The high degree of price stability remains an impressive achievement shared by almost all of the advanced economies. In 1996, the rate of consumer price inflation averaged 2½ percent, and only four countries experienced inflation above 5 percent; measured by GDP deflators, a broader measure of the price level, average inflation was just 2 percent. In terms of output and employment, the picture is much more mixed as underscored by sharp divergences in labor market performance in recent years. Whereas a number of economies including the United States, the United Kingdom, and several of the smaller advanced economies are operating at relatively high levels of resource use, the three major continental European countries have suffered protracted economic weakness that has been accompanied by a dramatic rise in unemployment to post-war record levels. Conditions for recovery have gradually improved, but few forecasters expect the upswing to make more than a modest dent in unemployment. In Japan, the recovery has also proven quite hesitant, as discussed below and in Chapter II in greater detail.

The unsatisfactory economic performance of the three major economies of Germany, France, and Italy, cannot be blamed on the external environment. In fact, external markets have been expanding strongly and exports have been the main source of stimulus in recent years. Thus, between 1992 and 1997, the real foreign balance is estimated to have improved by 1.8 percent of GDP in Germany (most of this occurring in 1996 and 1997), 2.5 percent of GDP in France, and 5.5 percent of GDP in Italy. This clearly indicates that the sources of weakness have been internal, and in fact domestic demand has expanded by less than 1 percent a year in these three countries combined over the past five years.

There are at least four sets of factors that need to be considered in explaining this exceptional sluggishness.

(1)  Fiscal consolidation. Since 1992, there has been a substantial effort in many countries to reduce fiscal imbalances that had reached unsustainable levels; although beneficial for growth in the longer run, those efforts have tended to weaken aggregate demand in the short run notwithstanding offsetting effects from lower interest rates and exchange rates. In continental Europe as a whole, however, fiscal policy (measured by changes in cyclically adjusted balances) has not been substantially tighter than in the United States or the United Kingdom. Differences in fiscal stance therefore clearly cannot by themselves explain the differences in growth performance.

(2)  Labor market rigidities. The lack of flexibility of continental European labor markets has undoubtedly exacerbated the weakness of economic activity at the same time as product market rigidities may have impeded the private sector’s adjustment to the withdrawal of fiscal stimulus. Some labor market measures, such as work sharing and early retirement, that were intended to reduce open unemployment, may actually have served to dampen growth by reducing the supply of skilled labor and increasing tax burdens and labor costs.

(3)  Confidence factors. Although such influences are difficult to assess in isolation from other forces, delays in addressing the root causes of structural unemployment and fiscal imbalances may well have affected business confidence, while labor-shedding in response to high labor costs has increased job insecurity and undermined consumer confidence. Excessive reliance on revenue increases to reduce fiscal deficits rather than reform-based reductions in expenditures may also have discouraged both investment and consumption. Recurrent uncertainties about the feasibility of the timetable for EMU have probably added to hesitation in business investment.

(4)  Monetary policy. The progressive easing of monetary conditions in Germany and the rest of Europe during 1993 and early 1994, and generally declining risk premiums in long-term interest rates, played a significant role in the first phase of recovery in 1994. As this initial pickup failed to turn into a self-sustained expansion, owing in part to the effects of an overly strong deutsche mark in early 1995, official interest rates were reduced further during 1995 and early 1996. However, while the stance of monetary policy since the latter part of 1993 has supported demand, a somewhat faster and ultimately more pronounced easing of monetary conditions would have helped put the recovery on a stronger footing without jeopardizing price performance. The timing of such easing was constrained by the rise in long-term interest rates in 1994, but an easier monetary stance was justified subsequently by the absence of inflationary pressures, the prevalence of significant cyclical unemployment, the large withdrawals of fiscal stimulus, and depressed levels of consumer and business confidence. As of August 1997, with the further weakening of the currencies participating in the European exchange rate mechanism (ERM) vis-à-vis the dollar and the pound providing additional stimulus, monetary conditions in continental Europe appear to be sufficiently supportive of the emerging recoveries.

