head **2.7** 2.8 **0.4** **0.2** is one of growth slowing

(% change)

toward its trend rate following

For definitions, see Table 2 for Belgium - the rapid surge of 1994 and
_Source: Commission's November 1995 forecasts_
_*_ Taking into account latest information 1995. The growth in

1 The 1995 figure includes the payment of arrears of social welfare payments consumption in particular
due under the Equal Treatment Directive and incorporates the more recent
information presented in the Irish Budget should moderate, following the

exceptionally strong growth in

1995. This is anticipated partly

because of the absence of the substantial budgetary transfers that occurred in 1995 and

also due to the expected attenuation of employment growth. Investment has particularly

benefited from the emergence of more balanced growth in the economy and the generally

G overnment budget balance

(% of GDP)

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

Real wages per head

(% change)

**2.7** 2.8 **0.4** **0.2**

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

1 The 1995 figure includes the payment of arrears of social welfare payments
due under the Equal Treatment Directive and incorporates the more recent
information presented in the Irish Budget

favourable business

**Chart 1 - Ireland**

Contributions to GDP growth climate suggests that
**annual** **%** **change**

**•** **Domestic** **demand** investment will remain

**ED Net exports**
**— GDP** buoyant. However,

investment growth is

expected to fall from its

1995 rate to about 6%

to 7% in the following

two years. Public

**1991** consumption is
_**Source:**_ **Commission services** expected to show the

lowest growth of the components of domestic demand as the authorities seek to restrain

the growth in public expenditure. On the external side, further improvements in

competitiveness should see export volumes continue the strong growth of 1995 resulting

in continued substantial trade surpluses.

Contributions to GDP growth
**annual** **%** **change**

**•** **Domestic** **demand**

**ED Net exports**

**— GDP**

**1991**
_**Source:**_ **Commission services**

6.3.1996

101 

The favourable outlook for growth and interest rates should, along with stricter control

of general government expenditure, see a renewed decline in the general government

deficit. The favourable cyclical conditions and the need to further reduce the debt ratio

warrant greater efforts to reduce the budget deficit. The continued absence of

inflationary pressure is encouraging, especially considering the shift from export-led

growth (where prices tend to be moderated by international factors), towards internally

driven growth. The success of the social partners in moderating wage increases and the

stability of the exchange rate provide the cornerstones of the anti-inflation policy.

Continued adherence to these policies should see the private consumption deflator
remaining at about 2V [/] 2%.

6.3.1996

102

ITALY

_**An economic recovery**_ _**with**_ _**poor employment content and**_ _**high**_ _**inflation**_

After the depreciation of the Lira, Italy enjoyed an export-led economic recovery earlier

than other countries. The economic upswing continued to gather momentum in 1995

despite the strains in financial and exchange rate markets and the unsettled political

situation. Inflation accelerated

TaUel

Italy: IVfacroeconomic performance

"H 1986-90 1991-93 1994 1995

GDP growth rate
(% change)

Total domestic demand

(% change)

Employment (% change)

Unemployment rate (%)

during the year but peaked in

November 1995, whereas

employment creation was

lagging. Italy's economic cycle,

however, might have reached its

peak in 1995.

Inflation (% change)

The path of the economic

recovery initiated in the last

months of 1993 has been, until

_Source: Commission's November 1995 forecasts_ now, the traditional one with the

~ initial irripulse coming from a

Balance of current account

(% of GDP)

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995 forecasts_

buoyant export performance followed by a steady increase of investment in equipment.

The latter surged in 1995 fuelled by a still robust external demand, strong profits and

capacity utilisation rates approaching historically high levels, while investment in

construction remained weak reflecting both the uncertainties affecting public works and

the high level of interest rates. Private consumption, unlike in previous recoveries,

experienced a continuous deceleration on a year-on-year basis. Tight fiscal conditions

and moderation in wages induced some squeeze on household real gross disposable

income. Moreover, throughout most of 1995 the consumer confidence indicator

deteriorated in spite of some positive signs in employment creation. Uncertainties over

the pace of the budgetary consolidation process, the reform of public pensions' schemes

and the lack of security of the new jobs appear to have made households more cautious.

Net foreign trade made a positive contribution to the growth of GDP and the surpluses

of both the trade and the current accounts widened compared to 1994. A specific

characteristic of the current cyclical phase as compared to previous consumption-led

upturns was that, late in 1995, private consumption was not taking the lead and emerging

as the main contributor to growth at a time when exports were running out of steam and

investment in equipment was probably approaching its peak.

6.3.1996

- 103 

**Chart 1** - **Italy**

10 [Thousands ]

50

-50

-100

-150 h

-200

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

1991 1992 1993 1994 1995

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

Employment creation in 1995 was disappointing (Chart 1) and had little impact on the

reduction in the unemployment rate which reached a peak of 12.2% in January 1995.

Without the significant reduction in the labour force due to the discouragement effect

this figure would have been even higher.

**Chart. 2 - Italy**

Inflation indicators
annual % change

10

—Producer prices

—Consumer prices

**J** **I** **I** **1_** **i** **'** **I** **I** **l** **I** **I** **I** **l, I**

1995

_Source:_ Commission services, ISTAT

In 1995, the net

increase in employment

was very marginal

(81 000 units) and only

the labour force

surveys of April and

July showed positive

employment creation

figures. On average,

employment fell by

J 0.5% compared to the

average employment level prevailing in 1994. In October, the labour force survey

showed a trend reversal for the first time since October 1993 and total employment

increased by 0.4% year-on-year (confirming the positive signals already emerged in the

6.3.1996

                   - 104

previous surveys of April and July). Most of this increase took place among independent

workers. Employment in the services sectors, in particular, increased by 2%

year-on-year, whereas in the agriculture and industry sectors it declined by 5.4% and

1.1%, respectively. In the early stages of the recovery Italian companies made a more

intensive use of labour before recruiting new employees as they preferred to re-engage

workers who were previously laid off and put temporarily aside in the Wage

Supplementary Fund and to increase overtime working. However, as the scope for more

intensive use of labour progressively narrowed, firms started to hire new workers. The

effects of the economic upswing on employment were smaller than in previous

expansionary phases. Moreover, the poor impact of the current economic recovery on

employment and the correspondingly high level of unemployment could be an indication

of the need to continue with the removal of the still existing structural constraints on the

labour market.

Inflation, as measured by the CPI, increased substantially in 1995 (5.4%) as compared to

the previous year (3.9%). A number of factors contributed to an upsurge in consumer

prices (Chart 2) since February 1995. Apart from the mechanical increase in the price

level induced by the February mini-budget, the weakness of the lira during most of the

year allowed for a widening in profit margins and fuelled import and producer output

prices [-] Moreover, the capacity utilisation rate in the manufacturing industry was

increasing at a rapid pace and business and consumer expectations on prices worsened.

Inflation, however, might have reached its peak in November 1995: producer and

wholesale prices peaked in June, the impact of the February 1995 increase in indirect

taxes is "over and the currency appreciated by the year end. In addition, wage

**TaUe2**
**Italy: Economic policy indicators**

**I**

Money growth

(% change)

Government budget balance

(% of GDP)

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

Real wages per head
(% change)

1986-90 1991-93 1994 1995

8.7 7.3 1.9 2.1

-10.1 -9.8 -9.0 -7.2

92.6 109.7 125.4 124.9

S.8 5.9 3.4 4.7

**2.7** 0.1 -1.3 -0.9

developments are not putting a

pressure on inflation, given that

wage setting did not seem to be

affected by the upwards trend

during 1995.

Monetary policy is playing a

major role in combatting

inflation. The central bank has

placed a tight rein on monetary

and credit aggregates. Official

rates were hiked twice in the

first part of 1995 and the Bank

6.3.1996

For definitions, see Table 2 for Belgium
_Source: Commission's November 1995 forecasts_

 - Taking into account latest information

105

of Italy did not follow the Europe-wide cut in official rates that occurred later in the

year. Real short-term interest rates remained at very high levels (above 5%) for most of

1995. The lira, which had fallen to a low of LIT 1 275 per DM in March, recovered

substantially from May onwards. After a brief emergence of tensions in October, it

remained on a clear upward trend in the last part of 1995, closing the year just above LIT

1 100 per DM. The recent reappreciation of the lira bodes well for combating inflation.

