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Growth and competitiveness in euro area economies

Speech by Lucas Papademos, Vice President of the ECB,
at the General Assembly of the German-Hellenic Chamber of Industry and Commerce, Athens, 22 September 2005

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(English language version of the speech delivered in Greek)

I. Introduction

It is a great pleasure for me to address the General Assembly of the German-Hellenic Chamber of Industry and Commerce. Over the years, the activities of the Chamber and its members have greatly contributed to the development of economic and financial ties between Germany and Greece. As early as the 18th century, Montesquieu observed that “two nations who traffic with each other become reciprocally dependent; for if one has an interest in buying, the other has an interest in selling; and thus their union is founded on mutual necessities”. The economic links between Germany and Greece have traditionally been strong. They can be expected to strengthen further as a result of the increasing integration of all markets in the European Union and as a consequence of the unique and irreversible connection between the economies of the two countries implied by their common currency.

Trade, investment and financial transactions between countries foster growth and prosperity. Clearly, however, the overall economic performance of the German and Greek economies will in the future also depend crucially on the evolution of the economic environment within which they operate. This environment has been undergoing rapid and profound changes as a result of technological advances and the globalisation of markets. Moreover, in Europe, the gradual completion of the internal market, the enlargement of the European Union and the introduction of the European single currency have further intensified competition; these factors have also fundamentally influenced monetary and financial conditions and imposed constraints on national economic policies.

Technological advances, market globalisation and European integration are transforming the environment within which our economies function. And they not only offer opportunities, but also pose challenges for the euro area economy and the individual Member States. This observation is not new. To say that the rapidly evolving economic environment provides opportunities and poses challenges may sound somewhat clichéd. But this does not make it less true. Indeed, I believe that it is more valid than ever. Therefore, the growth and prosperity of the European economies depend on their ability to effectively address the challenges and take advantage of the opportunities. This requires that we establish internally conditions and institutions that foster growth and adopt policies and market practices that allow our economies to successfully compete in the global market.

This brings me to the general issues I would like to address. How can we strengthen the internal sources and forces of growth in the euro area and the individual Member States? And how can we simultaneously enhance their international competitiveness? What are the necessary conditions and key policies that can effectively foster stronger sustainable growth in the euro area in the increasingly competitive global environment? The answers to these questions have aspects that pertain to the euro area as a whole and to the individual Member States. These aspects, of course, overlap and are interconnected, as the euro area economies are highly integrated and function under certain constraints imposed by the single currency. These constraints seem not to be fully understood or sufficiently appreciated by all market participants, social partners and economic authorities in some euro area countries.

In discussing the two broad issues of growth and competitiveness in the euro area, I will also address a number of specific questions concerning the economic performance of the countries of the European monetary union:

  • Have the economies of the 12 euro area countries converged sufficiently to thrive under the European single monetary policy, which is geared towards the maintenance of price stability in the euro area as a whole?

  • Are the observed divergences in growth, inflation and competitiveness across the euro area unusually large? Are they a cause for concern?

  • What are the main determinants of the relative growth performance of individual Member States?

  • Are these divergences likely to be temporary or are they likely to persist?

  • What can be done to reduce these divergences in the direction of price stability and higher sustainable growth?

II. Conditions and policies for higher euro area growth

It is no secret that the growth performance of the euro area has not been satisfactory and has repeatedly proved to be below our expectations. From the mid-1990s in particular the annual growth rate in the 12 euro area countries averaged 2.1% (1995-2004). During the six-year period following the introduction of the euro (1999-2004), real GDP in the euro area grew on average by slightly less, namely 1.9%. More recently, the recovery in economic activity following the trough reached in 2001 has been moderate and hesitant at times. This disappointing performance reflects the combined influence of several factors and shocks that, on the one hand, have adversely affected aggregate demand and, on the other hand, have constrained the expansion of aggregate supply.

Taking a long-term perspective, the determinants of potential output define an economy’s trend growth performance. Various studies have estimated that potential growth in the euro area is within a range of 2% to 2.5%. And some suggest that the lower limit of the estimated range of potential growth rates is a more realistic and relevant figure, given demographic trends and prevailing market structures and practices, and under the presumption of unchanged economic policies.

