1. Advanced Europe: Beyond Crisis Management
- International Monetary Fund. European Dept.
- Published Date:
- October 2010
With strong policy action to contain sovereign debt problems in the euro area, the recovery continues. But lingering uncertainties and market pressures make for moderate and unequal growth across advanced Europe. In the short term, in addition to dealing with weak banks and supportive monetary policy, this calls for credible fiscal consolidation, adjusted to country needs and designed to minimize the impact on growth. It will be just as important to address the governance issues revealed by the crisis. Better fiscal frameworks at the national and the EU levels will enhance the credibility of fiscal adjustment. And energizing and coordinating structural policies should help sustain and balance growth, supporting public finances in the longer term. Although the political economy of such reforms is complicated, they promise a much stronger Europe. Policymakers should seize the moment and act boldly.
The Recovery Continues
The Recovery Has Withstood Sovereign Debt Troubles …
The recovery in advanced Europe is well into its fourth quarter, but it was not an easy year. The eruption of sovereign debt troubles in early 2010 threatened confidence and shook a still weak financial system. Triggered by Greece’s public debt problems, fiscal sustainability concerns quickly spread in the euro area and beyond—first to other southern European countries and Ireland, then more widely—and euro area interbank markets seized up once more. Yet, as the euro weakened and global stock markets tumbled, policy actions helped contain the problem and the recovery endured (Figure 1).
Figure 1.Euro Area: Contribution to Growth, 2006:Q1–2010:Q2
Sources: Eurostat; and IMF staff calculations.
Note: Contributions from inventories not shown.
Far-reaching policy interventions were crucial. The Greek program co-signed by the EU and the International Monetary Fund in early May gave Greece time to put its public finances in order. However, when sovereign and financial markets did not calm immediately and tensions escalated to dangerous levels (Figure 2), even stronger measures were required. In early May, the European Central Bank (ECB) installed a Securities Markets Program (SMP) allowing it to buy private and public securities in secondary markets, and the ECOFIN Council (the Council) and euro area governments established the European Stability Mechanism (ESM) to provide the means and a mechanism to support governments and preserve financial stability. The ECB has accumulated some €61 billion through the SMP between May and September, albeit at relatively low levels recently. The European Financial Stability Facility (EFSF), which at a nominal €440 billion provides for the bulk of the ESM’s funding capacity, has been operational since early August. In addition, the ECB has taken steps to bolster liquidity, including with the help of central bank swap arrangements, in U.S. dollar markets.
Figure 2.Selected European Countries: Conditional Standard Deviation of Changes in 5-Year Sovereign CDS Spreads, January 2008–August 2010
Sources: Datastream; and IMF staff calculations.
… But Proceeds Unevenly
In many countries, the second bout of crisis slowed the rebound, and real GDP levels remain well below their precrisis peaks (Figure 3). With few exceptions, advanced European countries have seen output recuperating much slower than in the United States. By mid-2010, GDP in the United Kingdom, Sweden, and the majority of euro area countries remained well below its precrisis level, with those hit hardest by the crisis lagging behind even further.
Figure 3.Selected European Countries and the United States: Real GDP, 2006:Q1–2011:Q4
Sources: IMF, World Economic Outlook database; and IMF staff calculations.
1 Greece, Ireland, Portugal, and Spain.
The lack of momentum is also visible in the composition of growth. Looking at the euro area, while growth was strong in the second quarter of 2010, driven mostly by Germany, this reflected the unfreezing of past investment decisions rather than increasing overall momentum (Figure 4). Exports continued to lift growth also, driven by some of the same temporary factors operating at the global level—stronger overall expansions in other regions of the world, and the euro’s depreciation earlier in the year. However, the euro’s weakening (later reversed, to some degree) was also a worrying sign of changing financial market sentiment in light of fiscal and financial problems. Indeed, financial growth conditions tipped down slightly after a long period of improvement (Figure 5). These developments, combined with high unemployment in parts of the region and volatile confidence, contributed to lackluster domestic consumption and investment. And while an expansionary budget in Germany continues to buoy growth, the crisis-induced front-loading of budget consolidation in southern Europe has started to impact aggregate public consumption and investment.