_**Budgetary consolidation made significant progress but still represents the main**_

_**challenge**_ _**ahead**_

In 1995 the state sector borrowing requirement declined to 7.4%» of GDP from 9.5% in

the previous year. The primary balance reached a surplus of 3.5%» of GDP, considerably

higher than the 1.1% surplus recorded in 1994. The public debt is likely to have fallen,

albeit marginally, in terms of GDP for the first time since 1980.

The budgetary consohdation effort was carried out in two steps. The Budget Law for

1995 enacted a fiscal package with measures amounting to 2.7% of GDP. This package,

however, became insufficient to achieve the intended objectives due to the unfavourable

evolution of interest rates. Therefore, the authorities decided to adopt, in March 1995,

an additional package of measures, worth 1.2% of GDP, mainly consisting of an increase

in indirect taxes. The additional measures did contribute to the rise in prices, but had the

advantage of having an immediate and certain impact on the budget. The deficit - also

owing to the strong nominal GDP growth - was finally reduced below its original target.

The economic policy objectives for 1995 also included the reform of the pension system

and the advancing of the privatisation of the state-owned companies. A comprehensive

pension reform was approved in August modifying the former earnings-based system into

a contribution-based one. The new system has gained in transparency and equity

although its financial equilibrium might still not be secured. The new rules, however,

should facilitate a solution to the issue in the future. The privatisation process has made

significant progress: the legal framework for the sell-off of the public utilities was

established and the first phase in the privatisation of ENI, the energy conglomerate, has

begun with the quotation on the stock market and the placement of 15% of its shares. In

1995, LIT 8.3 trillion revenues from privatisation accrued to the Treasury, an outcome

not too far from the declared LIT 10 trillion target.

As for the future, in July 1995 the Italian Parliament approved a three year economic and

financial plan aiming at a general government deficit of 5.9% of GDP in 1996, 4.4% in

6.3.1996

106

1997 and 2.6% in 1998. In order to meet these objectives, the Budget Law for 1996

introduces a budgetary package (1.7% of GDP) quantitatively lower than those enacted

in the last four years.

The budgetary measures introduced in the past few years have reduced the room for

manoeuvre for further intervention with respect to increases in tax rates or cuts in the

spending of public institutions. Nevertheless, transfers, subsidies and tax breaks granted

to private enterprises and institutions should be scaled down in the present phase of

economic recovery. More important, a reform effort should be aimed at increasing the

efficiency of the public administration, at abating tax evasion and at enhancing the

budgetary discipline of local authorities. The measures defined by this year's Budget Law

appear to target these issues. They involve structural changes and often depend on

modifying the behaviour of public administrators and/or tax-payers, which makes it

difficult to either predict their degree of success or to quantify their effect on the budget.

6.3.1996

                     - 107

LUXEMBOURG

_Luxembourg economy still enjoying sustained growth_

The Luxembourg economy was largely unaffected by the 1992-93 recession and has

recovered from the world steel crisis which marked that same period. From 1994

onwards it benefited from the recovery in neighbouring countries, recording real GDP

growth of some 3% in 1995. Economic activity in 1995 was stimulated by both domestic

demand and exports. Private consumption, underpinned by fairly substantial wage rises,

grew by more than 2%. Investments recovered after dipping in 1994. Exports made a

positive contribution to growth in spite of an increase in the effective exchange rate. The

upward trend in employment continued, climbing by more than 2.5% in 1995, while the

downturn in manufacturing was more than offset by growth in the service sector.

TaUe 1

Luxembourg : Macroeconomic performance

j _\_ 1986-90 1991-93 1994 1995

GDP growth rate 4.6 1.6 3.3 3.1
(% change)

Total domestic demand 5.5 2.7 2.3 2.5

(% crmfige)

Employment _(%_ change) 3.1 2.8, 2.5 2.5

Unemployment rate (%) 2.1 2.2 3.5 3.9

Inflation (% change) ' 3.5 3.7 2.4 1.9

Balance of current account 28.1 21.6 15.9 29.6

(% of GDP)

For definitions, see **Table** **2** **for Belgium**

_Source: Commission's November_ _J_ _995 forecasts_

After a short-lived inflationary

burst in 1993 which saw price

rises of 3.6%, largely as a result

of the mechanical effects of the

rise in excise duties, the

increase in consumer prices fell

back to 2.2%) in 1994 and will

probably remain more or less

unchanged in 1995.

This favourable trend is set to

continue in 1996 even if the

buoyancy of exports is curbed

by the appreciation of the Luxembourg franc and by the cyclical downturn in

Luxembourg's main trading partners, because growth should still be buoyed up by

domestic demand, particularly private consumption and investment. Employment should

therefore continue to rise steadily.

General government as a whole recorded a surplus equivalent to some 0.4% of GDP in

1995; the small central and local government deficit was more than offset by the social

security surplus. Gross public debt, running at around 6.3% of GDP, has increased

slightly in recent years, whereas net public debt has fallen as social security has built up

6.3.1996

108

substantial financial assets. In view of the favourable outlook for growth, the public

finance situation is unlikely to worsen in the foreseeable future.

Table 2'
Luxembourg: Economie policy indicators

1986-90 1991-93 1994

Money growth

(% change)

However, this overall positive

trend conceals marked

differences between sectors.

Whereas the growth in

financial activity continued,

confirming its role as the

motor of the Luxembourg

economy, the steel industry

had to undergo further

restructuring. Employing

almost 18 000 people, the

financial sector now accounts

for about 10% of domestic

Government budget balance

(% ofGDP)

Gross government debt

_(%_ of GDP)

Nominal wages per head

(% change)

Real wages per head
(% change)

**i****

**0.4**

6.3

**3.7**

1.7

**2.2**

5.9

**3.4**

**1.0**

8.8

5.2

1.7

**1.5**

5.2

**5.7**

**1.9**

For definitions, see 'fable 2 for Belgium

_Source: Commission's_ _November_ _1995 forecasts_

employment, but a period of consolidation is now anticipated following the very rapid

expansion of recent years.

_**Unemployment,**_ _**although the lowest in the European Union, has risen sharply since**_

_**1990.**_

The expansion in domestic employment was very rapid between 1980 and 1994,

averaging 1.8% a year as against 0.2% for the European Union as a whole. The bulk of

this expansion was essentially met by an increase in the number of foreign workers,

__ whether resident in the

**Chart** **1** **Luxembourg**

**Employment,** **unemployment and non-resident workers,**

  - rv., **j** ( **absolute annual change)**

**C3** **Total employment**

**• Non-resident workers**

**Q** **Unemployment**

_**%**_ _**[Ê ]**_ [I] [ il Hf JlftllLlfl ] _**[M ]**_

78 80 82 84 86

_Source_ Commission services **and** Statec

country or, as was

primarily the case,

frontier workers. In

1994 resident foreign

workers and frontier

workers accounted for

28% and 25%

respectively of total

domestic employment,

with Luxembourg

citizens accounting for

6.3.1996

109 

only about 47%. The most spectacular increase was in the number of frontier workers,

which rose more than threefold between 1985 and 1994 in response to the high wages

paid in Luxembourg.

In spite of this very favourable labour market trend, unemployment has increased sharply

in recent years, from 1.7% in 1990 to 3.8% in 1995 (as defined by Eurostat). Although

this figure is the lowest for the European Union and would be considered very

satisfactory in most Member States, it is historically high for the Grand Duchy. Since this

albeit limited rise in unemployment can scarcely be attributed to unduly sluggish growth

or to an insufficient increase in the number of jobs available, it would seem to suggest

that the available pool of labour is no longer adapted to the quite specific structure of the

Luxembourg economy.

