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Improving the foundations for sustained economic growth Selected Policy Issues in the UNECE Region

Published:18 February 2005

Geneva

Strengthening growth and competitiveness in Europe

Geneva, 18 February 2005 - The overall growth performance of the European economy has been disappointing in recent years. Output and productivity growth have fallen behind the United States. There are also increasing concerns about risks of declining competitiveness in the face of increasing supply of medium- and high-tech products from low-cost countries driven by FDI. High long-term unemployment has been a major concern for many years.

Sustaining higher rates of growth of both output and employment is a condition sine qua non for preserving the European model with its strong concern for social cohesion. The adjustment pressures arising from the intensification of international competitive pressures associated with globalization, rapid technological change, as well as population ageing, all make this challenge even more difficult.

The Lisbon Agenda adopted by the European Union in March 2000 was designed to create a competitive and dynamic European economy at par with the United States by 2010. But progress has been falling significantly short of the intermediate targets fixed for 2005, as countries failed to deliver the agreed actions, partly reflecting an overloaded policy agenda and conflicting targets. This was one of the main conclusions of the Kok report (published in November 2004), which reviewed the Lisbon Strategy.

The European Commission has recently proposed a revitalization of the Lisbon strategy, with the main focus on measures to raise Europe’s growth potential and create more jobs. The Commission emphasized the shared responsibility between the European Union and its member States as regards the delivery of reforms and other policy measures required to meet the Lisbon targets. It has therefore proposed a European Partnership for Growth and Employment, which should also involve the social partners.

The proposed Lisbon Action Programme focuses largely on supply side measures to raise growth and employment. These include inter alia the completion of the Single Market, improved business regulation, and the promotion of technological innovation, especially the development and diffusion of ICT as well as the associated increase in R&D spending. But there is also a proposal to step up expenditures for enhancing and improving the European infrastructure (especially energy and transport).

More generally, market outcomes are not determined solely by supply but by the interaction of the forces of supply and demand. It will be difficult to meet the targets of the Lisbon Agenda in a context of weak growth of domestic demand.

Raising Europe’s growth potential will not only require impulses from both the demand and supply side, but also a sufficiently flexible macroeconomic policy framework (i.e. mainly fiscal and monetary policy) that is “as supportive of growth as possible” as indicated in the Kok Report.

It is thus important that a sensible reform of the Stability and Growth Pact be achieved as soon as possible. The recent proposals made by the European Commission that would lead to greater emphasis on public debt and medium- and long-term fiscal sustainability in the fiscal surveillance process go in the right direction, but it may not be easy to achieve a consensus on these matters.

The prospects for EMU accession by new EU member States

EU membership raises a number of policy challenges. On the macroeconomic front, the new members are expected to meet the Stability and Growth Pact criteria pertaining to inflation, long-term interest rates, government deficits, public debt and exchange rate stability, and eventually to enter the Economic and Monetary Union (EMU). Three economies (Estonia, Lithuania and Slovenia) joined ERM-2 in the second month of their EU membership, opening the way for their accession to EMU by 2007. Cyprus, Latvia, Malta and Slovakia also appear to be committed to a relatively early adoption of the euro. But this process can be expected to take longer time in the Czech Republic, Hungary and Poland.

Nominal convergence in the EU-10 is a multi-speed project. The majority of the 10 economies have failed so far to satisfy the EMU inflation criterion, which partly reflects the ongoing process of productivity catch-up. None of the 10 new member States fulfil the exchange rate stability and legal requirements necessary for entry into the euro zone. The legal criteria include the independence of the central bank in pursuit of price stability and other legal norms of the EMU. But fiscal consolidation remains the principal macroeconomic policy challenge in most new member States. A number of countries exceeded the 3 per cent threshold for the deficit to GDP ratio in 2003 and 2004.

However, strict abidance by the EU fiscal framework may impose unnecessary rigidities for some of the new member States. In particular, these economies need to undertake a lasting effort to improve their public infrastructure, which is an essential precondition for a successful catching up to higher productivity and income levels. Even more than the most developed members of the EU, the new members would benefit from a possible relaxation of some of the constraints on government borrowing for financing public investment. Relaxing these constraints would help prevent counterproductive fiscal tightening in these economies.

Another difficult challenge facing the EU-10 will be to maintain exchange rate stability preceding entry into the euro zone. The fundamental problem is the so-called trilemma of international finance – with open capital markets and a fixed exchange rate a country loses control over domestic monetary policy. In practical terms this means that the monetary authorities may not have sufficient instruments to achieve exchange rate stability and price stability at the same time. There is the possibility that the two targets will not be consistent with one another and thus cannot be achieved simultaneously. It is also possible that with these targets to satisfy, these countries will be forced to ignore what should perhaps be the most important target – rising levels of employment.


