September 16, 2003

CPB Report 2003/3

In many respects, the Dutch economy is presently in a deeper recession than in the early nineties. In particular the market sector has a hard time. In the wake of an expected strengthening of the world economy, activity could recover somewhat in the second half of this year, and gain further strength in the course of next year.
      • No economic growth for the Dutch economy in 2003; a modest recovery next year
      • Recovery driven by exports, while consumption growth declines sharply
      • Unemployment rises to 7% in 2004
      • Public sector deficit contained at 2.4% of GDP in both years

Economic growth is projected to be nil this year and 1.0% in 2004. Export market growth for the Netherlands will rise substantially next year, by 6.5%. Dutch exporters, however, are suffering major losses of market share due to many years of eroding price competitiveness. Rising pension premiums, a higher tax burden and cuts in government expenditure set limits to domestic expenditure. Due to the weak production growth the number of unemployed is expected to rise sharply, to about 540.000 persons, i.e. 7% of labour force, in 2004. In order to keep the public sector deficit below the ceiling agreed on European level, the new Cabinet has decided on additional budget cuts and tax increases on top of the measures taken last May. Thus, in the present forecast, the public sector deficit is not rising next year, but will be contained at 2.4% of GDP both in 2003 and 2004.

These are some headlines of the Economic Outlook in CPB Report 2003/3. CPB Report is the quarterly magazine in English of CPB Netherlands Bureau for Economic Policy Analysis. The outlook contains a summary of the Macroeconomic Outlook 2004 (In Dutch: Macro Economische Verkenning), also released today by CPB Netherlands' Bureau for Economic Policy Analysis. In this publication CPB presents analyses and projections for the Dutch and the world economy in 2003 and 2004. Next to the Economic Outlook, CPB Report also provides articles on various themes.

World economy expected to pick up
Factors that have depressed the world economy in the past twelve months, like the bookkeeping scandals, the political tensions in the Middle East, the Sars epidemic and the aftermath of the high-tech boom, are gradually loosing their adverse effect. Also the persisting relaxed monetary policy stance supports the expectation of a recovery as from the second half of 2003.
The upturn in the US is expected to gain substantial strength from the second half of this year, supported by low interest rates, improved profitability of enterprises, a healthy banking sector, further tax relief and a cheap dollar. Thus, economic growth is forecasted to rise to 3.5% in 2004, accompanied by declining unemployment.
The euro area clearly develops much less favourably than the US, which can be explained by the negative impact on exports of the strong euro, as well as on the smaller fiscal and monetary incentives. After the production decline in the second quarter of this year a turn for the better is in the cards, but definitely slower than in the US. Next year, the euro economy could grow by 1.75%, which is not sufficient for a reduction of unemployment. Also the public sector balances remain a worry. In the two largest member states, Germany and France, the public sector deficit will presumably once again surpass the 3% of GDP limit. Inflation in the euro area is expected to slow further to 1.25% in 2004, reflecting the weak economic growth and the strong euro (which is projected at 1.15 dollar per euro in 2004).

Zero growth for the Dutch economy in 2003; a modest recovery in 2004
Dutch economic growth stagnated from the first quarter of 2001 to the first quarter of the present year. Preliminary estimates for the second quarter indicate a bad fall. We project a GDP decline of 0.5% for the first half of the year, followed by a 0.25% increase in the second half. For the year as a whole, this implies zero growth, which is the weakest performance since 1982. The recovery, which can be attributed nearly fully to the pick up of the world economy, is expected to gain strength in 2004. The 1% GDP growth that is projected for next year is far below the estimated 2% structural growth rate. This means that the underutilisation of production capacity gets worse, and unemployment rises further.

