Despite headwinds from sovereign and financial tensions, the recovery continues. But downside risks still loom large, and divergences across advanced Europe persist. To avoid a protracted period of low growth punctuated by economic, financial, and social crises, further bold measures at the national level are needed to address weak banks, credibly restore fiscal health, and bolster structural reforms. An additional strengthening of the EU-wide policy response, building on the March 24–25 decisions, will also be essential, as will stronger economic governance and an integrated financial stability framework at the EU level to prevent the buildup of macroeconomic imbalances as witnessed prior to the crisis. Meanwhile, monetary policy can remain accommodative, though normalization lies ahead as economic slack wanes and the balance of inflation risks shifts.
Emerging Europe returned to growth last year, but performance varied widely across the region, reflecting the idiosyncratic legacies of previous boom-bust cycles. For 2011 and 2012, an economic expansion of 4¼ percent is projected with much less disparity in intraregional growth, as domestic demand takes over as the main driving force. Policymakers’ emphasis should be on protecting the solidifying recovery against still-considerable downside risks from unsettled global and euro area financial markets and from reemerging inflationary pressures. To this end, they need to tackle fiscal and financial sector vulnerabilities. Fiscal policy should support monetary policy to the extent possible to stave off price pressures in the wake of high global commodity prices and narrowing output gaps. For the many countries hard hit by the 2008–09 crisis, bringing down unemployment while reorienting their economies toward the tradable sector remains an ongoing task.
In the run-up to the crisis, financial integration in Europe boosted investment and reduced saving in countries that previously had high interest rates. As capital inflows increasingly went into the nontradable sector and contributed to credit and housing booms, countries in the euro area periphery and countries in emerging Europe with fixed exchange rates built up large current account imbalances, with ultimately unsustainable trajectories of net external asset positions. Financial markets did not pay sufficient attention to these vulnerabilities, and policies did too little to address market failures. When capital flows slowed, the boom ended, and sharp recessions ensued. The absence of EU-wide institutions to deal with banking crises and the incomplete integration of capital markets compounded the crisis. To overcome the crisis decisively, the most critical factor in the longer run is restoring growth in the crisis-affected countries. To prevent new crises, more vigilance is needed, better institutions to deal with financial sector problems must be developed, and more, rather than less financial and economic integration is needed.
The global recovery is gaining strength, though significant downside risks could still come into play. The April 2011 World Economic Outlook projects world real GDP growth of 4½ percent in 2011 and 2012, following last year’s slightly stronger 5 percent pace. Emerging and developing economies are expected to expand markedly faster—at 6½ percent—than the more sluggish rate of 2½ percent projected for advanced economies. This growth setting, and the accommodative monetary policies of the major central banks, revived capital flows to emerging economies. It also conspired—in concert with adverse supply shocks and concerns about political unrest in the Middle East and North Africa—to drive up commodity prices close to levels reached before the 2008–09 crisis. Key downside risks include (i) oil prices exceeding those currently predicted by futures markets; (ii) significant fiscal and financial vulnerabilities lurking behind recent benign market developments, especially in the euro area; and (iii) overheating in emerging market economies.
The May 2011 Regional Economic Outlook: Europe anticipates that recovery in the region will solidify, with recoveries in advanced and emerging Europe likely to be mutually reinforcing. Advanced Europe continues to absorb most of emerging Europe's exports, while the role of emerging Europe as a market for advanced Europe will expand. Chapters discuss the outlook and policy priorities for advanced and emerging Europe, and analyze the role of financial integration in the buildup and resolution of imbalances within the euro area.