Figure 4.Selected European Countries: Key Short-Term Indicators Figure 5.Euro Area: Financial Conditions Index, January 2003–August 2010
Sources: Datastream; Haver Analytics; and IMF staff calculations.
Note: The Financial Conditions Index (FCI) is a summary measure of developments in various financial variables and their impact on growth four quarters ahead. Higher readings imply easier financial conditions and higher growth. The FCI is constructed as the weighted average of euro area-wide measures of the real short-term interest rate, the term spread, the risk spread, equity market capitalization, and the real effective exchange rate, with the weights based on the coefficient estimates of a regression of real GDP growth on these variables.
The Outlook Remains for Moderate Growth …
Against this background, the forecast remains for a very modest expansion. Real GDP is projected to expand at 1.7 percent in 2010 and 1.5 in 2011 in the euro area (Table 1). At this speed, the euro area will continue to trail the United States and Asia’s emerging economies. In part, these growth differentials are due to the lingering impact of the crisis and the accelerating fiscal adjustment in 2011. But they also reflect well-known structural rigidities in the labor, product, and service markets that will limit the euro area’s potential growth now that the inventory cycle has run its course.
Intra-European growth differentials are set to widen. At between -2.6 and 0.7 percent in 2011, growth in Greece, Portugal, and Spain is projected as lagging growth in the euro area’s larger northern economies, reflected also in diverging labor market developments that could lead to higher long-term or structural unemployment (Figure 6). As discussed earlier (IMF, 2010g), these differences are driven by the deflation of precrisis asset and credit booms and the degree to which countries’ export sectors profit from the rebound in global trade. Fiscal austerity may have been a critical crisis reaction and prevented things from getting worse where market pressures were the highest. But this austerity, combined with elevated interest rate spreads, is also taking its toll on growth.
Figure 6.Selected European Countries and the United States: Unemployment Rate, January 1999–August 2010
Sources: Eurostat; Haver Analytics; and IMF staff calculations.
1 Excluding Ireland and Spain.
Some of the same forces are at work outside the euro area, albeit in different ways. With the effects of recently scaled up plans for fiscal consolidation partly offset by a still depreciated currency (more than 20 percent in real effective terms since the beginning of the crisis), the United Kingdom is likely to see growth of about 1.7 percent in 2010 and 2.0 percent in 2011. Switzerland, facing opposite circumstances of a stable fiscal outlook and a strongly appreciated safe-haven currency, should see growth of around 2.9 percent in 2010 and 1.7 in 2011. Sweden, which also operates at very moderate deficit levels and has seen financial growth conditions improving since the early phase of the crisis, can expect real GDP to expand by approximately 4.4 percent in 2010, among the strongest performances in Europe, cooling down to 2.6 percent in 2011.
Although the forecast is not without upside risks, downside risks have increased, with some of these being associated with the way in which announced policies are (or are not) implemented. The positive growth surprise in Germany could provide additional short-term thrust to the recovery by boosting private demand, and activity in the United States or emerging Asia might still exceed expectations. At the same time, however, global growth could very well be weaker than predicted, with a tail risk of a double-dip recession. Renewed volatility in European financial and sovereign markets is also a possibility.
More than ever, however, the recovery depends on policymakers getting it just right: fiscal consolidation, while inevitable, must seek to minimize the negative impact on growth and employment; monetary policy must steer between the need to normalize policies on the one hand and the necessity to mitigate sovereign market volatility and ensure bank liquidity on the other; and the recent checkup of European banks must be followed by rapid action to eliminate remaining weaknesses while safeguarding lending capacity. In addition, to stabilize the confidence of financial markets, consumers, and investors beyond the short term, EU and euro area governance will need to improve fundamentally (see below).
