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EUR 23166

Enlargement

EU RESEARCH IN SOCIAL SCIENCES AND HUMANITIES

Policy Review Series n°9K

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EUROPEAN COMMISSION

EU RESEARCH IN SOCIAL SCIENCES AND HUMANITIES

Policy Synthesis of EU Research Results

Series no 9:

Enlargement

Author:

László Halperm

Deputy-Director

Hungarian Academy of Sciences

Directorate-General for Research 2007 Citizens and Governance in a Knowledge-based Society EUR 23166 EN

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Table of content Executive Summary 7 Introduction 9 1. Domain Description and Policy Issues 11 2. Labour markets 13

2.1 Regional equity 13

2.2 Migration 14

2.3 Institutional Factors 15

3. Catching up and Restructuring 17 3.1 Technology transfer via foreign direct investment 18

3.2 Financial Deepening 18

3.3 Industrial Policy 22

3.4 Policies with a cluster-approach at regional and national level 23

4. Macroeconomic Issues 26 4.1 Trade 26

4.2 Science and Technology policy 26

4.3 Interdependencies between supply and demand 28

4.5 Coordination between macro and S&T 28

4.6 Euro-Integration and Exchange Rate Policy 31

4.7 Sustainable capital flows 34

5. Democracy and Institutions 36 5.1 Typology 36

5.2 Europeanisation and Governance 37

5.3 Regional Issues 39

5.4 Institutions and Social Policy 40

6. Conclusions and Recommendations 42 Appendix 45

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Executive Summary Twelve research projects dealing with enlargement were selected for reviewing in this report. They are related to the enlargement directly or indirectly. This report defines four clusters – labour market; macroeconomic issues; catching up and restructuring; and democracy and institutions – which were chosen to present the policy recommendations of these projects.

Enlargement has macroeconomic consequences and it is to be expected that favourable macroeconomic conditions affect the pace and depth of the integration process of the new member states. Two aspects of the enlargement have rather straightforward repercussion on the macroeconomic conditions, namely restructuring and catching up. As the economic aspect of the recent enlargement tends to dominate the discourse on EU issues it is important to recall that both restructuring and catching up are long term projects.

Different aspects of the labour market have been in the centre of the heated debates of enlargement. These debates were concerned with the economic and social consequences of the enlargement on labour markets and welfare systems of both the old and the new member states. There is a trade-off between equity and efficiency in regional development. If development funds are allocated to the regions where they are used in the most efficient ways, it implies the opening-up of the income gap between the wealthiest and the poorest. This trade-off is even more pronounced in new member states, where the migration is rather low.

A cluster includes all the issues related non-economic aspects of enlargement found in the projects: the typology of democracies, institutional aspects of social welfare, governance in different fields, like Europe, environment and regional issues.

There is an absolute priority given to the supply side when research and development is discussed. This one-sided way of looking at this policy should be replaced by a more balanced analysis of S&T supply and demand policies. It may shed light on the interdependencies between supply and demand and may give priority to ‘creative accumulation’ beside ‘creative destruction’. S&T policy interacts with other macro policies, therefore coordination between them may improve the efficiency of the R&D sector in general.

Exchange rate policy is treated in a special way during monetary integration. Its consequences on inflation and growth are transmitted through different channels and it has to ensure a stable and flexible exchange rate in the same time. These different requirements may lead to very different outcomes which affect the social costs of monetary integration and necessitate a selection according to social and political preferences.

The projects reviewed in this report cover quite a range of dimensions from macro to firm level analysis, from theoretical micro level issues to networking on social protection, from labour market to exchange rate. This implied that there was very few overlap between different policy recommendations derived by the projects; projects even within the same cluster dealt with rather different topics what prevented any in-depth comparison.

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The relatively high wage flexibility, the low persistence in unemployment rates and the low propensity to migrate despite substantial regional disparities suggest that any policy initiative to enhance the capability of the new member countries to adjust to labour market changes should give high priority to mobility. Policy trade-off between equity and efficiency in regional development exists when and where development subsidies allocated to the backward regions reduce the gap. This may work if the labour mobility is sufficiently high. Labour mobility – migration – depends on institutional factors among others. Obviously the development strategies should aim at coping with these institutional factors like education, infrastructure or more flexible housing markets, etc.

Labour market is affected by privatisation in time differently, as there is a negative correlation between privatisation and current unemployment rate, what is reversed and is positive with respect to the lagged unemployment rate. Privatisation starts with restructuring as the state owned firms tend to be overmanned and the efficiency gains in form of new hirings are obtained in the next phase. Overall it is to be hoped that the net employment effect is positive as the input and output efficiency in a private firm is higher than in a state-owned due to the structure of the incentive schemes. Post-communist new member states have already privatised the lion’s share of the corporate sector therefore the use of this policy advice may seem a bit late.

There are, however, countries where this policy advice has some actual relevance. First, the privatisation is never complete, there are utilities, infrastructure, services and concessions where certain rights can be privatised in order to enhance the efficiency of the unit to be privatised and to generate certain secondary spillover effects. Second, one should not forget that if politicians are against privatisation it may mask some rent seeking potential. Third, budgetary incomes from privatisation decrease the government debt, what reduces the expected risk premium on public borrowing. Fourth, any reluctance to privatisation may point at the insufficient or imperfect regulatory functioning of the state agencies, it is hard to believe that the regulation is unable to solve what ownership can. A legacy of the communist regime is still at work. Finally, employment considerations should not be used as an argument to postpone privatisation, as it is just shifted to the state budget in form of direct loss or in lower than possible welfare gain.

Social policies should take into account the employment consequences of economic policies. They should ensure that the greater flexibility and economic advantages should not be achieved at the expense of equality and social rights.

Europe has lost momentum in efficiency with respect to its competitors in the last decade. Therefore the responsibility of S&T policy leading to more efficient R&D is immense. The report recommends the reinterpretation of the role of demand in R&D – as the recent developments of the use side of ICT demonstrate it – and call for a more balanced role for supply and demand. Nevertheless it should not lead to fiscal laxity as it would undermine the efficiency and credibility of any expansion driven by demand.

Much stronger coordination is needed between macro and S&T policies. It starts from a much better link between public and private RTD efforts as they may be part of rather distant regulatory subsystems as the former is to be exposed to budgetary considerations while the latter may be burdened by an unstable regulation of the corporate sector. It then

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follows by the emphasis on the complementarities between technologies and skills. As the education responds to the demand with a very long lag different policies should pay adequate attention to the design of the expected skill structure and the way how it is best to be matched with the technology. Finally the national innovation system should focus on knowledge diffusion and on generating absorptive capacities.

New EU members in Central and Eastern Europe should continue to pursue an economic strategy of real convergence to the economic levels of the “old” member countries as rapidly as possible by securing sustained growth. It should be, however, noted that real convergence is connected with nominal convergence that calls for meeting the Maastricht criteria when entering EMU. There is a trade-off, the faster the nominal convergence, the slower the income convergence especially in the run-up to the EMU. Different exchange rate regimes distribute the burden of nominal convergence differently. Politicians in CEECs may add their preferences according to their assessment how to maximise their reelection chances and may prefer to shift the burden on EU. There are no institutional constraints within governance structures of exchange rate policy affairs in ERM II to curb CEECs’ moral-hazard behaviour. If there are only two options – overvalued parity when entering ERM II or provision of additional EU funds – to cope with this challenge their very different nature in political economy and in institutional arrangement may induce some delay in the integration process. If it is done in an ordered, mutually agreed way, then both old and new members may benefit. The alternative may have long lasting consequence on the credibility and efficiency of the economic integration itself.

