Reform and cut rates, 'flagging' Europe warned

The OECD warned Europe's leaders yesterday that failure to embark on root-and-branch reform of the continent's chronically under-performing economy would put the credibility of monetary union at risk.

In a scathing account of the eurozone's persistent failure to break out of the low-growth pattern of recent years, the Paris-based OECD said Europe had run out of excuses to explain away its poor recent record.

The OECD said attempts to deal with imbalances in the global economy were being hampered by sluggish growth in the eurozone and it called for a combination of lower interest rates from the European Central Bank and deep-seated structural reforms.

While revising up its forecast of growth in the United States this year from 3.3% to 3.6%, the thinktank used its half-yearly health check on the global economy to slash its prediction for expansion in the eurozone from 1.9% to 1.2%.

Growth had been buoyant in the world's leading developing countries: China, India, Russia and Brazil. These are not members of the OECD, which is a 30-strong group of rich nations. But the thinktank said the global economy was suffering from a soft patch. An expected pick-up later in the year depended on no further rises in oil prices.

Jean-Philippe Cotis, the OECD's chief economist, said: "The smooth scenario where the economy was expected to spread more evenly across the OECD has not materialised. While some elements of this scenario, such as a relatively 'soft landing' in the US and rebound in activity in Japan, may be in place, what is badly lacking is sustained momentum in the eurozone."

If the OECD is right, 2005 will be the fifth year running in which eurozone growth has failed to reach 2%.

"It is becoming increasingly evident that circumstantial arguments - Iraq war, oil and commodity price shocks, exchange rate fluctuations - are not sufficient to explain the series of aborted recoveries in continental Europe," Mr Cotis said.

He added that an encouraging upswing in the first half of 2004 had petered out and that a rebound in early 2005 had been followed by activity "flagging anew". Specific problems in countries such as Germany and Italy were amplifying the problem, Mr Cotis said.

Europe's slow growth and high unemployment has been a factor in the political turmoil affecting the eurozone's two biggest economies: Germany - where the chancellor, Gerhard Schröder, has called an early election - and France, where the referendum on the EU constitution is on a knife edge.

"Policy must address this chronic pattern of weak re silience and diverging activity within euroland as thoroughly and promptly as possible. It is of course a matter of central importance for the growth prospects of the countries involved but also, to some extent, for the credibility of the economic and monetary union itself," Mr Cotis said."

The OECD's outlook said the spare capacity in the eurozone economy created scope for the ECB to cut interest rates - currently 2% - but that policy would have to be tightened once recovery was under way.

"Since its inception, EMU has provided member countries with invaluable benefits, including internal financial stability and historically low interest rates, as well as an environment of price stability that stood the test of rising oil prices.

"In the long run, however, a successful monetary union that works to the benefit of all requires well-functioning product, financial and labour markets as well as a substantial measure of homogeneity in the economic structures of its member countries."

The OECD called for further interest rate rises in the US and action to reduce the size of the budget deficit. "Although some of the monetary stimulus has been removed, further tightening is needed to contain emerging inflationary pressures, not least because long-term interest rates have remained surprisingly low.

"Government finances have improved little, as faster revenue growth has been partly offset by higher spending," the OECD said, adding that projected deficits remained large, underlining the need to adjust tax and spending levels to curb the growing debt and prepare for an ageing population.