Why eurozone’s growth engine will stall

In December 2001, with stock markets plunging after the bursting of the dot-com asset bubble, the then New York Federal Reserve President Bill McDonough said that America was enjoying a productivity transformation.

Led by the spread of advanced information and computer technology (ICT), this productivity surge was helping to push the sustainable long-term US growth rate towards a heady 3.5%, he said.

Earlier that year, Jean-Claude Trichet, the then governor of the Banque de France, had guardedly suggested that, in time, Europe’s productivity might also benefit from ICT applications. If so, perhaps the EU’s sustainable long-term growth rate might increase, perhaps to a bit above 2%.

The durability of America’s dubious productivity ‘miracle’ is now in doubt. And even Trichet’s modest hopes for Europe have proved too optimistic. The eurozone’s level of hourly labour productivity, after converging towards America’s for decades, peaked in 1995, says Deutsche Bank Research. It has since declined. In 2005 it was 9% lower than the US’ - and falling. This is an ill omen given other long-term forces at work in Europe.

At a debate organised by the lobby group the Lisbon Council in Brussels last week (4 June), Martin Bailey, a senior fellow at Washington’s Peterson Institute for International Economics, said that perhaps the eurozone’s long-term growth potential may now be less than 1.7%. It could be worse. The European Central Bank (ECB) estimated in October 2006 that Europe’s demographic ageing would result in a sharp decline in the working age population by 2050. Unless each worker is able to produce more, people work longer (as is beginning to happen in some EU countries) or immigration is encouraged, by mid-century the EU’s sustainable long-term growth rate will fall dramatically. The ECB said that by 2050 average growth could drop to as little as 1%.

Not only would this mean living standards will stagnate, but also that social benefit systems (which Trichet, now president of the ECB, described last week as "too generous") would have to be hacked down to a size Europe can afford.

Are things really so bad? This year the eurozone economy is expected by the Organization for Economic Co-operation and Development to grow around 2.7%, faster even than America’s. It could outperform the US next year, too. But this is just a cyclical upswing. It is not very sustainable, according to the International Monetary Fund (IMF), which warned in its report on the eurozone (5 June) that the ECB may have to continue to raise interest rates to choke off a rate of expansion which looks too fast compared with Europe’s underlying long-term productive potential and which could, therefore, stir up inflation. Trichet has indicated he agrees.

On the positive side there is evidence in some countries that economic reform is making a bigger contribution to growth than had been anticipated. The best example among the big EU states may be Germany. Partly because of labour market reforms, the long-term German growth rate, some economists suggest, may have risen in the past couple of years by 0.5%, an extraordinary jump. The fact that German companies in the tradeable goods sector, with tacit support from trade unions, have been able to restructure to meet global competition is itself an indicator of reform, which requires a change in attitudes, not just reform-orientated laws.

Trichet pointed out last week that "courageous and successful" labour market reforms in Ireland and the Netherlands had helped to cut unemployment rates to below 4.5% last year compared with over 7.0% for the eurozone as a whole.

But even the optimists concede that what progress there has been in improving the structure of eurozone economies is at best patchy. According to the IMF, "the [euro] area’s productivity performance has been enduringly disappointing". It put its finger on the "sheltered" non-traded services sector, banking and retailing and wholesaling as the big bugbear.

Trichet also pointed to the "disappointing" labour productivity growth performance of the financial services sector. There is evidence, he said, that countries (and regions) with liquid capital markets grow faster and that efficient financial sectors can help absorb economic shocks. Inflexible labour markets, he pointed out, especially those that offer too much protection for "insiders" (usually union members) who have jobs compared with non-unionised "outsiders", also inhibit the spread of new, productivity and growth enhancing technologies.

As the euro economy rebounds, it is not just fears that politicians will ease up on cutting back budget deficits which worries economic policymakers. Political leaders will also be tempted to back away from growth-enhancing reforms and from the responsibility of telling their citizens that, in the face of global competition, Europe has a real battle on its hands if it is going to maintain its standard of living. As Economic and Monetary Affairs Commissioner Joaquín Almunia put it in a speech on 12 June: "Globalisation is intensifying...while ageing threatens to place our social systems under severe strain. The pace of change is quickening. We must act fast."

• Stewart Fleming is a freelance journalist based in Brussels.

In December 2001, with stock markets plunging after the bursting of the dot-com asset bubble, the then New York Federal Reserve President Bill McDonough said that America was enjoying a productivity transformation.