What are the fundamental causes of this unsatisfactory low trend growth in the euro area? The answers can be found by looking at the factors that determine potential or long-term economic growth: demographic trends, productivity growth and the degree of labour utilisation in the economy. The latter concept – the extent to which the labour potentially available in the economy is effectively utilised – depends in turn on the share of the working age population that enters the labour force (the labour force participation rate), the percentage of the labour force that is employed and the average number of hours worked by each person.

Europe’s long-term growth performance has been constrained by: (1) the low rate of increase of its population and the ageing of its society; (2) the deceleration of labour productivity growth since the mid-1990s, despite the fact that the level of labour productivity per hour is still very high in a number of countries; and (3) a low degree of labour utilisation (reflecting a variety of factors), despite some improvement in the utilisation of labour in recent years. I do not want to go into detail, but let me give you a few facts that help illustrate why growth in Europe is so subdued, especially when compared with the United States. Over the past decade, Europe’s population has been growing at a rate of just 0.3% per year; the United States’ population has been growing at a rate of 1.3%. Productivity growth in the United States is between 0.5 and 1 percentage point higher than on this side of the Atlantic, depending on the sector of the economy and the period chosen. Only around 70% of Europeans of working age participate in the labour market – compared with over 80% of Americans. Unemployment in the euro area is almost 9%, three percentage points higher than in the United States. Moreover, those who are employed work fewer hours. Europeans work, on average, around 300 hours less per year than Americans.

These facts reflect the influence of a variety of factors affecting the demand for and supply of labour and the ability of the European economy to further increase the efficiency with which goods and services are produced. It has been argued by a number of economists that some of these facts simply reflect a preference on the part of Europeans for more leisure time, rather than seeking additional income – in other words, that Europeans rather enjoy la dolce vita, while Protestant work ethics and a more materialistic attitude to life drive Americans to work harder. That may be an appealing explanation, but things are more complex. For example, the incentives for companies to hire staff and for people to take up work are also influenced by tax and benefit policies. More generally, productivity growth and the functioning of labour markets are affected by a host of (sometimes interacting) factors – institutions, regulations, traditions, preferences – which can be influenced, or even radically changed, by appropriate policies and reforms that can help to boost productivity growth and employment creation.

Supply-side reforms are undoubtedly of crucial importance for enhancing the long-term growth prospects and the competitiveness of the European economy. And I will elaborate on such reforms later in my speech. What should be stressed in parallel is that the maintenance of a stable macroeconomic environment is also essential. This is a necessary condition for sustained growth. The European single monetary policy has as its primary objective the preservation of price stability in the euro area. To achieve this objective, the ECB aims to maintain inflation at a rate close to but below 2% over the medium term for the euro area as a whole. During the six years (1999-2004) following the introduction of the euro, annual inflation in the euro area averaged 2%, so the ECB has succeeded in maintaining a high degree of price stability in an unfavourable environment characterised by many adverse inflationary shocks, including the continuous and substantial increase in oil prices over the last two years. More importantly, the credibility of the stability-oriented monetary policy has anchored long-term inflation expectations at levels consistent with price stability and this has helped to maintain bond yields at historically low levels. Indeed, the very low level of interest rates across the entire maturity spectrum has provided considerable and continuous support to economic growth over the past few years.

III. Output growth differentials in the euro area countries

So far, I have only talked about Europe or the euro area as a whole – as, indeed, I should, as a representative of a supranational European institution. Naturally, the aggregate data for the euro area disguise certain differences that exist between individual euro area countries as regards their growth and inflation performance. Much has been said and written about the sluggish growth in the large economies at the core of Europe, contrasting them with the “tiger economies” on the fringes. However, a careful look at the data shows that the differences in growth rates are not exceptionally large and have not increased in recent years. The dispersion of annual real GDP growth rates across euro area countries since the introduction of the euro is no greater than before. It is more or less the same as it was 30 years ago – around 2 percentage points on average. Indeed, contrary to some perceptions, the dispersion of annual growth rates has declined somewhat. It is also interesting to note that growth differentials across the euro area countries do not seem to be significantly different to those observed across regions or states within the United States.