… With (Mostly) Low Inflationary Pressure
Inflation will remain low in most of advanced Europe. In the euro area, with the output gap slowly closing, headline inflation is expected to rise to 1.6 percent in 2010 and 1.5 percent in 2011 (Figure 7). Long-term inflation expectations remain well anchored at about 2 percent, close to the ECB’s comfort zone. Switzerland, which has seen its currency appreciate in real terms since the beginning of the crisis, is expected to see very low inflation rates below 1 percent in both years. In contrast, in the United Kingdom, where inflation has been surprisingly high following a series of price level shocks and the strong depreciation of the pound, inflation is expected to nudge higher, averaging 3.1 in 2010 and 2.5 in 2011. Sweden, despite its more volatile growth path, will show more steady inflation of just below 2 percent in both years.
Figure 7.Selected European Countries: Headline and Core Inflation, January 2006–August 2010
Sources: Eurostat; Haver Analytics; national authorities; and IMF staff calculations.
1 Harmonized index of consumer price inflation (excluding energy, food, alcohol, and tobacco).
Policies to Sustain the Upswing
Massive policy intervention has helped stabilize Europe’s economies during the recession, but managing the recovery is just as demanding. The task of securing growth and containing risks involves financial and monetary policies and—crucially—fiscal action.
Financial Sector Cleanup Not to Be Delayed …
The recent sovereign bond market volatility has made dealing with remaining weakness in the banking sector even more urgent. In the euro area, banks’ holdings of government paper tightly link perceived sovereign and financial sector risks (Figure 8), limiting access to interbank lending for some institutions. In addition, banks face the anticipated (if phased-in) increase in regulatory capital, continued problems of low profitability, high loan loss provisions, and low capital ratios. These factors are fueling concerns about a credit crunch (IMF, 2010d). Indeed, with aggregate flows of corporate credit yet to show consistent signs of life, there are indications that smaller firms lacking access to bond-based financing could be constrained on the credit market (IMF, 2010b, Chapter 1) (Figures 9A and 9B).
Figure 8.Euro Area Countries: Sovereign and Banking Sector 5-Year CDS Spreads, 2007–10
Sources: Datastream; IMF, Fiscal Monitor, May 2010; and IMF staff calculations.
Figure 9A.Euro Area: Real Bank Credit and GDP Growth, 2000:Q1–2010:Q2 Figure 9B.Euro Area: Bank Loans and Bond Issuance, 2000:Q1–2009:Q41
Sources: Eurostat; European Central Bank; Haver Analytics; IMF, International Financial Statistics; and IMF staff calculations.
1 Unweighted averages of annual growth rates.
This summer’s EU-wide stress tests provide a road map. The tests were well coordinated—implemented in just four weeks, encompassing more than 90 banks from 19 member states, representing about two-thirds of the EU banking sector assets—and provided a wealth of information for financial markets (Table 2). The next step is to follow up by resolving, restructuring, or recapitalizing the banks identified as vulnerable (IMF, 2010d, Chapter 1). Early progress in that direction in Spain, where an existing government program was available to shore up banks where needed, have rightly been welcomed by the markets. However, similar action is required elsewhere, including in some cases for banks that only narrowly cleared the hurdle.
|Sovereign Debt of:|
… And Monetary Policy to Remain Supportive and Flexible
With financial sector strengthening on its way and little inflationary pressure on the horizon, monetary policy can and should remain supportive and flexible. For example, while the ECB seems comfortable with market forces bringing overnight rates up closer to the level of the policy rate at times, it has signaled its intention to keep the policy rate low. Moreover, with the risk balance of the recovery having shifted downward and fiscal policy options increasingly limited, the ECB should remain ready to adjust the time horizon of its low-interest-rate policy and redeploy extraordinary monetary measures if the recovery should stall unexpectedly. The Bank of England, in turn, has appropriately maintained a very expansionary stance and indicated that it will respond flexibly to incoming data, while paying close attention to the risk that recent above-target inflation outturns might adversely affect medium-term inflation expectations. In Switzerland, the main policy challenge will be to allow interest rates to increase over time, in an environment where the currency faces appreciation pressures.