Movements of major currency exchange rates since the spring of 1995 have corrected earlier misalignments, and the present configuration is generally helpful and appropriate in view of relative cyclical positions. Specifically, the present relatively strong values of the currencies of the United Kingdom and the United States in comparison with the currencies of Japan and continental Europe are helping to restrain potential inflationary pressures where capacity utilization is high while providing support to recovery where slack remains considerable. Over the medium term, while some of these recent movements in exchange rates point to a potential widening of external imbalances, they can be expected to be reversed as cyclical conditions become more balanced.

Already in the seventh year of its expansion, the United States economy has continued to combine solid growth of output and employment with low inflation and a diminishing fiscal imbalance. These achievements are a reflection of prudent macroeconomic policies together with an exceptionally dynamic private sector and a responsive labor market. Although there has been a tendency since around 1994 for wage increases to edge up, wage pressures have been less pronounced than in preceding cycles, and a number of other factors have helped to dampen inflation. Most of these factors, however, are likely to be temporary. The Federal Reserve has tightened monetary policy moderately but the continued surge in the stock market and the strength of consumer and business confidence suggest that the risk of overheating is still present. Further monetary tightening is therefore likely to be necessary and is assumed in the projections (Box 1), which indicate a moderation of real GDP growth to 2½ percent in 1998 after 3¾ percent in 1997. Inflation is expected to change little provided growth slows to the more sustainable pace projected.

Substantial and steady reductions in the actual and structural budget deficits have been achieved between 1992 and 1996, and a continued improvement in the former is expected in 1997, largely owing to higher tax revenue generated by the strong economy. The balanced-budget agreement enacted in August 1997 promises to bring overall balance in 2002. In view of longer-term fiscal pressures arising from the aging of the population, a more substantial fiscal effort will be needed to raise national saving and help to reduce the external deficit. Preliminary steps have been taken to address these problems, and prompt action to put the necessary measures in place would avoid more draconian measures in the future and spread the burden more equitably across generations. Another important policy challenge facing the United States is to sustain a higher growth rate of income for those whose living standards have stagnated or declined in the past two decades. This will require a strengthening of investment in education and training.

In Canada, the recovery has gained momentum since mid-1996, spurred by strengthened confidence, marked declines in both short-term and long-term interest rates, and improved external competitiveness following the depreciation of the Canadian dollar during the early 1990s. The fall in interest rates bottomed out late last year, reflecting the improved confidence in the recovery, and in late June official rates were increased modestly. Providing a strong stimulus to business and residential investment, the decline in interest rates in recent years has been made possible by an impressive improvement in fiscal performance, and a high degree of price stability well within the inflation target range of 1 to 3 percent. Unemployment has fallen from around 10 percent in late 1996 to 9 percent in July 1997. With still some slack in the labor market, there is continued scope for solid growth with little risk of higher inflation. As the labor market tightens, however, monetary policy will need to move gradually toward a firmer stance. The recent agreement on pension reform should help safeguard the strengthened fiscal outlook over the medium to longer run.

In Japan, the recovery strengthened in late 1996 and early 1997 due to a pickup in domestic demand, and net exports also began to recover reflecting a lagged response to the correction of the yen from its excessively appreciated level in early 1995. Subsequently, however, economic activity fell sharply in the second quarter following the increase in the consumption tax on April 1. Although a rebound in output can be expected in the second half of the year, growth for 1997 as a whole is now estimated at 1 to 1¼ percent, substantially weaker than projected in the May 1997 World Economic Outlook. Should growth fail to pick up in the second half of 1997 some fiscal measures will need to be considered to help underpin the recovery. In 1998, with a slower pace of fiscal consolidation, growth is expected to accelerate to some 2 to 2¼ percent, although repercussions of the recent financial crises in Southeast Asia constitute a continued downside risk. Given the absence of underlying inflationary pressures and uncertainties regarding the effects of the recent tax increases, official interest rates are not expected to be raised until recovery is firmly established. The exchange rate remains broadly consistent with current fundamentals including Japan’s relatively weak cyclical position. As the recovery proceeds, the yen can be expected to strengthen—as is indicated by interest differentials in favor of assets denominated in other currencies—and this will help contain the widening of the external surplus that is projected on the assumption of unchanged real exchange rates (Box 2).

