Title Page

THE MECHANICS OF A STRONG EURO AREA

IMF Policy Analysis

Editors

Petya Koeva Brooks and Mahmood Pradhan

Copyright

© 2015 International Monetary Fund

Cover design: IMF Multimedia Services Division

Cataloging-in-Publication Data

Joint Bank-Fund Library

The mechanics of a strong Euro area / editors: Petya Koeva Brooks and Mahmood Pradhan. – Washington, D.C.: International Monetary Fund, 2015.

• pages; cm.

Includes bibliographical references and index.

ISBN 978-1-49830-553-2 (paper)

ISBN 978-1-51356-676-4 (ePub)

ISBN 978-1-51357-943-6 (Mobipocket)

ISBN 978-1-51357-224-6 (PDF)

1. Euro. 2. Monetary policy – European Economic Community countries. 3. Currency question – European Economic Community countries. 4. Global Financial Crisis, 2008–2009. I. Koeva, Petya. II, Pradhan, Mahmood, 1957– III. International Monetary Fund.

HG930.5.M43 2015

Disclaimer: The views expressed in this book are those of the authors and do not necessarily represent the views of the International Monetary Fund, its Executive Board, or management.

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Contents

• Foreword

• Acknowledgments

• Preface

• Contributors

• Abbreviations and Acronyms

• PART I | THE LEGACIES OF THE CRISIS

• 1 | Investment in the Euro Area: Why Has It Been Weak?

  • Bergljot Barkbu, S. Pelin Berkmen, Pavel Lukyantsau, Sergejs Saksonovs, and Hanni Schoelermann

• 2 | Indebtedness and Deleveraging in the Euro Area

  • Fabian Bornhorst and Marta Ruiz-Arranz

• 3 | Rebalancing: Where Do We Stand and Where to Go?

  • Thierry Tressel and Shengzu Wang

• PART II | THE ROLE OF MONETARY POLICY AND THE FISCAL FRAMEWORK

• 4 | Fragmentation, the Monetary Transmission Mechanism, and Monetary Policy in the Euro Area

  • Ali Al-Eyd and S. Pelin Berkmen

• 5 | Possible Subordination Effects of Eurosystem Bond Purchases

  • Nico Valckx, Kenichi Ueda, and Manmohan Singh

• 6 | An Early Assessment of Quantitative Easing

  • S. Pelin Berkmen and Andreas (Andy) Jobst

• 7 | Fiscal Consolidation under the Stability and Growth Pact: Some Illustrative Simulations

  • Derek Anderson, Marialuz Moreno Badia, Esther Perez Ruiz, Stephen Snudden, and Francis Vitek

• 8 | Fiscal Governance in the Euro Area: Progress and Challenges

  • Luc Eyraud and Tao Wu

• PART III | COMPLETING THE ECONOMIC AND MONETARY UNION (EMU)

• 9 | A Banking Union for the Euro Area

  • Rishi Goyal, Petya Koeva Brooks, Mahmood Pradhan, Thierry Tressel, Giovanni Dell’Ariccia, Ross Leckow, and Ceyla Pazarbasioglu

• 10 | Toward a Fiscal Union for the Euro Area

  • IMF Staff Team Led By Céline Allard

• PART IV | THE ROLE OF STRUCTURAL POLICIES AT THE EURO AREA LEVEL

• 11 | Capital Market Development: Financing of Small and Medium-Sized Enterprises in the Euro Area

  • Ali Al-Eyd, Bergljot Barkbu, S. Pelin Berkmen, John Bluedorn, Andreas (Andy) Jobst, and Alexander Tieman

• 12 | Youth Unemployment in Europe: Okun’s Law and Beyond

  • Angana Banerji, Huidan Lin, Sergejs Saksonovs, and Rodolphe Blavy

• Index

Foreword

In line with its mandate, the International Monetary Fund has over the years been reviewing the design of and developments in the Economic and Monetary Union (EMU) in Europe. With the introduction of the euro as the single currency in 11 European Union member states at the beginning of 1999, the IMF faced the new challenge of having to conduct surveillance for a systemically important monetary union. It has addressed this situation by pursuing a dual-track approach: conducting a surveillance exercise of the euro area’s policies that provides an adequate context for national Article IV consultations with the now 19 members of the euro area. Furthermore, with the introduction of the euro and the single monetary and exchange rate policy conducted by the European Central Bank (ECB), the bilateral relationship with the ECB has been reinforced, as reflected in the granting of IMF observer status to the ECB in 1998.

