Speech

Is the Glass Half-Full or Half-Empty: An Outsider's Assessment of Europe's Socio-Economic Capacities, Remarks by Takatoshi Kato, Deputy Managing Director of the International Monetary Fund

May 20, 2006

As Prepared for Delivery

1. Good morning. I am delighted and honored to participate in this important symposium, and thank the organizers for their kind invitation. I welcome the occasion to discuss the opportunities and challenges facing Europe. And it is fitting that I make these remarks in Switzerland, a country that is centrally located in Europe and therefore very exposed to the region for its economic progress. Switzerland is also a staunchly independent nation, that should be justifiably proud of its neutrality and its truly global outlook. Its strong tradition of debate, within its system of competitive federalism, is the hallmark of its vibrant popular democracy.

2. Europe is going through a period of soul-searching, having been caught up since the turn of the century in a period of soft economic growth. The region is clearly transitioning to a new era where it must deal with the unstoppable forces of globalization and aging, and with significant changes between countries within the continent. To be sure, globalization, aging, and divergence within a region would be major challenges for any policy maker. But these factors may be especially difficult challenges in Europe, given the region's strongly held and cherished social preferences, that place political restrictions on how to deal with these problems. In this new era, the stakes are high and the rewards great for those countries and regions that can adapt well and work efficiently in the global economy.

3. I would like to structure my remarks around four themes. First, while the Symposium is called "Inspiring Europe", I would like to make the point that Europe itself has long been a source of inspiration to other regions of the globe in various aspects, and it continues to have a lot to offer the world. The second factor I want to draw attention to is that Europe is not fully firing on all cylinders in a world with three primary engines of growth: North America, Asia, and Europe. My third theme is that persistent divergences in Europe need our attention, and the fourth is that policy adaptations are required to fill the European glass to the rim once again.

A. Europe still has a lot to offer

4. Let me start with my main point: Europe has a lot to offer, and not least in the area of social and economic accomplishments. The standard of living and the degree of social welfare for the vast majority of Europeans is among the highest in world. Poverty across much of Europe has been largely eradicated, and access to education and physical and social infrastructure is very good and nearly universal. This is no small feat considering that a large part of the continent lay in ashes just 60 years ago. In the post-war period, Western Europe, of course, led the way, first with the steel and coal community in 1952, evolving into a customs union (the EEC) in 1957, and eventually to the currency union of today: the European Union with the group of Euro-area countries at its economic center. The economic progress that was made in a relatively short period of time was enormous, and the socio-economic institutions that emerged under the welfare state have attributes that are examples for many governments in the world today to emulate.

5. But apart from this well-known success, since the late 1980s Europe has played a critical role that perhaps we tend to underestimate: it has assisted significantly in integrating the states of the former Soviet Union into the global community. The economic panorama of Eastern Europe changed dramatically with the political transition of the former Soviet Union. Suddenly, a number of countries became independent, and Russia itself had to transform its economic model from a centrally-planned one to a market-based system. For Western Europe, this represented a large globalization shock right next door. For Germany it meant concretely the large challenge of reunification—handled with great success at the political level, but with costly consequences at the economic level. However one looks at this, Europe has been a steadfast and supportive partner for the states of the former Soviet Union, and continues to deserve credit for the unprecedented integration of the Eastern and Central states into the European Community—a process that is still ongoing.

6. Finally, Europe is widely recognized for its role in scaling up assistance to low-income countries and its leadership in making debt write-offs part of the global agenda. Net official development assistance averages close to 0.4 percent of GNI in the European countries, with even larger contributions from the northern states. The recent debt forgiveness for 19 qualifying low-income countries in the Multilateral Debt Reduction Initiative (MDRI), and further efforts underway in this program, owe much to leadership from Europe. Its efforts are helping to provide a new opportunity to the most heavily indebted poor countries, and are a reflection of Europe's inclinations toward equity and social solidarity.

B. Nevertheless, in a tripolar world, the European engine is sputtering

7. But Europe has clearly had difficulty adapting to the recent rapid changes in the global economic environment. The shocks to the region were not isolated to the events in Eastern Europe in the early 1990s. They also reflect the lingering effects of the investment crash following the bursting of the equity bubble in 2001, and the rapid "coming on line" of the largest emerging markets sometimes referred to as the BRICs—Brazil, Russia, India, and China, among other smaller new competitors.

8. The pressures from intensified global competition were mainly felt in two interconnected macroeconomic areas: output growth and unemployment. Output growth in the core of Europe, the Euro-area, has been well below that of the U.S. and Asia for some time now, including on a per-capita basis. This reflects especially slow growth in domestic demand where neither household consumption nor fixed investment have made a significant recovery. The flip-side of this weak growth, of course, has been high unemployment—in the 8-percent range in recent years, with only moderate improvement in sight. The picture looks even dimmer when one considers the related but more economically relevant concept of labor utilization, where the core of Europe is showing a steady decline in the number of hours worked per person, both in absolute terms and relative to the other two engines of world growth—the U.S. and Asia.

9. And there is some concern that Europe may respond to these pressures in the wrong way. Protectionism is an ever-present threat that comes in many guises. European agricultural and trade policies have not opened up sufficiently rapidly to the rest of the world, and the tribulations in the Doha round do not promise a significant turnaround in this respect. Stubborn restrictions on the free movement of labor is another example. Indeed, despite recent progress, the free movement of labor is not yet present throughout the European Community itself. This is clearly evident in the very difficult and protracted special arrangements remaining for workers from the new Eastern European member states. The fact, however, is that protectionism eventually is a self-defeating policy. In the case of labor protection, the more Europe is successful at preventing competitive labor from coming in, the more successful it will also be in motivating expensive capital to move out. Capital is increasingly mobile and will go where markets are most dynamic and where labor is relatively inexpensive. By erecting barriers in various ways (this could be for labor, goods, or services), domestic investment will remain weak and output growth will remain low.