Box 2. Alternative Exchange Rate Assumptions for Japan

The World Economic Outlook projections are based, among other things, on the assumption that real effective exchange rates remain constant at the values observed in a recent historical "reference period." For the current World Economic Outlook, for instance, exchange rates are set at their average levels during July 18–August 14, 1997. This convention avoids the need to make judgmental projections of exchange rates, which would be particularly problematic given the need to maintain consistency across countries in the World Economic Outlook’s assumptions for external variables. At the same time, however, it may be inconsistent with market expectations of future exchange rate movements, and also lead to tensions among various elements of the IMF staff’s forecast. These issues are particularly relevant for Japan. Although it is difficult to directly measure longer-term market expectations, interest rates on yen assets are currently well below those on assets denominated in other major currencies. As well as reflecting lower inflation expectations for Japan, this interest differential is, in part, attributable to Japan’s weak cyclical position relative to major trading partners, especially the United States. Given a high degree of international asset substitutability, and the likely course of inflation rates, the interest differential can be interpreted as reflecting market expectations of real yen appreciation over the medium term. In the event, recent interest differentials imply an expected appreciation of almost 3 percent a year in real effective terms.1 It is interesting to note that this is similar to the trend real appreciation of the yen over a long historical period (see first figure). Regarding tensions in the projections, the assumption of a constant real exchange rate assumes away an important channel of macroeconomic adjustment. In particular, the projection for the external balance should be consistent both with the relationships determining trade flows and those determining the domestic saving-investment balance. Over the medium term, as the economy returns to potential output, movements in the exchange rate would normally play a key role in bringing the trade balance into line with the underlying saving-investment balance. In the assumed absence of such movements, tensions may exist between the projection for the trade balance and those for saving and investment. Tensions of this type are evident for Japan. Specifically, the assumption of an unchanged real exchange rate leads to a gradual rise in the external surplus over the medium term to about 2½ percent of GDP. In contrast, the structural determinants of saving and investment—and especially the shift toward a more elderly population—point to a gradual decline in Japan’s underlying saving-investment balance and a corresponding reduction in the external surplus. This inconsistency raises the question of what will happen to reduce the external surplus, raise domestic saving, or lower domestic investment in the period ahead. To examine the implications of an alternative exchange rate path for the projection for Japan, a simulation was performed using the Japanese block of the IMF’s multi-country simulation model, MULTIMOD. The simulation was constructed such that the path for the yen was fully consistent with projected interest rate differentials—in other words, in each future period, the yen appreciates in line with the differential between interest rates in partner countries and Japan.2 This assumes that returns on assets denominated in yen and in other currencies are equalized: asset holders do not require a "risk premium" to hold one currency rather than another. The second figure compare the results of this alternative scenario with the baseline projection. In the alternative scenario, the real effective value of the yen rises steadily to stand about 17 percent above baseline by 2002, implying an average rate of appreciation of just over 3 percent a year—similar to the market-based real interest differential discussed above. The current account surplus falls from about 2 percent of GDP in 1998 to less than 1 percent of GDP by 2002, as opposed to rising in the baseline. Offsetting the effect on aggregate demand of the higher real exchange rate, the real long-term interest rate in Japan stabilizes at around 2 percent, compared with the gradual increase to 4 percent in the baseline. Indeed, the near-term effects on demand of lower real interest rates dominate those of the higher exchange rate, and output grows somewhat more quickly in the alternative scenario during the first few years of the simulation. Output growth in both scenarios converges over time as the economy returns to potential.3 These results illustrate the sensitivity of some key elements of the projection for Japan—most notably for the external balance—to alternative exchange rate assumptions. Of course, this analysis is subject to a number of caveats. Shifts in Japan’s trade behavior in recent years and the prospect of structural changes in the economy over the medium term may make past trends in the exchange rate an unreliable guide to the future. In addition, real interest differentials have often not provided an accurate forecast of subsequent developments in exchange rates, raising the question of whether they provide a suitable proxy for market expectations. Nevertheless, the results underscore the need to view the medium-term World Economic Outlook baseline as a conditional projection, as opposed to an unconstrained, fully consistent forecast for all macroeconomic variables. 1The nominal interest differential on five-year government bonds between other major industrial countries (weighted-average basis) and Japan stood at about 4¼ percent in mid-1997, while medium-term "consensus " forecasts by the private sector indicated a gap in projected inflation rates of about 1½ percent. The expected real appreciation is taken as the difference between these two numbers. 2Foreign interest rates were held exogenous in the simulation, while domestic interest rates reflected the assumed response of the monetary authorities to developments in activity and prices. 3The level of potential output is somewhat higher in the alternative scenario, however, as lower real interest rates crowd in domestic investment, raising potential GDP.