6.3.1996

110

THE NETHERLANDS

_**Steady growth maintained in 1995**_

Following a relatively mild recession in which gross domestic product never fell in

volume terms from one year to the next, the upturn began sooner than expected, i.e. at

the end of 1993. Growth was relatively strong in 1994, at approximately 2.5%», and was

slightly below 3% in 1995.

The upturn in activity was initially driven mainly by exports; in 1995 export growth

accelerated, while domestic investment, especially by firms, showed renewed buoyancy.

Domestic demand was also bolstered, by the increase in private consumption which

continued to grow at the moderate pace recorded in 1994, i.e. approximately 2%. A

slightly more marked increase in real disposable income and the improvement in the

labour market situation underpinned spending by households and improved their

expectations. With domestic demand expanding, a high rate of import growth was

maintained. In 1996 activity is likely to slacken in particular as a result of the cyclical

slowdown in the Netherlands' main trading partners.

Employment, which had

practically marked time in 1993

and 1994, showed a fairly sharp

upturn in 1995; total

employment increased by 1.2%,

paving the way for a reduction

in the unemployment rate

                           - measured as a proportion of

the labour force - from 7% in

1994 to 6.7% in 1995.

**For definitions, see Table 2 for Belgium**
Inflation remained low as a
_Source: Commission's November 1995 forecasts_
result of continuing wage

restraint and the strengthening of the exchange rate; consumer prices rose by no more

than approximately 1.9% in 1995. The external trade and current account surpluses again

increased, with the latter reaching 4.8% of GDP in 1995, as compared with 4.4% in

1994.

The main target of monetary policy is to maintain a stable parity between the guilder and
the German Mark due to the strength of the guilder in the exchange rate mechanism of

the EMS, the Dutch central Bank has been able to reduce secured loans rate to 2.75% at

6.3.1996

Ill

the end of 1995. Long-term rates have closely followed the German rates while short
term rates have been consistently lower than in Germnay, with the differential reaching 
0.25% at the end of 1995.

_**The priority economic-policy objectives: public finances and employment**_

The two main problems currently facing the Dutch economy, which constitute the

principal priorities of the last convergence programme adopted in December 1994 and of

the current government's programme, are the fight against unemployment and the public

finance situation.

Unlike most other

**Table 2** Member States, the
**Netherlands: Economic policy indicators**

Netherlands was successful,

**1991-93** **1994** **1995**

during the recession of the

Money growth **6.4** **-0.5**
(% change) early 1990s, in limiting the

Government budget balance -5.1 -3.3 -3.2 **-3.1** growth in the general
(% of GDP) government deficit, which

Gross government debt 77.3 79.9 **78.0** 78.4

reached a maximum of 3.9% of

(% of GDP)

Nominal wages per head 1.7 **4.1** 2.3 3.2 GDP 'in 1992. However, the
(% change) deficit decreased only slowly,

Real wages per head 0.8 1.2 0.0 **1.5** since it is still at 3.1% in 1995
(% change)

and should be reduced to 2.8%»

For definitions, see Table 2 for Belgium

in 1996, below the 3%

_Source: Commission's November 1995 forecasts_

reference value in the Treaty.

Taking into account the improvement of the economic situation since the beginning of

1994, this means that the structural deficit has only marginally decreased. The reduction

of the public deficit has not been sufficient to bring about a significant decrease of the

ratio of gross government debt to GDP, which has fluctuated around 80% since 1988

and still stood at 78.4% in 1995. The current fiscal policy in the Netherlands aims

simultaneously to reduce the ratio of government debt and deficit to GDP and to support

growth and employment by reducing taxes and social security contributions, aiming

especially at cutting non-wage labour costs.

**Table 2**
**Netherlands: Economic policy indicators**

**1991-93** **1994** **1995**

**-0.5**

Money growth

(% change)

**6.4**

Government budget balance

(% of GDP)

-5.1

-3.3

-3.2

**-3.1**

Gross government debt

(% of GDP)

Nominal wages per head

(% change)

77.3

79.9

**78.0**

78.4

3.2

2.3

1.7

**4.1**

Real wages per head
(% change)

0.0

**1.5**

0.8

1.2

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995 forecasts_

Since the second oil shock, the Netherlands has succeeded in reducing unemployment

more rapidly and more sharply than most other Member States despite an increase in the

labour force of almost twice the Community average. Similarly, unemployment increased

only fairly moderately during the last recession and remained far below the level recorded

in the early 80s, whereas it reached record levels in many other Member States. This

good performance by the Netherlands is due in part to the very low participation rate,

6.3.1996

112

**Chart 1 - Netherlands**

**Labour market trends**

Unemployment rate (%) Employment ( 1970 =100)
_(Left-hand scale)_ _(Right-hand scale)_

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

   - Employment - EUR 15

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

Note: Unified Germany from 1991 onwards

**Nominal compensation per employee**

relative to EUR15 (EUR15=100), 1980=100

130

80

which is a consequence of

the systematic recourse to

an early retirement system

and of an exceptionally

high number of persons

deemed unable to work

for medical reasons.

However, the favourable

evolution in Dutch

unemployment is also due

to the strong growth in

employment since the

second oil shock, which

resulted in particular in a

substantial increase in

part-time working,

especially with women

working in the service

sector. This growth in

employment reflects the

fact that, for almost 15

years, wage growth in the

Netherlands has been less

than in the Community as

a whole and the main

trading partners in

particular, either in

70 h

-Eur4inECU

-NL, in ECU

- NL, in Dutch guilder

70 72 74 76

Eur4=B DKWDF

iSowrce.Commission services

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

The economic performance of the Netherlands in recent years and its successful

emergence from recession, compares favourably with other countries, clearly placing it

among the Member States achieving the most satisfactory degree of nominal

convergence. However, further efforts need to be made in order to bring a fundamental

solution both to the problems of employment and of public finance.

6.3.1996

113

**AUSTRIA**

_**Although decelerating, growth was solid in 1995**_

As a small, open economy Austria is strongly affected by international developments.

Nevertheless, with the help of a specific policy mix it has managed in the past to partly

compensate negative external effects. Among others, a combination of a hard-currency

exchange rate policy and a productivity oriented incomes policy helped to keep both

inflation and unemployment low, while in general GDP growth rates were above the EU
average.

In recent years, the Austrian

**TaUe 1**
**Austria: Macroeconomic performance** economy benefited from

**1986-90** **1991-93** **1994** **1995** significant productivity gains

**GDP growth rate** **3.0** **1.7** **3.0** **2.4** and its exports to the European
**(% change)**

car industry. Tourism is another

**Total domestic demand** **3.4** **1.6** **4.5** _**in**_
**(%** **change)** traditional field of Austrian

**Employment** **(%** **change)** **1.1** **1.5** **0.3** **0.2** specialisation. That sector's

**Unemployment** **rate** **(%)** **3.4** **3.8** **4.4** **4.5** surplus has offset the large

**Inflation** **(%** **change)** **2.1** **3.6** **3.0** **2.2**

merchandise trade deficits,

**Balance of current account** **0.2** **-0.1** **-0.9** **-1.8**
_**(%**_ **of GDP)** especially with Germany. The

**For definitions, see Table 2 for Belgium** opening of Eastern Europe
_**Source: Commission's November 1995 forecasts**_
_*****_ increased competition, but also
**Taking into account latest information**

brought new opportunities:

Austria's eastern neighbours

showed a strong interest in Austrian consumer and investment goods and the process of

structural adjustment in Austria was to some extent speeded up by transferring

labour-intensive processes to neighbouring countries with considerably lower wage

costs.