The same flexibility should govern the exit from extraordinary crisis measures. Liquidity operations, such as the ECB’s full allotment refinancing, are still needed in light of the recent fiscal and financial sector turbulence, but their benefits should be balanced against the cost of distorting marked-based bank financing, the moral hazard invited by unlimited liquidity provision, and the risks accumulating on central bank balance sheets (Figure 10). This suggests a resumption of the gradual exit once systemic liquidity conditions have reliably returned to normal. In the same vein, the ECB will have to tread carefully when phasing out its sovereign bond purchases. The task of exiting from these particular crisis measures should be made easier with the ESM now operational.
Figure 10.Selected Countries: Central Banks’ Total Assets, January 2007–August 2010
Sources: National central banks; Haver Analytics; and IMF staff calculations.
Fiscal Policy Must Focus on Consolidation without Jeopardizing the Recovery
Getting fiscal consolidation right is the most crucial of the short-term tasks facing Europe’s policymakers—and among the most difficult. The current willingness of governments to support demand through higher deficits is still an important ingredient of the recovery (Table 3). And if growth weakened markedly more than projected, additional support might yet be needed. However, this is subject to there being fiscal space and market acceptance—it is precisely the fear that increasing debt could make public finances unsustainable that could put the recovery at risk. Elevated interest rate spreads and a steady stream of rating downgrades (or the fear thereof) serve as a case in point. The solution is a strong and credible fiscal consolidation effort, suitably phased in, differentiated across countries in size, speed, and timing (depending on existing market pressures), and designed to minimize the negative impact on growth and employment that comes with the reduction of government deficits.
|Current Account Balance to GDP||General Government Overall Balance to GDP2|
|Advanced European economies1||0.6||-0.1||0.4||0.8||1.1||-0.3||-1.9||-6.3||-6.4||-5.0|
|Other EU advanced economies|
|Non-EU advanced economies|
Weighted average. Government balance weighted by PPP GDP; current account balance by U.S. dollar-weighted GDP.
Net lending only. Excludes policy lending.
Weighted average. Government balance weighted by PPP GDP; current account balance by U.S. dollar-weighted GDP.
Net lending only. Excludes policy lending.
Deficits are being reduced in many countries, with efforts broadly mirroring the pressure felt in sovereign bond markets (Figure 11). Among the countries scrutinized by markets most, Ireland has started early, but Spain and Portugal have recently also implemented ambitious and front-loaded consolidation efforts, with the announcement of additional efforts in the future. In Greece, the government is on track to reduce its deficit by about 5½ percentage points of GDP in 2010 in line with the guidelines agreed with the EU and IMF.
Figure 11.Selected Advanced European Countries: Changes in General Government Fiscal Deficits, 2010–13
Source: IMF staff calculations.
1Greece, Ireland, Portugal, and Spain.
22013 over 2010 adjustment -0.5 percent; 2011 over 2010 adjustment -0.3 percent.
But the summer’s budget season has also brought signs of fiscal consolidation elsewhere in Europe. This is most visible in the United Kingdom, where the new government has laid out a strong consolidation agenda. France, too, has announced measures to significantly reduce the deficit over the next three years. Also, Italy has approved a fiscal consolidation package, based on expenditure savings, aimed at reducing the fiscal deficit to below 3 percent by 2012. Appropriately, countries with better starting positions are approaching the task at a slower pace. Germany, for example, has let its deficit increase in 2010, but plans to bring the general government deficit under the Stability and Growth Pact (SGP) limit by 2013, at the latest. For the euro area as a whole, the fiscal stance is about neutral in 2010, turning mildly contractionary in 2011 (Table 3).