The authorities recently have adopted a medium-term fiscal consolidation plan that includes a commitment to reduce the general government deficit, excluding social security, to not more than 3 percent of GDP by FY 2003 (compared with a deficit of over 7 percent of GDP in 1996). In addition to the need to restore a sustainable fiscal position notwithstanding pressures from a rapidly aging population, Japan faces major challenges in the area of structural policies. Despite some reforms, nontradable sectors have remained overregulated, subject to a low degree of competition, and relatively inefficient. The government is strongly committed to building on the growing consensus for reform and has announced important steps to reform Japan’s financial system—the "big bang"; new reform proposals have also been put forward for transportation, telecommunications, and power generation. Steps taken in some other areas remain more tentative, however. Greater efforts are clearly needed to enhance the efficiency of the nontraded goods and services sectors as the economy continues to mature and the importance of the industrial sector diminishes, as in other advanced economies.

In Germany and France, growth appears to be picking up after a disappointing performance in 1995 and 1996. Exports are providing much of the strength, with domestic demand so far remaining relatively weak. Construction is especially depressed in both countries. While the business climate has improved, consumer confidence has remained lowdue to various factors, including record unemployment, continued fiscal restraint, and job insecurity linked in part to significant restructuring needs. However, the stimulus from exports and a supportive stance of monetary policy suggest that the recovery should gradually gain momentum and contribute to a strengthening of confidence. The current projections indicate that the 3 percent Maastricht deficit targets may be exceeded by small margins in 1997 in both countries. Significant reform-based consolidation efforts are needed to firmly keep the fiscal deficits on a decreasing path in 1998 and beyond. Moreover, fundamental labor market reforms (discussed below) remain essential to restore satisfactory economic performances. In France, however, plans for public sector job creation and other labor market proposals may complicate fiscal consolidation efforts and hamper economic growth.

Interest rates were appropriately lowered in both Germany and France during 1995–96 to support economic activity, and the effective depreciation of the deutsche mark and the franc since mid-1995 has also helped to ease monetary conditions (broadly defined to include the exchange rate). The accommodative monetary stance has clearly not undermined the credibility of monetary discipline: inflationary pressures remain virtually absent and long-term interest rates have fallen significantly below those in the United States after being above them through most of 1995 and in early 1996. Under present circumstances, a tightening of monetary conditions should be avoided until a robust recovery is firmly established.

Economic activity in Italy has been particularly subdued owing to the necessary efforts to restore balance in public finances, with private sector confidence and behavior also being affected by the awareness that permanent measures will be needed in 1998 to replace the one-off measures introduced in 1997. Output increased by only 0.7 percent in 1996, and growth is likely to remain modest in 1997, even though recent indicators point to a pickup in the course of the year. The fiscal consolidation efforts, if sustained by means of an early agreement on structural cost savings on pension and welfare spending, will substantially enhance Italy’s medium-term economic and financial outlook. Reflecting Italy’s determination to qualify for participation in EMU, the fiscal deficit is expected to be reduced from 6¾ percent of GDP in 1996 to close to the Maastricht reference value in 1997, while inflation has fallen to 1½ percent. In this context, the long-term interest rate differential vis-à-vis Germany has narrowed sharply during the past year. Official interest rates have also been eased progressively and there should be scope for further easing as fiscal consolidation proceeds.