C. Economic divergence within Europe

10. The difficulties I have enumerated are not just between Europe and the rest of the world, but are also present within Europe. If you allow me to put it slightly bluntly, the later entrants in the EU—including the U.K., Spain, and notably the 10 new member states—are growing faster and are delivering superior labor market performance than the earliest member states. What the later entrants have in common is more flexible markets, more willingness to open up to external forces and, in all fairness, they are also catching up to the very high standard of living in the older member states, which is a more comfortable position to be in than converging from above. The U.K. is benefiting from an extended period of significant reforms initiated in the 1980s, and has not opted for restrictions on the free movement of labor from the new member states. Spain is receiving a massive influx of labor from Latin America and Northern Africa and is converging rapidly to the high standard of living in the northern continental states. And of course the new member states, especially those from Eastern Europe, have lower legacy costs in their social systems and tax regimes. They provide competitive labor, and enjoy a new spirit after the limits on entrepreneurship were removed, with the transition from a command-driven economy.

11. Europe can choose to benefit from these internal differences or suffer from them. Switzerland has a very long tradition of competitive federalism with strong internal debate and checks and balances through popular initiatives and referenda. In the EU, competitive federalism is sometimes viewed with trepidation, as if competition is akin to beggar-thy-neighbor policies. Instead, there is the specter of "National Champions." There is reluctance to proceed with structural reforms in the absence of similar reforms in other countries (the "waiting for the neighbors" syndrome). There are restrictions on the movement of labor, and difficulties to proceed vigorously with the creation of a truly common market for goods, services, and, I may add, financial services.

12. The resulting inflexibilities of allocating resources within the European Community actually lead to country differences becoming more acute because there is no automatic stabilizer of resources moving quickly from one country to the other. In turn, this creates stress on the common monetary policy because inflationary pressures will also diverge and become more acute than they would be otherwise. This not only creates complications for the European Central Bank, but it also leads to frustration in those countries that are temporarily growing more slowly and hence face a relatively high real rate of interest. In other words, the common currency area does not merely come into existence because we make a political statement to its effect, but rather because policies allow it to flourish, and are updated continuously to strengthen its performance even further over time.

D. What is needed for Europe to flourish again?

13. I do not want to imply there is a simple recipe for success. Nor would it be useful to single out one country or the other that needs to take the lead because all member countries have a part to play. All national governments naturally respond to pressures from their own constituents, as indeed they should. However, they need to avoid short-term fixes, and instead seek solutions that will stand the test of time and work toward a common objective: to lift growth and reduce unemployment across the continent in a durable way. These solutions need to be directed at the two key challenges of today: globalization and aging.

14. Meeting the challenges of globalization. Globalization is a competitiveness shock from outside Europe. It can bring big benefits in the form of lower cost goods and services, but it can also quickly put pressure on internal high-cost labor. Internal reform and external liberalization that allow unfettered access for these lower cost goods and services produces downward pressure on margins and can lift real disposable incomes. Europe still has a long way to go in establishing a common internal market. Network industries are far from operating in truly contested markets. And restrictions in the Services Directive, that are intended to protect labor, will eventually hamper growth in these sectors. They will lower, not raise, jobs and the standard of living. Research in Europe and by the IMF has shown time and again that simultaneous reforms in the markets for goods, services, and labor yield the biggest benefits. By moving simultaneously, not a single party (be it labor, capital, suppliers, consumers, or intermediaries) will have the power to capture rents and obtain an inequitable advantage. Now the onus is on implementation.

15. Meeting the challenges of aging. Arguably, the promises under most European social welfare systems have overshot. Even if globalization and its pressures on lowering labor costs did not exist, many welfare systems would still be unsustainable. This is because potential output growth is slowing together with population decline, and life expectancy is rising much faster than was anticipated when these systems were created—sharply pushing up dependency ratios and throwing the finances out of kilter.

• Social security reforms require that revenues rise and expenditures decline. Many countries have already started this process in pension systems: pensionable ages are being extended, and will need to increase further; benefit levels are being recalibrated and made actuarially fair; and costs are being muted by shifting from defined benefit to defined contribution plans in several countries, or by reducing indexation mechanisms. A very big challenge in all countries is how to manage the inexorable rise in health care costs. Much research is being done to improve efficiency and to squeeze out costs from the supply side, while sharpening incentives such as co-payments, rewarding preventive care, and installing better information sharing systems, etc., to address demand pressures.

• Labor practices will also need to be updated. The elderly will have to and want to work longer than what we are now accustomed to. This is one more reason for more forceful liberalization of the services sectors, where part-time work and tasks with more differentiated remuneration need to be created. Physical and managerial adaptations in the work place and in public and tax policies will also need to be made. Our colleagues in the OECD are doing systematic work to prepare country reports on "Aging and Employment Policies" that will provide further guidance in this important area. The general message is that labor utilization in Europe has fallen behind. Since Europe has high-quality labor on offer, this implies a large opportunity cost to the continent and needs to be reversed.

16. Having reviewed Europe's post-war achievements as well as the challenges ahead, I come away with the belief that Europe's glass has been filled over time through a combination of impressive vision by its political leadership—notably in pursuing the project of European integration—and painstaking implementation of the associated policies by governments and European institutions. Meeting the challenges of globalization and a rapidly aging society while preserving a quality of life that the rest of the world envies is a difficult task for the current generation of Europeans (albeit hardly as difficult as building an integrated Europe in the first place)—and it will again require both a clear and broadly-shared vision and steadfast implementation of policies. Europe's progress in meeting these challenges will be closely watched by the outside world.

Thank you.