New member states have to build knowledge how to operate within EU. They have to move into a mode of strategic management, prioritisation, and problem solving. In addition they have to adjust their administrative and institutional capacity to implement European law and learn how to operate within the new environment. A special attention should be paid to building and supporting institutions of regional governance.

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Introduction Twelve research projects dealing with enlargement were selected for reviewing in this report. They are related to the enlargement directly or indirectly, either the topic is defined in such a way that it is part of the enlargement itself or accession and/or new member countries are investigated as compared with the old member states.

The objectives and the applied methods of these projects are summarised in the following:

ACCESSLAB1 The research provides a set of stylised facts on how candidate/new member countries have adjusted to different labour demand and supply shocks in the past and compare them to the labour market dynamics of old EU member states. Different adjustment mechanisms of labour market in selected transition economies were analysed in details and the specific experience of border regions was investigated in order to infer implications for the regional labour market impact of EU enlargement for the new member countries.

ADAPT The objective of the research is to identify the common and diversified patterns of learning and Europeanization among Ireland, Portugal and Greece, as well as Hungary and Poland, in regional and environmental policy. This work involved the evaluation of the learning and Europeanization processes among the selected Cohesion and CEE countries in both policy areas according to the criteria established for measuring policy learning and adaptation and based on the outcomes of the comparative case studies in relation to all aspects of public policy-making.

DEMOCRATIC VALUES The project identifies the social and cultural bases for an integration of the Central and East European nations into the European Union. The project analyses the attitude structures of citizens, specific for societies in a situation of rapid social changes.

EPRIEE The research aims to examine the impacts of EU-widening on Central and Eastern European countries in general and on the causes and costs of instability, fragmentation and institutional paralysis of economic blocks in particular. A bargaining theory and institutional analysis will be used to consider the main institutional differences between a robust union and an unstable or weak one. Data and institutional analysis of the CMEA, USSR and Yugoslavia, and surveys of the literature on other historical experiences of international co-operation and integration, policy simulations were used to shed light on the need for appropriate institutional reforms in the EU.

EZONEPLUS The project analysed the role of exchange rate regimes in the enlargement process. The project investigated the exchange rate regime by looking at the various individual channels of transmission – capital markets, labour market, FDI and trade – through which the Eastern enlargement will affect accession/new member countries and member states of the EMU as well.

1 The full title and the most important data – starting date, duration, partners and website – about the

projects can be found in the Appendix.

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FLOWENLA The objective is the development of a comprehensive theoretical framework to understand the growth and employment consequences of international migration in an East-West setting and the empirical analysis and policy simulation of the effect of EU-CEEC migration on growth and employment.

MACROTEC The aim of the project is to pursue empirical investigation of interlinkages between macroeconomic and S&T policy and their effects on S&T performance, based on an analytical framework that is guided by theoretical considerations and literature surveys. The analytical component includes the impact of macro policy on the ‘supply side’ of S&T investments; the impact of macro policy on the ‘demand side’ of S&T policies; and the linkage of the supply side to the demand side.

OEUE The objective is to conduct research on the management of EU public policy making, on the adaptation of structures and processes of public policy making to Europeanisation in three existing member states and three candidate/new member states.

PFM The project aims at assessing the impact of the privatisation process on the development, integration and stabilisation of financial markets in Europe and elsewhere.

PGAP The objective is the explanation of the macro-, meso- and firm-level determinants of the productivity gap between old and new member states. Empirical analysis was pursued at macro or meso levels of the major determinants of R&D inputs and outputs and their role in productivity levels and changes in CEE by using econometric techniques. Field analysis of multinational company’s parent firms and branch plants was applied by way of secondary business sources, mail and telephone-interviews, selective, structured personal interviews, the sending out of a questionnaire to targeted subsidiaries of companies that invested in CEE.

SPECIAL The objective was to improve the knowledge to raise the public awareness, interest and dialogue in social protection reform in Europe by establishing a pan European, multidisciplinary network of scientists.

WEST-EAST ID The aim is to understand the (re)location process of industrial districts and what are the policy options for supporting them.

This report defines clusters which were chosen to present the policy recommendations of these projects. Four such clusters were defined: labour market; macroeconomic issues; catching up and restructuring; and democracy and institutions. They are presented consecutively. The detailed presentation is followed by a policy conclusion.

This report relies very heavily on the final/progress report of the projects as the aim was to present the policy relevant results to a non-specialist audience in a concise and compact manner. No citations are added. The report aims to show that what policy conclusions these projects have drawn with respect to the enlargement.

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1. Domain Description and Policy Issues The twelve projects presented can be classified into four clusters which are the most important issues of the enlargement. No doubt enlargement has macroeconomic consequences and it is to be expected that favourable macroeconomic conditions affect the pace and depth of the integration process of new member states. Two aspects of the enlargement have rather straightforward repercussion on the macroeconomic conditions, namely restructuring and catching up. As eight of the new member states and two candidate countries are post-communist countries and their transition to a full-fledged market economy has finished quite recently, the restructuring remains on the economic and political agenda for a while. Markets need further strengthening and the relation between state and business sector requires a careful design and revision to ensure the most efficient functioning of the private entrepreneurship. State should also take care of the regulatory role and to provide the public infrastructures. The other aspect of the restructuring – catching up – has been used countless times as a synonym for the measure of success of the whole integration. As the economic aspect of the recent enlargement tends to dominate the discourse on EU issues it is important to recall that catching up is a long term project as the income gap between the median old and new member states is rather significant and the maximum speed of its narrowing is determined by economic laws.

Different aspects of the labour market have been in the centre of the heated debates of enlargement. These debates were concerned with the economic and social consequences of the enlargement on labour markets and welfare systems of both the old and the new member states.

The fourth cluster includes all the issues related non-economic aspects of enlargement found in the projects: the typology of democracies, institutional aspects of social welfare, governance in different fields, like Europe, environment and regional issues.

Policy issues

Four projects deal with macro policy issues: EPRIEE, MACROTEC, PGAP, EZONPLUS.

There is an absolute priority given to the supply side when research and development (R&D) or science and technology (S&T) policy is discussed. This one-sided way of looking at this policy should be replaced by a more balanced analysis of S&T supply and demand policies. It may shed light on the interdependencies between supply and demand and may give priority to ‘creative accumulation’ beside ‘creative destruction’. S&T policy interacts with other macro policies, therefore coordination between them may improve the efficiency of the R&D sector in general.

Exchange rate policy is treated in a special way during monetary integration. Its consequences on inflation and growth are transmitted through different channels and it has to ensure a stable and flexible exchange rate in the same time. These different requirements may lead to very different outcomes which affect the social costs of monetary integration and necessitates a selection according to social and political preferences.

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Two projects studied the labour markets: FLOWENLA, ACCESSLAB. There is a trade-off between equity and efficiency in regional development, if development funds are allocated to the regions where they are used in the most efficient ways, it implies the opening-up of the income gap between the wealthiest and the poorest. This trade-off is even more pronounced in new member states, where the migration is rather low which reinforces the lock-in situation, wealthy regions become wealthier, poor will be poorer as the mechanism to equilibrate between wealthy and poor regions does not work through labour migration. The welfare consequences of migration can be unsustainable if the migration is driven by differences in welfare systems, which may necessitate harmonization in welfare policies. Countries rely on the directed migration by bilateral agreements what is the policy response to the demand for temporary migration as it can be a substitute for the spontaneous migration. However, its low efficiency and the fiscal consequences call for closer scrutiny.

Catching up and restructuring can be regarded as the main theme of three projects: PGAP, PFM, WEST-EAST ID. One central issue is how the privatisation can yield long term benefits for the society by increasing the efficiency of different markets during the transition period financial sector included. The correlation between privatisation and unemployment opens an up-to-date aspect for policy making. Recently the development of industrial clusters and their increasing role in regional development reshaped the framework of industrial policy by incorporating them instead of setting separate targets by industries and regions.

