Productivity Gains will be Essential to Sustain Euro Area Growth

International Monetary Fund. External Relations Dept.
Published Date:
June 2006
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The Euro Area’s recovery is gaining traction, with real GDP growth in 2006 expected to be about 2 percent, according to the IMF. A statement issued June 6 at the conclusion of the Fund staff’s discussions with Euro Area officials noted, however, that prospects for a sustained pickup hinge on decisive progress with structural reforms, including in fiscal policy. More must be done “to exploit the synergies between fiscal adjustment, welfare reform, and enhancing the efficiency of all markets, whether for labor, capital, goods, or—but perhaps especially—services, including financial services.” The region must also cope with “appreciable headwinds” in the form of higher oil prices, a strengthening euro, sluggish productivity growth, and a decline in the region’s population beginning in 2010.

On the monetary side, the IMF projected headline inflation to remain above 2 percent a year through much of 2006 and 2007 before dipping thereafter. With inflation only slowly returning to its benchmark and the recovery gaining traction, there was some scope for further withdrawal of monetary accommodation. The Fund did not, however, see the necessary conditions in place “for continued, and thus more substantial, tightening.” This “would seem to require a quickening in the fundamentals of the recovery—notably, under present circumstances, in employment growth—or the emergence of second-round effects or of yet further shocks likely to prompt increased domestic inflationary pressures.” Following the discussions, the European Central Bank raised rates by 25 basis points on June 8.

Boosting the payoff from reform

After a decade of reforms, the Euro Area’s labor markets are more flexible, pension programs are more fiscally sustainable, and some product and service markets have been liberalized. But, the IMF said, “labor utilization is still low, unemployment high, productivity growth decidedly disappointing, and long-term fiscal sustainability still an issue.” More reforms are needed, and, as the experience of Europe’s most successful long-term reformers suggests, the key ingredient will be devising mutually reinforcing and sustainable packages of fiscal and structural policies. Specifically, the IMF recommended more ambitious measures in several areas:

Fiscal. Given the formidable challenges ahead, adjustment should be at least ½ of 1 percent of GDP a year over the next four to five years—largely on the expenditure side.

Product and labor markets. More flexible labor markets remain a top priority, but greater emphasis needs to be placed on liberalizing product and services markets so that moderating wages translate into more jobs rather than higher rents.

Financial sector. More rapid integration of Europe’s financial markets is essential and should help boost productivity and alleviate regional imbalances. Greater regulatory oversight will also be needed to keep pace with integration.

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