Honing Europe's Competitive Edge

Remarks by Murilo Portugal, Deputy Managing Director, IMF
At the International Conference on Opportunities of the European Economy in Global Competitiveness
Dedicated to the 15th Anniversary of the Reintroduction of the Estonian Kroon
Tallinn, Estonia
May 23, 2007

1. It is a pleasure to be here on behalf of the IMF to celebrate the reintroduction of the kroon 15 years ago. The reintroduction of the kroon was a bold and decisive step taken at a time of considerable uncertainty; a step, I must admit, that the IMF was more cautious about. But I am pleased that, faced with the single-mindedness and determination of the Estonian authorities, the IMF quickly came behind the idea and backed it with technical assistance and the support of an IMF program. At the time, it seemed like a risky enterprise. How far things have come since then! Fifteen years on, it is clear that the kroon—and its supporting currency board arrangement -has been a cornerstone for Estonia's extraordinary economic transformation.

2. Allow me to shift now to my topic today, the competitiveness of Europe. Over the past decades, Europeans have seen their lives transformed tremendously. Europe has blossomed into a continent that is widely admired for its prosperity, its diversity and its caring for human rights and civil liberties. The region achieved much of what it has by garnering collective strength through a much admired process of economic integration, which boosted competition and growth across the continent.

3. For several decades after World War II, economic growth was based on the formation of capital and the adoption of existing technologies. Aside from history and geography, the main comparative advantages of European countries are a highly educated population, a commitment to the rule of law and property rights, and high-quality public services, including a world class public infrastructure. Of course, European countries have also had excellent educational systems that preserved and expanded their already strong human capital. But perhaps most important of all was the political commitment to European integration and the related unprecedented period of peace and social stability.

4. With much of the post-war economic catch-up completed by the 1970s, innovation and competition have now taken on a critical role for economic growth. Competition, in turn, is crucially related to the integration of European economies, including with the rest of the world. In fact, Europe has been competing very successfully in the industrial tradable goods sector—a sector that has been largely exposed to competition and where innovation and productivity growth have been the strongest. Openness to trade and competition in industrial goods has had many positive repercussions for Europe. It has led to a larger variety of intermediate goods and capital equipment, enhancing the productivity of Europe's other resources. It has also led to a greater use of technology developed worldwide and embodied in capital goods. And thirdly, openness to trade and competition in manufacturing has contributed to the more efficient use of resources by putting pressure on markups and inducing more competitive market structures. This is visible in Europe's productivity performance relative to the United States, for example, which is much more favorable for manufacturing than for services sectors.

5. Notwithstanding the successes of Europe's integration and its improving economic performance, Europe lagged behind the United States in terms of economic growth and productivity in the second half of the 1990s. As seen in Slide 2, which shows European per capita GDP, labor productivity and labor utilization as percentages of the corresponding US variables, European per capita income has been growing less rapidly than the US since the early 1990s, coinciding with a decline in labor utilization. And labor productivity has been growing less than in the US since the mid 1990s. Yet, the demographic challenges faced by Europe make the need for stronger productivity growth all the more urgent. A rapidly aging population is putting increasing strains on Europe's welfare states. Europe must take action in a number of areas. It must raise its labor utilization. Unemployment is still high and labor force participation remains low in many countries. Europe must also boost its productivity, and reform its welfare systems.

6. Continued integration in Europe remains essential for the economic prosperity of the continent and its individual members. And what better place to make this case than here in Estonia, a country whose remarkable economic performance owes so much to the enthusiasm with which it embraced free trade in goods and international competition in the financial sector? (Slide 3) In fact, most of the EU's new member states have shown very rapid productivity growth, reflecting both rapid convergence and economic restructuring. The enlargement of the European Union—from which Estonia and other new member states have benefited considerably—has also made the old member states more competitive. For example, studies show that German firms have become more competitive by outsourcing part of their production to Eastern Europe, re-importing the products as intermediate goods, and then exporting the final goods to the rest of the world.

7. When European leaders met at the Lisbon summit in March 2000 they set the European Union the goal of becoming "the most dynamic and competitive knowledge-based economy in the world" by 2010. The Lisbon agenda set out the way to achieve this objective with a series of ambitious goals in areas such as employment, innovation, enterprise, liberalization and the environment. Until recently, the results were somewhat disappointing. The European economy failed to deliver the expected performance in terms of growth, productivity and employment. To be fair, the Lisbon employment targets are demanding. While Europe has fallen short of these ambitious targets, job creation since the mid-1990s has been broadly comparable to that in the United States. Productivity, however, has been disappointing, and Europe has not caught up with the United States in terms of per capita GDP. In short, Europe has found it difficult to accelerate both employment and productivity at the same time.

8. Some of Europe's most successful performers show that the way forward is through comprehensive and coherent reform strategies that harness synergies. The recent Global Competitiveness Report by the World Economic Forum shows some encouraging signs that Europe is now making some progress toward the Lisbon goals. Indeed, six member states are in the top-ten ranking of the Global Competitiveness Index. (Slide 4) Productivity growth performance differs across countries, with Italy and Spain lagging, Germany and France in the middle, and with the UK, Sweden, Finland at the top. What do the better performers, especially the Nordics and the United Kingdom have in common? First, they share an openness to the rest of the world. The external sector is very prominent in these countries. Second, they share an openness to markets. According to the OECD, they all have relatively light product and service market regulations. Third, these countries all rely on the budget rather than on market restrictions as a means to redistribute income. And fourth, there is a willingness to adjust labor markets and the welfare state in response to new pressures. Taken as a whole, this was a very successful strategy: labor market and welfare reforms fostered labor supply, while product and services market liberalization fostered labor demand, with synergies setting in. This is in considerable contrast to strategies pursued in some other European countries, where attitudes to markets and competition are sometimes more ambivalent, especially where there are strong stakeholders defending special interests.

9. Thus, to further move ahead towards the Lisbon goals, an efficient single market—essential for boosting competitiveness in Europe—has to become reality. The remaining barriers to the full integration of goods and service markets, including obstacles to foreign entry, should be eliminated. Europe's service sector has been performing poorly and should be a focus for reform. (Slide 5) As shown in the figure, labor productivity growth in financial and business services has lagged behind that in manufacturing, mining and energy. Competition in services remains a major concern, with only 8 percent of services output traded, partly because of the many barriers at the national level. The Service Directive is a step that Europe needs to take in this regard, and its timely implementation is desirable. (Slide 6) A decomposition of the productivity gap between Europe and the United States indicates that wholesale and retail trade and financial intermediation explain most of this gap. (Slide 7) An examination of total factor productivity by sector indicates that financial, business and personal services are contributing negatively to growth. Therefore, financial services integration is an important concern. The Financial Sector Action Plan has been a major success on the legislative front, but it remains to be seen to what extent it will translate into progress on the ground. The lack of sufficient integration and competition in the financial sector plays an important role in Europe's disappointing productivity performance. I wish to point out that here too our host country, Estonia, has been an exception (Slide 8): its highly integrated financial sector has been the leading contributor to productivity growth.

10. As I mentioned at the outset, economic integration has helped Europe garner much collective strength over the past decades, and through it, competition and growth have flourished. But some segments of European society and of the economy have so far remained relatively sheltered, and it is important to instill more competition and change in those areas. This will be critical to achieving satisfactory growth needed to sustain high standards of living for aging populations in the old member states of the European Union. It will also ensure that he new member states will soon attain these same standards of living.

11. Fifty years ago, the founding fathers of the EU signed the treaty of Rome envisaging a Single Market. European policymakers must ensure that building that Single Market remains at the top of their agendas.



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