Four projects fall into the cluster of Democracy and Institutions: DEMOCRATIC VALUES, OEUE, ADAPT, SPECIAL. They cover the typology of democracies in order to understand how and why people in different regimes support the development of democratic institutions. The study of governance at European level helps new member states to develop their skills how to improve their administration to deal with European issues. The environmental and regional issues provide good examples. Finally, the potential advance between social, employment and economic policies are in the forefront of the European policy making.

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2. Labour markets There are three issues with relevant policy aspects covered in the projects: regional equity, institutional factors and migration. Regional equity raises the development and policy dilemma between equity and efficiency. The institutional factors in the development and formation of labour markets determine the framework in which employees, employers and state interact with each other. Migration is the most obvious social phenomenon reflecting the response of the individuals and families to the changing conditions of the local, regional, national, European and global environment.

2.1 Regional equity

The key problem – stated by ACCESSLAB – of the most backward regions in the new member and candidate countries consists of a combination of a lacking capability of attracting internal or external investments after a period of job losses combined with a regional lock-in of the resident population, which prevents people from escaping from depressed regions.

ACCESSLAB claims that there are two strategies at disposal:

- The first is to bring work to the workers by mobilising investments in the regions. The results of the project suggest that such a strategy could consist of subsidising investments in backward regions, measures directed at infrastructure, human capital and R&D development. These factors have been shown to be decisive for regional growth in the new member states and candidate countries. This strategy, however, has a number of unattractive features. In particular, ACCESSLAB indicates that regional problems in the new member and candidate countries are long term and may be expected to persist over a longer time period in the future. In consequence such strategy should not be expected to yield short term results. Experiences in the European Union suggest that rural development as well as restructuring old industrial areas are long term projects and may yield only limited results in the short term.

- The alternative strategy could be to accept regional disparities as a natural outcome of market processes and to devote attention more to issues of efficiency rather than regional equity. This would imply strengthening the existing growth poles and thus increasing regional disparities, at least initially. Clearly this would seem particularly tempting in many new member states and candidate countries since it is more compatible with the goal of aggregate growth and avoids much inefficiency generated by policies of providing subsidies to backward regions. While these features may seem attractive, a precondition for such a strategy to at least contribute to the goal of social cohesion is sufficient interregional mobility of potential workers, since under this strategy workers in depressed regions can only reap the benefits from the policy by moving to centres. In the absence of mobility, focusing policy on growth poles in all likelihood will increase labour demand in low unemployment regions, which cannot be satisfied through migrant labour from depressed regions. Thus in the current low mobility context of new member states and candidate countries, such a policy may be counterproductive by generating excess labour demand in centres – at least in the short run – while aggravating unemployment in the periphery.

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Thus due to the low internal migration the classical policy trade-off between regional equity and efficiency is more strongly felt in new member states and candidate countries. Clearly a policy that takes measures to remove barriers to migration in transition economies in order to avoid the "poverty-cum-liquidity" trap in which residents of more backward regions find themselves now is needed and should have a very high priority in all countries. The ACCESSLAB suggests that such a policy should take a relatively wide view on migration barriers and would need to address housing market inefficiencies, capital market inefficiencies and a range of wider institutional measures. Furthermore the project asserts that policies should be targeted towards the groups of people who have the greatest difficulties in adjusting to structural change (i.e. minorities, less well educated and in the case of spatial mobility women).

2.2 Migration

Enlargement may change the migration pattern of the population in new member states. These countries differ significantly in the migration propensity of the citizens within the country and across the border. It is, however, quite difficult to assume that the citizens of a country with low within-country migration record will change their across-border migration propensity as it requires some adjustment and specific skills. It is, however, conceivable that some social groups – e.g. high skilled and young – will drastically change their migration pattern as the outside options are much more attractive than those within the country.

FLOWENLA studied two aspects of policies being induced by the prospective migration flows. The first one was based on the hypothesis that migration streams are considerably influenced by the social assistance provided by potential host countries. It also studied the deeper question of how the members of the Union could coordinate if this is a serious distortion of the migration flows with the consequence of rendering the social security systems of member countries unsustainable.

While according to results it is not to be expected that there will be a strong orientation of migrants towards the welfare benefits offered by potential destination countries, there remains the problem that generous social assistance has the potential to distort migration flows in the sense that migrants might accept high probabilities of unemployment in anticipating high levels of support. With downward rigidity of wages generous social welfare systems might not be sustainable when confronted with induced migrations flows. Without coordination this fact could lead to a “race to the bottom” of dismantling welfare support to avoid an excessive inflow of migrants.

A way out of such a dilemma is the harmonization of welfare systems across the European Countries, developed as part of the FLOWENLA activities, based on an agreed minimum income in purchasing power parity terms. The FLOWENLA research looked into the benefits and costs of such a system, considering a number of financing options. These options are lump-sum taxes or proportional taxes, either as a country specific tax or as a harmonized European tax. It also shows that quite independent of the option considered some countries will always belong to the group of the implementation of such a scheme, indicating the prospective political difficulties to implement such a system.

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The second aspect dealt with systems of managed migration, concretely with bilateral migration agreements Hungary has signed, the most important ones being with Germany and Austria. The labour market effects of the current programmes are so far very weak, because to a major extent immigrant labour is attracted in sub-sectors where domestic labour supply is insufficient as in the case of seasonal labour, or it will be weak due to the small number of participants that is allowed to immigrate. Stronger effects could result in the border regions, due to the liberalisation of the trade in services.

Bilateral agreements could, however, become more important in the future. The host countries will try to allow immigration to respond to specific labour shortages, which might be transitory, or to avoid an upward wage drift for certain professions. Past attempts to achieve the latter objective, like with the German Green Card programme, have proven to be ineffective.

In a more general sense the bilateral agreements on temporary migration or more subtle measures like taxes or subsidies for certain professions and sectors to influence their labour market performance, imply the tendency of a (wasteful) competition between the potential host countries. Like other examples of cream skimming, such a competition can lead to distortionary fiscal measures which can only be avoided by multilateral cooperation.

2.3 Institutional Factors

Among the institutional factors, improving implementation at all levels of government and the development of good governance are important fields. This focus, however, should not mask that institutional aspects of labour market governance are still of importance. The results of ACCESSLAB suggest that relative to the early years of transition, where the major challenge for the set of countries analysed was in developing institutions typical for market economies, currently the challenge is with providing efficient implementation at all levels of government and the development of corporate governance.

The results of the ACCESSLAB project are indicative of the foci that policies to address these issues could take. They suggest that delay in industrial restructuring, poor implementation and potentially even corruption at the local level and inefficient corporate governance structures are an impediment to employment growth and job creation. In particular firm level job creation depends mainly on internal firm organisation (size, ownership status and multi- vs single plant firms) and human capital endowment of managers.

Issues of corporate governance thus are important also from a labour market perspective since the incentive structure of managers has a direct impact on firm level employment behaviour. Good corporate governance also improves long run employment prospects. The results, however, also suggest that with the completion of the privatisation processes, the focus of technical assistance oriented on firms performance and employment growth should switch to skills enhancement, since it seems to be primarily the complementarity of skills and management incentives that have the largest impact on improving corporate governance.

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Furthermore, since small and medium sized enterprises are important contributors to employment growth, focusing policies of skill enhancement to foster the development of SME's may add substantially to alleviating unemployment problems. In particular in depressed regions, this could activate endogenous development potentials.

