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The following OECD assessment and recommendations summarise Chapter 4 of the Economic Survey of the Euro Area 2005 published on 12 July 2005.
The causes of sluggish performance are mainly structural
The adoption of the euro by 12 members of the European Union represented a major step forward in the pursuit of economic integration, building upon and enhancing the achievements of the single market strategy. As a result, the euro area economy is undoubtedly in a better shape than it would have been without the continued progress towards monetary union – not least because it contributed to sustained low interest rates and enhanced financial stability. However, the economic integration that monetary union was seen as bringing has not yet translated into any visible strengthening of trend growth, while the recovery from the global downturn has trailed. There are causes at play which must be addressed primarily by structural – as opposed to macroeconomic stabilisation – policies.
With unchanged policies, trend growth would slow down further
Assuming no changes in labour force participation rates for relevant age cohorts, in structural unemployment and in labour productivity growth, potential GDP in the euro area is estimated to drop from about 2% in the period 2005 10 to 1¼ per cent in the period 2010 20 and 1% in the subsequent decade. This compares with growth rates of 3¼, 2½ and 2½ per cent in the United States. The euro area’s per capita income gap vis à vis the United States would widen from about 30% at present to 37½ per cent by 2020. This scenario looks rather bleak against the optimistic EU goal of 3% growth in 2010 and beyond; to reach it, growth would have to at least double against the unchanged policy baseline. Both productivity growth and labour force participation would have to rise substantially.
Enhancing the functioning of labour markets remains a priority
At the start of the 1970s, unemployment in the euro area countries averaged 2% of the labour force, less than half the rate in the United States at the time. The oil shocks in the 1970s, the global recession in the early 1980s and deteriorating supply side conditions dramatically changed this picture, with the unemployment rate in the euro area ratcheting up to around 9%. The euro area is still grappling with the legacy of this episode. There are signs that change is slowly occurring, as reflected in modest falls in structural unemployment and, more significantly, increases in employment rates, especially in some smaller countries. Taxes on low paid work have been cut, employment protection for temporary work eased and active labour market policies strengthened. However, there remains a large gap with the ambitions of the Lisbon Strategy. Since the European Union has a restricted mandate in this area, member countries must address the other features of labour market institutions that lead to the persistence of high unemployment and low employment rates. In particular, they should reduce the long duration of unemployment benefits, ease strict EPL for permanent jobs, move away from intervention in wage setting through administrative extension, cut the cost of low skilled labour further, reduce incentives to retire early or claim disability and lower the high tax wedge on labour. Moreover, obstacles to labour mobility should be removed to promote the efficient allocation of labour resources and enhance the resilience to shocks. The cross border portability of social benefit entitlements should be allowed and the Health Insurance Card implemented to facilitate health care provision for workers temporarily posted in another member country.
Tax wedges on labour (1)
As a percentage of gross labour costs (2), 2003
1. For a married couple with two children at the income level of 167% of an average production worker.
2. Gross wages plus employer's contributions.
3. Comparable data for Australia in 1996 is not available.
Source: OECD (2004), Taxing Wages, 2003/2004.
Integration of service markets could pay large growth dividends
Services have become increasingly important for growth and employment in all OECD economies. The examples of the United States and the United Kingdom, where services account for an even higher share of employment than in the euro area, suggest that services offer considerable job creation potential. Services markets in the euro area are still largely segmented, country by country, and this is reflected in trade statistics: internal market integration for services is nowhere near what has been achieved for goods. The potential gains from the integration of services markets fall in two broad categories: i) welfare effects associated with the convergence of prices towards the best performers; ii) faster trend economic growth by realising economies of scale, better exploiting comparative advantages and improving the allocation of resources. Regulatory obstacles to an integrated, competitive internal market for services should be removed, notably anticompetitive regulations within countries that act as entry barriers and rules that restrict the provision of services across national boundaries.
Employment in services
As a share of total employment
1. Excluding Ireland.
2. Includes Australia, Canada, Denmark, New Zealand, Sweden and United Kingdom.
Source: OECD, STAN database.
