Journal Issue

Regional focus: Mapping a strategy for recovery in the euro area

International Monetary Fund. External Relations Dept.
Published Date:
September 2005
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IMF Survey: Why has the euro area not benefited from the global expansion?

Deppler: Growth has certainly been disappointing—more disappointing than we had anticipated. This reflects short-term developments, such as the price of oil, and medium-term ones, such as cyclical adjustments in Europe’s corporate sector. More fundamentally, however, there are the long-term issues: the low employment rates inherited over the past three decades, the aging of the population that is poised to happen over the next four decades, and uncertainty about what governments intend to do about these problems. All these factors have come together to produce disappointing growth.

That said, the euro area is making progress. Although growth will not be buoyant any time soon, the situation is not as bad as it is sometimes portrayed. In the near term, we think growth will gradually pick up from percent this year.

IMF Survey: Have high oil prices and an expensive euro been impeding economic recovery?

Deppler: Oil prices and the euro have certainly played a role. Oil has probably slowed growth cumulatively by about 1 percent over the past two years, and the euro has probably taken off another ½ percent. That is not negligible when you are only growing by 1¼ percent! But the rise in oil prices has reflected strong global growth, which in turn has been good for euro area exports, so the area’s weak growth cannot simply be blamed on external developments. The real drag on growth is the domestic setting.

IMF Survey: Why is business sentiment still so weak in many countries?

Deppler: Investment boomed in the period up to 2000, but has since disappointed. This is true for much of the world, including the United States. In Europe, the corporate sector overinvested at the height of the stock market and became overleveraged as a consequence, particularly in Germany. As a result, companies are seeking to improve their balance sheets rather than invest. But the situation is stabilizing, and there are signs that business sentiment is improving.

IMF Survey: What about consumers and households?

Deppler: The wage moderation that is needed to generate employment over the longer term, together with sticky inflation, means real incomes are increasing only slowly. More fundamentally, the aging of the population, which is set to accelerate in the next few years, points to an underlying fiscal unsustainability throughout much of western Europe. As the population gets older, benefit payments will start increasing just as the workforce that helps pay for them will start shrinking. For the most part, governments have not yet mapped out in any convincing fashion how they intend to manage these challenges. This helps explain why consumers and investors are being careful.

IMF Survey: So what can policymakers do?

Deppler: First, let me say that we view the problems as fundamentally structural rather than cyclical—as long term rather than short term. To worry about the short term when there is no credible vision of the future is to no lasting purpose.

Instead, policymakers need to define, with a sense of purpose and vision, a strategy encompassing both fiscal and structural policies that strengthen employment and growth and make the social model sustainable. Let me give you an example. If governments deal with aging-related expenditure pressures by raising taxes and cutting pensions, labor supply and growth will suffer, as will demand, because households will then save to compensate. But if they raise retirement ages, this will increase labor supply and leave consumption relatively unaffected. What’s needed is a strategy that puts more people to work and makes work more productive.

IMF Survey:What has been done so far?

Deppler: Much has been done in terms of wage moderation and ending early retirement. We have also seen some labor market reforms over the past decade, and even though changes have been on the timid side, there are results to show for it. Despite what many think, the employment performance of the euro area from 1996 to 2004 was on a par with that of the United States—roughly 12 million new jobs were created. And there has been recent progress as well. I would single out Agenda 2010 in Germany and the pension reform in France as two reforms that have significantly strengthened incentives to work and reduced these two countries’ underlying fiscal unsustainability. That said, much more needs to be done.

IMF Survey:Does this emphasis on reform mean there is no role for monetary policy?

Deppler: No. There is a role for monetary policy, but it is not a primary one because the problems are essentially structural. So monetary policy should be as supportive of the transition process as possible, but within a framework that maintains price stability.

In our view, monetary conditions have been supportive and interest rates broadly appropriate. The difficulty faced by the European Central Bank is that, while growth has been weak, inflation has been and is very stubborn. After five years, headline inflation remains slightly above the “close to, but below, 2 percent” target, and it will likely persist at those levels for some time yet because of the pressure from oil prices. Since growth is expected to recover, we don’t see a case for cutting interest rates at this point. However, there would be a case if the recovery were to falter once again and underlying inflationary pressures remained contained.

IMF Survey:The IMF is calling on euro area countries to aim for fiscal balance. Is this realistic during a time of slow economic growth and rising demands on the welfare state?

Deppler: The bottom line is that policies must be consistent to be credible. One cannot on the one hand speak of reforms to make the social model sustainable and on the other have budgets that imply increases in public deficits and debt ratios ahead of accelerating population aging. Any short-term “relief” that is expected to result from higher deficits will be negated by people’s justifiable fear that this is simply postponing the inevitable.

