lisbon ii – opportunities for europe€¦ · two important initiatives are on this year’s...
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Economic Research Allianz Group Dresdner Bank
Working Paper No. 35, March 08, 2005 Authors: Dr. Ingrid Angermann Claudia Broyer Dr. Arne Holzhausen Dr. Harald Jörg Jutta Kayser-Tilosen Wolfgang Leim David F. Milleker _______________________________________________________________________
Lisbon II – Opportunities for Europe
Two important initiatives are on this year’s political agenda: the revitalization of the Lisbon Strategy and the reform of the Stability and Growth Pact. Fiscal policies in line with stability are easier to implement in a strong economy, and both issues are important in determining the international role of the euro.
It is crucial that the Lisbon objectives be implemented, in order to prepare Europe’s
economy for the future. The progress made towards meeting these goals can be promptly
measured using our Lisbon Indicator. At present, the indicator is returning disappointing
results, suggesting that much work remains to be done. Realization of the Lisbon agenda
would also cause Europe to become more unified. Although this closer integration,
together with greater economic correlation, would gradually reduce the need for national
policies to stabilize the domestic economy, the Stability and Growth Pact remains
indispensable, due to the unique structure involving uniform monetary policy in the euro
area alongside what are currently 12 national fiscal policies. Any undermining of the pact
could well lead to conflicts with the ECB’s monetary policies, something which could
ultimately damage the standing of the euro. However, this is not an issue at present. Just
the opposite, with regard to the single currency, the following question is being viewed
with increasing interest: Aside from our ambition to increase Europe’s global economic
power with the assistance of the Lisbon strategy, what are the chances of successfully
challenging the US dollar’s status as the sole global reference currency?
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1. The Lisbon strategy is in need of revival Overview of the Lisbon agenda
At the Spring Meeting of the EU held in Lisbon in March 2000, the EU heads of state and
government set the goal of making the EU the world’s most dynamic and competitive
knowledge-based economy by 2010. The intention is to achieve sustainable economic
growth in Europe, creating more and better jobs as well as promoting increased social
cohesion. The Lisbon strategy, a package of measures aimed at economic, social and
ecological modernization, was developed in order to achieve this objective.
The Lisbon strategy has been the main agenda item at the European Council’s annual
Spring Meetings ever since. The Spring Meetings are centered around the European
Commission’s annual report on the current status of implementation. Over the last five
years, an increasing assortment of new perspectives have been incorporated, causing
several shifts in focus. This has resulted in the lack of any clear plan. The Lisbon strategy,
however, can be broken down into the following main areas:
• Improving competitiveness through innovation
One key issue is the promotion of information and telecommunications technologies
with the aim of boosting productivity growth. A further aim is to intensify research and
development efforts and to increase the number of highly-qualified researchers in
Europe. This is to go hand-in-hand with improvements to both general and job-related
education. The intention is to promote the interplay between science and the economy
so that new innovations can more rapidly enter the market in the form of new products.
This includes Community-wide copyright protection to be ensured by an EU patent.
• Completion of the internal market through structural reforms
The EU Services Directive aims to reduce the number of obstacles currently standing
in the way of cross-border service provision. Another objective on the agenda is the
completion of the internal market for financial services and liberalization in
infrastructure-related areas (postal, gas, electricity, transport). A further aim is the
creation of efficient social welfare systems, also with regard to establishing a pan-
European labor market. In addition, the economic climate for the setting up or further
development of innovative companies is to be improved, i.e. less red tape and easier
access to risk capital.
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• Creation of jobs and stronger social cohesion
Active labor market and employment policies are supposed to increase the number of
people in work and create more equal opportunities. An expansion of investment, in
both the quantitative and qualitative sense, is also to be made in human capital
(lifelong learning). The agenda also aims to combat social exclusion and poverty by
modernizing the social welfare systems.
• Ecologically sustainable growth
The Lisbon strategy also prioritizes improved energy efficiency, renewable energies
and clean technology, as well as the implementation of the Kyoto protocol.
When the Lisbon strategy was introduced in 2002, the European economy was riding
high. At that point, it seemed perfectly realistic to set a target of 3 % p.a. average
economic growth in real terms. The “new economy” and Internet euphoria were also at
their peak. But those heady days soon came to an end. Since then not only has the
economy slumped, but implementation of the Lisbon strategy has also stalled.
Meanwhile half of the envisaged time frame has slipped away, but the targets are still a
long way off. As a result, at the beginning of their terms of office, both the European
Commission President Barroso and the current Luxembourg president of the EU Council,
Junker, have announced their intention to breathe new life into the Lisbon Agenda.
Moreover, the European Council intends to conduct a mid-term review at its next Spring
Meeting in March 2005. The upshot will be a major revision of the Lisbon Strategy. The
President of the European Commission has already announced that his priority will be job
creation and improving conditions for business in order to boost growth. Other voices,
however, do not want the issues of solidarity and the environment neglected. Independent
of this, the revision of the Lisbon objectives could be linked to the planned reform of the
Stability Pact.
As early as March 2004, the European Council called on the European Commission to
form an independent group of experts headed by Wim Kok to perform a mid-term review
of the Lisbon strategy. The so-called Kok report was published in November 2004. It is
highly critical of Europe’s unwillingness to reform. The objectives, according to the report,
would not be achieved, due to insufficient political action, an overloaded agenda, a lack of
coherency and coordination and the ongoing need for reform in the EU member states. In
spite of this, the report still considers the Lisbon strategy to be the right answer to the
challenges facing the EU. This is also reflected by the fact that there are no major
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discrepancies between the demands made by the Kok report and the original agenda,
other than a more urgent call for implementation of the goals. The report calls on EU
member states to set out their own national “plans of action” for implementation of the
Lisbon agenda by the end of the year, making sure that industry and labor groups are
involved. The European Commission could monitor the progress made, and the Lisbon
priorities be given appropriate consideration in the EU budget.
The EU Commission has adopted some of the critical points from the Kok report and in
early February presented its program to revitalize the Lisbon Strategy. This scales
down the targets and makes them more focused. There is no longer any mention of the
original intention to turn the European Union into the most dynamic and competitive
economy. The Commission proposes putting the focus of the revised agenda on the
promotion of growth and jobs. Implementation is to be improved by both putting together
an action plan at the EU level and getting member states to present their own action
programs. In addition, each country is to have its own national commissioner (“Mr. or Mrs.
Lisbon”) to oversee implementation. With the measures presented, the aim is to achieve
annual real growth of 3 % and create six million jobs by 2010.
The Lisbon Indicator
When the Lisbon objectives were formulated in March 2000, the Commission developed a
package of more than 100 highly varied indicators covering a vast range of issues from
economic growth to social and environmental indicators. The Commission has since
agreed on a shortlist of 14 indicators1 which are to be used to “monitor” the progress
made in the implementation of the Lisbon strategy. Along with economic indicators, social
and environmental variables are also still included in the package. One of the weaknesses
here has been the failure to fully develop a quantitative valuation system to measure the
achievement of the Lisbon strategy objectives. This is where the Lisbon Indicator comes
into play.
