European Affairs
c/o The European Institute
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Fall 2004
By Daniel Gros, Thomas Mayer and Angel Ubide
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After several years of
unsatisfactory economic
growth, the 12-nation
euro area is stuck in a vicious
cycle. Growth disappoints,
plans are outlined
reduce fiscal deficits
below the three percent
limit of the Maastricht
Treaty, and governments
embark on successive waves of structural reform to try to increase potential output.
Year after year, however, growth disappoints again and deficits only get worse. Citizens
grow tired of ever increasing demands for reforms that seem to mean only greater
labor market insecurity and lower pension and health care benefits.
As the cycle persists, governments
run out of political capital, voter dissatisfaction
increases, and the end result is
gridlock. Meetings of policy makers and
pundits about the future of Europe are
as festive as a funeral, ending typically in
agreement that the current situation is
unsustainable and that there is no clear
way out.
Dissatisfaction is widespread: the
European Parliament elections in June
2004 showed a high level of discontent with Europe's economic performance,
and in almost all countries governing
parties suffered sharp setbacks.More recently,
regional elections in Eastern Germany,
and the ritual of "Monday
demonstrations against changes to the
welfare state, showed that the German
electorate is increasingly willing to vote
for extremist parties that are opposed to
any reforms.
How did Europe end up in this sorry
state? In addition to general opposition to any cutback in lavish welfare benefits,
Europeans are rapidly growing older and
do not want to renounce the generous
pensions that they regard as hard earned
"acquired rights. Governments, however,
are finding it ever more difficult to
pay out all the pensions implicitly promised
under the dominant "pay-as-yougo
systems in continental EU countries.
Their attempts to do so have led to
higher payroll taxes, and thus higher
labor costs, with the predictable effect of
boosting structural unemployment and
lowering economic growth.
The long run challenge is well
known: by 2050 the number of pensioners
relative to those of working age will
double for the EU-15 (the fifteen EU
member states before the Union's enlargement
to 25 members in May 2004).
If the income of the elderly is to be kept
constant in relation to the average income
of the entire population, all other
things being equal, spending on pensions
will have to double. Since pensions
expenditure is already above ten percent
of Gross Domestic Product in most
member states, this would mean increasing
total government expenditure by
over ten percent of GDP from present
levels already close to 50 percent of GDP
(even without taking higher health care
costs into account). The pressure on
public budgets - and "crowding out
the private sector - will thus become extreme
in the longer run.
Less well known is that aging is also
having an impact on trend growth, and
not only for the next generation. Europeans
stopped reproducing at the rate
necessary to maintain current population
levels about a generation ago. This
implies that the work force will soon
stop growing and will be missing its
most productive elements. The consequences
of this for potential growth can be seen by looking at the ratio of the
working age population to overall population.
Other things being equal, changes
in this ratio show how far demographic
developments affect the scope for redistribution
of economic resources. If
the ratio increases by one percent, for example,
potential GDP per capita should
also go up by one percent, provided
other factors such as productivity and
employment rates remain the same. A
fall in the ratio indicates a decline in potential
GDP per capita, implying that
there is less to re-distribute to pensioners
and other interest groups.
"By 2050 the number of pensioners relative to those of working age
will double for the EU-15
Perhaps the country suffering most
from this problem is Germany, which is
why it has become much more difficult
to reorganize the German economic and
social system in recent years. During the
five years preceding reunification, demographic
factors provided a strong tailwind
for economic policy as the ratio of
working age population to total population
was increasing by about 0.8 percent
a year. This was the result of a falling
birth rate at a time when the rise in the
number of pensioners was still moderate.
During the five years up to 2005, on
the other hand, demographic factors
acted as a head wind to economic policy.
As the graph on page 80 shows, the
German ratio will improve sharply for
about ten years, starting in 2005, because
of the impact of World War II. During
the War, birth rates collapsed and thus the increase in the number of retirees
slows sharply 60 years later. After 2015,
however, the steep long-term decline in
the German ratio is due to resume.
The total dependency ratio started
to fall rapidly after 1995, with the deterioration
during the last five years equivalent
to about 0.54 percent a year, as the
"benefits from fewer children were
overtaken by the "costs of more pensioners.
The total deterioration in
potential output growth between the late
1980s and now thus amounts to almost
1.5 percent a year. The German economic
system, which until the end of the
1990s could count on a demographic
bonus each year, in the form of less private
and public spending on children,
was simply not prepared for this change.
The sails had been set for a following
breeze, and the ship of state could not
adjust to the fact that it is now heading
into the wind.
It is interesting that France is in a
quite different situation: given its higher
birth rate, demographic change is coming
more slowly, with an important deterioration
unlikely until the next decade. The United States is following a similar
path to France, but with a somewhat
more pronounced deterioration over the
next ten years. The U.S. demographic
ratio will change from an annual increase
of 0.7 percent today to a drop of
around 0.2 percent in the five years to
2015. That is equivalent to a negative
change of over 0.8 percent a year over
the next ten years - just when the budget
deficit is supposed to be being brought
back under control.
The demographic shock is thus not
just a long-term problem. It is a reality
that has already started to dent the
growth capacity of some European
countries, especially such large euro area
countries as Germany and Italy. And EU
enlargement does not solve the problem.
On the contrary; the demographic perspective
of the ten new member countries
is even worse than that of the
EU-15. In the latter the old age dependency
ratio is projected to double, but in
some new member countries the ratio
might even triple over the next two generations.
To make matters worse, increases in European productivity have also slowed
significantly in recent years. The growth
rate of GDP per hour in the euro area
has declined from about 2.6 percent in
1990-95 to less than 1.5 percent since
1995, a decline of 1.1 percentage points.
