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The following OECD assessment and recommendations summarise Chapter 1 of the Economic survey of the Euro Area published on 4 January 2007.
The recovery is underway and is becoming more robust
The latest economic news is encouraging and bodes well for the immediate future. The economic rebound is clearly under way and there are signs that it has begun to embrace households as well. Growth in the first half of 2006 was well above potential, driven to a large extent by a rebound in business investment. It seems that the pent-up investment demand that had been put on hold in 2005 due to economic and political uncertainty is now coming on stream. The recovery has been broad-based, with most member countries growing at a healthy pace. Employment growth has also picked up, albeit modestly, and the unemployment rate has fallen below 8%. While business and consumer confidence have eased back a little from their peaks in mid 2006, they remain fairly high. Incoming orders are strong and employment expectations are healthier than they have been for many years. All in all, this points to growth rates in the near term at or slightly above the economy’s potential rate. Further out, the durability of the recovery depends on how consumers react and on progress made with structural reforms. Consumers should become more willing to spend so long as there are no more negative shocks, although consumption growth could remain constrained by fairly modest wage growth. Moreover, the consumption path may not be smooth as consumption in Germany is likely to be shuffled around by its value-added tax (VAT) increase in January 2007. There are always risks, of course, the main ones being a sharper-than-expected slowdown in the United States, another jump in oil prices, a slump in construction activity if housing markets deteriorate and an abrupt appreciation of the euro if global current account imbalances trigger a realignment of exchange rates. On the other hand, oil prices may also come down, boosting real incomes and consumption, while the momentum behind the investment pick-up could be underestimated. But the most likely outlook for the euro area is continued growth a little above potential, in which case economic slack should be absorbed fully by 2008 at the latest. This suggests that supply constraints could soon become evident again. A self-sustaining recovery will also depend on the willingness of euro area countries to pursue supply-enhancing structural reforms, especially those focused on boosting labour participation, competition and innovation. These are needed to address the euro area’s Achilles heel: slow potential growth.
An important question is why it took so long for the recovery to take hold. Other OECD economies have dealt with international turbulence more easily. To be sure, the euro area has faced stronger headwinds from the appreciation of the euro and subdued confidence, which may have been partly caused by political uncertainties, notably concerning economic reforms. But even so, relatively low resilience caused by structural rigidities has hampered the economy’s ability to bounce back quickly from negative shocks. In addition, markets are more flexible in some countries than in others, so macro policy has different effects throughout the union. Insufficient flexibility prevents the euro area reaping the full benefits of economic and monetary union. Pushing ahead with the implementation of the National Reform Programmes within the revised Lisbon Strategy should go a long way towards addressing these shortcomings.
Economic and monetary union has been beneficial overall
The single currency has undoubtedly brought benefits. It has two basic aims: to deliver price stability and to foster economic integration. On the first goal it has been a clear success, especially for those countries which had a history of high inflation and erratic monetary policy. Inflation has been stable and inflation expectations have remained well anchored despite the large energy price shocks.
On the second goal, economic and monetary union has encouraged economic integration, but there has been more progress in some areas than others. Business cycles have become more synchronised, and the range of growth and inflation rates across euro area countries is broadly in line with regional divergences in other parts of the OECD, such as across states or provinces in Australia, Canada and the United States. The single monetary policy cannot address such cross-country divergences in the euro area. Divergences in performance are more persistent in the euro area, mainly because potential growth rates are so different. Inflation differentials are also persistent, a feature that seems to be unique to the European monetary union. Whether this is problematic depends on the underlying causes, and that has to be assessed on a country-by-country basis. For example, inflation differentials driven by a catch up process are not a problem as long as they are backed by productivity improvements in the tradable sector. Moreover, price levels in the euro area are converging on average, not diverging. A more significant concern is that unit labour costs in a few countries have overshot the euro area average, and ultimately that harms competitiveness and growth.
Divergences in growth and inflation
Average annual growth rates, 2000-05, per cent
1. Except for Canada, Japan and the United States where it is CPI inflation.
Source: OECD, National Accounts of OECD Countries – online database and OECD Economic Outlook: Statistics and Projections – online database.
Trade, investment and financial linkages are strengthening
Monetary union has also encouraged stronger economic links through trade. Empirical evidence suggests that EMU has boosted euro area trade by around 5 to 15% so far and the long-run effects may be greater still. However, internal trade in services remains very low. In this respect, the prospective Services Directive would be a positive element although more ambition would have been desirable. Such product market reforms help squeeze out economic rents by boosting competition in shielded sectors. Financial markets have become more integrated since 1999, especially for wholesale products. However, retail banking and mortgage markets remain fragmented mainly because of differences in national regulations, although there are several initiatives in train to address these issues. Finally, direct investment between euro area members has increased only modestly as a share of total direct investment, although there are encouraging signs of a pick-up in cross-border mergers and acquisitions (M&A) activity recently.
Cross-border lending by financial institutions
In per cent of total lending
The full benefits of economic and monetary union are not being reaped because of a lack of flexibility
A key lesson from the early years of economic and monetary union is that resilient economies tend to thrive whereas inflexible ones have a rough ride. The main built-in balancing mechanism – the competitiveness channel – has been slow to act. This can lead to boom-bust cycles in some countries and depressed activity in others. It is important to bear this lesson in mind as the union embarks on a significant wave of expansion, with Slovenia joining in 2007 and several other countries planning to join over the next few years. The priority for current and prospective members should therefore be to ensure flexible and competitive markets so as to foster speedy adjustment to economic shocks and a more effective response to macroeconomic policy. The key requirements include the following:
Ease employment protection legislation for regular contracts in those countries where it hinders adjustment to permanent shocks, and especially where it has led to a dual labour market.
Boost wage flexibility. Bargaining at the enterprise, rather than sectoral, level and linking wage developments to productivity would help firms absorb shocks by adjusting wages rather than employment and would give workers more incentive to lift productivity because they could share in the gains. Elements that cause wage rigidities such as administrative extension (where specific wage agreements are extended to larger parts of the economy) and implicit or explicit indexation should be, when possible, abolished, or at least it should be ensured that wage developments are closely aligned to productivity. Welfare reforms, especially stricter eligibility and job search conditions coupled with effective job-search support, could make wages more responsive to labour market conditions.
Reduce barriers to labour mobility, for example, through pension portability and recognition of qualifications.
Reduce inflation inertia. Boosting competition by cutting unnecessary product market regulations and lowering barriers to internal trade would help reduce prices and make the inflation rate more responsive to demand. It would raise the likelihood of current wage moderation getting passed on to consumers rather than being absorbed in higher profit margins.
Open financial markets further. Monetary policy would be more powerful if retail banking was more competitive and if regulatory reforms made it easier for homeowners to borrow their way through a downturn. Countries would also be more likely to move in step with each other and a more integrated financial sector would make the economy less susceptible to credit cycles.
How to obtain this publication
The Policy Brief (pdf format) can be downloaded. It contains the OECD assessment and recommendations but not all of the charts included on the above pages.
The complete edition of the Economic survey of the Euro Area 2007 is available from:
For further information please contact the EU Desk at the OECD Economics Department at firstname.lastname@example.org. The OECD Secretariat's report was prepared by David Rae and Boris Cournède under the supervision of Peter Hoeller.