**TaUe 1**

**Austria: Macroeconomic performance**

**1986-90** **1991-93** **1994** **1995**

**3.0**

**GDP growth rate**
**(% change)**

**3.0**

**1.7**

**2.4**

**4.5**

**Total domestic demand**

**(%** **change)**

_**in**_

**3.4**

**1.6**

**0.3**

**4.4**

**3.0**

**-0.9**

**0.2**

**4.5**

**2.2**

**-1.8**

**Employment** **(%** **change)**

**Unemployment** **rate** **(%)**

**1.5**

**Inflation** **(%** **change)**

**Balance of current account**

_**(%**_ **of GDP)**

**1.1**

**3.4**

**2.1**

**0.2**

**3.8**

**3.6**

**-0.1**

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

In 1995, real GDP may have grown by about 2 [1] /2%, somewhat less than in the previous

year (3%). The slowdown mainly resulted from adverse effects of the Schilling's

appreciation and a predominantly cyclical decline in construction demand. Nevertheless,

a favourable export performance and a strong demand for investment equipment

supported a solid real GDP growth. Private consumption developed well in 1995,

stimulated especially by the real disposable income but also by facilitated possibilities of

shopping abroad. Investment in equipment grew strongly, mainly reflecting the increased

6.3.1996

114

need to restructure and improve productivity in order to maintain competitiveness within

the European Union. Public consumption increased only moderately. At the same time,

investment in construction decreased, mainly due to the normal pattern of the

construction business cycle. Unlike in recent years, the budgetary strains limit the public

sector's possibilities for additional investment in infrastructure.

The external balance worsened significantly, mainly due to a sharp decrease of the

traditional surplus in tourism for the second year in a row. Despite the effective

appreciation of the Austrian Schilling, commodity exports performed very well, partly as

a result of improved market access due to EU-membership, but also benefitting from the

strong international demand for equipment investment, not just in the European Union

but also in Central and Eastern Europe. Exports outperformed imports, thus contributing

to a slight improvement in the trade balance. But the Schilling's appreciation stimulated

imports too, not least through travelling and shopping abroad. Low air-fares contributed

to this trend. At the same time, Austria's tourism exports were confronted with

decreasing demand. Especially tourists from Germany, which account for about 60% of

Austria's foreign guests, shifted towards other destinations. While the relatively price

inelastic winter tourism developed well, summer tourism experienced lower revenues as

a result of exchange rate related losses in price competitiveness and occasional

deficiencies in the quality supply. Tourism in Austria is not only highly specialised on

visitors from Germany and the Netherlands, but it is also confronted with significant

overcapacities, while low capital reserves increase the vulnerability with respect to

demand fluctuations. The stagnation in tourism revenues underlines the need for

structuraT adjustment.

These developments led to a marked deterioration of the current account. In addition, for

the first time Austria contributed to the EU-budget, which further weakened the current

account balance by some 0.7% of GDP. However, despite the breakdown of the

coalition government during the set up of the 1996 budget, the credibility of the

exchange-rate peg to the DM was not affected.

Price inflation moderated significantly in 1995. Agricultural producer prices dropped due

to the shift to the CAP; the Schilling's appreciation further relieved import costs.

Nevertheless, despite higher competitive pressure it took some time for prices and cost

advantages to be passed on to consumers. The effect of EU-membership is estimated to

have lowered consumer prices by _VA_ percentage points by the end of 1995.

6.3.1996

115

_**Labour market performance worsens and the budget deficit widenes**_

Recent output growth has not

Table 2
Austria: Economic policy indicators sufficiently translated into

employment growth. On the

1986-90 1991-93 1994 1995

Money growth **7.2** 5.4 5.3 contrary, especially in manu(% change) facturing increased investment

Government budget balance **-3.2** **-3.0** **-4.4** -5.5

in equipment reduced the need

(% of GDP)

Gross government debt 58.1 59.9 65.2 68.0 to hire additional labour in
(%ofGDP) order to meet increased output.

Nominal wages per head **4.4** 5.6 3.1 **4.0**

In contrast with past

(% change)

Real wages per head **2.3** **2.0** 0.1 1.5 experience, reduced job
(% change) opportunities in manufacturing

For definitions, see Table 2 for Belgium are not being compensated by
_Source:_ _Commission's_ _November 1995 forecasts_

new employment in the service

sector. The tourism industry itself faces a crisis, while the construction sector suffers from

decreasing demand, especially with respect to infrastructural investment. This

development is partly compensated by a stronger outflow from the labour force,

especially into early retirement, which, however, aggravates the financial problems due to

the strong increase in the number of pensioners and the decreasing labour force

participation raté of the Austrian pension system.

Table 2
Austria: Economic policy indicators

1986-90 1991-93 1994 1995

5.4

5.3

Money growth

(% change)

**7.2**

Government budget balance

(% of GDP)

**-4.4**

**-3.2**

**-3.0**

-5.5

65.2

68.0

Gross government debt

(%ofGDP)

58.1

59.9

Nominal wages per head

(% change)

**4.4**

5.6

3.1

**4.0**

**2.0**

Real wages per head
(% change)

**2.3**

0.1

1.5

For definitions, see Table 2 for Belgium

_Source:_ _Commission's_ _November 1995 forecasts_

**Chart 1 - Austria**

**General government net borrowing**
%ofGDP

—A H3EUR4 HEUR15

**i i**

80 81 82 83 84 85 86 87 89 90 91 92 93 94 95

 - EUR4: Four Member States with lowest deficits in 1993 and 1994 (Germany, Ireland, Luxembourg and Netherlands);
Unified Germany from 1991 onwards.
_Source_ Commission services

6.3.1996

116

After having been for a long time among those EU-countries with the lowest public

deficits, Austria's public finances deteriorated quickly from 1993 onwards, leading to a

more than doubling of general government net borrowing from 2.1% of GDP in 1992 to

4.4%o in 1994. This was partly caused by the effects of automatic stabilisers and the

second stage of a tax reform, both cushioning the negative effects of the 1993 recession.

Another important factor was a systematic underestimation of social policy related

expenditures. In 1995, Austria's EU accession increased total public spending by a further

2% of GDP. About half of those costs were internal payments to mitigate transition costs

for the agricultural and other hard hit sectors. These transition supporting payments will

fade out within the next four years, reducing the burden to the budget to less than l [x] /2%

of GDP. In order to bring public deficits back to a manageable, pre-1993 level, decisive

consolidation steps will have to be taken.

6.3.1996

117

PORTUGAL

_**Domestic demand continued to strengthen in the first part of**_ _**the**_ _**year**_

The upturn of economic activity in Portugal, which had started in 1994 primarily driven

by exports, was furthered in 1995 by the dynamism of investment and the recovery of

private consumption. Still subdued in the beginning of the year, private consumption has

gradually gained strength, as real income and consumer confidence improved. The late

recovery of private consumption reflected the consecutive fall of household real

disposable income in the two previous years as well as prolonged pessimism in consumer

confidence. In 1995, lower inflation and slower deceleration of nominal wages than in

the previous years allowed real income to increase, providing room for the recovery of

private consumption. Investment accelerated in the year, significantly induced by public

projects partly financed by the EU funds, but private investment has also picked up as

business confidence and economic activity improved. By the second half of the year,

however, this component of demand lost steam in line with the deterioration of the

external environment. Construction and machinery equipment were the most dynamic

components of investment in 1995, while transport equipment fell markedly, after the

exceptional increase in the latter part of 1994.

Exports continued to lead the

**Table** **1**
**Portugal:** Macroeconomic **performance** economic upswing in 1995, and

1986-90 1991-93 1994 1995 market share gains are likely to

GDP growth rate 5.1 **0.7** 1.1 2.5 have occurred in some external
(% change)

markets. The trend of both

Total domestic demand 7.6 **2.6** 1.7 3.3
(% change) export prices and estimated

Employment (% change) 1.8 -0.3 -02 -0.6 production costs suggests that

Unemployment rate (%) 6.1 4.6 7.0 7.2 exporters' profit margins

Inflation (% change) 11.7 10.2 5.5 4.1

increased as well. However,

Balance of current account -0.5 -2.0 -1.4 -1.4
(% ofGDP) **J** exports started to decelerate in

For definitions, see Table 2 for Belgium the second half of the year but
_Source: Commission's November 1995 forecasts_
_*_ the completion of a large
Taking into account latest information

automobile factory project

helped total exports to maintain

a significant growth rate in the year as a whole. Imports also grew at a marked pace, in

line with the expansion of total demand; as a consequence, the trade balance deteriorated

considerably in 1995.