The ECB, the European Commission, and other European institutions and bodies responsible for policies falling within the purview of the IMF participate in regular consultations with Fund staff as part of the IMF’s surveillance for the annual report on euro area policies. As such, the IMF is an important counterpart on macroeconomic, macro-financial, and macro-critical structural policy issues that are crucial to the functioning of the euro area as a whole and of its member states. The Fund has also given increased attention to further improvements to the institutional framework governing the euro area.

Following the global financial crisis in 2008, IMF surveillance of the euro area has been especially useful in the challenging environment facing the euro area. The subsequent euro area sovereign debt crisis added to the challenges the EMU had to cope with. In this more recent period, the Fund has significantly intensified its surveillance, including of the euro area and its constituent countries. It has responded to the shortcomings exposed by the crisis with new initiatives and a strengthening of practices in key areas, for example, with better analysis of spillovers, macrofinancial linkages, and risk assessment. In addressing the imperfections of the euro area governance framework as designed at the outset of the EMU, a shift from national toward more coordinated or centralized policymaking has been taking place. The Fund has actively made suggestions about how to reinforce the institutional architecture of the EMU, advocating in particular more financial and fiscal integration. This book presents a vivid example of Fund staff contributions of pertinent advice to euro area policymakers based on sound analytical underpinnings reflecting broad cross-country experiences.

Looking to the future, IMF surveillance of the euro area will inevitably adjust in light of strengthened EMU architecture. The main elements of a banking union have already been put in place, most notably the Single Supervisory Mechanism and the Single Resolution Mechanism. The recent Five Presidents’ Report on Completing Europe’s Economic and Monetary Union sets out various ideas for a further deepening of the EMU. Based on the experience of the past few years, as illustrated in this book, I have no doubt that the assessments and advice provided by Fund staff will continue to be highly appreciated by euro area policymakers as they strive toward a more complete EMU.

Peter Praet

Member of the Executive Board

European Central Bank

Acknowledgments

This book is the product of a long period of collaboration among many departments at the IMF. In addition to numerous colleagues in the European Department, including our Director Poul Thomsen and his predecessor Reza Moghadam, we are extremely grateful to our colleagues in the Fiscal Affairs Department; the Legal Department; the Monetary and Capital Markets Department; the Research Department; and the Strategy, Policy, and Review Department. All these departments have played an active role not only in reviewing the chapters in this volume, but also as energetic participants in the policy discussions at the Fund that have ultimately shaped the agenda for the annual Article IV consultations with the euro area institutions. Many of our colleagues worked very closely with us and are authors of some of the chapters in this volume.

We are also extremely grateful to numerous officials—certainly way too many to mention individually here—in Europe. During the past four years we have benefited from extensive discussions on all of the topics covered here with officials at the European Commission, the European Central Bank, the European Stability Mechanism, the European Investment Bank, and the European Banking Authority. They have all been exceptionally generous with their time and, without assigning any responsibility, their detailed comments have undoubtedly improved all of the chapters herein.

Preface

The euro area has experienced an unprecedented economic downturn and exceptional financial market turmoil in the past few years. Policymakers have faced the twin challenge of addressing cyclical economic weakness—not unlike other industrial countries following the global economic crisis—and the underlying weaknesses in the architecture of the currency union, weaknesses that appear to have been masked during the first relatively calm years of the Economic and Monetary Union (EMU). Among member states, many structural weaknesses were exposed when economic performance declined significantly and financial markets became more discerning.

It would be an understatement to say euro area policymakers have been busy addressing these challenges. Demand support in response to the pervasive weakness throughout the region has necessarily relied heavily on monetary accommodation given the constraints of the Stability and Growth Pact (SGP), including the need to balance growth and debt stability objectives in some countries. At the same time, the euro area has embarked on fundamental changes in its financial and economic architecture, such as the Banking Union, a much stronger and clearer bail-in mechanism for resolution of banks, and more centralized supervision of banks at the European Central Bank (ECB) under the Single Supervisory Mechanism.

Much has been done, yet important concerns linger. Unemployment, especially among the young, is still stubbornly and unacceptably high, posing the risk of a lost generation. Debt levels—both public and private—remain elevated. Capital markets have become more fragmented as cross-border flows have declined and banks have become more national. The impact of these reversals of trends toward more integration has been felt particularly in the small and medium-sized enterprise (SME) sector, where borrowing rates remain too high in some countries and credit flows too weak. Very low inflation is a worrying sign of the anemic recovery. It signals still-substantial slack in the euro area, and complicates the task of reducing debt and unemployment. And persistently low investment and high unemployment threaten the long-term productive capacity of the euro area economy.