Although the overall fiscal path is broadly in line with the need to support the recovery, securing its credibility will require additional work. In some cases, the underlying macroeconomic assumptions will need to be changed. And in many countries the details behind the announced consolidation effort remain to be specified, allowing uncertainty about the actual size and nature of the adjustment to persist. Some countries—such as Greece, Portugal, and Spain, but also France, Germany, Italy, and the United Kingdom—have already elaborated their consolidation plans beyond next year; others have yet to start that process.
Designing fiscal consolidation to minimize the negative impact on growth and employment is just as imperative. Cutting government spending or increasing taxes to reduce a deficit will generally have a detrimental impact on aggregate demand and GDP growth in the short term. However, households and firms affected by these measures will adjust their demand and supply decisions to the government’s actions, and, based on the precise composition of the fiscal consolidation package, this adjustment could mitigate the short-term impact on economic activity (Box 1). For example, a lasting reduction in public spending might convince households that future taxation will be lower and permanent net income higher, which can bolster private demand. Indeed, the historical record suggests that credible expenditure-based consolidations tend to be associated with lower GDP reduction and lower unemployment than tax-based consolidations, especially when investment spending cuts are avoided (IMF, 2010i, Chapter 3).
Compared with this benchmark, the expected structure of consolidation in the euro area and other European countries is broadly reassuring (Figure 12). The vast majority of euro area members’ fiscal adjustment plans are based on either mostly expenditure cuts or a broadly balanced mix of expenditure and revenue cuts, and the picture for other advanced European economies is fairly similar. That said, to maximize long-term fiscal sustainability gains and minimize any short-term impact on growth, adjustments should generally avoid reducing investment, including in education, and focus instead on distortive subsidies and better targeting social transfers. Entitlement reforms such as increasing the effective retirement age along the lines of France’s recently announced plans will not only deliver cost savings but also support aggregate demand by increasing lifetime income and consumption.
Figure 12.Euro Area: Structure of Expected Fiscal Consolidation, 2010–13
Source: IMF staff calculations.
Box 1.Fiscal Consolidation: Minimizing Side Effects
Public debts and deficits in most advanced economies are unsustainable. Large adjustments are needed to preserve, and in some cases restore, confidence in the ability of governments to face current and future obligations, including the payment of pensions and the guarantee of acceptable health care for all.
Does the situation imply a need for shock therapy? Or could softer treatments work? And is there a way to minimize side effects? The debate on this issue is ongoing, but two salient truths have emerged. First, denying the need to adjust or unduly delaying adjustment are not viable options, despite the difficult choices that lie ahead. Second, the economic literature, regardless of the methodologies used, suggests that certain therapies entail less unpleasant short-term side effects than others.
By far the most feared side effect of fiscal retrenchment is that sharp cuts in government spending or tax increases would reduce aggregate demand to a point that could cause a relapse into recession. However, an ample literature has qualified the simple Keynesian version of the argument, suggesting the existence of feedback effects that depend on the phasing, composition and institutional underpinnings of the adjustment strategy. In principle, fiscal adjustment can have expansionary effects that work from both supply and demand sides.
On the supply side, lower transfers to households may encourage job search, thereby reducing labor costs and boosting employment. By contrast, labor tax hikes would have the opposite effect, and cuts in public investment could dampen private investment (if private output depends in part on public capital). This illustrates very clearly the importance of the composition of the adjustment, pointing to the likely superiority of selected spending cuts over tax increases. That said, if the scale of the adjustment requires revenue measures in addition to spending cuts—as is likely to be the case in a number of countries—increases in indirect taxes should generally be preferred, especially in an environment where tax rates are at already high levels, firms have little or no pricing power, and where monetary policy is likely to remain expansionary or neutral for some time.