**Table** **1**

**Portugal:** Macroeconomic **performance**

1986-90 1991-93 1994 1995

1.1

GDP growth rate
(% change)

5.1

**0.7**

2.5

3.3

Total domestic demand

(% change)

1.7

7.6

**2.6**

-02

7.0

5.5

-1.4

-0.6

-1.4

Employment (% change)

Unemployment rate (%)

6.1

1.8

-0.3

4.6

10.2

-2.0

7.2

Inflation (% change)

11.7

4.1

Balance of current account

(% ofGDP)

-0.5
**J**

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

6.3.1996

118

Due to the delay in the

Table 2
Portugal: Economic policy indicators recovery of domestic demand,

[

the labour market situation

[ 1986-90 1991-93 1994 1995 |

| Money growth 17.0 12.5 9.4 continued to deteriorate in
| (% change) 1995. Total employment fell

| Government budget balance -4.7 -5.6 -5.7* -5.2*
I (% of GDP) by 0.6%o on average, more

R Gross government debt 64.4 66.6 69.4 70.5 than in the year before.
| (% of GDP) However, this is due to a

I Nominal wages per head 16.4 11.0 4.8 6.0
I (% change) slower expansion of the

Real wages per head 4.2 0.7 -0.7 1.7 number of self-employed. In
(% change) fact, self-employment, which

For definitions, see Table 2 for Belgium represented about 30% of total
_Source: Commission's November_ _1995_ _forecasts_

 - Taking into account latest information employment in 1995, increased

only marginally (by 0.3%),

after having grown by more

than 5% in the previous year. The significant expansion partly reflects a growing

preference on the part of enterprises to switch from permanent employment contracts to

"out-sourcing", with a view to reducing payroll costs. The number of wage-earners, in

turn, decreased by 1%, in 1995, after a 2% fall in the year before (-2.8% in 1993). Total

hours worked declined less, by 0.3% (in 1994 and 1993, they had fallen by, respectively,

0.4% and 2.2%). The unemployment rate (which has followed the economic cycle with a

lag of one year) rose to 7.2% on average, after 6.8% in 1994 and 5.5% in 1993;

nevertheless, it remained clearly below most EU countries, reflecting the more flexible

labour market in Portugal. But long-term unemployment increased significantly,

amounting to roughly 40% of total unemployment (34.2% in 1994); youth

unemployment grew faster than the total as well; both these facts suggest an increase in

structural unemployment. In line with labour market developments and helped by the

declining path of inflation, nominal wage growth continued slowing in 1995, albeit less

than in the years before. Excluding general government, wages implicit in collective

agreements increased by 4.8% in 1995, after 5.1% and 7.3% respectively in 1994 and

[

Table 2

Portugal: Economic policy indicators

[ 1986-90 1991-93 1994 1995 |

| Money growth 17.0 12.5 9.4
| (% change)

| Government budget balance -4.7 -5.6 -5.7* -5.2*
I (% of GDP)

R Gross government debt 64.4 66.6 69.4 70.5
| (% of GDP)

I Nominal wages per head 16.4 11.0 4.8 6.0

I (% change)

Real wages per head 4.2 0.7 -0.7 1.7

(% change)

For definitions, see Table 2 for Belgium

_Source: Commission's November_ _1995_ _forecasts_

 - Taking into account latest information

1993.

_**Inflation continued decelerating**_

Foreign exchange stability, wage moderation and the sluggish recovery of consumer

demand allowed inflation to continue on a downward trend in 1995. This trend has been

6.3.1996

119

steadily maintained since the end of 1990, when exchange rate policy was geared

towards escudo stabihty. In 1995, the consumer price index (excluding rents) rose by

4.1% on average, down from 5.2% in the previous year, and the differential vis-à-vis the

three besf performing EU economies narrowed, to 2.7 percentage points from

3.6 percentage point in 1994. The VAT rate increase in January 1995 from 16%» to 17%

affected price performance in the first quarter of the year; but the 0.75% reduction in

employers' Social Security contributions, declining labour costs, and some narrowing of

Chart 1 - Portugal

**Inflation developments**
(12 month moving average, % change)

**20**

**•Tradeables**

**Non tradeables**

**Differential** **(percentage** **points**

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

```
   1990 I 1991 I 1992 | 1993 | 1994 | 1995

```

_Source:_ `Commission` `services`

**15**

**10**

**—Portugal**

**^EUR** **average**

itt **Differential vis-à-vis 3 best countries (percentage points)**

**KatKCWttWttrev+ttX^^**
```
 1990 | 1991 | 1992 1993 1994 1995

```

profit margins in retailing may have partly offset the impact of that measure on inflation.

However,- the pattern has not been the same as regards inflation for tradeables and

non-tradeables: the first remained on a downward course over the year, assisted by the

relative stabihty of the escudo and the moderate increase of import prices; the latter,

which had particularly contributed to the deceleration of overall inflation in 1993 and

1994, showed a more moderate improvement, reflecting slower progress in wage

moderation and the revival in consumer demand.

The Spring 1995 exchange rate turmoil affected particularly the volatility of the Spanish

peseta and, to a lesser extent, the Portuguese escudo. Strong market strains led the

Spanish peseta to be realigned within the ERM, on 6 March 1995; the escudo followed

and its central parity was devalued by 3.5%. Nevertheless, in effective terms, the escudo

appreciated by about 2%, on average, in the year. Despite the relative stability of the

escudo after the currency turmoil and steady progress in nominal convergence, the

interest rate differentials vis-à-vis the German mark remained wide.

6.3.1996

120

_**Government deficit below the budget target but faster progress is required**_

The general government deficit was reduced in 1995 to 5.2% of GDP [6], after 5.7% in the

previous year. This development was mainly due to the growth of direct tax revenues,

reflecting further progress in efficiency in tax collection. The primary balance improved

slightly and just moved into surplus; but, after having fallen since 1992, interest payments

increased albeit at a lower rate than the other current expenditures. Public investment

grew significantly, by 20%, in line with the allocation of the EU structural funds. The

government debt ratio increased marginally, to 70.5% of GDP from 69.4% of GDP in

1994.

The general government deficit needs to be further reduced in line with the objectives of

the convergence programme. A strict budgetary policy must be followed, namely

because investment expenditures should be allowed to grow, in line with the availability

of EU structural funds. A rigorous budgetary policy should contribute to consolidate the

credibility of the policy pursued by the authorities, therefore allowing domestic interest

rates to come down and so reducing the still wide differentials vis-à-vis the best

performing EU economies.

6 This figure corresponds to the latest estimate of the Portuguese authorities included in the proposal of
the 1996 budget, submitted to the Parliament in February 1996. At the time of the Autumn forecasts,
the official estimate for the general government deficit in 1995 was 5.4% of GDP.

6.3.1996

121

**FINLAND**

_**From deep recession to well-founded recovery**_

Finland has been recovering from the very deep recession of the early 1990's, but the

high unemployment and public sector indebtedness will take time to be tackled. In the

second half of the 1980's, financial liberalisation and favourable terms-of-trade

developments led to a rapid credit expansion which, in turn, resulted in an unsustainable

soaring of asset prices, an overheated investment activity and an excessive rise in the

indebtedness of .the private sector in the late 1980's. The subsequent weakening of

domestic demand owed much to a sharp reversal of asset prices and the ensuing debt

problems. The severity of the recession was magnified by the falling apart of the Eastern

export markets and terms-of-trade losses, which all together led to high interest rates in

the wake of weakening confidence on the markka.