The prospect of EU membership as a catalyst of reforms in south-east Europe

The agenda for the next round of EU enlargement focuses on candidates from south-east Europe. In 2004, Bulgaria and Romania closed all the negotiation chapters and are scheduled to join the EU in 2007. Accession negotiations with Croatia and Turkey are expected to start very soon. The realistic prospect of EU membership is an important stimulus to the economic reforms in these countries. The preparation for accession to the EU defines a broad reform agenda with clearly specified goals and the means to achieve them, and establishes strong and clear incentives for policy makers. The institutionalization of the policy commitments within a tight schedule of accession negotiations helps both to accelerate and provide direction to the reform process.

The policy process and agenda in the other parts of south-east Europe, however, lack the clear direction that can be seen in the EU candidate countries. Reform progress in individual countries hinges on their success to establish clear, long-term policy goals as national priorities and for these goals to be accepted by a significant majority of their populations. The absence of such a consensus about the general direction of reform in some of these countries is one of the stumbling blocks to their economic transformation.

Structural and institutional reforms remain an important challenge for the whole south-east European region. The reforms of health care and pension systems are either at an early stage or have not yet started at all. Public institutions for a market economy in most of these countries are still underdeveloped and this has a negative effect on the business environment. The protection of property rights, including law and contract enforcement, is generally weak; the public administration is widely perceived as inefficient and lacking in transparency; and corruption is still widespread.

An integrated set of structural reforms focused on increasing employment (employment rates being excessively low at present) is one of the areas where success could bring wide-ranging benefits not only for labour market development but also for strengthening social cohesion, which is a crucial dimension of human capital development. Policies aimed at reducing inequality – without diluting incentives to work – can also have a positive effect on future growth prospects. In particular, greater social solidarity will help to create a general consensus about the nature and direction of the reform process, which, in turn, will increase the probability of it being maintained.

Aside from Turkey, market fragmentation in the region limits investment and decreases the ability of these countries to reap the benefits of scale economies. More progress is needed to create some type of umbrella over all of the free trade agreements that exist in this region with the aim of ensuring consistency and making the rules of origin less difficult to fulfil. Ideally, a customs union might be the most desirable alternative, but achievement of this objective is unlikely due to a number of practical considerations such as Bulgaria and Romania joining the EU.


The policy challenge of economic diversification in the CIS

The key factor behind the current economic boom in the resource-rich CIS economies has been the expansion of their extractive industries (especially, the crude oil and natural gas sectors) coupled with a surge in world commodity prices. The narrow base of the recovery exposes these economies to fluctuations in the highly volatile global commodity markets, making them vulnerable to external shocks. The central policy issue is whether and how public policy can help to broaden the growth base and reduce the excessive reliance on natural resources in the medium and longer term.

The economic argument underlying diversification policies is that a comparative advantage in the international division of labour should not be regarded as something given once and for all. Comparative advantage (as revealed in the structure of net exports) changes over time as a result of shifts in the pattern of physical and human capital accumulation. But new areas of comparative advantage will only be cultivated if properly developed by venturing entrepreneurs.

Based on the experiences of other countries, the broad paradigm of a policy framework targeting economic diversification in the CIS economies should incorporate key ingredients such as:

  • A coherent long-term strategy outlining the main goals to be achieved. Importantly, the formulation of long-term goals should involve a broad public debate;
  • An incentive structure that will stimulate economic agents to act in a direction consistent with the policy goals as well as the mechanisms of coordination and management of conflicting interests (for example, between the public and private sectors);
  • An appropriate framework of public institutions with delegated authority to implement the related policies;
  • Adequate funding. Resource-rich economies can in principle draw on the rents associated with natural resources to fund the strategies targeting new areas of comparative advantage.

There is no unique policy model of economic diversification; success as well as failure can take many different forms, and this applies with full force to the related policy agenda in the CIS. But experience of other countries unambiguously suggests that the adequacy and quality of the institutional arrangements is probably the key factor of success in implementing diversification policies. In other words, the normative policy rules and objectives must be matched by an appropriate institutional framework in the broader sense of formal and informal “rules of the game”.

Recent experience suggests that the most effective institutional arrangements targeting economic diversification are those that engage all the relevant stakeholders (both from the public and from the private sector) in the process of policy design and in its implementation, and steer them towards the common goal. Instead of “picking winners” in the sense of traditional industrial policy, this approach involves a more flexible strategic alliance in which the government and the private sector exchange information and ideas, and coordinate their actions in the development of new activities, products or technologies.

Diversification policies require specific skills from the government agencies that will be involved in implementation. A public administration with adequate capacity is in fact a precondition for engaging in any large-scale government-sponsored programmes. Capacity building efforts thus emerge as an important policy step that should be assigned high priority, especially in the lower-income CIS countries.

Economic diversification in the CIS region should be regarded as a long-term policy goal. It requires an integrated and consistent policy framework that relies on comprehensive reforms in many areas and calls for a lasting and dedicated policy effort.


For further information please contact:

UNECE Economic Analysis Division

Palais des Nations
CH - 1211 Geneva 10, Switzerland
Phone: +41(0)22 917 20 84
Fax: +41(0)22 917 03 09
E-mail: info.ead.@unece.org
Web site: http://www.unece.org/ead/ead_ese_new.htm

Ref: ECE/GEN/05/P05


United Nations Economic Commission for Europe

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CH-1211 Geneva 10, Switzerland

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