Finally, these results presented by ACCESSLAB suggest that in new member states and candidate countries the relevant comparative advantages are moving in the direction of high human capital. In particular the substantial increases in returns to education in the new member states and candidate countries suggest that the increased demand for better educated workers exceeded the supply of such workers. As in the old EU-member states education policy and strategies to implement life long learning are key elements in facilitating the adaptability of the labour supply in new member states and candidate countries. While in this respect both candidate countries and new member states do not differ much from the old EU-member states, ACCESSLAB argues that the priority given to designing efficient strategies of increasing the human capital stock in new member states and candidate countries (and in particular in backward regions), should even be higher, because the dramatic increases in returns to education and the low mobility of less skilled workers, suggest substantial skill mismatch in the regional labour markets.

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3. Catching up and Restructuring Intensified competition, unhindered access to European markets, technology import, transfer, and spillover, as well as the participation in the European division of labour are amongst the market forces that can be assumed to be best suited to produce the most efficient market result of integration. If, however, income convergence is defined to be an overriding objective, then the result produced by market forces through real economy integration might prove to be an undesired one. Rather, convergence clubs have typically emerged between groups of economies or regions according to common country-specific criteria. Integration is assumed to be a necessary condition for real economy catch-up, but could prove to be insufficient to produce the political objective of income convergence. In the case of Central East European economies, such policy-intervention could subscribe to the aim of preventing a ‘club’ of less developed economies in CEE.

According to PGAP political intervention supporting flexibility of employment and capital allocation with a view on sectoral change – as called for in the EU’s second cohesion report – could prove to be a decisive factor in the cases of the Slovak Republic, Slovenia, and possibly Poland. The sectoral structures of those countries increasingly imply a limit to the prospects for real convergence. In the case of Hungary, sectoral structures explain a large share of the national productivity gap, yet at variance with the afore-mentioned countries, the sectoral content did not increase in recent past. Sectoral patterns appear to be indifferent with respect to catching up prospects in the cases of Estonia and the Czech Republic.

The industrial sector proved to be the most responsible for national productivity gaps. Hence economic policy could be the most efficient if focused on the qualitative development of industries in new member states. Industrial support need not however target the relative sizes of industrial sectors in terms of employment, as new member states typically still have some degree of overmanning in industry. Qualitative development could either support structural change between industrial branches of different technological intensities, or target directly technological and organisational upgrading within industries.

CAP, and in particular where this policy takes the form of direct income-support, is most detrimental to the prospects of catching up: one could expect CAP to retard employment shifts from agriculture to other sectors, mainly enterprise-related services. In a scenario where the agricultural sectors remain relatively larger on a long-term basis due to comparative advantages, the method of direct income-support would also be ill-advised: in the new member states where the agricultural sector plays an important role in explaining the national productivity gap (as in the Slovak Republic and Estonia, and possibly Poland), this is paralleled by above-average productivity gaps in this sector. A support of technological advancement could be expected to produce more sustainable comparative advantages as compared to income subsidies.

Analysis of foreign trade identified the prevalence of a quality-product-cycle between the current EU and the new member states: the quality advantage of the EU in mutual trade is overwhelming and appears to still grow as of lately. The main advantage of new member states was found in costs. Pure reliance on – wage – costs might have been amongst the causal factors or a driving engine behind the emergence of the quality-product-cycle via

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vertical intra-industry trade. Such patterns do support technological upgrading. However, catch-up will only occur if technological upgrading in new member states is in fact faster than in the EU which is not a typical feature of product-cycle patterns. In particular, analysis suggests that strengthening the role of technology policy in new member states might be more efficient as compared to attracting FDI to overcome this pattern in trade between the integrating partners.

3.1 Technology transfer via foreign direct investment

The government should systematically increase the absorptive and technological capacity of domestic firms and foreign subsidiaries, e.g. through human resource and management capabilities development. This could prove to be decisive especially in specific industrial sectors. Economic policy could additionally target firms’ managers to intensify their co-operation with related industries. The government could induce the creation of knowledge and production clusters.

For technology transfer via FDI to be particularly intense, advanced foreign technology first has to be installed in the foreign investors’ subsidiaries. Only then can technology flow into the rest of the host economy. Hence, in a first step, economic policy can strive to assist subsidiaries to learn how to adapt foreign technology (e.g. in programmes matching up networking partners). A high level of adaptive ability turned out to be the most decisive factor for the subsidiary developing along the FIE learning curve. Once up this curve, the subsidiary is then apt to engage into the dynamic form of technology transfer in a two-way interaction between the investor and its local subsidiary.

In the second step, economic policy can try to increase the intensity of technology flowing from foreign subsidiaries to the local economy. Motivating foreign subsidiaries to increase local content could serve this objective. Restricting foreign direct investment above a threshold level of local content, however, works against the market and is hence not efficient: foreign investors can only be successful if allowed to follow the kind of strategy they derive from their analysis of the market. Policies could be targeted at assisting local firms with the kind of networking, technological, and managerial upgrading necessary in business with foreign investors. Additionally, local content does not need to consist of procurement of semi-finished products, material, or personnel, but just as well of business services supplying those areas of subsidiary-competitiveness. Finally, local banks supplying sources of finance could learn from foreign subsidiaries in terms of business plan management and risk assessment strategies. In some cases, this could consist of management education programmes, as potentials are often not sufficiently perceived.

3.2 Financial Deepening

Share issue privatisation – i.e. privatisation in public equity markets – improves diversification opportunities of agents, allowing public and private investor to structure better diversified portfolios. Improved diversification opportunities – according to PFM – have important consequences in terms of financial market deepening and efficiency. As a result, larger and importantly more liquid domestic stock market stems from a sustained privatisation program based on the floating of shares of state-owned enterprises in the

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domestic market. Therefore, privatisation is indeed a sensible tool to foster domestic financial market development: a privatisation program finds full legitimacy in this perspective.

Even if governments do not consider domestic financial market development as a worthy objective per se, they should bear in mind that financial market development has important spillovers to the real sector of the economic system. First, a deep and liquid stock market allows the efficient mobilisation of domestic savings, with direct implications on capital accumulation, and economic growth. Second, it is a key factor to provide a stable funding for pension systems, which is becoming a priority for many European countries. Indeed, the availability of a large number of listed companies with a wide percentage of capital floating in the market is a prerequisite for the construction of well diversified portfolios by financial institutions such as pension funds. Third, the financial market development matters for corporate performance.

A liquid stock market provides incentives for information acquisition by financial analysts. Their private signals are in turn aggregated and partially mirrored in stock prices. This positively affects corporate performance and growth because it makes possible to design stock-based managerial incentive schemes. Furthermore, a well developed stock market allows for a more intense M&A (Mergers and Acquisitions) activity, facilitating corporate aggregation and importantly forcing managers to pursue value maximising policies to avoid the threat of a take-over.

A government interested in pursuing social welfare and economic growth should privatise its stakes in state-owned enterprise. Clearly, the privatisation method is crucial in this respect, as only share issue privatisation allows to garner the benefits from improved diversification opportunities and risk sharing.

The policy implication stated by PFM holds in mature European economies, with some degree of financial market development pre-privatisation. The case of post communist countries of Central and Eastern Europe is different as several trade-offs exist in the process of transition to a market economy. One of those is the potential trade-off between privatisation and the reduction in social welfare: absent a reasonable financial market to start with, privatisation may be welfare-reducing at least in the short run. The construction of efficient ownership structures may bring along a substantial increase in unemployment, a reduction in social benefits, and thus a decrease in welfare. At the same time, different objectives of the privatisation process itself (such as the creation of incentive mechanisms, fairness, fast privatisation, etc.) are conflicting and involve trade-offs.