On the demand side, adjustments may have positive effects on private expenditure if agents believed that a no-adjustment scenario would lead to catastrophic outcomes and much more damaging consolidations in the future (Blanchard, 1990). Compared with a scenario of no or late adjustment, this would lead to lower precautionary savings, lower interest rates, and a lower probability of negative shocks to wealth. This would ultimately lead to higher consumption and investment. As a consequence, early adjustments are likely to be less painful in terms of foregone demand than textbook linear multipliers may suggest.
The extent to which policymakers succeed in devising adjustment strategies that minimize the side effects of fiscal consolidation is largely an empirical question. There is considerable empirical evidence that large and persistent changes in fiscal policy are indeed associated with strong offsetting forces, to the point of making fiscal contractions expansionary (see Giavazzi, Japelli, and Pagano, 2000, for a comprehensive cross-country analysis). Composition appears to matter a great deal, with expenditure-based adjustment being more likely to trigger only a small negative or even a positive response of output (Alesina and Ardagna, 2009; and Giudice, Turrini, and in’t Veld, 2007). More recent evidence using real-time data on policy actions strikes a note of caution on the strength of non-Keynesian effects, suggesting that most consolidations lead to some output loss (IMF, 2010b). But the study also confirms that expenditure-based adjustments—especially those relying on transfers—are likely to hurt the economy less than revenue-based adjustments. The same applies to countries under market pressure, pointing to the important role of particularly adverse counterfactuals in the absence of adjustment.
How do fiscal adjustment plans in Europe fare compared with these broad criteria? In current circumstances, theory and empirical evidence suggest that adjustments should be (i) phased in (except when credibility has been lost as evidenced by market pressure), and (ii) expenditure based. Surveying current plans, the adjustment looks broadly appropriate (see figures below). First, the size and degree of front-loading of the proposed adjustment clearly reflect the magnitude of the initial problem (Ireland, the United Kingdom) and the extent of market pressures (Ireland, Portugal, Spain). Second, expenditure plays a considerable role in the planned retrenchment, especially in countries under strong market pressure. That said, the credibility of the adjustment plans could be improved. Although a number of countries have already backed their adjustment plans by clearly identifying or already adopting measures beyond the very short term, others have yet to do so, leaving room for uncertainty about the actual size and nature of the adjustment.
Overall, fiscal consolidations currently planned or implemented in Europe are mostly in line with a few key features that the economic literature tends to associate with successful and growth-friendly fiscal adjustments.
Regional Adjustment of Primary Deficit/GDP 2013 over 2010
Adjustment of Primary Deficit/GDP 2013 over 2010
Sources: IMF, World Economic Outlook database; and IMF staff calculations.
Steps to Complete the European House
The financial crisis and sovereign debt troubles have revealed a number of gaps in the governing framework supporting financial markets—in the EU and the euro area. As envisaged by the EU’s architects, building the “European House” was to be a work in progress, with some parts to be completed faster than others. However, while the development of the single goods market built upon an appropriate structure of intensifying coordination and gradual centralization of competition policies, financial integration outpaced the development of a common financial stability framework.
Moreover, it has become clear that the institutional safeguards put in place to support the functioning of the common currency in the areas of fiscal and structural policy have been less than complete. The SGP, lacking both effective surveillance and enforcement, largely failed to deliver the kind of “good-times” fiscal discipline that would have lowered debt levels and secured fiscal space for when it was needed. Efforts to accelerate and coordinate structural reforms in labor, service, and product markets under the Lisbon agenda also fell short, so there was little improvement in the euro area’s ability to deal with intra-area imbalances in the absence of nominal exchange rate flexibility.
Policymakers have scrambled to make the most of the opportunity posed by the crisis to fill these gaps—but the momentum has differed across policy areas. The completion of the financial stability framework is clearly farthest advanced (Box 2). In contrast, the discussion on how to improve fiscal governance is ongoing and the least tangible progress is visible in the area of structural policies. There is widespread consensus, however, among policymakers and observers alike, that it will take a wholehearted effort along all three dimensions to sustain confidence in the recovery and the long-term success of European integration.