###### **r Chart 1 - Finland**

1990 Ql = 100, seasonally adjusted

**From** **recession** **to recovery**

150

125

100

-fsfCGDP '

Domestic demand

Exports
—Imports

75 I I

1990 I 1991 | 1992

_Source:_ Commission services, Statistics Finland

**fM^K**

1993 1994 1995

Despite some deceleration of growth, Finland's GDP growth reached an estimated 4.4%

in 1995. The recovery was initially driven by rapidly expanding exports since the second

half of 1991; the turnaround in domestic demand, however, came later and has been

much weaker (Chart 1). Export growth decelerated in the second half of 1995 and, due

to increasing imports, the contribution of net exports to GDP growth is turning negative.

However, due to a marked improvement in the terms of trade, the current account

showed a record surplus in 1995.

6.3.1996

122

Private consumption picked up in the second-half of 1993 as households reduced their

saving, but the recovery remained modest until mid-1994, when the pent-up demand for

consumer durables, accumulated during the recession years, started to turn into effective

demand. Private confidence has recovered in line with rising employment and increasing

real incomes, and households indebtedness is already back to the pre credit-boom level,

though households still remain cautious as to their borrowing decisions. In 1995, private

consumption increased by a figure close to 5%.

Investment provided the main impetus to economic growth in 1995. Investment in

equipment, which declined by more than 60% during the recession, picked up in the

course of 1994 and grew strongly during 1995. Export industry investments expanded

particularly fast: they had started from a low level, capacity utilisation rates were high,

**Table 1** companies profitability was
**Finland:** **Macroeconomic performance**

1986-90 1991-93 1994 1995

GDP growth rate
(% change)

Total domestic demand

(% change)

Employment (% change)

Unemployment rate (%)

Inflation (% change)

Balance of current account

(% of GDP)

4.4

3.6

-1.1

18.4

1.3

1.3

**3.4**

**4.0**

**0.2**

**4.7**

**4.5**

**-32**

**-4.0**

**-7.3**

-6.0

12.9

4.6

-3.8

4.4

4.9

2.2

172

1.1

3.5

companies was

good and their balance sheets

were relatively sound. By

contrast, construction activity

remained subdued throughout

1995: public investment

continued to decline and

private building activity was

depressed by an over-supply of

old business premises and

dwellings.

For definitions, see Table 2 for Belgium
_Source: Commission's November_ _1995_ _forecasts_

- Taking into account latest information

Employment fell strongly

during 1991-94 (by 19%) and started to pick up only in the second half of 1994,

accelerating to a 3% annualised growth in the first half of 1995, despite further job

losses in some home market services. This job increase did not, however, translate

into an equivalent fall in unemployment, because of a rebound of the activity rate

from its recession-induced low levels. Finland's traditionally low unemployment rate

rose sharply in the early nineties, having reached 19% in early 1994 before dropping

to 17.2% in 1995.

In the past, Finland had in general healthier public finances than most EU countries, with

general government balances showing surpluses. The level of public gross debt was low

and, due to large surpluses in the pension funds, there was even a strong net asset

6.3.1996

-123

position. The recession, however, led to a sharp rise in the general government deficit,

Table2

Finland: Economic policy Indicators

j """" 1986-90 1991-93 1994 1995

Money growth 135 35 6.1 :

(% change)

Governmentbudgetbalance 40 -5.1 -63 * -5J6 
(% of GDP)

Gross government debt 165 40.6 59.8 603 *

(% of GDP)

Nominal wages per head 8.8 _22_ _IS_ 53 *

(% change)

I

Real wages per head I 4.1 -1.7 12 42 *

which was attributable to state

finances, as local government

and social security funds

showed surpluses. The recovery

has already contributed to put

the deficit onto a declining

trend, although in 1995 a

number of temporary and

exceptional factors affecting

both revenues and expenditures

(e.g. timing of tax refunds, and

transitory effects of the change

from sales tax to value added

tax as well as of joining the EU)

For (% definitions, change) see Table 2 for Belgium I

_Source: Commission's November 1995 forecasts_
 - Taking into account latest information

masked this trend; however, the central government deficit remained large in 1995 (10%

of GDP).

So far the upswing has shown no signs of emerging inflationary pressures. In 1995,

consumer prices rose only by 1.1%; in December 1995, the increase in the CPI from

the previous year was only 0.3%. Import prices remained stable throughout 1995 due

to the strengthening of the markka, and food prices declined by a tenth as a result of

Finland's accession to the EU. The centralized two-year wage agreement signed in

September 1995 has further contributed to moderate inflation expectations. The

agreement will constrain wage increases to about 2 % in both years.

Monetary policy remains targeted at low inflation. The development of monetary

aggregates has been very moderate. In response to inflationary pressures, the Bank of

Finland one month tender rate was first raised in February and then in June 1995, when it

reached 6%. After September 1995, however, the tender rate was cut four times

altogether by _VA_ percentage point to 4Vi% by the end of 1995. Low inflation, favourable

inflation outlook and, later, lower economic growth motivated these interest rate cuts.

By the end of 1995, interest rate differentials with Germany had narrowed to one

percentage point in the long end and half a percentage point in the short end.

6.3.1996

124

_**High unemployment and central government indebtedness are the main challenges**_

Whereas the economic recovery seems to be on sound ground, high unemployment

and heavy central government indebtedness remain the main challenges ahead for

economic policy. Fiscal policy up to 1999 is due to be conducted in the framework of

the convergence programme of September 1995 and the multi-annual employment

programme of October 1995. Hence, the two main priorities will be the reduction of

the government net borrowing and the increase in the flexibility of the economy.

The stated goal of economic policy is to meet in time all the convergence criteria of

the Economic and Monetary Union. The government is committed to maintaining

permanently the former temporary austerity measures, amounting to approximately 6:5%

of GDP, and to new expenditure cuts amounting to 3.5% of GDP, most of which are to

be implemented by 1997. The austerity measures concern grants from central

government to local government, subsidies to industry and agriculture, child benefits,

student grants, national pensions and other social assistance grants.

Government finances will be consolidated without raising the overall tax burden, but

the structure of taxation will be reformed to encourage working and employment. The

taxation of earned income will be eased, while the tax rate on capital income and the

corporate tax rate have been raised from 25 to 28%. Also environmental taxes and

indirect taxes will be increased.

Unemployment remains the biggest problem for the Finnish economy. The multi
annual employment programme aims at the very ambitious target of bringing the

unemployment rate down to 8-9% by 1999. However, structural problems, as

reflected in the increasing share of long-term unemployed, make it hard to achieve

such a target. Even if the labour market is to be made somewhat more flexible, the

fiscal consolidation process limits the scope for tax incentives such as those leading to

significant tax wedge reductions.

6.3.1996

125

SWEDEN

_**Improved economic situation**_

After the severest recession since the 1930s, during which GDP fell by about 5% of

GDP, the Swedish economy is recovering. GDP grew by 2.6% in 1994 and in the first

half of 1995 the growth rate accelerated further. The recovery is led by exports which

have induced a strong increase in manufacturing production and investment. This has

resulted in a relative increase of the industrial sector in the Swedish economy offsetting a

trend relative decline in recent decades. In 1995 it is expected that GDP growth averaged

3.7%.

During 1995, the situation of

TaUel
Sweden: Macroeconomic performance the public finances was the

1986-90 1991-93 1994 1995 focal point of Swedish

GDP growth rate 2.3 -1.6 2.6 3.7 economic policy. In the
(% change)

Total domestic demand 2.9 -2.9 1.8 1.5 beginning of the year, despite
(% change) announced measures to reduce

Employment (% change) 0.8 -3.9 -0.9 1.7

the fiscal deficit, lack of

Unemployment rate (%) 2.1 6.2 9.8 9.2

confidence resulted in a further

Inflation (% change) 6.6 6.1 3.1 2.8

Balance of current account -0.9 -2.6 0.3 1.6 depreciation of the krona and
(% of GDP) an increase in the interest rate

For definitions, see Table 2 for Belgium differential against Germany.
_Source: Commission's November 1995 forecasts_

A supplementary budget bill

with some further measures was presented in April 1995, but this could not prevent the

krona falling to an all time low against the DM and the long-term interest rate differential

against Germany increased to around 4.5 percentage points. Since then, however, the

strong growth, a marked improvement in public finances and falling inflation

expectations has increased the credibility for the Swedish economy and economic policy.