The indicator focuses on five macroeconomic variables from the criteria list, which allow
meaningful assessment with regard to the central goal of boosting economic and jobs
growth. One requirement for the selection of the statistical series was ready availability on
1 The 14 structural indicators on the list comprise: GDP per capita, labor productivity, employment rate, employment rate of older workers, education attainment, R&D spending, business investment, comparative price levels, at risk of poverty rate, long-term unemployment, dispersion of regional employment rates, greenhouse gas emissions, energy intensity, volume of transport.
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at least a timely quarterly basis in order to be able to plot a steady development path and,
as far as possible, capture the current status quo. The individual readings are set against
a defined target figure or target path, with a reading of at least 1 having to be reached in
order to fulfil the target. Finally, the individual readings are combined into one overall
indicator, each with an equal weighting.
Lisbon indicator Economic growth Employment rate
Per capita income (per capita GDP) Labor productivity Investment ratio
Q1 00 0.90 0.98 1.00 1.10 0.44 1.00Q2 00 0.93 1.03 1.01 1.09 0.53 1.00Q3 00 0.95 1.05 1.01 1.10 0.59 1.00Q4 00 0.99 1.08 1.01 1.18 0.71 1.00Q1 01 1.02 1.09 1.01 1.21 0.80 1.00Q2 01 1.04 1.06 1.01 1.27 0.89 0.99Q3 01 1.07 0.99 1.01 1.32 1.07 0.98Q4 01 1.06 0.88 1.01 1.32 1.13 0.97Q1 02 0.92 0.74 1.00 1.32 0.56 0.96Q2 02 0.86 0.61 1.00 1.37 0.37 0.95Q3 02 0.82 0.51 1.00 1.35 0.29 0.95Q4 02 0.79 0.45 1.00 1.28 0.29 0.96Q1 03 0.77 0.38 0.99 1.18 0.34 0.95Q2 03 0.70 0.33 0.99 0.97 0.28 0.95Q3 03 0.65 0.29 1.00 0.76 0.23 0.94Q4 03 0.61 0.30 0.99 0.61 0.22 0.95Q1 04 0.62 0.34 0.98 0.52 0.30 0.95Q2 04 0.64 0.39 0.99 0.53 0.33 0.95Q3 04 0.64 0.43 0.99 0.52 0.33 0.95Q4 04
Notes on the composition of the indicator:
With regard to economic growth, the European Council had set an average growth rate
of 3 % in real terms as an achievable goal for the subsequent years at its Spring Meeting
in 2000. Although this turned out to be an error of judgment, the European Commission is
hoping to achieve a GDP increase of 3 % in 2010 with its program to revitalize the Lisbon
strategy. So this figure still applies, if somewhat less binding. The indicator used will
therefore relate current economic growth pro quarter, i.e. the real rate of change in EU15
GDP on a year earlier, against the 3 % target. In order to smooth short-term fluctuations
and focus more on longer-term trend growth, the data will be adjusted using a moving
eight-quarter average. The result of this analysis shows trend growth falling significantly
below 3 % until mid-2003, when it gradually began to firm up.
Originally, an equally clear target was set in Lisbon for employment growth, by which the
labor force participation rate, i.e. the proportion of employed people aged between 15
and 64 as a percentage of the total population in the same age group, was to rise to 70 %
by 2010. From this objective, we have charted a target path, based in 2000 (when the
labor force participation rate stood at 63 %) depicting the quarterly growth required in
order to meet the 70 % target by 2010. The current labor force participation rate is then
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compared to the target rate for the respective point in time. After an initial period of
development in line with the target, employment growth started to lag further and further
behind the required target from 2003 onwards. Although the figures are still close to the
targets, the gap is threatening to widen in the coming quarters. At the end of last year, the
economy was roughly 3 million jobs short of getting back on target.
In February, however, the Commission proposed leaving it up to the member states to set
targets for the labor force participation rate in their national action programs. For the EU
as a whole, the Commission merely penciled in the creation of over 6 million jobs. Even if
this figure is confined just to the EU15, it does not look particularly ambitious: According to
our calculations, the participation rate would just top 66 % in 2010 (it reached 64.5 % in
2004). The intention to water down the very target on which progress had been relatively
encouraging is curious. It remains to be seen whether the EU Council will adopt the
Commission’s proposals in March. If this were to happen, the employment component
would move from an underperformer to a current outperformer (see chart below), but this
would not alter the central finding of our overall indicator.
EU15: Employment (million)
150
155
160
165
170
175
180
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
target path for 70 % employment rate 2010
target path for 66 % employment rateactual
By contrast, no specifications were made with regard to the two Lisbon indicators for per capita income and labor productivity from the outset. Given that the EU heads of
government set the objective of making this the “world’s most competitive and dynamic
economy”, we have taken the USA, the world’s largest economy and one of the EU15’s
closest trading partners and competitors, as a yardstick. The European Commission also
apparently continues to deem the USA an example to be emulated, at least with regard to
the macroeconomic data. Since an absolute comparison would give rise to certain
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measurement problems, we have used a comparison of the annual rates of change as our
indicator. This also eliminates any distorting exchange rate effects. Here too, a trend is
observed based on a moving eight-quarter average. Both indicators show if, and to what
extent, the EU15 member states are succeeding in closing the gap with the USA in terms
of both prosperity and productivity (which would require the indicator to consistently
exceed 1). The result, however, indicates that the opposite is true. Labor productivity in
particular is lagging well behind. This is an area that deserves urgent attention over the
next few years (see section below), although it is worth noting here that economic growth,
employment growth and labor productivity quite naturally cannot be examined and
analyzed in isolation from one another – they are closely linked. However, the comparison
with the USA on per capita income and labor productivity provides supplementary
information helping to avoid close definitional relationships.
The fifth and final indicator we have chosen from the Commission’s list is the investment ratio, which provides a good assessment of the overall economic conditions (including
R&D expenditure), although its informative value is subject to some limitations, for
example, in a country-to-country comparison. Our benchmark for this indicator is the
investment activity of the EU15 in 2000, the year in which the Lisbon process was
launched and which was also characterized by solid economic growth. The result of our
analysis shows that just one year later, investment activity had already fallen short of
requirements.
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Lisbon Indicator
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
Q1 00 Q2 00 Q3 00 Q4 00 Q1 01 Q2 01 Q3 01 Q4 01 Q1 02 Q2 02 Q3 02 Q4 02 Q1 03 Q2 03 Q3 03 Q4 03 Q1 04 Q2 04 Q3 04 Q4 040.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
economic growth labor productivity Lisbon indicator
0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
Q1 00 Q2 00 Q3 00 Q4 00 Q1 01 Q2 01 Q3 01 Q4 01 Q1 02 Q2 02 Q3 02 Q4 02 Q1 03 Q2 03 Q3 03 Q4 03 Q1 04 Q2 04 Q3 04 Q4 040.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
employment rate investment ratioper capita GDP Lisbon indicator
Our overall indicator, which packs the components into a single number, provides a
quantified comparison of the target and actual values for the respective status quo over
time. The indicator has fallen continuously since 2002, reaching a low of 0.61 at the end of
2003 – a long way off the target. It has improved somewhat since then, and it remains to
be seen what impact innovative strategies and the revival of the Lisbon agenda will have.
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Trend growth and labor productivity
As mentioned above, the Lisbon strategy aims to achieve economic growth of 3 % p.a. in
the EU. At present, trend growth in the euro area (see box) is still lagging well behind
this target. Having climbed from around 1 % at the beginning of the 1990s to 2 ½ % in
1998, it has been moving steadily downward ever since, recently falling below 1 ½ % (see chart).