In contrast to the difficulties that have characterized the major continental European economies in recent years, the United Kingdom’s economic expansion has permitted a progressive narrowing of the output gap and significant reductions in unemployment since 1993. Growth is expected to be stronger in 1997 than in 1996, with buoyant domestic demand more than offsetting the effects of the appreciation of sterling. The welcome decision to grant the Bank of England operational independence in monetary policy to meet the inflation target—now set by the Chancellor of the Exchequer at 2½ percent—had a clear impact on the authorities’ anti-inflation credentials as indicated by an immediate narrowing of long-term interest rate differentials vis-à-vis Germany from about 180 to about 140 basis points. With the increases in short-term interest rates since May, and the strong appreciation of the exchange rate, monetary conditions have tightened significantly. The fiscal deficit has been reduced in recent years from the unsustainable levels reached in 1992–94. The July budget accelerated the pace of fiscal consolidation, with the deficit set to decline by a further 4 percentage points of GDP over this year and next. Policies thus appear well geared to alleviate inflationary pressures but will need to pay close attention to signs of excessive strength in domestic demand.

With a few exceptions, the smaller and medium-sized advanced economies are also enjoying relatively solid economic growth with moderate inflation. Ireland continues to grow at more than double the pace of the rest of Europe, and Denmark, the Netherlands, and Norway have also reached mature stages of their expansions with high levels of resource use; in all four cases, because of exchange rate constraints, fiscal policy will need to bear the brunt of the policy tightenings that are warranted to reduce the risk of overheating. Finland’s and Sweden’s strong fiscal consolidation efforts have been rewarded by improvements in confidence and their recoveries are expected to continue during the period ahead. Spain and Portugal have also witnessed marked improvements in economic and financial conditions and a pickup in growth, which should facilitate the achievement of fiscal deficit targets. Austria, Belgium, and especially Switzerland continue to lag in the cycle and their expected recoveries will remain sensitive to economic conditions in Germany and France.

Outside Europe, in Australia and New Zealand growth moderated during 1996 due in part to preemptive monetary tightening; as inflation risks have abated, monetary conditions have eased and growth is expected to accelerate in the period ahead. Relatively large external deficits point to the need for prudent fiscal policies over the medium term in both countries. In Israel, growth is expected to slow in 1997 and there remains a need for greater fiscal discipline to support anti-inflationary monetary policy. Among the newly industrialized economies in Asia, Hong Kong, China’s economic performance remains impressive as the changeover to Chinese sovereignty has proceeded smoothly; the authorities plan to increase land supply to alleviate pressures in the real estate sector.² Taiwan Province of China is also enjoying continued rapid growth and modest inflation. In Singapore, a moderation of growth in 1996 has helped alleviate inflation risks and exports have picked up after last year’s slowdown. In Korea, economic growth is expected to slow somewhat further in the near term partly as a result of uncertainties stemming from weaknesses in the corporate and financial sectors.

EMU and the World Economy

In the spring of 1998, the member countries of the European Union (EU) will decide on the initial group of participants in the planned euro area. The establishment of EMU will be a milestone in the 40-year long quest to strengthen economic and monetary integration in Europe. It will also constitute the largest change to the international monetary system since the breakup of the Bretton Woods par value system, with the emergence of a new international currency whose role may eventually match that of the U.S. dollar as a means of payment and as an international reserve asset. And it promises to promote a more stable financial climate in Europe.

For Europe, it is to be hoped that EMU will herald a new era of stronger economic growth. A common currency shared by a majority of EU member countries, and potentially by all of them, would lower transaction costs and generally promote economic integration, generating long-term efficiency gains. In addition, the commitment to price stability and prudent fiscal policies underpinning the euro promises to produce lower real interest rates, on average, than has been observed in the past couple of decades; and the elimination of the exchange risk premiums associated with multiple EU currencies will also tend to lower real interest rates and promote investment.

Conditions for participation in EMU, as set out in the Maastricht Treaty, emphasize the need for a high degree of convergence of key economic and financial variables. Compliance with the inflation and interest rate criteria now appears to have been achieved by all those EU members that plan to participate initially. This has also fostered a high degree of stability within the exchange rate mechanism of the European Monetary System. Progress in meeting the fiscal criterion is more difficult to assess. Without additional measures, it seems likely that a number of candidates for membership, including France and Germany, may not strictly satisfy the 3 percent fiscal deficit target in 1997, partly owing to relatively large margins of economic slack, which have raised public expenditures and reduced tax revenues.