Therefore, the policy implication drawn by PFM is to fine tune the privatisation mechanisms to the primary goals to be achieved. These may be free share distribution, temporary government ownership, set up of holding companies, insider privatisation or sales to outsiders. In this context, an important policy implication arises from the interests of politicians regarding the privatisation process. Being able to manipulate the basic trade-off between the costs of restructuring and efficient privatisation, politicians might obtain private benefits from hindering privatisation. Bargaining models of privatisation suggest that in order to achieve efficient privatisation, corruption should be avoided as much as possible and hard budget constraints should be imposed on firms.

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Expectations play a particularly important role in transition economies. When agents expect that large stakes will be given to private ownership at early stages, privatisation will be successful with great probability, and a “full” privatisation equilibrium arises. This implies that governments in transition economies should aim at privatisation to the largest possible extent, even at an early transition stage.

Since people know that politicians are interested to reallocate value after privatisation, benevolent governments seeking efficiency need to build up credibility. Public sales of companies at a discounted price at initial public offerings (IPO) can serve as signals of commitment. When obtaining high revenues from privatisation is a primary objective, gradual sales of equity (with a large initial retention) can substitute underpricing and signal commitment at the same time. Therefore, credible privatisation through the stock market should be gradual. Besides obtaining credibility by offering underpriced shares, the government also induces the liquidity and thus the development of the stock market. Indeed, privatisation has an indirect effect on stock market development: both through the positive feedback provided by each new entry to market size and liquidity, and through the resolution of political risk.

The nature of the privatisation processes in advanced and in transition economies are quite different, both from a theoretical and from a policy perspective, also in terms of financial market integration. While privatisation with international equity offerings tend to enhance market integration in advanced economies with well established financial markets, on the contrary in transition economies with less developed financial systems international equity offerings seem to increase market fragmentation. Accordingly, international equity offerings tend to improve domestic market integration in advanced economies, while institutional reform such as accounting, insider and take-over legislation and enforcement seem more urgent than international placements in the case of transition economies.

However, the analysis of the policy choice of privatising in international versus domestic markets yields the following indication: governments maximising privatisation revenues should select that (international) market for a listing that will aggregate most relevant private information on the privatised stock. To the extent that international markets are informationally linked those governments will even prefer double listings in their national market as well as in the relevant international market. A national listing will help to aggregate some local factors that can be credibly communicated to global investors. Stabilisation oriented governments, on the other hand, may want to just do the opposite. They should opt for single listings to double listings and, under plausible parameter constellations, domestic listings to international ones. The reason is that informational efficiency unambiguously enhances price volatility and associated risks. Last, the global process of integration of the financial systems world wide does not seem to generate large measurable gains in terms of per capita consumption and improved risk sharing. According to these findings integration of global financial markets still has to go a long way. The potential for further privatisation and reduction of ownership concentration still seems large. On the other hand, pension reform and the liberalisation of hitherto nationally organised pension systems will also be crucial for consumers to be ultimately able enjoy the gains from improved risk sharing in international capital markets.

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Privatisation – especially in emerging economies – plays a strong potential in stabilising the financial sector. Particularly, the resolution of policy risk through sustained privatisation and liberalisation policy has been an important source for the recent growth in emerging stock markets. Confidence building must be gradual, with privatisation, just as financial liberalisation, being the engine of the process, contributing to the resolution of policy risk and significantly to stock market development and stabilisation. Sustained privatisation seems to gradually strengthen the institutional framework by forcing a resolution of policy and legal uncertainties which had till then hindered equity market development, leading to increase in investor confidence. On average, this process takes place gradually as privatisation proceeds, with much of the resolution taking place during actual privatisation, as opposed to the announcement and preparation period. The greater significance of policy risk measures is consistent with the notion that both privatisation and liberalisation initiate a process of confidence building which requires consistency in the announced policies.

These policy conclusions – drawn by PFM – are well grounded as they stem from an attempt to investigate the dynamics of required returns on investments. There is by now a general consensus in finance that required returns on equity evolve over time. Some evidence of such dynamics for country risk, particularly in emerging markets can be found. The confidence building model yields another important policy prescription, suggesting that major reforms such as privatisation and liberalisation may have a delayed rather than immediate effect on market development, and can thus explain the so called “return to integration”: in countries which liberalised and maintained their policy, investors have been able to capture excess returns during the process on all domestic assets, as their ultimate payoff and risk profile depends on the actual degree of protection of property rights. Other more direct benefits of privatisation, such as improved risk sharing and liquidity as a result of new listings, would be instead immediately incorporated in market prices and volumes.

Market oriented policy reforms such as privatisation require legislation to reduce regulatory and legal uncertainty, greater protection of investors, removing restrictions on foreign ownership and competitive entry, and a reduction in the bias historically favourable to public sector borrowing. The real test is of course the proper enforcement of such rules. While there may be resistance from established interests to improvements in such rules, the necessity to attract investors often leads to more reliable supervision, the promotion of better accounting standards and transparent disclosure rules, the support of procedures to contest managerial decisions.

A related important point is that it is possible that privatisation can by itself resolve policy risk by helping to overcome political resistance to market reforms and their effect, perhaps because it establishes a broader-based ownership. Indeed, a large privatisation program may be designed so as to reduce policy risk of future policy reversals. A market oriented party may increase the probability of being re-elected by implementing a series of underpriced sales, where excess demand is rationed so as to ensure a broad diffusion of shareholding and to reward long term holdings. A wide diffusion of shares may then shift the voting preferences of the middle class, creates political support for market reforms and reduces policy risk and the equity risk premium.

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Finally, as to the impact of privatisation on the stabilisation of the real sector, PFM has shown that there exists a statistically significant and negative relation between privatisation receipts and public debt. This empirical result yields an important policy prescription: financially distressed governments should privatise and the revenues are useful to improve fiscal conditions. Interestingly, privatisation has a statistically significant and negative effect on the current unemployment rate and a positive effect on previous period’s unemployment rate. This result may also be of interest for policy makers: when privatisation is announced, the accompanied restructuring, which urges firms to operate more efficiently, can cause job losses, and, thus, increase the unemployment rate. On the other hand, when privatisation is implemented, new entry in the market occurs, increasing the demand for labour and, thus, decreasing unemployment rate explaining the negative effect of privatisation receipts on current period’s unemployment rate.

3.3 Industrial Policy

Given globalisation, European countries can no longer sustain economic growth solely on the basis of factors such as cheap capital resources, low-cost labour or market proximity. This is true for the old member states in Western Europe as well as for the new and future member states in Central and Eastern Europe. With the rise of the global knowledge-based economy, the successful, commercial exploitation of knowledge has become the crucial factor for the continuous positive performance of the European economy.

Combined with the continued integration of the ten new member states into the single market, new commercial opportunities and industrial adjustments are rapidly all over Europe. A stronger emphasis on the development and internationalisation of clusters is one way to deal with the challenges and it is therefore paramount for policy-makers to seize such opportunities through the strengthening and integration of clusters across Europe. Cluster covers a large group of firms characterised by geographical concentration, the dominance of SMEs and inter-firm networks in a few interrelated industries. One particular issue facing both local and EU policy makers is the re-location of firms from West European clusters to Central and East European clusters. In policy terms this includes, on the one hand, the successful re-organisation of the industrial structure of those clusters where firms have moved away from, as well as the development of strategies for the internationalisation of the remaining firms. And on the other, it includes the integration of the relocating firms in the “hosting” cluster securing maximum benefits from knowledge transfers, while coping with the rapid transformations in the composition of the cluster. Cluster policy is a new area of governmental involvement which is designed in a top-down manner to create and manage clusters. In contrast with this, policies with a cluster-approach are a set of public or semi-public initiatives collectively streamlined to provide effective solutions to the bottlenecks and problems of existing clusters.