Of course, real GDP growth has a cyclical and a trend component, and our analysis shows that the cyclical component has had a relatively limited influence on growth dispersion since the early 1990s. This indicates that the observed dispersion can be largely explained by differences in trend output growth, which are relatively long-lasting – hence the fairly stable profile of growth dispersion in the last few years. These differences in trend output growth rates might reflect structural factors, including reforms implemented in recent years.

Differences in trend growth caused by structural factors may, at least in part, reflect demographic trends or normal and healthy catching-up processes in some countries. Such growth differentials should not be a cause for concern. Catching-up processes seem to have been underway in Spain, Greece and Ireland for several years, and output growth in these countries has persistently exceeded the euro area average. In terms of cumulated GDP per capita, these countries have since 1999 grown much faster than the euro area average.

However, growth differentials may indeed be a cause for concern if they reflect rigidities and inefficiencies in product and labour markets resulting from insufficient structural reforms, or if they are caused by losses in competitiveness in some countries. Since the mid-1990s Germany and Italy have persistently been growing at rates below the average observed across the rest of the euro area, which might reflect some long-lasting structural problems in these countries. In Germany, a rigid labour market with low employment growth has prevented a pick-up in domestic demand. In the case of Italy, a strong deterioration in its price and non-price competitiveness in the context of increasing competition from the new EU Member States and from non-EU countries (especially from China), may have dampened real activity, particularly real exports. This observation leads me to the next issue I would like to address: divergence across euro area countries in terms of competitiveness.

IV. Competitiveness of the euro area countries

Competitiveness developments are of crucial importance to the real economy, and to real export performance in particular. Price competitiveness is a somewhat complex concept to define because it involves several elements. First of all, nominal exchange rate developments play a key role in determining the price of euro area exports abroad, expressed in foreign currencies. But the nominal exchange rate is not, of course, the only determinant of price competitiveness. The fact that there is a single euro exchange rate for all euro area countries is the very essence of a monetary union. This means that a period of exchange rate depreciation or appreciation represents a common shock for all euro area countries. However, countries do not all cope with this shock in the same way.

During a period of euro appreciation, euro area exporters try to lower their prices in euro terms. But the individual euro area countries have not all been equally successful in lowering their export prices in euro terms and thus maintaining their export performance. For instance, whereas German exporters have managed to significantly reduce their export prices in euro – thus staying competitive and maintaining or even expanding their market shares – Italian and Greek exporters have been less successful in reducing their export prices, partly as a result of domestic cost pressures. The differences in the evolution of domestic costs per unit produced has been a key factor helping German real exports to rise far more rapidly than Greek and Italian real exports over this period. Thus, some countries have been unable to respond in a competitive manner to external challenges, partly as a result of product and labour market rigidities that have prevented swift and adequate adjustments to relative wages and prices.

Needless to say, the international competitiveness of an economy is a broader concept than price competitiveness. It depends on the range and quality of the goods and services a country can produce and export and, correspondingly, on the way markets, institutions and policies support and promote the other aspects of the competitiveness of the country’s products. Nevertheless, the export performance of the euro area countries does depend on price competitiveness, which can be substantially affected by the cumulative differences in inflation and cost developments across euro area countries over a period of time.

V. Inflation and cost differentials across the euro area countries

Looking at the evolution of inflation rates across euro area countries over time, we observe a remarkable convergence since the early 1990s. Specifically, inflation dispersion across the 12 euro area countries declined substantially, by around 5%, between the early 1990s and 1998. Since the start of Economic and Monetary Union in 1999, inflation differentials have remained fairly stable. A measure of dispersion, the unweighted standard deviation of inflation differentials from the average euro area inflation rate has oscillated around 1 percentage point.[1] Moreover, inflation dispersion within the euro area since the launch of the single currency is no greater than in the United States.[2] It is also no greater than among regions within individual euro area countries, such as Germany and Spain.[3]

What is distinctive about the euro area is the fact that these differences in inflation rates are more persistent than elsewhere. By persistent, I mean that in some euro area countries inflation is systematically either above or below the average inflation rate in the euro area as a whole. In no less than six out of the twelve euro area countries, we have seen such persistence in differentials since 1999. Specifically, inflation has, over this period, persistently been above the euro area average in Ireland, Spain, Portugal and Greece and below the average in Germany and Austria.