Euro area: Production trend and GDPin 1995 prices, % y-o-y
GDP euro area production trend euro area production trend USA
92 93 94 95 96 97 98 99 00 01 02 03 04-2
-1
0
1
2
3
4
5
Trend growth in the USA, by contrast, was higher over the entire observation period. It
also reached its high in 1997/98, when it stood at almost 4 %, and was recently near
2 ½ % - a good percentage point above the figure for the euro area.
Estimating trend growth There are various different methods and models available for estimating trend growth.
The statistical filter represents one simple option. A frequently used procedure was developed by Hodrick and Prescott and aims firstly to separate trends and cycles to produce an indicator of trend component development which is as smooth as possible Secondly, the aim is to keep trend deviations from the actual values at a minimum. The filter characteristics can be altered by choosing suitable parameters. The more weighting given to the trend component, the smoother the trend development. Our trend growth calculations are based on seasonally-adjusted quarterly figures for real GDP from 1991 onwards and standard filter settings for the quarterly figures.
Another theory-based and more complex method was developed by Germany’s Council of Wise Men (Sachverständigenrat). This approach assumes a production technology where the capital employed for production is the factor that limits production. Other approaches provide a direct estimate of an overall economic production function. We do not yet believe, however, that these methods are practicable for the euro area due to a lack of, or at least partially inadequate data on the total investment capital stock. Comparative studies for Germany, however, show that the application of a statistical filter produces more or less the same result as theory-based approaches.
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Growth in labor productivity is generally regarded as the key prerequisite to higher trend growth for industrialized nations. An economy’s total labor productivity indicates
how much output (in general, real GDP) can be produced per unit of work (in this case per
person employed). A country’s labor productivity depends both on its capital resources as
well as the qualifications of its employees and on labor market conditions. An increase in
labor productivity, so goes the assumption, tends to result in heightened international
competitiveness, higher levels of economic growth and, thus, greater prosperity. For this
reason, the Lisbon agenda has also set higher productivity growth as a key goal.
At least this is what a comparison between labor productivity in the euro area and the US
would suggest. The growth differential, in particular since the second half of the 1990s,
can be attributed to substantially stronger labor productivity growth (per employed person)
in the USA. The chart below shows the development of US labor productivity in relation to
the euro area. It is evident that labor productivity in both economic regions ran more-or-
less parallel until the mid-1990s. Labor productivity in the USA has recorded much stronger growth since then, exceeding euro area levels by around 13 percentage points
in 2004 (estimate). Along with stronger economic growth, this is largely due to higher
levels of US investment in IT and communications technology. Investments in new
technology take several years to pay off. This is why labor productivity in the USA has
grown so substantially, especially in recent years.
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Labor productivity: Euro area vs USAChange against euro area, 1991 = 100
91 92 93 94 95 96 97 98 99 00 01 02 03 0497.5
100.0
102.5
105.0
107.5
110.0
112.5
115.0
Still, a modest increase in labor productivity should not necessarily be looked upon as a bad thing. At a given growth rate, this will actually lead to improved employment
growth, helping to defuse problems on the labor market. This accommodates at least one
of the other main aims of the Lisbon strategy: To increase labor market participation and
improve equality of opportunity. Conversely, an increase in labor productivity at a given
growth rate would have a negative impact on the labor market.
The question as to whether a lower or higher increase in labor productivity is positive or
negative depends on the causes behind the productivity increase.
• If labor productivity grows due to a high rate of investment, this boosts international
competitiveness and economic growth. The latter is generally strong enough to create
new jobs in spite of rising labor productivity. The same applies to general technical
advancement implemented with the help of investment (e.g. IT and communications
technology).
• Sharply climbing wages lead to increased labor productivity growth. When the factor
labor becomes more expensive, the production factor capital increasingly steps in to
replace it. The same output can be generated using less work. Rising wages,
however, normally lead to a parallel increase in unit labor costs. International
competitiveness suffers, price increases on the domestic market erode household
purchasing power, and growth rates wane. This means that either fewer new jobs are
created or jobs are actually cut.
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• Reforms on the labor market can help to increase demand for labor at a given output
level. This is especially true when the reforms promote part-time work. Even though
this puts the brakes on labor productivity growth, or even pushes it down, economic
growth does not suffer, but is actually helped by the deregulation of the labor market.
The discussion above illustrates that labor productivity is an ambivalent indicator. Stagnant or slightly declining labor productivity is not necessarily synonymous with
declining trend growth. Similarly, rising labor productivity is not always accompanied by
higher growth.
Labor markets are becoming more flexible, but more reforms are needed EU employment growth was strong from the mid-1990s onwards. Although in purely
mathematical terms this curtailed the improvement in labor productivity, it meant almost
14.5 million new jobs for the 15 countries between 1995 and 2001. The economic
slowdown that emerged at the beginning of the decade put a damper on employment growth, albeit less dramatic than in earlier economic cycles. The current economic upturn
is being accompanied by only a slight increase in the number of jobs. For 2004, estimates
show employment growing by 0.6 %, and we expect it to rise by around 1 % and 1.3 % in
2005 and 2006. The positive side of this dulled sensitivity to economic cycles is that
underlying unemployment did not increase as dramatically during the economic downturn
as in the past.
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Labor market EU15in million
Employed persons (rhs) Unemployed (lhs)
2004: estimate91 92 93 94 95 96 97 98 99 00 01 02 03 04
150
155
160
165
170
175
12
13
14
15
16
17
18
The structural advances made on the European labor markets point towards a further
gradual increase in employment until the end of the decade. This should be more than
sufficient to fulfill the European Commission’s unambitious new aim of creating at least six
million new jobs. According to our projections, however, job creation in the EU15 would
not have been enough to meet the original Lisbon target of a general labor participation rate (no. of people in work/population of employable age) of 70 % by 2010.
Of all of the reform efforts over the last few years, we address only a few key points here.
Striking is the importance being attached by politicians, companies and employees to
part-time work. Not only in Germany, a number of measures have been introduced
aimed at cutting unemployment and boosting the labor participation rate, including the
promotion of so-called mini jobs. Already in the period between 1991 and 2001, for
example, part-time work proved to play an important role in EU employment growth for
women, and young people as well. According to an OECD study, the majority of part-time
workers had actively chosen reduced working hours. This would tend to suggest that the
efforts being made by several countries to make part-time employment more accessible
with more attractive conditions will continue to improve employment opportunities, in
particular for women with children (which will lead to better use of workforce potential and
the related investments in human capital). This means that there is a good chance that
one of the aims of the original Lisbon agenda will be met: To increase the labor
participation rate among women (2003: 56.1 %) to at least 60 % by 2010.
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The importance of various forms of fixed-term work has also increased across Europe.
For instance, since the end of the 1990s, it is possible to extend a contract up to three
times in Germany. Fixed-term contracts have become a commonly employed instrument
for Spanish employers. Furthermore, the nature of fixed-term employment is rarely
temporary. In an environment dominated by relatively strict dismissal protection, the
regulations governing the conclusion of temporary contracts have been gradually relaxed.