Effective policies must respect the differences in institutional contexts and structural conditions across clusters, so rather than providing a one-size-fits-all solution, the recommendations focus on policy issues that need further governmental attention.

From a macro-structural perspective, the 15 clusters studied by WEST-EAST ID have both similar policy needs, however from a micro perspective, their needs differ. In order

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to develop flexible solutions for both types of policy needs, clusters must focus on policy learning. Policy learning is a process of the systematic adaptation of different policy initiatives in accordance with the changing situation and needs of the cluster. To produce effective and legitimate policies, it is crucial to involve firms as well as all relevant public and semi-public institutions in the learning process. Ideally, policy-learning processes should strike a balance between the short-term and long-term: In the short-term, firms and institutions must develop shared definitions of the present situation in the cluster. And in the long term, policies must develop from collective goals which will improve the structural performance of the cluster.

Two types of policy learning

• Internal learning processes bring together multiple stakeholders in order to reflect on the cluster’s vicious and virtuous circles and thereby improve the policy solutions. Such learning can, for example, help bridge the gap between the firms’ and the understanding of relevant support mechanisms. This gap is observable in most of the 15 surveyed clusters. Internal learning can also focus on collective strategies of relocation (in West European clusters) or absorption (in Central and East European clusters).

• External learning refers to communication channels between clusters through networking and benchmarking. It is most effective when the participating clusters are identical in relation to industrial specialisation or institutional organisation. Such learning also helps to stimulate the internal learning processes. It furthermore carries a particularly strong potential in terms of learning relations between clusters in both old and new member states.

3.4 Policies with a cluster-approach at regional and national level

Policies at cluster and at EU level unfold in the context of regional and national policies relating to clusters. An understanding of those policies is therefore necessary for the development of successful policies at cluster and EU level. The report analyses the regional and national policies in Germany, Italy, the UK, the Czech Republic, Poland, Romania and Slovenia and formulates brief recommendations for their development.

The West European experience

The policy landscapes in the three West European countries represent some of the most successful experiences of cluster-oriented policies in Europe and can thus provide important lessons for the development of policies in Central and Eastern Europe.

The national level plays a different role in the three countries with regard to both policy formulation and implementation. The primary responsibility for cluster policies as well as policies with a cluster-approach tends to lie at a lower level of government. The three countries represent different approaches to the instruments of territorial devolution: In Italy national and local law is preferred, while funding is used to a greater extent in the UK and Germany. Internally, all three countries are characterised by large differences between regions’ active engagement in cluster activities.

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The Central and East European experience

The experience with cluster policies and policies with a cluster-approach is significantly shorter in the four new member states than in Germany, Italy and the UK. But the differences between the national approaches are nevertheless important. In Slovenia, the government has successfully been able to follow a cluster policy, while this has not been the case in the three other countries. In those countries, clusters have hardly surfaced as an issue at national level, partly because the policy agenda has been dominated by accession issues.

Just as in Western Europe, large national differences between regions’ active engagement in cluster activities exist. In some regions policies with a cluster-approach are developing although they tend to be hampered by limited institutional capacities at regional level.

Three types of policies

Existing international initiatives run by the EU, OECD, UNIDO and others include three types of policy instruments: 1) benchmarking of cluster activities with the primary intention of knowledge exchange at macro level; 2) networking activities, where local and regional actors are intended to learn directly from each other’s experiences; and 3) initiatives, where activities aimed at the strengthening of clusters are directly supported.

The more promising of the latter two types provide small-scale examples of successful initiatives focused on channels for external learning through networking and on internal learning through the formulation of development plans on innovation by multiple local and regional stakeholders respectively.

Current EU policies are unfocused and uncoordinated

More than a dozen smaller EU initiatives have in recent years touched upon the development of clusters. The focus on clusters under the structural funds and other larger programmes is, however, marginal. And taken as a whole, the initiatives do not represent a coherent approach, although the expected reform of the structural funds might lead to a stronger focus on clusters under the European Regional Development Fund.

Clusters and the Lisbon Strategy

Compared with the OECD and the US, the EU has been reluctant to focus on the development of clusters. This does not mean that existing policies are a failure. If the development and strengthening of clusters are to help reach the goals of the Lisbon Strategy as well as the cohesion objectives of the treaties it is paramount for policy-makers to pay more attention to clusters. Without tailor-made policies it will not be possible to realise the full economic benefits clusters offer. Neither will it be possible to overcome the problems of unemployment in Western Europe and absorption in Central and Eastern Europe caused by the accelerated relocation of firms.

The limits of policy

But such policies should not reduce the market dynamics created by the integration of the new member states in the single market. The market is the engine for clusters’ growth and policies should therefore be aimed at creating favourable framework conditions that facilitates the growth of clusters and fosters the dynamics of the market. At the same

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time, mirroring the realities of current EU politics, policies must reach the goal of cluster development in a cost-effective and flexible manner.

On the basis of the above considerations it is recommended to introduce a stronger cluster approach in the relevant, existing EU policies rather than designing a new cluster policy per se. To realise this, the following six objectives must be followed:

1) Enhance the cluster approach in already existing EU initiatives of regional, enterprise and innovation policies.

2) Enhance the horizontal coordination of policies at EU level. 3) Boost the external policy learning at EU level. 4) Enhance cross-border policy learning in the entire EU. 5) Mobilise the existing competences and improve partnerships at all levels of

government through the following instruments.

6) Support the internationalisation and relocation dynamics in the EU25.

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4. Macroeconomic Issues Three issues are presented: trade, S&T and exchange rate policy.

4.1 Trade

Assuming that trade between the CEECs and EU has been constrained by significant non-tariff barriers, accession to the Single Market is expected to generate large gains in trade (up to 100%), GDP (up to 20%) and real wages (up to 15%) for the new members at little cost to the incumbents.

Trade expansion is likely to be driven by outsourcing of unskilled-labour intensive production from incumbent members as it is stated by EPRIEE. This is also likely to generate strong sub-regional integration, such as has been observed around the Baltic Sea.

The pre-accession strategy enabled the candidates to take trade liberalisation further than could non-candidates by increasing the level of reform that is best for GDP growth.

Preparations for negotiating EU membership and the negotiations themselves do not appear to have caused reform to have significantly deviated from the pattern generated by sequencing, with the exceptions of bank reform and competition policy.

Prior to the Europe Agreements, export growth of the candidates appears to have been a consequence of the low ratio of exports to GDP. This catch-up process was a consequence of large currency devaluations, hardening of budget constraints and preferential access to the EU market. As many of these factors are either not sustainable in the long run or are parts of processes that are almost complete, export growth in the future will depend upon how well countries adapt to the Single Market.

4.2 Science and Technology policy

MACROTEC asserts that in the second half of the 20th century, and especially in its final quarter, the choice between supply-oriented and demand-oriented macroeconomic policies turned into acute and often bitter conflict, not just among theoreticians but more broadly across the scene of practical policy-making. The primacy of aggregate supply over aggregate demand is reflected in the macroeconomic policies of the EU and especially in the ‘Maastricht criteria’ for joining the EMU. In policy terms, there are a number of ways in which one might expect to see macroeconomic policy helping to drive (or obstruct) technical progress, and hence the active effects of S&T policies.

The orthodox supply-driven macroeconomic policy looks at the role of costs and prices, as briefly set out in the EU’s 1995 Green Paper on Innovation, and this has been the primary channel of impact entertained by governments of EU Member states since the 1970s. The lowering of unit labour costs for either unskilled or skilled workers may be expected to increase profitability, and more widely competitiveness in international trade. However it may act as a disincentive to labour-saving technical change, and hence to industrial ‘upgrading’.