Exports driving force behind recovery
Exports of goods are expected to rise by 1% this year and 5.5% in 2004. This makes exports the driving force behind the economic recovery next year. Still, the Dutch export performance is not as good as it appears because the exports of domestically produced goods can not at all keep pace with relevant world demand. This means that Dutch exporters are losing market shares. A significant factor is the erosion of price competitiveness, which has two causes. First, since 1998, Dutch unit labour costs have risen more than in competing countries inside and outside the euro area, due to the relatively tight labour market. Second, since summer 2001, the euro has appreciated against the dollar by about 30%. Next year the deterioration of the Dutch competitive position is expected to come to an end. Unit labour costs will probably develop more favourably than those of euro competitors, mainly thanks to a stronger productivity growth.

Major setback of consumption growth
Private consumption is not expected to grow this year, mainly because of a decline in disposable income. Purchasing power is falling due to rising pension and health care premiums. Moreover, a substantial number of families will suffer a reduction in income because of job losses. Next year, private consumption could rise by 0.75%, thanks to a slight recovery in the income of households and the recent upturn of the stock market.

Further fall of fixed investment
Fixed investments by enterprises are expected to continue their decline this year by 3.75%. Given the sharp setback in production growth, there is ample capacity to satisfy demand, so entrepreneurs are not eager to invest in new capacity. Moreover, financial opportunities for investments are restricted because of low profitability and tightened loan conditions of banks. Investments could continue to shrink next year, in particular in industrial building. With the projected recovery of production and profitability all other components of investment could develop more favourably than this year, varying from a modest decline of investment in machinery and computers, to a growth increase of investment in means of transportation.

Unemployment rising sharply
Weak activity and the efforts of companies to restore their profitability are reflected in a declining employment in the market sector, by 2% this year, or nearly 100.000 labour years. Employment in the health sector and in the public sector will probably continue to rise. This is, however, far from sufficient to prevent a steep rise in unemployment, to about 5.5% of the labour force. Thus, the labour market cannot be called tight anymore. Next year, unemployment will continue to rise sharply, to about 7% of the labour force. Employment in the market sector will fall less than this year, but, on the other hand, employment in the public sector does not increase anymore, due to the Cabinet's measures. Burden increases and higher premiums are widening the wedge this and next year: the gap between wage costs of enterprises and net wage incomes of employees is widening considerably.

Wage rise moderates slowly but surely
Contractual wage increases in the market sector are projected to moderate from 4.5% in 2001 and 3.4% in 2002 to 2.75% and 1.5% respectively. The slowdown mainly reflects the falling inflation and the sharply rising unemployment. The adaptation process towards moderate wage contracts, that took only one to two years during the recession of the early nineties, has now already taken three years. In 1994 and 1995 contractual wage increases dipped below inflation, but this is not expected this time. It should be noted that in the previous recession wage moderation was accompanied by burden relief, whereas in the present situation the burden for households becomes much heavier.

Inflation continues declining trend
This year's inflation rate is projected at 2%, substantially lower than the 4.5 and 3.5% rates of 2001 and 2002. The upward impulses from the side of labour costs are diminishing, but will remain high due to the rising pension premiums. Import prices, on the other hand, show an unusually sharp decline thanks to the strength of the euro. Although consumers still experience the present price increases as high, the 2% rate of this year is not higher than the average increase during the past two decades. Next year, Dutch inflation could drop further to 1.5%. Unit labour costs will probably contribute only marginally to inflation, given the combination of moderate wage developments and a cyclical recovery of labour productivity. On the other side, indirect taxes will contribute considerably next year, in particular because of rising road tax and higher duties on tobacco and fuels.

Pension contributions rising strongly
The pension premiums of enterprises to be paid by employers and employees will be raised from 10.6% of gross wages in 2002 to 13% in 2003 and 14% in 2004. In addition to the increase in contributions, the pension funds take other measures to put the financial position in order and reduce the sensibility to stock market fluctuations. These measures include a reduction of the indexation of retirement pay, stripping of pension schemes, transition from final pay to average pay schemes, as well as changes in the investment portfolio.