As well, a number of empirical studies attest that dismissal protection increases the
impact of exogenous shocks on unemployment.
Although the availability of fixed-term contracts increases the number of jobs and allows
employers to exercise more flexibility with their workforce, it would appear not to create
“better” jobs as far as employees are concerned. The OECD survey showed that more
than 40 % of the fixed-term employees in its member states would rather have a
permanent employment contract. One reason for this, apart from better job security, is
likely the improved access to further training that comes with a permanent position.
The marked increase in fixed-term contracts has resulted in a split on the labor markets. In the southern European countries, for example, the rate at which fixed-term contracts
were converted into permanent ones stood at less than 40 % between 1998 and 2000.
Whether or not fixed-term contracts will eventually lead to permanent employment
depends largely on whether or not the dismissal protection measures in the primary
market are relaxed. A glance at the OECD indicator for dismissal protection in the table
below shows that, on the whole, dismissal protection policy has actually been tightened
since the end of the 1990s. This means that the two market segments have become less
permeable, i.e. for many employers, fixed-term contracts remain a substitute for
permanent employment. In order to create more and better jobs, the EU countries must
relax the regulations governing permanent employment.
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Employment Protection for Regular ContractsOECD indicator of the overall strictness *
Late 1980s Late 1990s 2003Germany 2.6 2.7 2.7France 2.3 2.3 2.5Italy 1.8 1.8 1.8Spain 3.9 2.6 2.6Netherlands 2.6 2.7 2.7Belgium 1.7 1.7 1.7Austria 2.9 2.9 2.4Finland 2.8 2.3 2.2United Kingdom 0.9 0.9 1.1
EU15 2.24 2.14 2.20
* Scale from 0 (no protection) to 6 (high protection); Partial indicators like for period of notice, severance payand trial period are weighted according to a fixed scheme;Source: OECD; own calculations
Over the past few years, the reform policy in the area of unemployment benefit payments has been dominated largely by a tightening of the conditions that apply to
would-be claimants together with incentives to find employment. In France and Sweden,
for example, the amount of time for which claimants are entitled to unemployment benefits
was reduced, and the rules governing the suitability of a job more clearly defined. The
example of Denmark, however, makes it clear that the deciding factor is always the
combination of measures taken. The Scandinavian country has managed to significantly
improve labor market dynamics by implementing a combination of minimal job protection,
generous unemployment benefits and a targeted, active labor market policy.
In most EU countries, the long prevailing view is that claimants can only reasonably be
expected to accept jobs located nearby their place of residence. It only makes sense to
link entitlement to unemployment benefits to the claimant’s willingness to work in another
town or city if the transaction costs involved in mobility are acceptable. This shows that
factors other than pure labor market policy play an important role in securing a successful
labor market. Higher transaction costs, as well as insufficient wage differentiation, a lack
of language skills, and the insufficient portability of social benefits, go some way to
explaining why the regional and international mobility of EU employees is much lower than
that of workers in the US. These transaction costs include not only the taxes and fees
involved in the purchase or sale of a house, but also the consequences of
underdeveloped private rental housing markets. In Spain and Italy, for example, there
are very few rental properties available and people tend to be unwilling to move as a
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result. Although both countries are trying to promote the construction of rental housing,
this has sometimes been coupled with several regulatory hurdles. It is therefore
questionable whether or not these efforts will result in a functional and needs-focused
housing market.
This brief analysis highlights the considerable need for action in the EU15 economies,
particularly with regard to employee mobility. Although an increased focus on part-time
work and fixed-term contracts has made the labor markets more flexible, more reforms of
job protection rules for standard employment contracts are needed.
Nonetheless, one thing is clear: There is no one measure that is the key to reforming the
labor market. Rather, given that each country is starting out with a different range of
conditions, success will be based on finding the right combination of different measures.
This is why it is important that the EU bodies ask the member states to draw up action
plans, but without prescribing specific measures.
Starting points for strengthening the impact of the Lisbon strategy
The EU has set what are, on the whole, ambitious goals in the form of its Lisbon strategy.
Nonetheless, many areas of the agenda have thus far not been binding enough or have
been too vaguely worded. When there are no concrete guidelines in place, the
implementation of targets often falls short of the mark, something evidenced by the slow
implementation of EU Directives, for example. This means that the target programs must
contain clear goals, time frames and allocate responsibilities (as was the case with the
introduction of the euro). Otherwise, it is questionable whether tangible results can be
achieved. On the other hand, the agenda often goes into far too much detail (e.g. the
guidelines on school access to the Internet and the accompanying teacher training). This
means that the challenge lies in balancing the too vaguely and too specifically defined goals. In this regard, the national plans of action recommended by both the Kok
report and the European Commission could help. However, the proposed changes do not
contain any incentives or sanction mechanisms. As a result, there can be no guarantee of
improved strategy implementation.
As the Lisbon Indicator shows, even the central aims of the strategy are still a long way
off. There are deficiencies not only in the measurable targets, but also on the structural
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front. In order to make the Lisbon strategy more effective, stronger focus has to be placed on the fundamental aims and the agenda has to be trimmed down. The priorities
include growth, employment, labor productivity, increasing per-capita income and investment. For this, the way these factors interact with each other must be taken into
account. The development of labor productivity as an indicator is well-suited to measuring
the impact of investment in human capital (lifelong learning), the impact of the use of
innovations or the promotion of IT and communications technologies as well as the effect
that the interplay between science and industry have on trend growth. Any interpretation
of the indicator must, however, bear in mind the effect of labor market reforms, which,
despite their positive impact on trend growth, slow labor productivity growth.
In order to improve the overall conditions for business, it is crucial to identify where EU-
wide policy is required and where national policy offers better solutions. One of the core tasks for EU policymakers is the integration of the single market, in which the EU
Services Directive, for example, which is on the Lisbon agenda for 2005, plays a key role.
This Directive is based on the idea that service providers that do not have branches in
other EU member states can still provide services in those other countries without having
to comply with additional regulations. It also sets forth a fundamental simplification of
procedures, in order to ease the establishment of branches in another EU country. The
liberalization of cross-border service provision would contribute to higher growth and
employment. The EU is also responsible for EU-wide copyright protection, which requires
consensus on a Community patent. This would promote innovation and, thus, investment
Furthermore, the mobility of employees must be improved, for example through the
portability of welfare entitlements.
The EU Directive on Services The nucleus of the Directive is the country of origin principle, according to which a
service provider may also operate temporarily in other EU Member States without having to satisfy their possibly more extensive regulatory provisions. Liberalization of the services sector is expected to have substantial growth and employment effects, given that the sectors involved generate around 50 % of EU GDP and some 60 % of employment. Also, many of the sectors concerned are labor-intensive. Wherever legal and administrative barriers are dismantled within the Union, competition intensifies and unleashes price wars. Companies come under pressure to boost productivity so that they can cut their prices. Lower prices, in turn, stimulate demand and hence employment. The European Commission therefore estimates that cross-border services and direct investment could rise by 15-35 % and GDP by 1-3 %. Although this figure appears plausible, the Directive is unlikely to be implemented in its original form.