Alternatively, reduced costs may affect the cost of capital, either tangible or intangible. Empirical studies generally showed the importance of physical capital, especially in the

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catching-up countries. However in the more advanced countries a clear shift from physical to human capital as a proportion of GDP over the last quarter-century has prevailed, and linked to the ICT revolution etc.

MACROTEC suggests that there may be some negative relationship between the real rate of interest, as a rough measure of the cost of capital, and the relative decline of physical capital investment. However this also implies an unexpected positive relationship with the relative rise of R&D (intangible investment), contrary to the Green Paper’s predictions.

It is widely accepted that too high a rate of inflation will reduce and perhaps destroy the incentive to innovate. The more controversial issue is what happens with regard to low rates of inflation. Here, MACROTEC claims that at both theoretical and empirical levels that some positive rate of inflation may be beneficial for technology. Combined with the observation about hyperinflation, this suggests an inverted U-curve for the relationship between inflation and innovation. The reference is made to Poland and to Iceland where high rates on inflation did not seem to obstruct strong performance of the real economy, suggests that the maximum point may be higher than often thought.

While inflation in isolation may be an evil, taking its cure too far may do more harm than good. This opens the door to more expansionist fiscal and other policies. One key area of transmission has been the impact of aggregate demand on new firm formation at the more micro level, skill upgrading comes about to a large extent through establishing new firms. Macro-level demand expansion has encouraged the growth of higher quality output. MACROTEC however finds areas of positive impact from public expenditure. Fears that public spending may ‘crowd out’ private spending, e.g. in relation to R&D, appear to be often rather exaggerated. On the contrary, negative effects of tight macroeconomic policies appear to have restricted, or largely curtailed, R&D activities in countries like Hungary and Bulgaria. However unlimited expansion of the public purse would not be advocated. In Poland, the hard budgets associated with fiscal responsibility have coincided with better technological performance, though there has been some tailing off in more recent years.

Equally, traditional Keynesian policies of boosting demand through budgetary expansion are of limited use unless they can be oriented to productive purposes. Here this means calling forth not just underutilised supplies of existing resources but in the end new supplies of hitherto unexploited resources. Fiscal expansion for its own sake is not exonerated in our analyses. For the case of Greece, it was shown that macroeconomic policies that were ‘inappropriate’ for their economic context, e.g. through being expansionist when the country could not afford it, or being unduly austere when growth was urgently needed, also probably had little positive impact on S&T. The era of ‘hard budgets’ in Poland has been more successful than pre-transition days of ‘soft budgets’ – one way in which hard budgets can be reconciled with some expansion is through setting quid pro quo targets for technology or production or export deliverables. What is needed is not a crude Keynesian apparatus but a new hybrid of Keynesian and Schumpeterian policies in order to call forth the interdependencies between supply and demand.

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4.3 Interdependencies between supply and demand

Thus, MACROTEC enhances the neglected but often dominant role of impact through the demand side, but does not support take a crude post-Keynesian line that expanding public-sector demand will increase technological performance and thereby growth. The important point here is the need for complementarity with private-sector domestic actions. In a catching-up context, it is again the ‘absorptive capacity’ of the country, as outlined in the ‘national systems of innovation’ approach, that primarily dictates the technological response. Force-feeding expansionary demand without attention to micro-level responsiveness – and perhaps accompanying policies – will be little better than crude inflation. This exemplifies why it is crucial to trace the ‘transmission mechanisms’.

MACROTEC results carry strong implications for policy-making by the European Commission. An obvious one is that policies aimed at supranational macroeconomic stability through meeting the Maastricht criteria, emphasising the supply side of the coin, could have unintended negative consequences on the demand side for technological progress and hence growth. This may have deleterious effects on the accession countries as they aim to meet the acquis for the accession process. These have to be weighed against the potential gains from the stabilisation policy in the medium to longer term, working their way through output growth to productivity growth in Kaldorian fashion, for which MACROTEC finds some empirical support. Moreover, the shift from harmonisation to ‘open methods of coordination’ as an EU strategy may call a greater flexibility of response at the level of the individual ‘national system of innovation’. However the evidence presented by MACROTEC for Greece indicates that the policies may produce little if they are not backed up by inflows of resources, probably on a scale larger than currently planned under the accession process.

4.5 Coordination between macro and S&T

Macroeconomic policies and S&T policies are invariably disconnected across the countries surveyed by MACROTEC, and there is a need – most powerfully in the catching-up countries – for much greater coordination between them. Raising intangible capital intensity, through R&D, human capital formation, etc., does have positive effects on growth, as the new growth theory maintains, but that the payoff may be rather disappointing relative to expectations in the short to medium term. This is mainly because shifting course to a new technological paradigm such as the ‘knowledge-driven economy’ may be expensive in the medium term, and governments need to look further into the long term for sustained gains. MACROTEC has drawn special attention to two factors drawing out and attenuating the productivity gains from technological change, namely the enhancement of skills and the need for institutional change.

MACROTEC perspective on the Barcelona target of raising EU R&D intensity to around 3%, with two-thirds to come from private sources, is very much framed by these considerations of complementarity. From neo-Schumpeterian perspectives a prior sympathy for aiming at such a target can be revealed. However it is also to be considered that its benefits will be greatly reduced, and the target itself probably become unattainable, unless due attention is given to the complementarities between aggregate demand and aggregate supply.

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While the details of what the Schumpeterian component may consist of remain somewhat tentative, it seems clear that an element of his ‘creative destruction’ may be involved. The current round of renewed soul-searching in the EU over the Common Agricultural Policy may be a case in point, but it extends too to the use of Structural Funds for non-agricultural purposes. At the same time, MACROTEC would more vigorously stress the point that a dichotomy between high-tech and low-tech as the strategic choice for industry is misconceived. For one thing, if countries crowd into high-tech industries the gains will be driven down through competition and diminishing returns; in any case it is blindingly obvious that such a strategy is not viable for most countries because the technology gap to be bridged is far too wide. The main point is however more constructive: that by distinguishing technologies as ‘inputs’ from products (goods plus services) as ‘outputs’, strategies can readily be envisaged whereby countries preserve their traditional strengths in particular product markets, but aim to produce those more traditional products using new technologies and new skills. MACROTEC thus points more towards ‘creative accumulation’ than ‘creative destruction’; though in the same breath it needs to be stressed that the former implies change just as much as the latter.

This then makes a case for enhancing R&D across the whole spectrum of productive activities, from agriculture through manufacturing to services – the last of these especially in view of its ever-growing predominance in GDP. High-tech activities under the OECD definition account for only about 3% of EU GDP, so even a doubling of these will make only a minor difference to overall growth rates. There is also empirical evidence from the OECD databases that broader change has been occurring in a modest way over recent decades as witnessed in sectoral growth rates of GERD (Gross Domestic Expenditure on R&D) and BERD (Business Enterprise Expenditure on R&D), though the levels of RTD (Research and Technology Development) activity remain very disparate across sectors. On the latter grounds, the obstacles to inculcating an RTD-oriented behaviour in the low-intensity sectors are evidently much greater than in sectors with high R&D intensity. This reinforces the case for institutional reform to be set alongside the quantitative expansion of R&D activity.

Such institutional reform should, by MACROTEC, be aimed at promoting the requisite complementarities. This goes beyond the standard encouragement of networking to ‘aligning’ the existing multiplicity of networks. The kinds of expenditure that may be augmented by additional R&D should be tailored to areas promising real long-term productivity growth. Thus productivity per person-hour rises through reducing the ‘hours’ required to produce the existing level of output rather than reducing the number of ‘persons’. This has powerful implications for the employment effects of the suggested policy changes. It also implies a very direct ‘transmission mechanism’ whereby greater demand for output feeds back into greater need for process innovation to supply that increased output. Nor should one overlook the speed-up in technology itself and in product development, which as the employment literatures indicate tend to have positive impacts on total employment.

