After the cyclical deterioration in 1995, the European economies are likely to grow by no more than 1½ percent in 1996 and by 1¾ percent in 1997. The slow pace of economic growth hinders the fiscal consolidation of the public sector as well as improvement in the labor market. Unemployment is expected to stagnate at the high level of 11¼ percent. In early 1995 the cyclical upswing in Europe ended abruptly after an unusually brief period of expansion. The recession was more pronounced in the hard-currency countries than in those countries whose currencies had again lost in value in March 1995. Demand and output have not yet recovered from this setback; the short-term outlook remains bleak. The underlying economic factors have both positive and negative implications for growth: In important trading partners of the European Union the growth prospects are favorable. The U.S. economy, guided by a successful monetary policy, is about to shift to a path of steady growth of 2¼ in real terms per year. Since 1992 economic activity has expanded at a rate of over 2 percent per year; this high growth has contributed substantially to the decrease in new debt of the public sector (to about 1¾ percent of GDP) and the decline in unemployment (down to 5½ percent). In the reform countries of East-Central Europe, strong economic growth, fostered by high investment and private consumption expenditures, continues at a rate of about 5 percent. In Japan, massive doses of monetary and fiscal stimuli have brought about a sustained economic recovery; economic activity is likely to expand by 1¾ percent this year, by 2½ percent next year. Monetary stability also tends to exert a positive influence on Europe's economies. Given the sanguine economic outlook for the USA, the U.S. dollar has markedly gained in value for over a year. This increase tends to stabilize the exchange rates in the European Monetary System as well as the rates prevailing between Japan and its trading partners in South-East Asia. Moreover, the steady decline in short-term interest rates favors the cyclical position of the European economies. A tightening of monetary policy and expectations of a rise in inflation could push up interest rates in the U.S. bond market. In the past, such a rise has most often been transmitted to Europe, which in turn may dampen the incipient recovery. So far, however, the attempt by almost all European countries to simultaneously consolidate their budgets has had a more depressing effect on consumption and investment demand, at least in the short run. Public sector borrowing as a percentage of GDP is likely to be as high as 5 percent in 1996, far above the agreed-upon target of the convergence criteria.
