EUROPE

Spring 2011

by Celine Allard / Luc Everaert

As well as being beset by national debt crises among its most vulnerable members, the eurozone looks to be caught in the doldrums of low growth and an aging workforce. IMF economists Luc Everaert and Céline Allard put forward their plan for infusing it with new vigour

Never before has economic growth been as important as now for the euro area. The region is not only struggling to emerge from one of the deepest shocks in history, but it is doing so on the eve of a dramatic aging of its population. Stubbornly high unemployment is threatening to become chronic, and is also very unevenly distributed across the area.

Both the crisis and demographics are therefore dampening the region’s growth potential, and are putting pressure on budgets. As people live longer, demands on these budgets for spending on pensions and on healthcare especially are set to rise dramatically. There is little doubt that without a rapid return to strong and sustainable growth these problems will be very hard to resolve. The long-term success of the region, its cohesion, its fiscal sustainability and its inclusive social model will all be at stake.

But is growth in the eurozone destined to remain elusive? Not necessarily, we argue in a recent IMF staff paper where we look for possible answers and reform priorities for balanced growth in the region. Obviously, in the very near term the lingering slack in the economy requires policies that are supportive of demand. As many euro area countries will attest, this is far from easy when fiscal space is severely curbed and the financial markets are so nervous about rising levels of public debt. Thus the burden of supporting activity will mainly fall on monetary policy, even if ultimately it is the supply side that will need to do most of the work.

So when and how did growth in the eurozone falter? At some point in the mid-1980s, living standards in what is now the euro area stopped converging toward the level of the best-performing countries. Arguably this was for two main reasons: The first being that Germany, France and some smaller northern European countries did a good enough job by matching or even exceeding the productivity of their most advanced peers, but failed to keep up their employment rates. That people choose to work fewer hours can easily be understood, but being unemployed or staying outside the labour force can hardly be ascribed to preferences. And it is especially women, older workers and the young who suffer from this predicament.

Second, in southern euro area countries, it is low productivity and the consequent lack of competitiveness that are the source of trouble. But productivity is likely to become increasingly important for all euro area countries as and if labour utilisation rises: People who are presently unemployed or underemployed will not easily become as productive as those who are already in jobs.

It’s not just more jobs that are needed but also better ones. So creating better jobs should be just as great a priority. Policymakers will clearly need to try and improve the functioning of Europe’s labour markets, but that alone won’t be enough. What is needed is a comprehensive approach to reform that would take advantage of the possible synergies that exist between labour and service sector reforms.

Europe’s post-crisis recovery is still only tentative, these reforms should be sequenced with their effects on demand very much in mind, at least in the short run. Making it easier for new companies to enter some service sectors would unleash investment, new activity and job creation – especially in the retail sector and for professional services. In the latter case there are too many restrictions that create barriers to innovation and entrepreneurship. At the same time, introducing or better targeting income tax credit schemes could help consumption while also encouraging new economic activity. In much the same way, targeted tax incentives and better child care arrangements could encourage more women to enter the labour market.

But labour markets will nevertheless need to be adjusted in a holistic way. Making work pay is not an empty slogan because those people who are now outside the labour force need a real financial incentive to re-enter it: it makes no sense to withdraw benefits and then tax employees in such a way that there is virtually no net gain from taking on a job. Labour market dualism should also be reduced, and employers can be made less reluctant to hire by lowering administrative barriers and costs. Finding a job will be easier if overall labour flows become less constrained, and labour flows in Europe will be boosted. A more dynamic labour market will also equip European society better to direct resources towards the more innovative and vibrant sectors of the economy. Over the longer run, nobody doubts that better education and more innovation are needed to help fill the eurozone’s productivity gap with the United States and Japan.

So how can a comprehensive reform agenda best be achieved? The eurozone’s own short history teaches us that challenges of this magnitude can only be solved in a collaborative manner. This is all the more the case now that economic and financial integration has advanced further, and – as the crisis has demonstrated – requires a strong centre that can effectively design policies for the euro area as a whole.

Reform agendas co-ordinated from and implemented by the centre – such as the EU’s Single Market initiative that opened product market access – have recorded tremendous progress. In contrast, where action was left to national authorities, peer pressure has failed to deliver. Labour market reform, social policy measures and structural reforms under the Lisbon agenda all provide unsatisfactory examples of this.

The steps being taken in the wake of the financial crisis to strengthen governance both on fiscal and structural policies at the euro level go in the right direction. But it is still far from clear that they constitute the “great leap forward” that many are calling for, the reforms leave many enforcement issues unaddressed.

Stronger incentives to foster reform in individual eurozone countries should be embedded within the euro area’s overall framework. And that means that steps to secure a more effective functioning of the economic and monetary union will have to include four key elements.

The first is a better design for the EU's structural funds. At present, the Common Agricultural Policy and the other structural funds absorb more than 70% of the EU budget, and their disbursement isn’t linked at all to the implementation of reforms. Instead – and in line with the Commission’s proposals to re-tool financial sanctions and use the EU budget as an incentive scheme – their disbursement should be made conditional on agreed ex ante measures, reflecting countries' own National Reform Agendas but to be assessed by an independent expert group.

Secondly, we need a larger EU budget. Increased EU transfers could be financed through more transparent EU-wide instruments – such as green levies. This approach would allow a eurozone-wide approach to shaping initiatives for boosting economic growth, employment and cohesion through, say, R&D or infrastructural investments. To avoid “moral hazard”, to be eligible countries would have to commit to specific reforms and abide by EU deficit limits.

Thirdly, we need a eurozone project focused on labour market reform to reinvigorate the economy that would amount to a sequel to the Single Market initiative. Even in a “Single Labour Market”, specific features need not be entirely identical across countries – just as VAT rates are not. But a degree of harmonisation particularly for labour taxation, unemployment benefit and job protection would help level the playing field for all employees in the eurozone and improve the functioning of the economic union.

Lastly, there should be a new network of productivity commissions to renew momentum in product market reform. Newly created independent national productivity commissions could be mandated to facilitate the implementation of the services directive and to expand it to sectors not yet covered. They would be co-ordinated by a mechanism at EU level that would assess the economic costs and benefits of compliance with EU directive and regulations. Member governments would be required to respond to their recommendations in Parliaments.

Making better use of available labour is essential if Europeans are to live up to their growth potential and secure our inclusive social model. Only a comprehensive reform approach combined with stronger co-ordination at EU level will deliver the momentum needed.