On a cyclically adjusted (or structural) basis, however, the IMF staff’s estimates suggest that the deficits of all EU members aspiring to join EMU from the start will be within about 2 percent of GDP in 1997 (Figure 2). This clearly suggests that underlying fiscal positions have converged considerably and that fiscal imbalances pose less of a risk to macroeconomic and financial stability than might be inferred from the unadjusted deficits provided the excesses of the actual deficits over the reference value are indeed small, as expected. What is important at this stage is a clear commitment of those countries to go significantly further in their fiscal consolidation efforts in 1998 and beyond with greater emphasis on fundamental reforms. It should be the objective relatively soon to bring underlying budgetary positions broadly into balance in accordance with the objectives of the Stability and Growth Pact.

As a politically independent institution with a strong mandate for price stability as its primary objective, the European Central Bank (ECB) will clearly be well positioned to demonstrate through actual performance the dedication to economic stability that the participants in the monetary union desire and expect. A low-inflation environment will give the credibility needed to allow it to help stabilize output without jeopardizing inflation performance. The choice of an operational target for monetary policy needs to take into account the structural changes that are likely to take place in financial markets with the introduction of a common currency. In these circumstances, since it will be difficult to rely solely on a monetary target, an inflation target approach may be helpful by providing an anchor for price expectations and a yardstick for performance. The exchange rate of the euro will probably also help guide monetary policy even though exchange rate considerations naturally will be given a relatively small weight in the conduct of monetary policy in such a large currency area. In fact, the ECB, like other major central banks, will presumably use a wide range of indicators in assessing the appropriate settings of its policy instruments.

The rest of the world has a strong interest in a successful EMU and a solid euro. A successful EMU should lessen fears of globalization and the risk of a protectionist backlash to Europe’s unemployment problem. It is likely to make Europe a better place to do business and to invest than has been the case in recent years. This in turn should boost the demand for euros and promote the new currency’s success as an international transaction currency. How strong and stable the euro becomes will depend on many factors, in addition to the credibility and consistency of policies in the monetary union. There will naturally be a need to accept a reasonable degree of variability in the exchange value of the euro to reflect divergences in cyclical conditions across the major currency areas. The effectiveness of policy coordination with other major countries is also likely to influence the variability of the exchange rate. Ultimately, it is important that the value of the euro properly reflects the economic fundamentals of the participating countries. The anti-inflation mandate of the ECB and the prudent fiscal rule embodied in the Stability and Growth Pact suggest that the euro will have the key attributes of a strong reserve currency.

Enhancing labor market flexibility in Europe

A particularly critical factor for the success of EMU, in addition to sound financial policies, will be the extent to which governments succeed in improving Europe’s labor market performance. Comprehensive reforms to reduce structural unemployment would not only help boost medium-term growth and improve fiscal performance but would also help Europe adjust faster, and with less unemployment, to adverse economic disturbances, including those with asymmetric effects across countries. Conversely, a failure to implement such reforms could well result in further increases in unemployment, which ultimately could undermine public support for the project.

While macroeconomic policies affect labor market conditions in the short run, there is substantial evidence that by far the most important reason for continental Europe’s lack of economic dynamism and persistent unemployment is the slow pace of structural reform. In fact, in addition to a sizable cyclical component in total unemployment (which may also in part reflect the slow adjustment of the labor market, most of the continental European countries suffer from very high structural unemployment rates which may be on the order of 8 to 9 percent of the labor force in the three largest countries. International comparisons suggest that this is 3 to 3½ percentage points more than might be attributed to normal frictions and mismatches in the labor market. There is wide agreement on the root causes of this "excess" structural unemployment problem: the adverse (and unintended) consequences of elaborate job and income-protection arrangements that raise the cost of labor (including through high taxes needed to finance social safety nets), discourage job creation and jobsearch, and favor substitution of capital for labor. Product market distortions also appear to have contributed by distorting relative prices, reducing efficiency, and impeding competition. In contrast, the forces of globalization and increased trade with low-wage countries seem to have played only a minor role as discussed in the May 1997 World Economic Outlook. There is also a wide measure of agreement on the potentially substantial benefits of reforms that would reduce the generosity of income replacement schemes, permit a lowering of taxes on labor (especially for the unskilled), alleviate the cost of redundancies (and thereby lessen an important obstacle to hirings), and generally make labor and product markets more responsive to market forces.

