IMF Survey, Volume 35, Issue 17


Regional Focus: Without Deeper Reforms, Euro Area’s Recovery may be Short Lived

International Monetary Fund. External Relations Dept.
Published Date:
September 2006
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A buoyant economic recovery is finally under way in the euro area. But anemic productivity growth and low labor utilization bode ill for Europe’s ability to deal with the challenge of population aging. Only through a concerted reform effort, especially designed to lift sagging productivity, will the euro area be able to make a transition to faster, yet sustainable, growth.

After several false starts, the long-awaited euro area recovery has finally arrived (see chart, this page). Real GDP growth should reach about 2½ percent this year and could even turn out to be higher. But the good news is tempered by a weak labor market outlook and still-sluggish productivity growth, which could hold back domestic demand. Moreover, the risks to growth—slowing global growth, unresolved global imbalances and the related potential for euro appreciation, continued high oil prices, and flight from risk in capital markets—will become more pronounced in 2007.

The current upswing has implications for monetary policy. A stubborn tendency for headline inflation to remain above the European Central Bank’s (ECB’s) inflation objective of “close to but below 2 percent” has understandably prompted the central bank to raise official interest rates after keeping them on hold for two and a half years. The ECB’s key rate now stands at 3 percent, with markets expecting another 50 basis points of increases before year’s end. Headline inflation is projected to remain above target, so some further tightening will likely be necessary if the expansion proceeds as expected. But caution is needed, given the risks to growth and given that underlying inflationary pressures are still well contained.

Finally turning a corner

After years of lagging behind the United States, the euro area is enjoying a nascent recovery.

(quarter-on-quarter percent change in real GDP growth, annualized)

Data: IMF, World Economic Outlook September 2006.

Long-term outlook remains precarious

Beyond the current cyclical upswing, the euro area still has a long-term growth problem. Lackluster growth, rooted in low productivity growth and insufficient labor utilization and threatened further by the looming demographic shock, offers little scope for catching up with living standards in the United States. Certainly, employment growth over the past decade has been relatively strong, matching that in the United States (and exceeding it in private sector job creation). But productivity growth has slowed dramatically while soaring in the United States through the early years of this decade (see chart, next page).

Why the poor productivity growth? Part of the explanation is Europe’s success in moderating labor costs and adopting reforms that stimulate labor-intensive production. But this is not the whole story. Sluggish productivity growth is also related to high job-turnover costs and a lack of competition in product and services markets. Recent research points to a positive correlation between deregulation and productivity growth. This correlation is especially evident in telecommunications and transportation, two sectors that have already seen some liberalization. But deregulation in other sectors, especially in wholesale and retail trade, as well as in the financial sector, is still lagging.

A strategy for growth

The euro area needs to boost both productivity and employment. But where should it begin? IMF research suggests that fiscal adjustment, combined with more flexible labor and product markets, would allow wage moderation to translate into jobs rather than rents (profits captured by industry insiders because of a lack of competition).

Overall, national reform programs based on the rejuvenated Lisbon Agenda (the European Union’s (EU’s) blueprint for improving competitiveness) offer new hope for structural reform. But countries continue to shun difficult decisions—particularly decisions that would have the greatest potential payoff. For instance, countries have focused on active labor market policies and lower payroll taxation rather than on reforming employment protection legislation, which is much more controversial. Similarly, they have been much more eager to increase spending on research and development than to tackle barriers to more open and competitive markets.

Allowing for more competition

Reform of the services sector, where rents (stemming from the lack of competition) are still rife, should be a top priority. Services account for about two-thirds of the EU’s GDP, but less than 8 percent are currently traded across borders. Following much controversy, a new services directive (drawn up by the European Commission to liberalize trade in services and endorsed by member states) was finally adopted. The directive is a promising start even though the country-of-origin principle, which would have allowed a service provider abiding by the rules of its home country to operate in another country without having to also apply that country’s rules, was dropped, and even though services provided by architects, lawyers, notarists, and other professions were excluded.

Nearly half the productivity growth gap between the euro area and the United States can be attributed to the financial services sector.

Given the imminent onset of rapid population aging in Europe, fiscal adjustment is more important than it has ever been. Recent estimates suggest that public expenditure will rise by 3¾ percent of GDP through 2025, and this estimate may be on the low side. Countries would therefore do well to aim for structurally balanced budgets by 2010.

The Stability and Growth Pact, following its reform in 2005, is regaining some leverage over national fiscal policies, but Europe still needs to overcome the temptation to loosen fiscal policy during good times. Better governance mechanisms, such as independent fiscal committees that monitor developments at the behest of national parliaments and offer nonpartisan advice, could help.

Improving productivity remains a top priority

Productivity growth in the euro area, as measured by total factor productivity, continues to lag behind that in the United States.


1Euro area: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain.

Data: IMF Country Report No. 06/287, Euro Area: 2006 Article IV Consultation.

Stepping up financial sector integration

The euro area can foster productivity growth partly by chipping away at the remaining barriers to financial sector integration. Estimates suggest that nearly half the productivity growth gap between the euro area and the United States can be attributed to the financial services sector.

While there has been some progress toward integration under the EU’s financial services action plan, numerous factors still hold back the development of Europe-wide capital markets. These include fragmented payments systems as well as clearing and settlements systems, divergent tax procedures, consumer protection rules, and contract law. Too often, special interests have succeeded in capturing legislative initiatives, turning integration into something more similar to a collection of national practices than to best practice.

The segmentation of the supervisory framework is increasingly at odds with the changing nature of financial risk. Coordination problems between home and host country supervisors are exacerbated by legal and regulatory differences and by differing incentives, making it difficult to identify risks early enough and to formulate the best policy response.

The latest steps to improve financial sector supervision deserve support and must be implemented quickly. Europe should focus first on improving information flows between supervisors, including by establishing a central repository with up-to-date information on financial institutions that have systemic importance. Such a repository could also serve as a platform for crisis coordination. More fundamentally, postponing political decisions on key issues, such as the nature and size of fiscal bailouts following a crisis, continues to slow integration.

The economic news from the euro area suggests that the region may have turned a corner. But action in areas ranging from fiscal policy and labor market legislation to financial sector integration will be necessary if the recovery is not to be cut short. Meaningful reform in the product and services sectors—including the all-important financial sector—would instill new energy, allowing the region to catch up with living standards in the United States.

Anthony Annett

IMF European Department

Copies of Euro Area: 2006 Article IV Consultation, IMF Country Report No. 06/287, are available for $15.00 each from IMF Publication Services. See page 272 for ordering details. The full text is also available on the IMF’s website (

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