17
The planned Directive on Services focuses on consumer sovereignty. Consumers can
make up their own minds whether they are prepared to pay a high price for a high-quality service or would rather pay less for lower quality. This, of course, reduces market transparency. Although service providers are obliged to make information available (e.g. via the Internet) on their qualifications, the scope of their service or guarantees, no consumer can be expected to be conversant with all EU-wide standards. All that remains is to seek out one of the European consumer advice bureaus dotted sparsely across the EU.
The differences in professional qualifications EU-wide are quite considerable. However,
the recognition of professional qualifications is dealt with in a separate proposal for a Directive. As long as service providers work only temporarily in the host country, they may essentially do so without an explicit procedure for the recognition of their professional credentials.
To monitor and supervise cross-border activities and regulations, the national
administrative authorities are obliged to work together. However, it is not certain whether this will suffice to expose any abuse, e.g. so-called “shell “ or “letterbox” companies. The definition of “branch” also needs to be made more precise, to avoid inadvertently encouraging such brass-plate companies.
For all the harmonization so far, the barriers and regulations imposed on service
providers in some EU Member States are still lower. This may put pressure on domestic providers in border regions in particular. The upshot would be discrimination against the domestic service providers obliged to comply with more restrictive regulations.
Whereas the new EU Member States with lower social standards and wages will
benefit from the expanded market, countries such as Germany could be squeezed into a tight corner, particularly since high social security contributions would weigh all the heavier. German service providers could have difficulty competing on the price front. One solution would be to specialize more on know-how-intensive areas and to advertise this (e.g. with certificates).
The planned deregulation of the services sector would therefore bring winners and
losers. While German consumers would enjoy greater choice and lower prices, the consequences for the German labor market could be negative, at least in the short term, notably for workers with low skills. The debate on minimum wages could flare up again as a result.
In the process, however, it must be remembered that Europe is a heterogeneous group of
countries with more significant regional differences than the USA, for example – with
varied cultures, different languages, differing economic strength and willingness to reform.
Thus, it is all the more important to define clear responsibilities and incentives to ensure
the realization of the objectives. The appointment of a Mr. or Mrs. Lisbon in each member
state may well be helpful, but above all the split between EU-wide tasks and national action programs also needs to be mastered successfully.
18
2. Public finances on a worrying path
In terms of fiscal policy in Europe, implementation of the Lisbon strategy is important in
two respects. First, it brings the European Monetary Union a step closer to becoming an optimum currency area. To be sure, the one-size-fits-all ECB monetary policy may
sometimes still sit uncomfortably on smaller member countries in particular. Temporarily
at least, inflation differentials may additionally boost/check booming/flagging economies
through real interest rates. But realization of parts of the overall Lisbon goals, such as
more flexible product and labor markets, should reduce the need for national fiscal policy
to balance out differences in growth within the euro area.
Second, the measures on the Lisbon agenda to promote growth are, to a certain extent, also consolidation policy. Once strong economic growth has been achieved, it
makes healthy public finances much easier to attain. Jürgen von Hagen, for example,
concludes in a study that “growing out” of a high debt-to-GDP ratio seems a more
successful strategy than reining in borrowing without regard for economic growth. The
following chart also highlights the quandary of those EMU countries in particular that are
having the most difficulty complying with the Stability and Growth Pact: The three biggest
euro area economies and Portugal are mired in a combination of relatively low GDP
growth and high deficit ratios (Greece is an exception here with a high deficit ratio and
robust economic growth).
Deficit and GDP growthaverage 1999 - 2003
-4
-2
0
2
4
6
0 2 4 6 8
Fin
Lux
Irl
Ger
Ita
FraPrt
Grc
NldAut
Bel
Esp
Pub
lic d
efic
it ra
tio (%
)
Real GDP growth (y-o-y)
19
Looking at the development in the overall euro area deficit, we see the following picture:
After the Maastricht Treaty entered into force in 1992, the EMU-wide deficit ratio initially
stabilized at close to 5 %. Then in the second half of the 1990s it was trimmed significantly
in the wake of fiscal consolidation as countries strove to fulfill the Maastricht criteria to
qualify for membership of monetary union on the basis of their 1997 data. Falling interest
payments were an added fillip, and after the launch of EMU the positive economic
environment facilitated a further reduction in the budget deficit relative to GDP, bringing it
down to 1 % in 2000. The subsequent economic downswing pushed the euro area deficit up again. Indeed, last year it presumably fell only just short of the 3 % Maastricht limit, with extremely low interest rates preventing an even poorer performance.
At the beginning of the 1990s the ratio of public debt to GDP was close to 60 %, peaking
at 76 % in 1996. Then the consolidation drive ahead of monetary union and falling new
borrowing up to the turn of the millennium had an impact here, too. Temporarily the EMU debt ratio dipped slightly below 70 %. In the past two years, however, it has edged up
again to around 72 %. This is far removed from the 60 % Maastricht ceiling, fixed back
then with reference to the ratio of total public sector debt to GDP at that time. The
benchmarks set for this and the deficit criterion were also influenced by considerations of sustainability, the aim being to ensure that government finances were viable in the
long run. To achieve sustainability, the debt ratio must at least be stabilized at a level
deemed acceptable. To maintain it at 60 %, the deficit ratio may not overstep the 3 %
mark on sustained nominal economic growth of 5 % – the figure assumed for Europe at
that time. The relevant equation is:
Euro area: Public debtin % of GDP
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 0640
45
50
55
60
65
70
75
80forecast
20
public deficit in % of GDP ≤ total public sector debt in % of GDP * nom. GDP growth (D ≤
S * g)
However, the nominal increase in euro area output since conclusion of the Maastricht
treaty in 1992 has barely averaged 4 % a year. As we saw in the first part of this study, at
present real EMU trend growth is estimated somewhere in the region of just 1 ½ %.
Adding the ECB’s definition of price stability as inflation “below but close to” 2 %, we arrive
at nominal trend growth of around 3 ½ %. It is not at all surprising, therefore, that debt
levels have failed to stabilize at 60 % of GDP. Applying the above equation, we can
calculate the maximum deficit ratio that would keep the debt ratio at its current level on the actual rates of economic growth. A comparison of this “ deficit ratio for
sustainability ” with the actual statistic provides enlightenment on the viability of public
finances. In the chart below we have augmented past data with our forecasts.
Euro area: Public deficitin % of GDP
Max. deficit ratio for sustainability (D=S*g) Actual deficit ratio
91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 060
1
2
3
4
5
6
forecast
Until 1997 the ratio of the EMU-wide public sector deficit to GDP was higher than it should
have been to stabilize the debt ratio, from 1998 to 2002 it was lower. Of course the
economic cycle is clearly evident in the calculation of this maximum deficit ratio for
sustainability, because in each case current economic growth is extrapolated into the
future. That said, it is not only the fault of the period of economic weakness as from 2001 that public finances have developed unsatisfactorily in recent years. The broad
21
consensus opinion meanwhile – and one to which the OECD also subscribes in its latest
economic survey on the euro area – is that in the previous cyclical peak some EMU
members, among them the big economies, failed to set aside an adequate “war chest” for harder times. On the contrary, some countries cut taxes on the basis of the upbeat
economic prospects at that time.