Because the United States was moving in
the opposite direction (statistical arguments
notwithstanding, the growth rate
of GDP per hour grew 0.8 percentage
points during the same period), the European
decline cannot be blamed on
global developments.What are the idiosyncratic
factors that have caused this
decline in productivity growth?
Europe has not turned its back on
the adoption of information technology
(IT), so that cannot be the answer. In a
recent report,1 we argue that the decline
in productivity growth is due to two
main factors: insufficient investment in
non-IT intensive sectors, and a decline in
labor quality. The decline in labor quality
is probably associated with an increase
in the share of low-skilled workers
in the labor force - one of the main objectives
of the labor market reforms.
With unemployment levels still close to
10 percent, however, one wonders
whether the fault really lies with lower
skills or, more worryingly, with a mismatch
of skills, and thus an inadequate
education system.
What does this mean for future economic
growth in Europe? To answer this
question, it is important to review the
objectives of the Lisbon Agenda, adopted
by EU leaders in 2000, which is intended
to make the European Union the world's
most technologically competitive economy
by 2010. One Lisbon target is to increase
the employment rate by about
one percentage point a year. Given population
growth, this means that employment
growth has to average about 1.5 percent a year until the end of the
decade. If, however, current trends of investment
continue despite this accelerated
pace of job creation, the current
shortage of capital stock will worsen. In
addition, an acceleration of employment
growth is likely to lead to a further decline
in labor quality, as employers reach
deeper into the pool of unemployed
workers. Thus, if the Lisbon targets for
employment rates are met, productivity
growth will decline further under current
investment rates.
A sharp increase in investment will
therefore be needed to generate productivity
enhancing, sustainable growth in
the euro area. This requires a continuation
of structural reforms that free resources
from declining sectors to be
invested in growing sectors. It also requires
a decline in fiscal deficits, for they
crowd out much needed private investment,
and thus a stricter enforcement of
the European Stability and Growth Pact
(SGP).
As argued above, however, insufficient
growth has all but exhausted the
room for fiscal consolidation and structural
reform, and the risk of a collapse of
the policy making structure of the European
Union has increased - witness the
conflict between the Commission and
the Council of Ministers over the SGP.
Europe is stuck in a low growth trap.
There is a policy gridlock, in which those
responsible for fiscal and structural policy
claim their hands are bound until the
economy recovers and those responsible
for monetary policy call for fiscal and
structural policy reforms so that interest
rates can remain low.
It is a critical situation requiring
critical action. To break the policy gridlock,
one of the players must move first,
and we believe that player should be the European Central Bank (ECB). The
Bank is the only EU institution with a
reputation for prudent economic management
and, with price stability not seriously
endangered, it could afford to be
more ambitious in pursuing the secondary
objective of the Maastricht Treaty -
contributing to the general policies of
the European Union. In short, we believe
that the ECB should adopt a policy that
fosters investment and gives the European
Union "room to grow.
It is true that agreements among
governments, social partners and central
banks have, at times, succeeded in kickstarting
economies. But these are not
normal times. The risks to price stability
from a breakdown in the policy making
structure of the European Union - abandonment
of fiscal discipline, no structural
reform, and even loss of central
bank independence - are very large compared
to the risks of tolerating higher
growth for a while. Central banks must
use careful judgment in balancing sticks
and carrots. This is one of those moments
where the carrots are badly
needed. The ECB should say loudly and
clearly that it will be patient and keep
monetary policy accommodating to give
fiscal and structural policy a chance to
speed up reform.
A monetary carrot from the ECB at
this point would have the added advantage
that it might also be appropriate to
re-balance growth from a global point of
view. The risk of a sharp dollar correction
is increasing as global imbalances
(embodied by the exceptional U.S. current
account deficit) widen. The European
position has been that this issue is
not a European problem, because the
European Union is in balance. One
could thus argue that the problem lies in
the "excessive surpluses in Asia that mirror the U.S. deficit. But Europe is the
world's largest trading block and cannot
just leave the global scene to a game between
the United States and Asia.
Without the extraordinary U.S. contribution
to global demand, EU growth
in the last two years would probably
have been even lower, and the European
Union might then not have been in balance.
Europe has been free riding on "excessive
U.S. consumption, and should
therefore contribute to the resolution of
the global imbalances.
The optimal solution would be for
emerging markets to run current account
deficits to allow for a turn around
in the U.S. current account and enable
the aging developed world to accumulate
net foreign assets. But the risk of a sudden
balance of payments crisis makes
this option unfeasible. A second best
choice would be for Europe to contribute
to resolving the problem by
adopting policies that foster domestic
demand growth and accommodate an
appreciation of the euro. In view of the
need for fiscal discipline, a patient monetary
policy would be adequate from this
perspective.
In conclusion, the euro area is at a
critical juncture, with increased uncertainty
about the sustainability of its policy
making structure. The Stability and
Growth Pact is already being twisted and
partially abrogated, and the same might
happen to the independence of the ECB
if growth does not return. There is a
limit to the patience of politicians, and if
reform does not yield any growth payoff,
governments may conclude that reform
is no longer worth the trouble and
adopt populist and myopic policies.
We believe that the ECB has an important
role in preventing this from happening.
Daniel Gros (above left) is the Director of
the Centre for European Policy Studies. He has served on the staff
of the IMF, as an advisor at the European Commission and as visiting
professor at the Catholic University of Leuven and the University
of Frankfurt. Thomas Mayer (center) is Managing
Director and Chief European Economist at Deutsche Bank in London.
Previously, he was Director of Euroland Economics at Goldman Sachs,
Frankfurt. Angel Ubide (right) is Director of Global
Economics at Tudor Investment Corporation in Washington, DC. He
was previously Chief Economist at the French Desk of the International
Monetary Fund.
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