In order to maximise learning possibilities, it is crucial to take the labour issue on board as part of the technological mission. Getting people to work faster is, ceteris paribus, less likely to induce pain than throwing large numbers of them out of work. Technology all too often raises fears of unemployment, so the compensating mechanisms described in

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the theoretical literature to offset this effect must be made to work, other than where the case for creative destruction is overwhelming. It has to be recognised that the pattern of skill development over the past quarter-century has been exclusionist and inegalitarian. As the technology lifecycle progresses this should reverse itself, but it may not do so entirely unaided. Over the long term education responds to demand even with long supply lags – strategies of ‘building education ahead of demand’2 – may have worked in parts of East Asia, but gearing training programmes etc. into effective demand seems more likely to succeed.

In addition to the complementarities between technologies and skills, MACROTEC suggests the fostering of links between public and private RTD efforts. The large ‘mission-oriented’ projects of the third quarter of the 20th century seem to have given way to more ‘diffusion-oriented’ strategies even in the countries which most utilised them, but there seems to be room to go further. Studies of US technology policies since the late 1980s suggest a gulf between rhetoric and reality, with rhetoric placing the emphasis on large-scale, pre-competitive public-sector activity and the reality on small-scale, widely diffused, near-market activity.

The EU itself, along with international organizations such as the EBRD and World Bank does of course tackle the provision of finance for infrastructure. The burden between the public and private sectors may become necessary, and the two are being cautiously interlinked by present-day governments through ‘private finance initiatives’ and the like. The main concern here is that, while again spending for its own sake is clearly most inadvisable, undue respect for the budgetary ratios in the Maastricht criteria may deter investments with positive long-term payoff. The English saying ‘penny-wise, pound-foolish’, that saving a small amount of money today may be very costly later, appears to be an appropriate description of the ‘savings’ on infrastructural maintenance and investment in the name of monetarism in the UK in the 1980s.

MACROTEC consistently finds substantial effects from externally oriented national policies, in regard to both trade and FDI. These appear to be most pronounced for catching-up or ‘intermediate’ countries. The relationships between technology and these external policies appear to run in both directions, from technology to trade and vice versa. The principal finding is however the external impacts depend upon internal activities, in particular the need to generate ‘absorptive capacity’ to take advantage of any favourable external conditions. FDI by itself may not be enough.

Studies in MACROTEC have therefore been directed at ‘open economy’ versions of the putative Schumpeterian model for macroeconomic policy, an area which is particularly underdeveloped in the theoretical literature. The primary consideration again is on the inputs rather than on the outputs side of the production processes – the international movements of technology, skills (human capital) and physical capital rather than trade in products (goods and services). The general presumption is that accession will lead to a rise in FDI into the accession countries; though whether this will come primarily from the old EU member-states or from outside is less immediately obvious (Spain after 1986, for instance, experienced a surge in extra-EU sources of FDI). Such FDI will embody new

2 This was the phrase what Schumpeter originally applied to the US railroad network.

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technologies and new business practices, which in themselves help advance the host countries. The main issue, though, is whether such FDI and the embodied technologies and skills are complements to or substitutes for indigenous technologies and skills in these host countries. The evidence from the earlier ‘cohesion countries’ is mixed – the most positive impact was (eventual) complementarity in Ireland, but in Greece the situation was more or less simple substitution for a long period. The bulk of the evidence for the transition economies to date unfortunately suggests mainly the latter. This is a serious threat to the long-run viability of the transition economies. The national innovation systems of the countries need rebuilding, especially in the direction of realigning them with supranational and global systems, in order for the benefits of FDI to be fully realised. In no way this is a zero-sum game: interacting with improved domestic resources could easily enhance the returns obtained by multinational companies. But a new public-private interaction needs to be forged.

PGAP claims that the identified lack of a coherent long-term policy in restructuring S&T and in particular R&D systems led to insufficient restructuring of industrial R&D. The analysis of determinants of broad development of National Innovation Systems (NIS) suggests an order of priority for economic policy from demand-determinants, to R&D-incentives, and to technology-diffusion-determinants. It is, however, in a sharp contrast with the recommendation made by MACROTEC on the role of demand. A re-orientation of R&D systems is required from the current exclusive orientation on knowledge-generation to one that is more focused on knowledge diffusion as well as on absorptive capacities.

4.6 Euro-Integration and Exchange Rate Policy

The underlying idea of EZONPLUS is that the new EU members in Central and Eastern Europe should continue to pursue an economic strategy of real convergence to the economic levels of the “old” member countries as rapidly as possible by securing sustained growth, e.g. by increasing private savings and by reducing the current account deficit. The attempt to catch up to EU levels has produced considerable progress indeed over the recent years because the new Member States have grown faster that the EU 15 since the mid-1990s by 1.5 per cent above the EU average. The GDP per head gap, however, is still considerable. It should be, however, noted that real convergence is connected with other costly kinds of convergence CEEC have to strive for, e.g., nominal convergence that calls for meeting the Maastricht criteria when entering EMU, or institutional convergence aimed, e.g., at the implementation of EU legislation and comprehensive changes of their respective economic, political and institutional environment and care for appropriate social acceptance.

Exchange rate policy Exchange-rate policies deal primarily with the choice of exchange-rate regimes and their timing. In addition, exchange-rate policies are evidently linked to fiscal and financial policy issues respectively.

The starting point of EZONPLUS considerations is that CEECs’ economies have to rely on sizable capital influx in order to stimulate growth and real convergence towards current members of EMU. The general trend towards real exchange rate appreciation in CEECs fostering their catching-up is desirable and has to be maintained for a prolonged period. Though, the trend real appreciation in course of leaps in productivity as well as

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possibly due to erroneous economic policies is in peril of undermining the stability of the convergence process. The particular problem is that Maastricht criteria and especially ERM II stipulate the adoption of those kinds of fixed exchange-rate regime — i.e. so-called soft pegs — which are particularly prone to speculative attacks impeding the process of sustainable convergence.

Exchange-rate policies should be organized in a way that the risk of disordered devaluations and currency crises is at least reduced. The most obvious thing to ensure sustainable convergence is, first, to keep CEECs as long as necessary at long range until these countries get their economies mature. Thus, CEECs should slow down their rush to EMU. Second, fluctuation bands should be as wide as possible in order to allow catching-up economies for equilibrium real exchange-rate appreciations. This applies, third, also to the choice of central parities and in a similar manner to that of conversion rates.

The policy mix required particularly for achieving compliance with Maastricht criteria qualifying for EMU membership is likely to slow down output activity and employment. The nature of the arising conflict between current and new EMU-members originates from both parties admittedly inclined to complete the enlargement process but less willing to burden the costs. The legal provisions of ERM II allow for the time being only a few alternative exchange-rate regimes.

Currency boards are not considered to be a substitute for participation in ERM II. However, accession countries that are currently operating with a currency board might not necessarily be required to, firstly, float their currency within ERM II before they, secondly, re-peg it to the euro later. Currency boards would offer accession countries an opportunity to draw on the ECB credit facilities quite directly and, thus, possibly impair the ECB’s price stability objective.

An early accession, even unilateral euroisation, will provoke too much heterogeneity inside the EMU. This will seriously impair controlling in terms of monetary policy, for instance, because the transmission mechanisms of monetary policy and the functioning of automatic stabilisers in CEECs are still unclear. Therefore, a premature inclusion of CEECs will result in a mark-up on the euro’s risk premium. Most notably, however, the Council of Ministers would have no influence to determine the final conversion rates at which the accession countries enter