Prospects for the Lisbon Strategy

DISCLAIMER: All opinions in this column reflect the views of the author(s), not of EURACTIV Media network.

This paper by Daniel Gros for the Centre for European Policy Studies (CEPS) analyses the predicament of the original EU-15 member states as they face a weakening economy in terms of both demand and supply.

The main theme of the eurozone economy continues to be weakness of both demand and supply. And it is not only the economy that is weak. Any observer of economy policymaking in Europe must be struck by the deterioration in the quality of economic policy in general. This can be seen on many fronts: fiscal policy plans go constantly awry, the Lisbon agenda is constantly invoked but no action is taken, etc. 

Gros argues that this disarray among policy-makers can be explained by the fact that the existing policies and institutions are geared for a growing economy in which growth allows for some redistribution each year. Growth prospects are now rather dim throughout most of the eurozone due to lower productivity growth and, particularly in Germany, due to demographic developments. Economic policy-making is thus squeezed on two sides. 

The fall in potential growth implies a squeeze on the potential for re-distribution, which in turn has an impact on both fiscal and monetary policy. Fiscal policy is deteriorating as finance ministers try to save and then discover every year that despite their attempts at cutting expenditure the ratio of public expenditure to GDP does not go down and that, year after year, deficits are higher than expected. What they fail to understand is that measures that would have redressed the balance ten years ago are now barely sufficient to avoid even larger deficits. 

Monetary policy is less directly affected by the slowdown in growth and the vanishing space of redistribution. Judging from its own predictions, the ECB has also been slow to recognise the fall in potential growth and has thus regularly overestimated growth prospects and underestimated inflation. However, the magnitude of the error, about half a percent per annum, was such that price stability has not seriously been put in danger. This might change when the pressure on economic policy increases. Experience shows that price stability cannot be maintained when there is extreme pressure on public finances as, for example, during wars. This is where the danger lies. The long-run impact of ageing on public finance in Europe is actually comparable to the cost of a major war. (see Deutsche Bank (2004), ‘Inflation is Dead, Long Live Inflation’, Deutsche Bank Global Markets
Research, 8 April). 

This CEPS paper documents the structural weakness of the eurozone, or rather its larger member countries (France, Germany and Italy). It is apparent that even the best structural reforms cannot change some fundamental parameters. Structural reforms cannot change negative trends in demographics and, at least not directly, in a declining capital-labour ratio. But it is also clear that reform can help. The example of smaller euro member countries shows that better performance is possible. However, the rejection in early 2005 of the draft directive on liberalising trade in services by countries such as France and Germany suggests that some countries are resisting this lesson.

Gros concludes that the key reason is that policy decisions are determined by short-term considerations. This applies in particular to fiscal policy which is now governed by a mix of political expediency and some primitive Keynesian ideas. In this context, the long-term objectives and issues are often forgotten. Two of these long-term considerations are particularly germane for Europe today: 

  1. Ageing makes it desirable to generate surpluses today to prepare for ageing in future. 
  2. Deficits crowd out investment! 

This suggests that a fiscal policy oriented towards the long run could produce a ‘double dividend’: it would prepare governments for ageing and it should crowd in investment, making it easier to maintain the capital-labour ratio and hence productivity growth. What is needed today is thus not only structural reforms, but also a structural reform of fiscal policy. Unfortunately, the reform of the Stability and Growth Pact agreed in early 2005, at the instigation of France and Germany but with almost unanimous support of the other member states, suggests that policy-makers are going in the opposite direction. They are looking for excuses to continue a policy that emphasises short-term expediency at the expense of longer-run gains.

Please click here to read the CEPS working paper in full.

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