What are the reasons for different inflation rates in different euro area countries, and why have they not converged (or have converged only partly), now that we have a single currency and a single monetary policy? The reasons are manifold. Some inflation differentials are simply a normal and even desirable feature of a monetary union that help to correct country-specific imbalances when national monetary and exchange rate policies are no longer available options. Such inflation differentials may reflect, inter alia, adjustments to shocks or catching-up processes. National fiscal policies, resulting in different changes to indirect taxes or administrative prices, also seem to explain part of the inflation differentials. Even though some of these factors have indeed contributed to the persistence of inflation differentials, they should not automatically be considered a cause for concern.

However, other factors, such as rigidities in price-setting mechanisms or excessive wage developments, leading to strong rises in unit labour costs in some countries, may give rise to inflation differentials that could be of concern. These factors may delay the necessary adjustment of relative prices to economic shocks and amplify fluctuations of the business cycle. According to recent research by the ECB, domestic factors, such as diverging unit labour costs, seem to be of key importance in explaining overall inflation differentials within the euro area.[4]

Let me therefore elaborate further on developments in unit labour costs across the euro area. Unit labour cost increases reflect wage developments relative to productivity gains. Since the introduction of the euro, unit labour cost developments have, indeed, differed markedly across the euro area countries. During this period the cumulative increase in unit labour costs has in some euro area countries, such as Spain, Greece, Ireland and Portugal, been significantly higher than the euro area average. As mentioned before, these are also economies where inflation has been persistently above the euro area average. On the other hand, countries such as Germany and Austria are among those with very limited cumulative unit labour cost increases over the same period, and inflation in these countries has been lower than in the rest of the euro area.

When discussing these facts we should keep in mind that unit labour cost developments in the economy as a whole can mask different developments across sectors. For instance, looking only at the manufacturing industry – which constitutes, on average, around 20% of the whole economy – unit labour cost developments seem much more benign than is the case for the economy as a whole in many countries, including Greece. This, of course, implies that unit labour cost growth is stronger in the non-manufacturing sector of the economy, especially in the services sector, which is less exposed to international competition. This seems to confirm that inflation differentials are primarily explained by domestic cost factors.

Decomposing the cumulative change in unit labour costs for the whole economy over the period 1999-2004 shows that cross-country differentials appear to stem primarily from differences in developments in compensation per employee across countries, while changes in labour productivity have been more homogeneous.

With a single currency, cost developments in individual countries, as captured by unit labour costs, play a key role in determining changes in competitiveness across the euro area countries. If a country’s unit labour costs persistently rise by more than the euro area average, this will obviously have a negative impact on its competitiveness vis-à-vis the other euro area countries as well as vis-à-vis other (non-euro area) countries that are competitors in world markets. Remaining competitive by favourably influencing domestic cost developments is, therefore, crucially important for economic activity and employment. This is not the only way, but it is an essential way.

I have so far spent a fair amount of time trying to explain the causes and implications of growth, inflation and competitiveness differentials. After all this analysis, it is time to ask: What are we going to do about it? What is the message? During the Cold War, a US Secretary of State once described a warning message sent to the Russians, rather paradoxically, as “a calculated ambiguity that would be clearly understood”. My message today contains no ambiguity, and I would like it to be clearly understood: higher long-term growth and improved competitiveness for the euro area and its member countries are urgently needed and are indeed possible. The way to achieve them is through the determined implementation of the necessary structural reforms in an environment of price stability.

VI. Structural reforms for higher (long-term) growth and improved competitiveness

This message about the urgent need for structural reforms has been repeated time and again. And by now there is indeed a large consensus in Europe about the kind of remedies that are needed to bring European economies on a sustainably higher growth path. The Lisbon agenda, as recently refined and refocused – and endorsed by all 25 EU Member States – is evidence of this broad support. The next urgent step is to focus on implementation. We have to move from recognising what is necessary to doing what is necessary. There is not enough time for me to address the appropriate structural reforms in detail. However, let me just briefly mention a few areas in labour and product markets where I think that further progress is most urgently needed.