The krona has gradually strengthened and interest rates have fallen. From its low point in

April, the krona had appreciated by more than 15% against the DM by the end of 1995

and the long-term interest rate differential against Germany had diminished to some

2.5 percentage points.

TaUel

Sweden: Macroeconomic performance

1986-90 1991-93 1994 1995

2.6

GDP growth rate
(% change)

2.3

-1.6

3.7

1.5

-2.9

Total domestic demand

(% change)

2.9

1.8

-3.9

6.2

6.1

-2.6

-0.9

9.8

3.1

0.3

1.7

9.2

2.8

1.6

Employment (% change)

Unemployment rate (%)

Inflation (% change)

Balance of current account

(% of GDP)

0.8

2.1

6.6

-0.9

For definitions, see Table 2 for Belgium

_Source: Commission's November 1995 forecasts_

The economic recovery has been led by exports induced by the strong competitive

position of industry. In volume, exports of goods increased nearly 16% in 1994 and are

expected to expand by a further 13% in 1995. At the same time, world market prices for

6.3.1996

126

important Swedish export products, such as paper and pulp, increased sharply during

1995 implying strong gains in the terms of trade. As a result net exports have given a

major boost to GDP growth both in 1994 and 1995. The strong growth in exports has

led to a rapid increase in industrial production. This resulted in a sharp increase in

capacity utilisation early in the upturn, that raised fears of an upsurge in inflation. A

strong increase in investment particularly in manufacturing has, however, led to a rapid

expansion of production capacity and despite a continued increase in industrial

production during 1995, the rate of capacity utilisation remained broadly unchanged

through the year.

**Chart 1 - Sweden**

**Exports of goods and industrial production**

**Volume** **indices.** **1990** **=** **100,** **seasonally adjusted**

**'** **'** **' '**
**1985** **|** **1986** **|** **1987** **|** **1988** **|** **1989** **|** **1990**

_**Source:**_ **Commission services**

During the latter part

of 1995, a slowdown in

export growth and

industrial production

was registered due to

recent economic

indicators. This may

partly stem from the

weaker demand in

other European

countries. It may also

be partly due to the appreciation of the krona which to some extent has eroded the

previously extremely strong competitive position.

**Table 2**

**Sweden: Economic policy indicators**

1986-90 1991-93

Money growth H 7.4 6.1

(% change)

Government budget balance I 3.2 -7.1

(% ofGDP)

Gross government debt 51.8 65.4

(% ofGDP)

Nominal wages per head 8.3 4.3

(% change)

Real wages per head 1.6 -1.2
_(%_ change)

For definitions, see Table 2 for Belgium

_Source: Commission's November_ _1995_ _forecasts_

 - Taking into account latest information

**1994**

-10.8

79.3

In 1995, household disposable

incomes have been affected by

the tight stance of fiscal

policy. The result of various

fiscal consolidation measures

in 1995 is a reduction in

disposable income of more

than 5 percentage points.

Together with rather modest

wage increases in 1995 and

employment growth, this

resulted in a decrease in

disposable income of 1.5%.

6.3.1996

127

Nevertheless private consumption increased modestly and the household saving ratio

decreased somewhat compared to 1994.

In 1996, growth is expected to slow. Domestic demand is expected to remain rather

subdued partly because of a continuously strict stance of fiscal policy in coming years

that will restrict the growth of household disposable income. In such a situation, a strong

growth in exports is needed to keep up the growth rate in the economy. In this respect,

the tendency toward a slowdown of external demand during the second half of 1995 may

be cause for concern.

Producer prices increased at a rapid pace in the beginning of 1995 partly as a

consequence of the weak krona. Another factor was price increases for pulp and paper.

These price increases raised fears of a pick-up in inflation which has been the case in

previous episodes of depreciation induced recoveries in Sweden. There was also an

acceleration in the consumer price index in the beginning of 1995 and the year-on-year

increase exceeded the upper tolerance margin of the Swedish central bank's inflation

target. This upturn was, however, only temporary and in line with the appreciation of the

krona the rate of inflation has since gradually dampened and was at the end of 1995

again well inside the tolerance band.

_**Major challenges for economic policies in**_ _**coming**_ _**years**_

To bring down the rate of unemployment is one of the major challenges facing the

Swedish'authorities at present. Despite some employment gains during 1995,

unemployment has remained at an historically very high level. In this respect, the

outcome of the wage agreements in 1995, which will result in wage increases above

competitor countries in coming years, is not an encouraging sign. This is particularly

worrying given the fact that wage increases in the sheltered part of the economy

exceeded those in industry. This indicates a need to increase the efforts to improve the

functioning of the labour market. Otherwise there is a risk that the result will be an

erosion in competitiveness and an upsurge of inflation, which would be damaging for

employment prospects.

Another major challenge is to put the public finances on a sound footing after the severe

deterioration during the recession in the beginning of the 1990s. In this respect,

economic policies have so far been successful and public finances have improved

considerably since the budget deficit peaked at 13.4%» ofGDP in 1993. The deficit is

6.3.1996

128

expected to amount to some 7% of GDP in 1995 and is forecast to continue to improve

in coming years. At the same time, the rapid build-up of the public sector debt has almost

come to an end. This would be in advance of the path laid down in the convergence

programme presented in June, which forecast a considerably higher budget deficit in

1995 and also a stabilisation in the consolidated public debt at a later date than now

foreseen.

The improvement in public finances stems from the government's consolidation

programme of 118 billion kronor corresponding to some 7.5% of GDP, which is the

cornerstone in the convergence programme. The stronger economic activity has also

played an important role in the improvement. As a result of the high level of public sector

revenues and expenditures the Swedish budget is very sensitive to cyclical swings. The

improvement is due both to increased revenues and lower expenditures in roughly equal

parts. A marked slowdown in the economy in the coming years might therefore raise

fears concerning prospects for employment and public finances.

As regard monetary policy, the explicit inflation target that was announced after the

krona was left to float is for an annual increase in the consumer price index of 2% with a

tolerance limit of 1 percentage point on either side. From August 1994, monetary policy

was gradually tightened in response to indications of higher inflation expectations and

pressure. The main inflationary impulse came from the weak krona, although the

appreciation of the krona that took place in the latter part of 1995 and subdued domestic

demand helped to keep inflation within the tolerance band. Inflation expectations also fell

gradually'in the course of 1995. In January 1996 the official repo rate was reduced twice

with in total 0.46 percentage points.

6.3.1996

**-** 129

**UNITED KINGDOM**

_**The recovery continues though growth slows down**_

The recovery is now well into its fourth year and is of longer duration than that in the

rest of the EU where recovery started later. The expectation for 1995 was that growth

would slow down to more sustainable rates than the 3.9% of 1994 but, in the event,

growth was less than generally expected. While GDP in 1995 as a whole rose by 2.6%,

growth in the second, third and fourth quarters of the year averaged just under 2% at an

annual rate.

Tallel

United Kingdom: Microeconomic performance

| 1986-90 1991-93 1994 1995

GDP growth rate 3.3 -0.1 3.8 2.6
(% change)

Total domestic demand 4.0 -0.3 3.3 2.0

(% change)

Employment (% change) 1.9 -2.3 0.0 0.8

Unemployment rate (#) 9.0 9.8 9.6 8.8

Inflation (% change) 5.0 5.2 _1.5_ 3.0

Balance of current account -3.8 . -2.6 -2.1 -2.1

(% ofGDP)

In 1994, the output of

production industries grew by

5.1%, partly as a result of an

upsurge in oil production as

output from newly developed

fields came onstream.

