No immediate reform benefits

FRANKFURT – Structural reform is likely to weigh down European consumers’ confidence until it actually produces a tangible reduction in unemployment, analysts say. Weak consumer sentiment and a lack of economic flexibility are respectively the two main barriers to short- and long-term growth in the eurozone, but policies to improve countries’ lasting competitiveness may come at a cost to immediate growth. «The risk is that the reforms that are taking place in the euro area are unlikely to bring about benefits to the consumer in the near term,» said Jacques Cailloux, an economist at investment bank JP Morgan. German Chancellor Gerhard Schroeder unveiled a package of labor market reforms two years ago to boost growth and create jobs. The government cut benefits for millions of unemployed Germans and listed hundreds of thousands of welfare recipients as eligible for work. Germany’s opposition Christian Democrats (CDU) – favored to win general elections in September – last week unveiled detailed plans to build on the current Social Democrat government’s reforms. The CDU wants to encourage job creation by making it easier to sack workers and by reducing non-wage employment costs, which it will fund by raising value-added tax two percentage points to 18 percent. This approach was likely to cause short-term pain, as consumers worried about job security, Cailloux said. «Extra flexibility in the labor market, maybe a reduced cost of hiring and firing, these measures – usually at the start – can have a negative impact.» France and Italy, which like Germany are suffering from high unemployment, are also under pressure to follow the path taken by Britain, Sweden and the Netherlands, which reformed their economies in the 1980s and 1990s and now boast higher employment rates. ECB dilemma The European Central Bank has been one of the loudest voices calling for more reform. In addition to more general benefits, structural reforms have the potential to simplify macroeconomic management by making the 12 national economies in the eurozone respond more predictably and similarly to economic changes. But the ECB is reluctant to use the main carrot at its disposal, its power to cut interest rates, while structural reforms proceed at a different pace in different countries. Nor does it want to damage its independence by getting enmeshed in national political debates. (Speaking after a meeting with French Prime Minister Dominique de Villepin, European Central Bank President Jean-Claude Trichet said yesterday economic conditions in Europe were extremely favorable for growth. Trichet also said market interest rates were historically extremely low, adding that he was keeping a close eye on oil prices.) «So long as you have a diverse policy framework, monetary policy is unlikely to be the appropriate tool,» Cailloux said. Royal Bank of Scotland economist Jonathan Hoffman went further to say this made monetary union a mixed benefit for countries trying to remodel their economies as they lacked the ability to cut rates to soften their own reform process. «It’s another facet of the fact that currency area countries need to be convergent. They don’t only need to be convergent in inflation terms and in growth terms, but also in terms of their starting point for structural reforms,» he said. Holger Schmieding, an economist for Bank of America, said structural reforms might, however, tempt the ECB to keep rates at 2 percent for longer – first if widespread reforms dampen consumer demand, and second if they succeed in increasing the rate at which the eurozone can grow without raising inflation. The ECB has spelled out ways in which structural reforms could boost confidence even before they produce tangible results in terms of employment, drawing on the work of the early 19th century British economist David Ricardo. Trichet refers to the so-called Ricardian effects of lowering budget deficits, making citizens more willing to spend money now they would otherwise have saved to pay future taxes to fund government debt. But economists doubt that consumers can overcome their anxiety about the job market by thinking about stronger government finances and better employment prospects to come. «Initially the risks tend to dominate, because you see first how you are going to be hurt. You can’t see the uncertain gains which may come in the future,» said Schmieding. RBS’s Hoffman agreed. «Particularly in Germany, the fact that there have been so many changes to peoples’ entitlements from the government in recent years has tended to make people less trustful of government.» «I think if you told the average German in the street that this structural reform would mean he would have to pay lower taxes in 30 years’ time, he’d be pretty skeptical about that.» Instead, JP Morgan’s Cailloux said national governments would be hoping continued strength in the global economy would help dull the pain while structural reform takes full effect. «There are a number of other factors you will need to look at as regards consumer spending going forward which are more cyclical,» he said. «Ultimately if the global recovery continues, it benefits the euro area cycle and businesses will become more positive about the outlook.»

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