The lack of provision can possibly be explained by special factors, as the IMF notes in its
latest World Economic Outlook. For one, following the consolidation effort in the race to
join EMU the determination to retrench further may temporarily have flagged in some
countries (particularly since in Germany, for instance, a lighter tax load was also
imperative). For another, “New Economy” euphoria contributed to the overly optimistic
growth forecasts. Yet the question still arises as to whether this overly expansive fiscal
policy in a period of strong economic growth really can be considered an exceptional
phenomenon or whether, within the framework staked out by the Stability and Growth
Pact, the danger exists of a similar pro-cyclical fiscal policy again in the next economic upswing.
Basically, commitment to the rules introduced in the SGP was designed to protect against discretionary policies, which generally threaten to act pro-cyclically. Although
the IMF concludes that after Maastricht fiscal policy in the euro area became less pro-
cyclical, this assessment rests on less restrictive behavior in economically hard times.
Since this was not balanced in good times by sufficiently stringent cuts in borrowing,
continuation of such a policy poses the threat of an unsustainable deficit bias.
A similar “ratchet effect” is often also associated with electioneering tactics. Before
and immediately after elections, governments dole out fiscal sweeteners but fail to adopt
appropriate retrenchment policies in election-free periods. In research on the early years
of European Monetary Union Marco Burti and Paul van den Noord conclude that unlike
the run-up to the launch of EMU, there was a bias to expansive fiscal policy and that
discretionary measures were adopted in the context of important elections. This suggests that the Stability and Growth Pact works less well as a disciplinary mechanism than the Maastricht criteria.
Burti and van den Noord identify the reason for this in regime change at the start of
monetary union, citing the following key changes: There has been a shift in political support for the rules. Whereas Germany in particular pressed for the Maastricht criteria,
support for the Stability and Growth Pact is now coming from the smaller countries, who
22
have less difficulty with compliance than the big EMU players. This constellation is
weakening political enforceability of the regulations. Moreover, there was a clear timeline
for membership of monetary union, and the “carrot and stick” effect of numbering among
the founder members or being left out acted as a powerful motivator. However, under the Stability and Growth Pact the incentive structure is weaker. On the one hand the
danger of sanctions is hazy. The loss of reputation caused by a breach of the rules is
limited. On the other hand, the notion that fiscal policy in conformity with the rule book will
enable “automatic stabilizers” to play freely to smooth cyclical fluctuations does not
appear rewarding enough to outweigh other political considerations.
What will happen to the Stability and Growth Pact?
Whereas the Maastricht criteria served as a screening device to select the members of
EMU, the Stability and Growth Pact was supposed to write fiscal discipline in stone. For
this it must affect both the short term (cyclical stabilization) and the long range
(sustainability of public finances). Now, it is broadly acknowledged that without the SGP national budgets in the euro area would certainly have fared worse. The pact
institutionalized multi-year stability programs, heightened transparency and intensified
peer pressure. Nonetheless, the experience and insights gained so far with the system do
give cause to ponder meaningful alterations. An important opener is the asymmetry of
the SGP. Its preventive part (measures to gain fiscal leeway for the future at times of
robust economic growth or in election-free periods) has proved too ineffective. There is
need for improvement here. The course adopted, focusing more on cyclically adjusted
deficits, points in the right direction. It remains questionable, though, to what extent
application of the fiscal rules can be secured.
From the outset the SGP’s weak spot was perceived in the ultimate possibility of a
breakdown in the self-regulation mechanism, with potential “offenders” sitting in judgment
on current “offenders”. Even if the European Commission is not capable of exercising any
real external control, its monitoring function and criticism should help keep up the
necessary pressure to put public finances in order. But key to more effective peer
pressure would be greater commitment again by the big EMU member states to implementation of the Stability and Growth Pact. They are economic as well as
political heavyweights. This means that when their fiscal policy strays from the straight
and narrow the threat to euro area stability is graver than in the case of a smaller country.
One challenge confronting planned reform of the Stability and Growth Pact (agreement
23
could be reached by the March European Council meeting) therefore lies in coming up
with a solution to which the big countries can relate without draining the pact of too much
of its substance. Of course, improving the substance would be desirable, but this is not
politically viable.
In respect of the 3 % deficit criterion, in our judgment the mere arbitrariness alone of the
proposal variously advanced to strip out expenditure on areas such as research and
development, defense, structural investment or net payments to the EU renders it
inappropriate. At the most, certain items could be included in an appraisal of the quality
of public finances, although this should not amount to temporarily factoring them out. But with regard to the aspect of sustainability, greater allowance for debt levels (contained in the Maastricht criteria but not in the SGP) seems quite proper, particularly
since public budgets will have to shape up to the demographic burdens facing them in the
foreseeable future.
By and large, the assessment of public finances should not take too many factors into
account. The requirements of a set of fiscal policy rules are, inter alia, that they be simple,
transparent, consistent, well designed and flexible and that they allow effective
implementation. There are trade-offs between the various criteria. For instance, more
country-specific differentiation of the rules can undermine their transparency. And greater
flexibility of the SGP – a frequent demand – may impair the implementation of sanctions.
Crucial in upcoming reform of the pact is that it regain credibility. Given that the
single monetary policy in the euro area is not accompanied by a common fiscal policy, the
SGP is important as a counterpart with which to commit national fiscal policies to a stability-oriented stance. One reason for this is that excessively high public debt might
impair the central bank’s ability to generate price stability (even though the ECB is more
independent of government influence than national central banks were pre-EMU). The
combined effects of stability-oriented monetary and fiscal policy form the bedrock for a stable euro. The role that the single currency can play on the international stage
hinges on this.
All in all, in our forecasts on the development in EMU public finances described here we
assume that the Stability and Growth Pact will retain a certain disciplinary effect after its overhaul. This will certainly not be intensified, though, and will therefore remain
less pronounced than in the Maastricht criteria. Conversely, however, we consider a
further serious loss of credibility for the pact unlikely, because given unanimous
agreement on reform, the big EMU countries will have to demonstrate more political
24
commitment to abiding by the new rules. Our assessment is, however, predicated on
enhancement of the preventive part of the SGP as a major element of reform (i.e. the
disciplinary mechanism should bite rather more strongly than before in good economic
periods and slightly less when times are bad). Simply hoping that countries will learn from
past mistakes and build up a modest “nest egg” against hard times during the present –
albeit modest – economic recovery, would hardly be a very helpful line. With economic
growth forecast in the region of a modest 2 % in real terms, both this year and next the deficit ratio in the euro area will stay below 3 %, even though it will probably not decrease to any notable extent. We do not expect success on lowering the debt ratio
by 2006, although it should stabilize within a whisker of 72 %. A clear improvement in
public budgets in the euro area is unlikely in our view, especially with important
parliamentary elections approaching in the big EMU countries.
25
3. Euro gaining in international standing
Of all policy areas, monetary policy is the most highly integrated among the EU member
states. The euro, as the single currency, is a vital outward sign of the integration process and is also stepping up the integration of other internal policy fields, as with the
creation of functioning markets or coordination in fiscal policy.
The US dollar’s recent period of weakness has rekindled debate on whether the role of the euro might not extend significantly beyond that of a common currency for 12 to 25 European countries. In the long run might it not even challenge the dollar’s function
as an international currency? To answer this question, besides casting a glance back on
the importance and development of the euro in the past six years, it will also be expedient
to highlight a few implications for the future on the basis of monetary history.