Completing the Push for European Supervision and Macroprudential Policies
In the most visible sign of progress along these lines, the forthcoming establishment of European Supervisory Authorities (ESAs) will bring long-desired tighter coordination of financial supervision within the EU and euro area. As the crisis amply demonstrated, financial risks travel quickly across European borders and markets, and the desire of national authorities to act alone can add to the uncertainty and confusion of financial markets in times of turbulence. While shortcomings in the financial stability framework remain—in particular in the area of crisis resolution—the new institutional arrangements constitute significant progress by providing a European platform for cross-border information sharing, rulemaking and implementation, and supervision.
The European Systemic Risk Board (ESRB), also set to be established in 2011, is another important step in that direction. The ESRB should provide essential coordination in crisis prevention across countries and markets, including by guiding preventive macroprudential policies to prevent the buildup of liquidity and credit risks. Given that the ESRB will operate with limited resources and without own policy tools, a key to its success will be access to information and effective interaction with other European and national policymakers. Given their joint European mandate, the ESRB will also profit from a strong coordinating role of the ESAs.
Strengthening Fiscal Governance
Fiscal governance reform is coming into focus amidst extensive discussion.1 The van Rompuy task force on economic governance installed by the European Council,2 the European Commission, and the ECB all have supported the necessary strengthening and widening of financial and nonfinancial sanctions to ensure compliance not only with the Excessive Deficit Procedure (EDP), but also with the requirements under the preventive arm of the SGP. More effective enforcement is crucial and should go along with sound economic judgment in the application of rules. An excellent example is the proposed extension of the EDP’s focus beyond formal compliance with the deficit ceiling on troublesome debt dynamics. There is also the notion of introducing or bolstering national fiscal rules conforming to EU targets as recently in Germany and under consideration in France and elsewhere. Finally, there is the welcome suggestion to equip the euro area with permanent crisis management capabilities, with current proposals leaning toward transforming the EFSF into a permanent scheme. But while the ECB has called for a “quantum leap” in reforms, the Commission and the task force prefer somewhat less ambitious approaches that could be implemented more quickly and securely within the existing EU treaty.
Box 2.Toward a More Integrated Financial Stability Framework for the EU
The EU’s new financial stability framework is taking shape. In recent months, final agreement has been reached on a more integrated supervisory framework, and the Commission has announced plans for greater harmonization and cooperation in the areas of crisis management and resolution, as well as deposit insurance. These are important steps toward the integrated financial stability framework that the EU’s single financial market needs.
The New Supervisory and Regulatory Framework
The EU’s new supranational supervisory and regulatory framework will formally be established on January 1, 2011. It comprises macroprudential and microprudential institutions, brought together in a European System of Financial Supervisors (ESFS), and new rule-making procedures. It offers the opportunity for a fundamental shift toward dealing with risks to financial stability at the EU level.
The ESFS’s macroprudential body is the European Systemic Risk Board (ESRB), which will be closely linked organizationally to the European Central Bank (ECB). The ESRB will not have binding powers but it will have a broad mandate to issue risk warnings and recommendations to European or national authorities. Follow-up will be sought through an “act or explain” rule and through the Economic and Financial Affairs Council (ECOFIN). The latter and the microprudential authorities will likely be the ESRB’s main counterparts.
The modus operandi of the ESRB still remains to be clarified. Ideally, its agenda should cover at least three broad areas of risk, namely those related to (i) the largest and most interconnected financial institutions; (ii) financial imbalances, such as credit-fueled asset bubbles, at the aggregate level and for particular countries or sectors; and (iii) changes in the structure and technology of the financial system.