Rapid adoption and implementation of the services directive is crucial
The European Commission has identified a large number of obstacles in all parts of business sector services, and their removal is crucial for the completion of the internal market. These include the provision of some services by national monopolies, favourable tax treatment reserved to services purchased from local providers, residence requirements for shareholders, staff and regulated professions, lack of recognition of foreign diplomas, different company tax regimes and accounting rules, complicated rules for the reimbursement of value added tax to cross border service providers, restricted reimbursement of medical care provided abroad, and country specific technical standards. In January 2004 the Commission tabled a draft services directive to remove the major obstacles. The draft directive is aiming at freedom to establish a business in another member state and free trade between member states. In order to reduce obstacles to the free movement of services, the proposed directive lays down a country of origin principle, meaning that service providers are mainly subject to the legal regime of their country of establishment. However, the host country principle would continue to apply to employment conditions consequent to the Posting of Workers Directive, thus limiting the risk of “social dumping”. The proposal also aims at establishing a right for consumers to purchase services from foreign providers. Despite its anticipated EU wide benefits, the services directive has met with heavy opposition from some quarters, echoed by a call by the March 2005 European Council to duly consider the social implications of the reform. The European Commission has flagged that it will reconsider the most contentious provisions of the directive. In revising the directive it should secure the pursuit of the objective of free movement of services within the internal market. Against the backdrop of the call of the Spring 2005 European Council to make the internal market of services fully operational while preserving the European social model, ways should be found that facilitate the political acceptance of the services directive, while resisting a major watering down of its main objectives.
There also remains unfinished business in financial and transport services
The services directive does not cover some activities such as financial services, transport and telecommunications where other Community initiatives are already underway, but where progress varies. The implementation of directives concerning the liberalisation of telecommunication networks varies across countries. The European authorities have urged those countries for which implementation gaps exist to take appropriate action. The Financial Services Action Plan, the Community’s central tool to foster financial market integration, is due to be fully implemented by end 2005. However, it is important that political agreement at the EU level be reached on three proposed Directives relating to cross border mergers, aspects of company law (including the transfer of headquarters to another EU member state) and capital adequacy. Moreover, the cross border integration in financial retail markets evolves at a snail’s pace. Progress needs to be made to enhance competition and service provision, including in retail mortgage markets. The air transport sector remains fragmented despite the adoption of the “single European sky” in 2004. EU efforts to liberalise the railways sector are also incomplete. The first railways package, passed in March 2001, established the principle of vertical unbundling between transport providers, infrastructure operators and regulators, but it is still not fully implemented. A second railways package provides that freight services will be fully open to competition as from 1 January 2007. A third railways package, which proposes the opening up of international passenger services as from 2010, is still under discussion in the Council. A directive on liberalising port services, despite a 25 year delay before exposing incumbents fully to competition, has met with fierce opposition and was rejected by the European Parliament in November 2003, even though a new reform package was tabled in late 2004. The EU authorities should aim for faster progress towards competitive markets for financial and transport services, as this is crucial for the achievement of a fully fledged internal market.
Innovation policy should transcend national interests
A key to better innovation performance at the EU level is to remove cross border barriers to diffusion. Relatively weak innovation activity – including but not solely with respect to information and communication technology – is among the factors that have shaped the productivity slowdown in the euro area. As part of its Lisbon Strategy, the European Union has singled out R&D as an important lever for innovation policy, but leaving the primary competence for innovation policy in the remit of the EU member countries. However, an important key to better innovation performance in the euro area is to remove the sources of market segmentation that currently hamper the diffusion of new technologies. At the EU level, a Community Patent – still not in place due to disagreements on several issues should be implemented, and national research grant competitions should be open to interested parties from across the Community, which will create incentives to pool research budgets and thus strengthen the European Research Area. Moreover, a decline in market segmentation in the services sector would help raise the market potential for small innovative firms. At the national level, politically sensitive areas will need to be tackled, including the introduction of merit based pay and research funding, greater university autonomy and a change of culture towards the commercialisation of research. Financial market conditions for technological development also need to be strengthened, so as to ensure that successful entrants in hi tech industries are able to expand more rapidly.
The gains from structural reform are considerable
Simulations suggest a strong impact of changes in structural policy settings affecting labour markets, product markets and innovation on overall economic performance. Even partial progress would enhance employment and growth prospects significantly. Stronger potential growth would also help to improve fiscal performance so that the tax burden could be prevented from increasing or even eased, while unemployment would fall without rekindling inflationary pressure. Pushing ahead with reforms would launch a virtuous circle where growth and employment are rising and inflation declines, whilst at the same time the fiscal rules are respected. Enhanced ownership of common policy orientations in the aftermath of the Lisbon re-launch would drive forward this virtuous circle.
The macroeconomic impact of structural reform
Deviations from baseline, percentage points, average 2006-12
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For further information please contact the Euro Area Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Paul van den Noord, Boris Cournède, Line Vogt and Alexandra Janovskaia under the supervision of Peter Hoeller.
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