Manufacturing and

Inflation (% change) 5.0 5.2 _1.5_ 3.0 construction output also grew

Balance of current account -3.8 . -2.6 -2.1 -2.1 strongly - by 4.3% and 4.0%

(% ofGDP)

respectively. Service output

**For definitions, see Table** **2** **for Belgium** rose by 3.6%. However, in
_Source: Commission's_ _**November**_ _**1995**_ _**forecasts**_

1995 industrial production

was subdued as oil production peaked; in addition manufacturing output was broadly flat

throughout the year and construction output fell. The service sector provided most of the

rise in GDP throughout 1995.

**For definitions, see Table** **2** **for Belgium**
_Source: Commission's_ _**November**_ _**1995**_ _**forecasts**_

The reasons for these production trends seem to be associated with changes in the

pattern of growth of final demand. Net exports contributed significantly less to growth in

1995 than in 1994. However, private consumption, despite weak retail sales, grew by

2'/2% in 1995 as a result of growth in spending on services. Real disposable income was

depressed in these quarters due to subdued wages growth and the introduction of some

personal tax rises: consequently, growth in consumption was associated with a fall in the

saving ratio. While the economy is well into the fourth year of recovery, fixed investment

has yet to enjoy the growth normally observed at this stage of the cycle and in 1995 it

rose by only 1 _Vt%._ Chart 1 contrasts the current investment performance with that of the

previous recovery. The performance has not, however, been uniformly disappointing.

6.3.1996

                  - 130

**Chart 1 - United Kingdom**

**Total fixed investment - recoveries compared**
**(seasonally adjusted)**
**Trough in GDP** **=** **100** **v** _**.**_ _**J**_ _*****_ _**'**_

**Quarters from trough** **in GDP**

_**Source:**_ **Commission services**

Though investment in

buildings and works

remained depressed,

manufacturing investment

in the first three quarters

of the year grew by 14%

at an annual rate.

Stockbuilding continued

to increase during most of

1995 and may be partly

involuntary in the face of

subdued final demand.

Growth of exports of goods was 10% in 1994 and contributed considerably to the

strength ofGDP. However, in 1995 growth of exports slowed down - partly as a result

of subdued oil exports and partly as a result of the pause in growth in other EU member

states which account for 59% of exports of UK goods. Even netting out oil, exports rose
by only an annuaUsed 2 [J] /2% between the final quarter of 1994 and the third quarter of

1995 despite the improvement in competitiveness associated with sterling's depreciation

in 1995.

TaHe2

United Kingdom: Economic policy indicators

" " 1986-90 1991-93 1994 1995

Money growth 16.3 4.6 3.5 10.1

(% change)

Government budget balance -1.1 -5.6 -6.8 -5.1

(% ofGDP)

Gross government debt 43.5 42.0 50.3 52.5

(% ofGDP)

Nominal wages per head 8.3 6.0 3.5 3.2

(% change)

Real wages per head 3.2 0.8 1.0 0.2
(% change)

The latest indicators of the

economy are mixed though

they do not suggest that

growth in activity is much

different, currently, from that

throughout most of 1995.

Retail sales grew strongly, by

(% ofGDP) _3_ _A%,_ in the fourth quarter of

Nominal wages per head 8.3 6.0 3.5 3.2
(% change) 1995 having been flat for most

Real wages per head 3.2 0.8 1.0 0.2 of 1995. Export volumes rose
(% change)

by 1% in the three months to

**For definitions, see Table 2 for Belgium** November while imports fell
_Source: Commission's November_ _1995_ _forecasts_

by _Vz%._ In contrast,

manufacturing output remained stagnant and shorter and longer leading indicators of the

economy continued to fall suggesting, and confirming, a slowdown. However, forward

**For definitions, see Table 2 for Belgium**

_Source: Commission's November_ _1995_ _forecasts_

6.3.1996

131

looking survey indicators for manufacturing suggest a pick-up in output and increased

orders in the first quarter of 1996.

Underlying inflation, measured by the rise in retail prices excluding mortgage interest

payments, crept up very gradually throughout the year to average 2.9% in the final

quarter of 1995, though this is comfortably within the Government's target range of

1-4%. This acceleration was associated with a rise, over this period, in annual producer

price inflation. In turn, this followed the earlier strong increases in input prices resulting

from rises in world commodity prices. Annual input price inflation declined significantly

in the latter months of 1995. In addition, wage inflation remained law despite a

tightening of the labour market: underlying earnings growth was no more than 3^4% in

the third quarter of 1995 - the lowest for two years. These trends are shown in Chart 2.

Monetary policy is set to achieve a target of underlying inflation of 1-4% with an aim of

securing it in the 1-2V&% range by the end of this parliament (May 1997 at the latest) and
beyond. Successive rises in base rates from _5_ _[l]_ _A%_ to _6VA%_ from September 1994 to

February 1995 ensured that inflation remained comfortably within the wider target band

despite sterling's depreciation of some 7% in 1995. However, as described above,

economic activity remained sluggish throughout 1995 and was accompanied by subdued

inflationary pressures. Base rates were reduced to _6Vz%_ on 13 December 1995 and to
_6_ _[l]_ _A%_ on 18 January of this year. The challenge facing the Government is to bring

underlying inflation within the narrower range in the short term specified and to hold it

there but, at the same time, to deliver adequate economic growth.

Though economic growth slowed down, employment continued to grow in 1995 albeit

modestly. The

**Chart 2 - United Kingdom**

**Underlying consumer price inflation (CPI*) and wages**

**%** **change on previous year**

***** **Retail** **price** **index excluding mortgage payments**
_**Source:**_ **Commission services**

employer-based survey

showed annual growth

of 0.9% in the first

three quarters of 1995

whereas the

household-based

Labour Force survey

suggested employment

growth was more

rapid. The possibility

remains that the former

**6.3.1996**

132

is not picking up new jobs in newly created businesses adequately or rising employment

in parts of the construction sector. Unemployment continued to fall and at the end of

1995 was just over 8% of the labour force: more than 2 percentage points below the EU

average. However, falls in the second half of 1995 were generally lower than those

earlier in the year as growth has slowed down markedly.

Employment growth, in association with recent GDP growth, resulted in a productivity

increase of 2.5%» in the first three quarters of 1995 at an annual rate - rather slower than

the 3.3%» of 1994. Wage inflation, as noted above, was subdued and unit wage costs in

the first three quarters of 1995 rose by only an annualised 2.1%. However the picture is

rather different for manufacturing where growth has recently been flat and underlying
earnings inflation in the third quarter of 1995 was _4_ _[l]_ _A%_ - well above the whole economy

average of _VA%._ Accordingly, productivity in manufacturing in the third quarter of 1995

was only 0.7% up on a year earlier whereas unit wage costs were some 3.7% higher.

_**Growth to continue at sustainable rates**_

The outlook is for growth to continue at sustainable rates. Certainly the economy would

seem capable of growing around productive potential of 2*/2% in the near future - a little

above "Current growth rates - as there is little indication of capital or labour shortages and

inflationary pressures remain subdued.

One factor expected to contribute to growth is a long-awaited recovery in fixed

investment though this will be moderated by falls in that of general government.

The prospects are for subdued inflation. The current moderate nature of growth is

expected to restrain wage inflation in the short term and expected growth is unlikely to

lead to a major resurgence in wage inflation over the next two years.

The UK government presented an update of the convergence programme in March 1995

based on measures introduced in the November 1994 budget. In particular, reductions in

cash expenditure on previous plans were introduced that were permitted by a better than

projected inflation outturn. A more rapid improvement in government finances was

therefore expected. In the event sluggish economic growth and, even allowing for this,

an unexpected weakness in revenues in 1995 slowed down the fiscal consolidation. This

arithmetic was acknowledged in the budget for 1996-97 presented in November 1995

which was broadly neutral in its impact on public finances.

6.3.1996

**ISSN 0254-1475**

COM(96) 86 final

### **DOCUMENTS**

EN 10

Catalogue number : CB-CO-96-105-EN-C

ISBN 92-78-01358-7

**Office for Official Publications of the European Communities**

**L-2985** **Luxembourg**