With signs that the recession is bottoming out, European policymakers now need to focus on securing a durable recovery and addressing the threats to potential growth from the financial crisis and the continent’s traditional structural rigidities. In the near term, further action to restore normal functioning of the financial system remains crucial, while policymakers will need to move carefully both to sustain the upswing and to prepare for exit from the extraordinary interventions in a coordinated fashion. And many emerging economies will need to adapt to lower capital inflows, address debt overhangs, and institute structural change.
Few doubt that the crisis will have a negative effect on economic growth in Europe beyond the short term, but considerable uncertainty prevails over its magnitude. For countries where the financial sector contributed heavily to economic growth before the crisis, a continuation of historical levels of trend growth may be difficult, while economies relying on strong capital inflows could suffer a dent in their long-term growth or convergence process. In the medium term, the time-varying component of potential growth could be negative in almost all advanced European countries. Emerging economies could see lower medium-term growth because of dwindling capital inflows and higher government debt levels. Hence, intensified structural reforms are crucial to alleviate some of these adverse effects on potential growth and, in many emerging economies, need to be complemented by a further strengthening of policy frameworks.