A strong and sustained recovery is needed to repair the damage from the crisis. Because many factors are weighing on growth, no single action can address its revitalization. Instead, reviving growth requires complementary policy actions to (1) support demand (by undertaking monetary policy measures and pacing fiscal adjustment while preserving the integrity of the SGP), (2) make more progress on EMU architecture (by repairing bank balance sheets and advancing and consolidating the banking union agenda), and (3) boost trend growth and foster rebalancing (by implementing structural policies).

This book focuses on the analytical underpinnings of real-time policy advice given to euro area policymakers during four cycles of the IMF’s annual Article IV consultations (2012-15) with euro area authorities. The papers in this collection are part of the background analysis for the IMF’s policy perspectives on the euro area. They are presented here in their original form (many of these were published as “Selected Issues Papers” supporting the “Staff Reports” of the Article IV consultations during 2012 to 2015, while some were published as “Staff Discussion Notes”). The book does not cover some important policy developments since July 2014. In particular, it does not assess the Bank Recovery and Resolution Directive, and some of the recent changes in the Stability and Growth Pact.

The first section of the book examines the legacies for the euro area of the crisis: low investment, high debt, and external imbalances. Chapter 1 analyzes the behavior of private investment, which fell substantially during the crisis and has remained subdued since. What does low private investment portend for economic recovery? The analysis here provides firm evidence that low growth is integral to the story. But in some countries, high corporate leverage, policy uncertainty, and financial constraints are also holding back investment. These factors highlight the role of banks, and their health, given the heavy reliance on bank financing in the euro area.

Public and private debt levels in the euro area rose to unprecedented levels in some countries during the crisis. This debt overhang has undoubtedly added to deleveraging pressures both in the public sector and in the private sector. But it could also be weighing on growth, even though aggregate public debt for the euro area as a whole compares favorably with that of other large industrial countries. Chapter 2 establishes that high private and public sector debt is restraining growth in the euro area. It argues that simultaneous deleveraging across all sectors is unique to the euro area when compared with other deleveraging episodes in many industrial countries, and represents a significant challenge. And negative feedback loops between high debt and a weak financial sector are exacerbating the constraints on economic growth and credit conditions.

In an environment of much lower cross-border capital flows, large internal imbalances of member states vis-à-vis other member states have become external imbalances, necessitating policy adjustments and relative price changes within the euro area. Chapter 3 finds that relative price adjustments and current account improvements are taking place. Although exports have rebounded, slumping internal demand (and imports) accounts for much of the reduction in current account deficits in debtor countries. This trend has not been matched by stronger demand and narrower current account surpluses in creditor countries. Thus the current account balance of the euro area as a whole has shifted from deficit to surplus, and internal rebalancing has been accompanied by subdued activity, notably very high unemployment in the deficit economies, contributing to a more painful adjustment.

The second section of the book turns to the role of macroeconomic policies in supporting the recovery. Starting with monetary policy, Chapter 4 illustrates that despite important actions by the ECB, fragmented financial markets, particularly banking systems, along national borders led to substantially higher interest rates for borrowers in stressed markets—far above those in the core. The analysis shows that the credit channel was impaired during the crisis particularly in stressed markets, and that SMEs in hard-hit economies appear to be most affected. Given these stresses, the authors argue that the ECB can undertake additional targeted policy measures, including through various forms of term funding, looser collateral policies, and direct asset purchases. These actions would relieve funding constraints on banks and should, in principle, cause ECB monetary policy to have a more uniform impact across the region.

The ECB’s quantitative easing efforts under the Securities Markets Program raised occasional market concerns about private holders of sovereign being subordinated, and may have reduced the impact of the program on sovereign borrowing costs. Chapter 5 looks at various ways—both empirical and theoretical—to quantify the extent of subordination arising from ECB debt purchases in some countries. The main finding is that the impact of ECB seniority is primarily related to the perceived probability of default and the proportion of outstanding debt already in the hands of the central bank.

