Product Market Review 2009:Microeconomic consequences of the crisis and implications for recovery
Examining the microeconomic consequences of the crisis can help us better understand the drivers of recovery. The 2009 Product Market Review explores the impact of the crisis on the structure of the EU economy and on innovation. It concludes that the bulk of adjustments will be within rather than across sectors and that product market support measures need to be smoothly withdrawn in order to avoid distorting competition in the Internal Market. The Review notes that the framework conditions for R&D and innovation must be improved as public spending neither can nor should make up for gaps in private sector R&D.
The fall in EU GDP since autumn 2008 is unprecedented in the history of the Union and is partly the aggregate outcome of microeconomic decisions taken by firms and households. An in-depth examination of the microeconomic consequences of the crisis, therefore, is necessary in order to better understand how decisions by consumers and producers may shape the drivers of the recovery. “The way and extent to which markets and whole sectors have been affected by the crisis will in the end have a major impact on aggregate, macroeconomic outcomes. But more importantly, the nature and characteristics of these microeconomic reactions contribute to shaping the recovery. This is why understanding them is crucial in designing appropriate and effective policies to return Europe to robust growth,” said Gert Jan Koopman, ECFIN Director responsible for the economic service and structural reforms.
Is this recession different?
A key question is whether in the longer term the crisis will lead to significant shifts in the sectoral composition of the EU economy. Since productivity varies widely across sectors, any change in the structure of the economy would have a profound impact on economy-wide productivity. Moreover, the allocation of capital and labour across sectors would have to change, posing a formidable adjustment challenge. Experience from past downturns suggests that once growth resumes, Europe’s sectoral structure does not durably deviate from its adjustment path, which tends to be determined by long-run trends. Despite the fact that this crisis is broader and much more severe than past downturns, preliminary evidence points at possibly modest changes in the relative importance of broadly defined sectors. However, given very low capacity utilisation rates and preexisting weaknesses in a number of sectors, there is likely to be a significant degree of restructuring and consolidation within sectors. These processes pose their own significant challenges but might be easier to complete than major cross-sectoral changes which in Europe are hampered by significant product and labour market rigidities. If the initial indications that the EU economy will follow this pattern when exiting from the present crisis prove right, the impact on potential growth may be relatively muted.
In fact, most adjustments are likely to be within rather than across sectors and, in some sectors, are likely to concern not just sub-sectors but also markets and even companies. Some sectors have developed production overcapacity as a result of the crisis and have problems in market functioning that pre-date the crisis. These sectors may need to restructure.
Using the recently re-formulated market monitoring tool, the Commission’s departments have evaluated possible evidence of market malfunctioning. Sectors experiencing market malfunctioning appear to share a weak performance in innovation and often exhibit poor levels of market integration. Reforms that improve the EU’s performance in innovation, rapid implementation of the Services Directive to reduce service market fragmentation and a generally well-functioning internal market could help Europe recover faster from the crisis. “We need “deep dives” into the causes of Europe’s relatively low productivity growth. Without looking in depth into sectors and innovation systems, it is not going to be possible to formulate truly adequate policy responses. This is why we need high quality evidence-based instruments such as market monitoring”, stresses Koopman.
The pre-crisis agenda is still relevant today - indeed it has become even more urgent than beforeGert Jan Koopman, Director, Economic Service and Structural Reforms, DG ECFIN”
Unwinding support measures
Member States have introduced support measures on a scale not seen in Europe since the 1980s, one third of which have targeted specific sectors, especially motor vehicles, tourism and construction. Every effort has been made to ensure that they do not unduly distort competition and that they support long-standing EU objectives such as enhancing R&D and innovation. An assessment by the Commission’s departments of the crisis measures implemented by Member States suggests that these objectives have broadly been achieved 1“The EU’s response to support the real economy during the economic crisis: an overview of Member States’ recovery measures”, European Economy Occasional Paper 51/2009. Nevertheless, such measures may affect the conditions of competition in the Internal Market, especially if they are maintained over time, given that they differ across actors in production chains and Member States. With fiscal space in the Member States diminishing, consideration should increasingly turn to how they could be smoothly withdrawn. Otherwise, the efficient functioning of the Internal Market could be impaired and necessary adjustments hindered, with negative consequences for EU growth.
Case: the car manufacturing sector
The significant support given to the car manufacturing sector illustrates the challenges facing policy makers. The sector generates up to 3.5% of GDP in Germany and the Czech Republic and directly or indirectly accounts for a significant share of all manufacturing jobs in the EU as a whole. It has been hit very hard by the crisis and is now struggling with overcapacity. It also shows evidence of pre-existing poor market performance and depends on innovation and strategic R&D capacity for a competitive edge (car producers and their suppliers spend more on R&D than any other sector in the EU). For these reasons, a very large share of all the sectoral measures introduced across the EU support the European car industry. On the demand side, for example, temporary car scrapping schemes costing €8 billion over 2009-10 were introduced in 12 Member States to encourage the purchase of new cars. On the supply side, some Member States provided loans and guarantees worth approximately €10 billion to the automotive sector, and a €5 billion partnership was established by the Community, the European Investment Bank, industry and Member States to fund research into a broad range of technologies and smart energy infrastructures.
The scrapping schemes may have encouraged car sales in 2009 and car production has rebounded in some Member States. However, the current rise in demand may reflect consumers taking advantage of incentives today at the expense of future car purchases. If so, the measures may only be postponing restructuring. Increased car sales may also have replaced purchases of other durable goods, which would partially offset the macroeconomic impact of the schemes.
The automotive sector supply chain is also an area of concern. Currently, many of the leading technologies needed to produce cleaner cars are owned and developed by upstream suppliers. But these suppliers have received much less public sectoral help than manufacturers. There is, therefore, a risk that manufacturers may exploit this relative financial strength to lever control of new technology development away from the suppliers, which could affect innovation incentives. Since policy must ensure a sufficient degree of competition at every level of the supply chain, improving upstream suppliers’ access to finance should be a priority.
A key risk is that the crisis could lead to a deterioration of current levels of accumulated knowledge capital or create a drag on their growth. This would have a lasting effect on Europe’s future economic growth. Commission departments estimate that, after strong growth in 2008, business R&D spending may contract by over 6% in 2009 and 2010.
However, since the crisis broke, two thirds of Member States have stepped up public R&D spending, especially through direct funding but also through tax incentives to encourage private R&D spending. Member States’ public R&D investments are estimated to offset about half the contraction in private R&D spending. Whilst this is welcome, constraints on public finances mean that policies must ultimately focus on improving the framework conditions for private sector R&D. This entails improving the general business environment to facilitate the emergence and growth of innovative, new companies and removing regulatory barriers to R&D and innovation. R&D regulatory reform should address both horizontal and sectoral issues. One important horizontal issue is the impossibility in Europe of obtaining a valid patent enforceable throughout the EU27; this puts European businesses at a severe disadvantage compared to their international competitors. The importance of broad framework conditions is illustrated by the fact that about half of the gap in private R&D expenditure between the USA and the EU is due to the relatively unfavourable sectoral structure of the EU economy.
Taking microeconomic reform forward
The crisis may lead to a less radical change in the European economy’s sectoral structure than expected. The pre-crisis microeconomic policy reform agenda, therefore, remains very relevant, especially since public finances will be extremely constrained. And developing systematic evidence based instruments such as market monitoring is essential. These instruments can be used to analyse structural microeconomic problems with macroeconomic impacts, and help to more precisely identify reform needs.