A wide variety of reforms have been implemented across Europe in recent years, but many have been postponed and some measures may in fact have exacerbated structural problems in labor markets.³ A common problem has been the failure to implement sufficiently comprehensive labor market reforms because of strong opposition from insiders—those who have jobs and feel they benefit, rather than suffer, from existing labor (and product) market institutions and regulations. In fact, labor market policies have often sought to mask the underlying problems by promoting early retirement or work sharing. Such measures appear to be intended to reduce open unemployment not by increasing the demand for labor but by reducing labor supply. But with unreformed labor markets, such measures tend to improve the bargaining position of insiders and raise their real wages, with little benefit to outsiders who are likely to remain unemployed. Such measures also involve costs to producers or to government budgets. Instead, what is needed are reforms that give outsiders a better chance to compete for jobs, thereby raising the effective supply of labor, and that also increase labor demand. In addition to reducing unemployment on a durable basis, such reforms would have important positive effects on growth and public finances. They would in fact allow most of the remaining fiscal imbalances in Europe to be worked off through reduced costs of income support for the unemployed as well as higher tax revenues associated with rising employment and higher levels of national income. Failure to implement reforms that reduce structural unemployment would require much tighter fiscal policies over the medium term, reduce the scope for tax reduction and productive public expenditure, and in all likelihood permit only modest growth of output and real incomes—that is, a continuation of recent experience.

Despite the strong case for comprehensive product and labor market reform, and the promising examples of several countries that have been quite successful in enhancing the flexibility of their economies, including New Zealand, the United Kingdom, Denmark, and the Netherlands, most continental European countries continue to face major hurdles in their efforts to tackle these problems. In particular, the gradual approach favored by many governments often leaves particular groups with the impression that they are being unfairly targeted to give up their acquis sociaux. As such groups frequently succeed in winning general public sympathy for their cause, many selective reform measures have failed to gain sufficient political and public support. And even when selective reforms are adopted, thebenefits are often insignificant because of lack of progress in other areas. This experience increasingly points to the need for governments to build a broad consensus for comprehensive reforms based on the fact that the economy and society as a whole will benefit from higher employment and lower tax burdens. To achieve such a consensus, governments need to enhance the public’s understanding of the causes and costs of unemployment, the social costs of the protection of the interests of insiders, and the benefits of reform. This may not be easy, but the piecemeal approach is clearly not working.

Another problem for policymakers is the misperception that labor market reforms may conflict with Europe’s traditional objectives of equity and solidarity, a view that is nourished by often-exaggerated claims that more flexible labor markets (as in the United States, the United Kingdom, and New Zealand) may entail a widening of the income distribution. There is growing evidence, however, that the observed tendency for wage differentials to widen in some countries reflects the effects of technological advances that particularly enhance job and income opportunities for skilled labor. This suggests that equity concerns can best be addressed through education and training that increase the adaptability of the labor force to changing circumstances. It is also appropriate to pursue policies whereby those who benefit the most from technological progress and the increasing division of labor among countries contribute to the assistance of those less well positioned. Indeed, as the example of the Netherlands demonstrates, there does not need to be a conflict between labor market flexibility and social cohesion. But in designing such policies it is important to avoid creating poverty traps while promoting incentives to enhance skills and to pursue better employment opportunities. In any case, enhancing the functioning of labor markets is the most effective way to alleviate the problem of persistent unemployment, which is a principal cause of inequality and social exclusion.

²In view of Hong Kong's return to the People's Republic of China on July 1, 1997 as a Special Administrative Region of China, in the current World Economic Outlook references to this economy appear as "Hong Kong, China. "

³Progress with labor market reform and country-specific additional reform needs are assessed in OECD, Implementing the OECD Jobs Strategy—Lessons from Member Countries' Experience , (Paris: Organization for Economic Cooperation and Development, 1997).