Consistency requires a clear view on how to deal with medium- to long-term trends, which means a balanced and reinforcing mix of fiscal and structural adjustment. The mix varies across countries, but for the euro area as a whole we see a need for fiscal policy to move to a roughly balanced position by 2010, which implies adjustment of ½ percent of GDP a year. This goal stands in rather sharp contrast with actual fiscal positions, which have been drifting badly.

What’s needed is a strategy that puts more people to work and makes work more productive.

—Michael Deppler

IMF Survey:The Stability and Growth Pact [SGP] doesn’t seem to be doing a very good job at getting countries to live up to their commitments. What can be done to encourage more fiscal discipline?

Deppler: This has been a difficult period for Europe, and many of the difficulties came to a head in the context of the implementation of the SGP. The response has been a reform that made the euro area’s fiscal framework more flexible. Technically speaking—that is, forgetting about the policy context—there is nothing particularly wrong with what has been done. Indeed, if governments buy into the reform fully, it would represent a step forward. We will then have ownership of the SGP, which we didn’t really have before.

However, fiscal discipline in a monetary union with decentralized fiscal policies is a chancy business. You need to guard against free riders. This is a real concern in a situation where fiscal policies in most countries are already in trouble. The proof of the reformed SGP, therefore, is going to be in the eating—in how the European Council of Finance Ministers applies the new rules. If they follow through with vigorous implementation, then the new SGP will be a step forward. If they don’t, one has to worry about what will happen.

IMF Survey: What will it take to create more jobs?

Deppler: The employment rate in the euro area is, on average, only about three-quarters of the level in the United States. This is the euro area’s main problem—fewer workers will have to pay for more benefits—but it is also its main opportunity. There are, potentially, enough workers to sustain the social model. Although politically difficult, the policies needed to encourage job creation are well known: more flexibility in hiring and firing, continued wage moderation, and improving incentives for finding a job for those who are out of work.

Indeed, Europe has been practicing wage moderation and reforming its labor markets for more than a decade, and has more to show for it than is often realized. While this needs to continue, the challenge now is also to strengthen the payoff in terms of growth.

For this to happen, countries must improve their productivity, which has been lagging.

Unfortunately, we know a lot less about increasing productivity than about increasing employment, but one instrument that does seem to work—on both fronts—is to increase competition in the domestic economy. This forces companies to become more efficient and, hence, more productive. Moreover, by disciplining pricing behavior, increased competition strengthen real incomes and consumption and thus helps offset the dampening effects from wage moderation alone. This should yield more “bang for the buck” in terms of translating wage moderation into jobs and output growth.

What is needed, therefore, are strategies that are more comprehensive than in the past—strategies that combine labor and product market reforms. The revised Lisbon strategy provides avenues for doing so.

IMF Survey:Do you think the euro area will manage to move forward again, given the reluctance in many countries to undertake reform?

Deppler: There is considerable dissatisfaction with the economic performance of the euro area, and I have no doubt that governments are keen to address the problems facing their societies. Once current political uncertainties get resolved— elections will be held in Germany later this month, in Italy next year, and France is gearing up for presidential elections in a year and a half—there will be a renewed momentum. But the question is whether the initiatives will once again be piece meal and partial instead of decisive and comprehensive.

IMF Survey:There is a lot of talk about political differences within the EU and the euro area—between large and small countries, between old and new members, and between “liberals” and those wedded to protecting Europe’s social model. Do these differences threaten Europe as we know it?

Deppler: Unfortunately, what we are seeing right now is people questioning whether the euro area and the EU are part of the answer or part of the problem. There is a pause for reflection. And as part of that media-heavy reflection, there has been a polarization of views. But in my experience, there is a broad consensus among policymakers on what needs to be done, with the differences being second order. The challenge is for governments to come up with the credible visions to make it happen.

But there is one unfortunate byproduct of the current skepticism. There has been a narrowing of the focus on national solutions, including a tendency toward protectionism. In one sense, this narrowing is healthy. Since many of the problems can only be solved at the national level, it is certainly appropriate for countries to get out from hiding behind Brussels and start taking ownership of their problems.

But policymakers should also not lose sight of the considerable added value that comes from acting together. Our view is clear—amid its various ebbs and flows, postwar European integration has been beneficial overall. What’s more, the benefits of cooperation are especially marked in a decentralized monetary union such as the euro area. I expect people will once again come to appreciate the benefits of working closely together once this difficult moment has passed.

Copies of IMF Country Reports 05/265 and 05/266, Euro Area Policies, and Euro Area Policies: Selected Issues, are available for $15.00 each from Publication Services. See page 280 for ordering information. The full text of the reports is also available on the IMF’s website (

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