Looking into the past, we see that since the creation of money-based economies
dominant leading international currencies have emerged time and again, from the Roman
sesterce through the Spanish doubloon and the pound sterling to the US dollar. The
rationale behind the existence of regional or global key currencies is, most importantly, that they simplify economic and monetary relations between countries.
The introduction of an anchor currency (numeraire) as the benchmark for all other
currencies considerably reduces the total number of currency parities that have to be
measured. Without an anchor, for ten different currencies 45 exchange rates would have
to be calculated, against a mere nine with an anchor currency. The more currencies there
are, the greater are the transaction cost savings generated by the introduction of a key
currency. Further transaction cost benefits arise from invoicing international trade flows in
the key currency, because each participant in international trade then needs only keep an
eye on fluctuations in the exchange rate of their own currency against the numeraire,
while being able to disregard all fluctuations against the currencies of supplier and buyer
countries.
Modern times have brought the added motive of importing stability through a currency peg and obtaining easier capital market access. Developing countries in
particular often suffer from their own currency’s inability to tap the international capital
market, a shortcoming frequently caused by tight capital markets and in some cases high
and/or volatile rates of inflation. The only way of attracting foreign capital nonetheless is to
eliminate the exchange risk for international investors by borrowing in foreign currency.
But then exchange rate fluctuations become very dangerous for the domestic economy: If
the national currency depreciates on a serious scale, the burden of debt and interest
26
payments in the domestic currency soars in parallel, until in a worst-case scenario it is no
longer sustainable. So while a fixed exchange rate peg often looks like an attractive way
in the short term for these countries to stabilize inflation and their foreign liabilities, in the
medium term this policy entails considerable risks, because the domestic possibilities for
exerting influence ultimately consist only of weakening rather than strengthening the
domestic currency. This syndrome is known as “conflicted virtue”. The risks are, of course,
particularly great when countries operating rate pegs do not engage in the appropriate
stability and fiscal policy, themselves inducing substantial potential for depreciation.
At present, only two currencies are up to the task of acting as a global currency, the US dollar – and the euro. At the age of six, the euro is still very much in its infancy, yet
already it is the dollar’s only potential rival for the status of the world’s currency. Basically,
the euro can boast everything needed to rival the greenback: stability both inwardly (low inflation) and outwardly (exchange rate) as the sine qua non for the role of reserve currency (a store of value); a big, open economy whose international integration
generates a multiplicity of currency transactions; and finally, an open and sophisticated
financial market attracting international money and capital market dealings.
In no time at all, therefore, the euro has earned itself the status of official challenger. As
regards the last item, however, the international importance of its own financial market,
the euro area certainly cannot yet compare with the breadth, depth and liquidity of the US
capital markets, for all the progress it has made on integration in the recent past. In terms
of stability, on the other hand, the single European currency appears recently to have
gained an edge on the dollar. As America’s net external debt swells, the strong
depreciation of the US dollar has raised fresh doubts over its continuing global currency
role. Dollar critics are already drawing comparisons with the development in sterling in the
mid-20th century, whose pre-eminent status was forfeited with the United Kingdom’s
transformation from a sovereign creditor to debtor.
But this brief journey through monetary history also underscores that the switchover in a key currency function is a protracted process and not something accomplished in a day. Benchmark currency status is not conferred by “decree”, it is the outcome of many
millions of decisions by dealers and investors all round the globe on the currency in which
they wish to settle their business. Often long-range investment decisions are affected, as
with the question of a reserve currency, so that the creeping nature of a switchover in key
currency is hardly surprising. Viewed in this light, the euro’s first six years went by all means as expected: Since the launch of monetary union it has been able steadily to build
up its position as an international currency.
27
At the end of 2003 almost 20 % of all currency reserves were held in euro, marking
an advance by some 3 ½ percentage points on 2000. The increases in the two years 2002
and 2003 do not stem from the appreciation affect alone. Euro reserves also continue to
be stocked up in quantitative terms, although recently on a smaller scale than dollar
reserves. Boosted by in some cases massive interventions on the foreign exchange
markets by various Asian countries, dollar reserves have defied price adjustments,
boosting their share of total foreign exchange reserves again slightly in 2003 in both
absolute and relative terms (to just under 64 %).
0%10%20%30%40%50%60%70%80%90%
100%
2000 2001 2002 2003
Official foreign exchange reservesCurrency shares as % of total holdings
Euro
Pound SterlingYen
Source: IMF.
Other
US dollar
The picture on the foreign exchange markets is similar: The euro is the second most important currency, but well behind the dollar. Whereas in a good third of all
transactions on the foreign exchange markets the euro is either on the buy or sell side, the
dollar is traded in almost 90 % of foreign exchange transactions. It is perhaps this
dominance on the foreign exchange markets, stemming from the greenback’s function as
a vehicle currency, that reflects most forcibly its role as the global currency. In the past
few years the euro has not managed notably to bolster its position in this area.
28
Foreign exchange market turnoverCurrency shares as % of average daily turnover in Apil 2004
88.7
37.2
20.3
16.9
36.9
Euro
Pound Sterling
Yen
Note: The sum of the percentage shares of individual currencies totals 200 %, because two currencies are involved in each transaction.Source: BIS.
Other
US dollar
In its role as an international transaction currency, however, the euro is making progress.
The share of extra-EMU trade invoiced in euro has climbed appreciably in recent years
by around 10 percentage points and is now well over 50 % in most EMU countries. This
trend covers exports, imports and trade in both goods and services, although it is most
pronounced in merchandise exports.
Invoicing of extra-euro area exports of goodsEuro share as % of the total
Source: ECB.
010203040506070
Germany France Italy Spain
2001 2002 2003
There can be no question, though, of the progress the single European currency has
made in its function as a financing currency, i.e. on the international debt markets. Not
least because of its strong appreciation, the stock of euro-denominated international debt
29
securities outstanding is considerably higher than that in dollars: about 45 % of all long-
and short-term debt securities are denominated in euro. This means that since the launch
of monetary union the share of the euro in these markets has soared by a remarkable 20 percentage points.2
International debt securitiesCurrency shares as % of the total amount outstanding, bonds and notes and money market instruments, at current exchange rates
0
10
20
30
40
50
60
Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3
Euro
Pound Sterling
Yen
Source: BIS; own calculations.
US dollar
1999 2000 2001 2002 2003 2004
Striking, though, is not only this rapid jump, but also the fact that it is mostly private
international issuers who are discovering the euro for their purposes, with shares of
around 80 % in latter-year new issuance. Headlong growth in the euro-denominated
international debt securities market is thus running in parallel to the development of
national euro-denominated bond markets, which is similarly driven mainly by private
issuers. Corporate bond issuance in particular has registered a strong spurt since monetary union. This rise, a reflection of increasing recourse to the capital markets in
corporate finance (disintermediation), certainly cannot be ascribed to the existence of a
common currency alone. It is, however, an undisputed fact that since the launch of EMU a
fast-expanding, increasingly integrated European market for corporate bonds has
emerged – with substantial benefits to the issuers. Rapid development of the market has
intensified competition among the issuing houses, causing underwriting fees to fall. Unlike
2 In the European Central Bank’s portrayal this development does not appear quite so spectacular, however. For one, the ECB applies a narrower definition of international debt securities, excluding issues in the home currency, and for another it strips out exchange rate fluctuations by basing its calculations on a fixed exchange rate (from the first quarter of 1994). By the ECB’s reckoning the share of euro-denominated international debt securities stands at only 31 % (against some 44 % for the dollar). This puts the rise since the inception of monetary union at a “mere” 10 percentage points.