Structural reforms are crucial in labour markets so as to make them more flexible and adaptable, to support the creation of new jobs and to increase labour utilisation. Employment protection legislation and wage-setting mechanisms, including wage indexation, also need to be reviewed. A sufficient degree of wage differentiation is important to ensure that wage adjustments closely reflect differences in regional and sectoral productivity.

At the same time, labour market policies should go hand in hand with structural reforms resulting in enhanced competition in goods and services markets. This in turn requires measures aimed at increasing the number of potential players in the market. There are significant productivity gains to be reaped in Europe by removing the considerable barriers to competition that still remain at the national and EU levels. Further efforts should therefore be made to reduce firms’ entry costs, such as the administrative burden on start-ups, and – more generally – to reduce red tape. In this context, specific emphasis should be placed on enhancing competition within and across our economies by liberalising trade in services – which account for almost seven out of ten jobs in the EU. Ensuring an institutional environment that encourages business creation and expansion should therefore be among our priorities, together with supporting innovation and the diffusion of technological progress. In order to successfully harness technological advancements – and thus to compete in world markets on the basis of superior quality and scientific and technological edge – a continuous improvement in human capital is crucial. As economic activity becomes increasingly knowledge-based and jobs shift from low to high-skilled workers through the process of Schumpeterian “creative destruction”, sustained investment in education and in research and development becomes indispensable.

To plead for all this is not “to dream the impossible dream”. That it can be done successfully is shown in the Nordic countries, which have undergone such structural reforms in the past decade – and have done so without abandoning the basic features of what we call the European social model. These countries are now reaping the benefits of these reforms in terms of growth, employment and technological excellence. We should seek to learn from each other, to analyse what works and what does not, and to adapt suitable policies to local conditions. In so doing, we should avoid unnecessary regulation or bureaucratic procedures that might be well-meant, but end up stifling growth.

In these efforts to enhance the growth performance of the European economies, fiscal policy plays a crucial role. Sound fiscal policies are not only necessary to support the stability-oriented single monetary policy; healthy public finances are a key element in shoring up the confidence of investors, businesses and consumers. Moreover, public expenditure should aim to deliver efficient and competitive public services. A reformed public sector can also play an important role as a catalyst in stimulating the restructuring of the private sector, eliminating rigidities and dismantling structures that impede competition, efficiency and the adaptability of the economy. Finally, fiscal policy should not only aim to reduce the fiscal burden, but also give due regard to the “quality of public finances”, i.e. the structure of public expenditure.

VII. Conclusions

There are plenty of challenges ahead in seeking to cope with the impact of globalisation and technological change. Not just for the euro area as a whole, but also for its individual member countries – especially those whose level of international competitiveness is relatively low and which may have been adversely affected in recent years. While Monetary Union in Europe has been an effective – and hugely successful – response to globalisation for the euro area countries, it has also placed those countries under a specific constraint – that there is only one single monetary policy, geared towards price stability in the euro area as a whole. That said, we already have the tools in our hands to address these challenges: the Lisbon strategy, as refocused and reaffirmed by the European Council this year. The tasks ahead of us are demanding, but I am optimistic. After all, we can all remember the jubilations of last summer, when “Lisbon” acquired a very special and positive connotation in Greece: as an impressive joint effort that was crowned by an overwhelming success.

Thank you very much for your attention.

[1] During the ten years before the introduction of the single currency, this measure of dispersion stood at around 2.9 percentage points.

[2] Compared with the differences in inflation rates among the 14 US metropolitan statistical areas typically used to measure such phenomena.

[3] When comparing inflation dispersion within the euro area with that within individual countries, we need to be cautious for various reasons. For instance, the methods used to calculate these differences or the definition of the number and size of the geographical regions within a Member State may differ.

[4] See also European Central Bank (2005), “Monetary policy and inflation differentials in a heterogeneous currency area” ECB Monthly Bulletin, May 2005, pp. 61-78

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