Public sector deficit limited to 2.4% of GDP in 2003 and 2004
Although the cyclical low is reflected in a weak growth of public sector revenue and strongly rising expenditure on unemployment benefits, the rise of the public sector deficit is rather small. Thanks to the measures taken by the first and the second Cabinet Balkenende, the public sector deficit will increase by only 0.8 percentage point to 2.4% of GDP, and is likely to remain at that level next year. The budget proposals for 2004 contain additional budget cuts and tax increases to the tune of 2 bln euro. Together with the 5.5 bln euro of measures to improve the balance taken by the first Cabinet Balkenende, and the 3.5 bln euro agreed in the Headlines Agreement, the measures for 2004 total 11 bln euro, of which 6 bln net budget cuts and 5 bln burden increases. Without these measures, the deficit would have largely surpassed the 3-percent limit of the Stability and Growth Pact (SGP).

SGP requirements ask for serious action
Structural public sector accounts have to move toward balance according to SGP, which in practice means a structural deficit below 0.5% of GDP. As long as that is not yet the case, the structural deficit has to be reduced by at least 0.5 percentage point per year. With a structural deficit of 1.4% in 2003 and 0.9% in 2004, the Netherlands does not yet satisfy the level requirement, but will meet the improvement requirement next year.
The deficit reductions agreed in SGP are necessary to be able to finance the costs of ageing without additional burden increases or expenditure cuts. In this respect, the agreed policy measures are not very ambitious. That some countries surpass the 3% deficit ceiling in the present cyclical low means that they have not made enough progress in the prosperous years. Thus, they have to fulfil their obligations in bad times. Although it looks more sensible from the economic point of view to implement structural improvements in good times, it may be politically easier to carry out drastic reforms when conditions are worse.

Also in CPB Report 2003/3
This issue of CPB Report also contains articles on various subjects, including: European wage coordination: Nightmare or dream come true?; Spillover effects of ICT; The cyclically adjusted government balance: Some recommendations for Brussels; Competition on European energy markets; Half a century of Dutch manufacturing.

The cyclically adjusted government balance: Some recommendations for Brussels
One of the main criteria in the Stability and Growth Pact is the level and development of the public sector budget balance. In discussions about this 'hot' variable the focus has recently shifted towards the developments of the cyclically adjusted budget balance. The cyclical component of the budget deficit is calculated by a method which was published by the European Commission last year. In a note in this issue of CPB Report this method is discussed and compared with a more elaborate method which CPB Netherlands Bureau for Economic Policy Analysis uses for the Dutch economy. Also some recommendations are discussed which could improve the method of the Commission. The Commission could make the outcome of the cyclically adjusted balance less sensitive to (adjustments of) the forecasts for the near future by introducing alternative methods to calculate the structural productivity and the structural equilibrium unemployment. Introducing a country-specific lag between the output gap and the cyclical component of the budget balance is another recommendation. This is relevant when taxes and unemployment benefits react (as they do in the Netherlands) with some delay to changes in economic growth.

Spillover effects of ICT
One of the most impressive stylised facts of the previous decade was the economy wide acceleration of ICT investment. As this ICT boom coincided with an acceleration of total factor productivity (TFP) growth, this raises the question whether the rebound of productivity was due to ICT. Through technology spillovers or network effects ICT has affected total factor productivity for the Netherlands and thus also labour productivity in the second half of the previous decade. This is the main conclusion of the article 'Spillover effects of ICT'.
This article summarises a recent CPB study of the importance of two sources through which ICT can increase productivity: 1) the direct contribution of ICT through an increase of the capital intensity per worker (also known as capital deepening); and 2) the indirect contribution of ICT to productivity through technology spillovers or network effects. ICT spillovers emerge when social returns on investment exceed their private returns, a case which seems to be rather relevant for investment in information technology because the benefits of computer usage increase when ICT is adopted by more users.


Dick Morks
Johan Verbruggen