30
the situation prior to monetary union, prices no longer differ in this market segment for
issues in euro or dollar.
Total amount outstanding of euro-denominated corporate bondsBy euro area residents, EUR billions
0
1 0 0
2 0 0
3 0 0
4 0 0
5 0 0
6 0 0
01.09.1990
01.09.1991
01.09.1992
01.09.1993
01.09.1994
01.09.1995
01.09.1996
01.09.1997
01.09.1998
01.09.1999
01.09.2000
01.09.2001
01.09.2002
01.09.2003
01.09.2004
Source: ECB.
start of EMU
Developments on the international and national bond markets cannot, of course, be
viewed in isolation. After all, practically 40 % of all euro-denominated debt securities are
international bonds.3 Progress on these markets is thus interdependent. Status as an international currency attracts international issuers and can provide a welcome lift to the home capital market from added liquidity and professionalism. On the other
hand, developed markets with internationally competitive pricing and infrastructures are
needed to attract international issuers. Ideally, this constellation can give rise to a positive
cycle in which external and internal development triggers are self-reinforcing. For the
European corporate bond market this point seems to have been reached. Given the
growth momentum and drop in issuance costs so far, it seems fairly safe to assume that
bond financing in euro will continue to gain in appeal for both euro-area companies and
international corporations.
Development of the financial market is pivotal to international currency status. Besides being essential to fulfilling the duties of a global currency, capital market depth
3 International markets are of far less importance to the US dollar. Little more than 20 % of all debt securities denominated in US dollars are international paper.
31
and liquidity are the key channel through which global currency status can stimulate
growth of the relevant currency area by reducing the cost of capital.
Gratifying as progress so far has therefore been, the euro has not yet exhausted its
potential as an international currency. What we have seen so far is mainly
“internationalization of the euro markets”, with very little “euroization of the global financial
markets”. The surge in international debt securities denominated in euro is driven first and
foremost by the investors resident in the euro area themselves. Their capacity to invest is
attracting international issuers looking specifically to broaden their investor base with
European investors as well as adequately to model their business activities in the euro
area on the financing side as well (hedging motive). In the past few years about 80 % of
these issues have gone almost exclusively to European investors.
At least in terms of the financial market, we can therefore postulate that the euro’s growing international importance is rooted chiefly in the euro area’s role as a lender of capital. This stands in stark contrast to the situation with the dollar. The euro
certainly has an edge on the American currency in that it is used not only for borrowing,
but that EMU as an aggregate can still even lend money, whereas the US is both a net
debtor and also needs to attract substantial amounts of capital every year to cover its
current account deficit. That said, as far as the euro’s ambitions as an international
currency are concerned, the fact that it is not in equal demand as an investment currency
is a negative. This is reflected not only in the still relatively low proportion of official
reserves held in euro, but also in the demand structure of international euro-denominated
bonds. Asian or American investors have shown marked reticence in this segment so far.
But here, too, there are signs of a positive shift: in the past two years the share of issues
in which Asian or American investors were to be found as buyers has climbed to around
30 % and 20 % respectively
This suggests that in the coming years the euro will be able further to boost its status as
an international currency. But what advantages and disadvantages does this bigger part
on the world stage involve?
Since the role of key currency importantly consists of third countries also using that
currency for transactions among themselves, conversely this implies for the key currency
country that it must permanently provide the rest of the world with liquidity and assets. To begin with, this brings a string of benefits: External borrowing can also take
place entirely in the domestic currency (as in the case of the US), which has the effect of
lowering risk. International demand for domestic assets improves real valuation levels
32
and reduces the real interest rate. Both increase prosperity for the key currency country
and broaden the scope for risk-adjusted borrowing at home. Moreover, the country’s
discretionary scope in its own economic policy is heightened. High external debt (but
which is raised in the domestic currency) will tend to be reduced by depreciation, provided
external credit balances are invested in foreign currency. Taken to its hubristic extreme,
this discretionary economic policy scope is reflected in the statement by former US
Treasury secretary John Connally “[the dollar] is our currency but your problem”. This
scope is, however, restricted inasmuch as in the medium run its exploitation also leads to
erosion of the central conditions for a key currency function.
When a country provides liquidity to third parties, control over the money stock is rendered
more difficult and simple financing can lead to a current account deficit. Following
abandonment of the Bretton Woods system of fixed exchange rates, which ultimately
collapsed not least because mounting global demand for dollar reserves was increasingly
mismatched with the United States’ more or less constant level of gold reserves (Triffin
dilemma), these relationships are no longer so pronounced as in the past. Nonetheless, anchor function, the provision of liquidity and control over monetary expansion and/or the current account position hold a fragile balance, as the present debate on
the US current account and the weakness of the dollar vividly recalls.
A greater international role for the euro is therefore unquestionably within reach.
Given the dynamic feedback on the development of the euro area’s own financial market,
the positives will arguably outweigh the negatives for the time being. Fragmentation of the
European financial markets in certain segments, notably the stock markets, ought
therefore to be remedied as quickly as possible.
Yet for the foreseeable future it seems highly unlikely that the euro will replace the US dollar as the sole global currency. The sheer size of the international financial
markets reduces the (liquidity) benefits of a single international currency. Nowadays,
operating in different market segments with different dominating currencies is quite
conceivable – without the fear of higher transaction costs. So while the euro is hardly
likely to oust the dollar, it will steadily grow into the role of equal partner as an
“international regional key currency” alongside the dollar. At a later date an Asian currency
may conceivably also assume a key regional function; indeed, this would tally with the
increasing emergence of a tripolar global economic structure.
33
Conclusion
Time is getting short, in terms of both failure to realize the Lisbon strategy as intended and
the inadequate consolidation of public finances. In view of foreseeable demographic
change in particular, convincing progress is overdue. Driving this ahead at the EU level
instead of relying on national activities alone considerably improves the likelihood of
success. That the member states are obliged to draw up multi-year stability programs for
their public budgets, for instance, creates a transparent monitoring basis. If checks by the
European Commission reveal that certain countries are taking wrong turns, those
responsible will at least come under pressure to justify themselves. At the same time,
national politicians can point to the Stability and Growth Pact if demands are voiced in
their own country to steer a course departing from the focus on stability.
Similarly, the action programs envisaged in the Lisbon process look set to have a positive
impact. Although there will probably not be an incentive system in the form of rankings,
greater transparency and more systematic comparability of events in the member states
could act as sufficient spur to their ambition. A country that succeeds in meeting targets
better than others could turn this to its advantage in domestic election campaigning.
Conversely, there is likely to be less temptation to put off painful reforms for the sake of
election tactics if the population has an awareness and acceptance of how pressing these
reforms are. But for this, the people need to be better acquainted with the Lisbon strategy.
In respect of the euro, progress on implementation of the Lisbon agenda will place the
European currency in a better position to compete more strongly with the US dollar;
because for an international key currency it is not just the size of the relevant economic
area that matters, but also its strength. What is more, with completion of the single
European market for financial services the Lisbon agenda is planning closer integration in
an area of crucial importance to the common currency.
34
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