Despite substantial monetary accommodation, by December 2014 euro area inflation had been falling for 17 months, and 12 out of 18 countries in the common currency area were in the grip of deflation. The ECB had already lowered interest rates to zero and introduced various unconventional policies such as private asset purchases and very cheap funding for banks. The ECB’s expanded asset purchase program (announced in January 2015), to include sovereign assets, was larger and more open ended than markets had anticipated. Chapter 6 assesses this program and compares it with quantitative easing in other industrial countries—Japan, the United Kingdom, and the United States. Its findings are encouraging. In Europe, quantitative easing has had a stronger initial impact on term premiums and other asset prices than it has elsewhere, and it has been particularly successful in arresting the decline in inflation expectations. The experience of other countries also shows that the impact on bank lending, and on the real economy, typically takes longer to materialize.

Turning to fiscal policy, Chapter 7 assesses the pace of consolidation driven by the SGP, particularly whether it is appropriate in the face of an extremely weak economic environment. It quantifies the output effects from fiscal consolidation implied by the SGP and illustrates that multipliers are likely to be larger than normal (given negative output gaps, joint consolidation efforts, and monetary policy constraints). This outcome suggests that, while preserving its integrity, SGP rules should be applied more flexibly to accommodate unexpected events, and that where financing conditions permit, the pace of fiscal consolidation should take into account the adverse economic conditions.

Looking beyond the crisis, Chapter 8 contributes to the discussion on fiscal governance in Europe. Despite recent improvements, the European fiscal governance system faces a number of challenges. The remaining gaps are most apparent in the complex design of fiscal rules and their poor enforcement mechanisms. Given that public debt is approaching unsafe territory in several member states, the fiscal framework has a key role to play in putting public finances back on a sound footing. In this context, the authors take stock of recent reforms; identify areas for further progress; and examine a menu of policy options for making the fiscal governance framework simpler, more transparent, and more robust in the medium term.

The third section of the book discusses the importance of completing the EMU architecture—by moving toward a banking union and greater fiscal integration. Chapter 9 discusses how a banking union will help end the adverse downward spirals between sovereigns, banks, and the real economy. The interconnection between sovereigns and banks is also the underlying reason for the marked financial fragmentation in the euro area, which has resulted in the vastly uneven impact of monetary policy across the area. It argues that a banking union—comprising a single supervisory and regulatory framework, single resolution mechanism, and common safety net—for the euro area is the logical conclusion of the idea that integrated banking systems require integrated prudential oversight. The case for a banking union for the euro area is both immediate and longer term. Moving responsibility for potential financial support and bank supervision to a shared level can reduce financial market fragmentation, stem deposit flight, and weaken the vicious loop of rising sovereign and bank borrowing costs. A single framework should bring about a uniformly high standard of confidence and oversight, reduce national distortions, and mitigate the buildup of concentrated risk that compromises systemic stability.

The euro area crisis exposed a critical gap in the economic architecture of the EMU: the capacity for country-level shocks, whether exogenous or home grown, to spread across the euro area, calling into question the viability of the common currency. The European Union’s fiscal governance framework—centered around the SGP—is designed to address fiscal discipline in member states, but it cannot deal with economic shocks that become pervasive across the region. Chapter 10 explores the role that deeper fiscal integration can play in correcting these architectural weaknesses in the system, to reduce the incidence and severity of future crises and lend long-term credibility to the crisis measures in progress. The chapter argues that a clearer ex ante approach to fiscal discipline and transfers will further strengthen the architecture of EMU, ensuring the stability of the euro area.

The final two chapters focus on two structural challenges for the euro area: developing capital markets and tackling youth unemployment. Overcoming these structural problems would ensure that the long-term productive capacity of the economy is not permanently impaired. Chapter 11 assesses the structure of private capital markets in the euro area, their role in financing growth, and prospects and policies for further development, at both the national and the euro area levels. It explores the potential for reducing the excessive dependence of SMEs on banks and expanding direct access to capital markets, particularly through securitization. More capital market finance for firms and households would, in principle, make the real economy more resilient to the travails of the banking system.

Chapter 12 delves into explanations for the extraordinarily high youth unemployment rate, especially in comparison with adult workers. Can these youth unemployment rates be explained simply by the extent of the economic downturn, or are other institutional factors at work? Cyclical weakness explains much of the increase in youth unemployment, but it also masks institutional and structural rigidities that reduce the incentives for firms to hire young people. The chapter discusses policy initiatives both in individual member states and at the euro area level—active labor market policies such as more training and the use of tax policies and more flexible labor contracts—that could help increase youth employment and reduce the risk of a much more permanent decline in the productive capacity of the many member states in which this problem is particularly acute.

Petya Koeva Brooks and Mahmood Pradhan

Contributors

Abbreviations and Acronyms