EEAG European Economic Advisory Group at CESifo

Report on the European Economy 2005

Executive Summary

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Executive Summery

This is the fourth annual report by the European Economic Advisory Group (EEAG) at CESifo. It contains four chapters addressing different topics of policy concern for the European Union and the euro area and also a macroeconomic outlook for the European economy. This executive summary provides a synopsis of the analysis and policy proposals of the report.

Chapter 1 discusses the current situation and economic outlook for 2005 for the European economy. As a main scenario, it is forecasted that GDP in the euro area will grow at about the same rate as in 2004, that is around 13/4 percent on average. The recovery remains fragile and depends on continued growth in the world economy. The recent rise of the euro against the dollar and any additional oil price hikes represent significant downside risks to the basic scenario. For economic policy the basic scenario is that interest rates remain at current levels and that the stance of fiscal policy is similar to 2004. An appendix to the chapter reviews the current problems with the Stability and Growth Pact of the EU.

Chapter 2 is devoted to the widely debated topic of outsourcing of production and jobs from the Western EU member countries to the new member countries and also to the rest of the world. This trend is clearly visible in the manufacturing sector in the European Union. Outsourcing is mainly a consequence of the trade integration of ex-communist countries as well as other producers that offer their labour at low cost. While outsourcing can bring benefits from increased international trade and division of labour, these benefits may not materialise fully given the labour market rigidities in many Western EU countries. These rigidities may induce outsourcing to overshoot its optimal level and destroy more jobs than can be created in other parts of the economy.

Chapter 3 reviews working time developments in Western Europe. The main issue is whether recent agreements on longer working time (at unchanged pay) in Germany represent a reversal of the earlier trend towards shorter working time that could also spread to other Western European countries with low working hours, such as Belgium, France and the Netherlands. The chapter views the agreements on longer working hours in Germany as a response to credible employer threats of outsourcing jobs. Increases in working time will certainly raise output, but they are also likely to increase the number of jobs, especially in the long run.

Chapter 4 is a primer of key economic issues in the reform of pension systems in the EU. The chapter begins with an overview on the strains on European pension systems that loom ahead as a result of the ageing populations in the EU countries. The old-age dependency ratios are forecasted to grow to very high levels, which has major fiscal implications, as the pension system is, to a large extent, a part of the public sector. The chapter discusses principles for reforms of the pension systems that are needed to fix the emerging budget problems and to improve efficiency. The strain can be relieved to some extent by increasing the retirement age and lowering pension benefits, as well as by adopting more general structural policies that enhance economic growth. Our key recommendation is to add a funded pillar to the existing pay-as-you-go systems, to mitigate the missing human capital (due to ageing) by adding incentives for real capital formation. Moreover, the pay-as-you-go pension could be differentiated according to the number of children, provided individually tailored savings plans for the funded pillar are designed to ensure a sufficient level of overall pensions for the childless.

Chapter 5 considers recent developments of house prices in different European countries. There has been widespread worry that house prices might collapse as happened in Japan, the United Kingdom and the Nordic countries in the early 1990s. The country experiences in the last ten years are far from uniform, with rapid price rises in some countries (for example, Ireland, Spain, the Netherlands and the UK) and only small price increases in other countries (for example, France and Germany). A variety of different economic determinants influence the level of house prices Houses provide accommodation services, and, being durable assets, investment motives also affect house prices. Analysis of these economic factors suggests that, while current house prices may be overvalued to some extent in some EU countries, there is little evidence of major speculative bubbles in house prices in these countries. In our view, there is no scientific basis for claims that house prices are about to collapse due to a bursting bubble.