Labour-market deregulation is crucial, the OECD argues

And governments must take tough action if they expect sustained growth.

After a "subdued" 2003, the region could expect modest growth of up to 2% next year, the OECD forecast in a report on the eurozone economy.

And even this cautious recovery faced a multitude of challenges - notably a slower-than-expected rebound in key trading partners such as the United States.

To help guard against this sort of unpredictable risk, the OECD recommended Europe accelerate the deregulation of its labour market.

It also called for the dismantling of barriers to trade, reining in of state budgets and a new focus on developing innovative industries.

"At this juncture it is therefore all the more crucial that the vast structural reform agenda be pursued with vigour," the OECD concluded.

Labour pains

In the OECD's eyes, structural reform is vastly more important than short-term measures such as interest-rate changes or budgetary tweaks.

The main focus of structural reform, it argued, should be the labour market.

Making European workers more flexible and productive, and encouraging the sort of entrepreneurship that the continent has tended to lack was paramount, it said.

In particular, the OECD argued the eurozone should:

• Reduce incentives to retire early or leave the workforce
• Make public employment services more effective
• Make workers more mobile
• Tear down restrictive wage-setting arrangements
• Scale back on employment-protection laws.

If this is combined with measures to encourage innovation - cutting back red tape, fostering research and development, or boosting anti-trust mechanisms - Europe could enjoy "considerably faster employment growth", the OECD said.

Such reforms could increase potential per-capita eurozone growth from 1.75% to 2.25% - the same rate as the US.

Foresight failure

More immediately, the report criticised some eurozone members for sloppy budgeting.

Portugal, Germany and France - as well, to some extent, as Italy - allowed their state deficits to inflate beyond regional targets.

This was particularly unfortunate, the OECD argued, in light of the mounting challenge of Europe's ageing population and underfunded pension schemes.

It also left these countries acutely exposed to the current downturn, with no fiscal room to defend their economies against the global slowdown.

Overall, the OECD concludes, the EU has little chance of achieving the target it set itself at the Lisbon Summit in 2000, to turn the European economy into "the most competitive and dynamic knowledge-based economy in the world by 2010".