Economic recovery in the eurozone: how strong?

29 November 2006

Michael Deppler, Director of the International Monetary Fund’s European Department, predicted “moderate but sustained expansion” of the eurozone’s economy. He said economic recovery in Europe, falling unemployment and moderate wage increases were fuelling consumption and investment, and the IMF is predicting an economic growth rate of 2-2.25% in 2007.

Given the current spare capacity in the labour market, Mr Deppler believed that a 1.5% growth in employment could be sustained, and said that steady, but subdued, economic growth would replace the past cyclical pattern of troughs and peaks. He added that he believed the euro was “fairly valued” at 1.20-1.30 to the US dollar.

However, despite this positive picture, there are risks. Chief among these, said Mr Deppler, was the fact that European productivity remains relatively weak.

On the fiscal side, Mr Deppler said some eurozone countries had made considerable progress in reducing budget deficits, but should take advantage of the economic recovery to do more. On the monetary policy side, the European Central Bank should gradually raise interest rates to achieve long-term “neutrality”.

Structural reforms

Although Europe has introduced significant structural reforms over the past decade, Mr Deppler said Europeans remained “extremely pessimistic” about the impact of these changes, ignoring the fact that they had led to a bigger increase in private-sector employment than in the US – showing that such reforms do work.

Labour market reforms, including changes in pension entitlements, have increased the participation of older workers’ in the labour force, but this will need to increase still further to cope with the ageing of Europe’s population.

Mr Deppler said the focus in Europe now should be on raising productivity, which has fallen relative to the US in recent decades. In some sectors, the productivity gap between the US and the EU now stands at a startling 8% per annum.

One reason for this could be that while labour force participation rate in the eurozone has risen steadily, per capita income growth has declined. Current trends indicate a long-term fall in EU per capita incomes relative to the US, down from 75% to 62% of US incomes since the mid-1990s. To stimulate greater dynamism in the economy, productivity needs to increase to raise per capita incomes and boost consumption.

Other possible tools for raising productivity in this context are increasing the incentives for research and development (R&D); introducing more competition and reducing entry barriers to the services sector; and speeding up the completion of the internal market in the financial services sector.

Mr Deppler concluded that while the eurozone’s prospects were “reasonably good”, it faced significant long-term challenges which need to be addressed now, so that when the next economic downturn comes – “and it will come” - countries in the eurozone will be better equipped to cope with it.

Europe – a ‘catching up’ economic model

Marc Stocker, Senior Adviser at UNICE, said that while current growth rates stood at 2.5% in the eurozone and 2.9% in the EU as a whole, these were “fragile” and likely to decline to around 2% in 2007.

He warned that productivity was also likely to fall next year, and questioned whether the eurozone economy had the capacity to face the challenges of an ageing society and global and internal imbalances.

Mr Stocker said Europe’s institutions and policies were still those of a “catching up economy”, and needed to move into a new phase based on innovation. In this context, competition could act as a spur for productivity and innovation and help new companies with good investment projects to gain a larger share of the market.

Mr Stocker said it was important to link “flexicurity” and the “productivity challenge in Europe”, since one drawback of Europe’s relatively rigid labour markets was that it reduced adaptability and therefore the benefits of positive shocks such as that delivered by the ICT revolution. He stressed that flexibility was a key aspect of the reform agenda, and must be spread across the labour market.

Turning to budget deficits, Mr Stocker welcomed the “good news” that these were on the decline, but pointed out that while some countries had made significant efforts to reduce them, others which already had deficits below 3% were less inclined to take action to reduce them further.

He said the lack of fiscal discipline was hindering the recovery, by reducing the central bank's capacity to keep interest rates down and by triggering expectations of more painful adjustment in the future.

Mr Stocker added that his organisation had asked Jean-Claude Juncker, Luxembourg Prime Minister and President of the Eurogroup, to strengthen the ‘preventive arm’ of the eurozone’s Stability and Growth Pact.

Europe – the engine for its own economic growth

Reiner Hoffmann, Deputy Director General of the European Trade Union Confederation (ETUC), stressed the need for Europe to become its own engine for sustainable economic growth.

He said trade unions were working with other social partners to ensure a moderate wages policy but, at the same time, the population’s purchasing power had declined because of the growth of low-wage sectors. Trade unions strongly defended “social Europe”, so were dismayed about the growth of more precarious jobs and of the “working poor”.

Mr Hoffman emphasised that the trade unions supported structural reforms in the labour market, such as increasing older workers’ participation rates and pension reforms, but regretted that few people over 45 were offered the opportunity to learn new skills.

On using competitiveness to increase productivity, Mr Hoffman stressed that policies must ensure that competition was not based on lowering wages or creating excessively long working hours. Productivity could be improved by more investment and reskilling, as sectors with shorter working hours were often more productive than others with longer hours and poorly-trained staff.

The ETUC will continue to support labour market reforms, including in the services sector, providing that flexible workers also had “safety nets”, as it was important to continue “with the high road” for reform with decent incomes and conditions.

While he agreed that reforms in the financial sector were necessary as a part of economic and monetary union, Mr Hoffman believed that the current emphasis on shareholder value in some companies and sectors had led to “unsustainable” payouts.