The microprudential arm of the ESFS comprises the existing national supervisors, three new sectoral European Supervisory Authorities (ESAs), and a cross-sectoral Joint Committee.1 The ESAs will be charged with harmonizing supervisory practices, and will have binding powers to mediate and settle disputes between supervisors. Cross-border groups will be supervised by standardized colleges of national supervisors in which the ESAs will have an enabling role. Compared with the Level 3 committees under the Lamfalussy structure that they will replace, the ESAs will have increased resources, greater powers, and improved governance systems. Key challenges they will face include making judicious use of their binding powers, establishing a workable balance between these powers and the scope of the fiscal safeguard clause,2 achieving effective and harmonized oversight of cross-border groups through the colleges, building a systemwide esprit de corps, and ensuring that information flows freely within the system to all who are entitled to it. In this regard, a general review of the appropriate level of confidentiality of prudential data is warranted, given how a perceived lack of transparency has exacerbated the crisis in Europe.
The ESAs are expected to work toward establishing a single rulebook for the financial sector. To do so, they will be able to establish technical regulatory and implementing standards that will be given force of law by the Commission and that will be directly applicable in the member states. The work of the ESAs is expected to be complemented by efforts, led by the Commission, to achieve greater harmonization in existing and future legislation. This legislative work will be essential for the emergence of a true single rulebook, including because it will determine the extent to which the ESAs can establish technical standards. As in the past, many key elements of the rulebook will be based on international standards. Notably, “Basel 3” is expected to constitute the basis for the EU’s regulatory reforms in the banking sector.
Crisis Management and Resolution
Progress in crisis management and resolution is slower and more complex than on the supervisory front. The Commission’s approaches amount mainly to harmonizing and improving national systems, and leaving the question of integrated frameworks to be revisited in 2014 along with the planned review of the supervisory arrangements. However, the European Parliament is insisting on quicker and more substantial progress.
As outlined in a May 26 position paper,3 the Commission intends to seek the EU-wide introduction of harmonized early intervention tools, bank resolution regimes, national resolution funds, and deposit guarantee schemes. Harmonization would strengthen national regimes and improve their interoperability, but additional work toward a separate EU-wide regime for cross-border financial institutions is also urgent. Meanwhile, the European Parliament on July 7, 2010, adopted a resolution requesting the Commission to come up with a legislative proposal for an integrated framework by end-2010.4
IMF staff has argued for a European Resolution Authority (ERA) that is armed with the mandate and the tools to deal cost effectively with failing cross-border banks. This ERA should be supported by an industry-financed European Deposit Insurance and Resolution Fund (EDIRF) and a fiscal backstop. Given the fundamental reforms that would be needed to establish such a system, it is important that preparatory work start without delay and that the main parameters of the long-term system be established as early as possible.
On July 12, 2010, the Commission adopted a legislative proposal on deposit guarantee schemes (DGS).5 The basic thrusts of the proposal are harmonization of systems and coverage (at €100,000); standardized funding relying primarily on ex ante, risk-based contributions by banks; a mutual lending duty between systems; and an oversight role for the EBA. The Commission deferred making a decision on a pan-European scheme and wants to keep deposit insurance and resolution funds separate. It envisages DGS paying up to the level of the insured deposits in resolution cases. DGS would also be obliged to lend to each other when liquidity needs arise and have back-up liquidity arrangements in place. However, the draft directive does not have provisions for back-up solvency support and leaves the question of government responsibility for shortfalls open.Note: The main author of this box is Wim Fonteyne.1The three ESAs are the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA).2The fiscal safeguard clause states that the ESAs should make sure that their decisions do not impinge in any way on the fiscal responsibilities of Member States. The scope of this clause will likely be established by precedent, through Council decisions in particular cases.3Available at http://ec.europa.eu/internal_market/bank/docs/crisis-management/funds/com2010_254_en.pdf4Available at http://www.europarl.europa.eu/sides/getDoc.do?type=REPORT&reference=A7-2010-0213&language=ENmode=XML5Available at http://ec.europa.eu/internal_market/bank/docs/gurantee/comm._pdf_com_2010_0368_ proposition_de_directive_en.pdf
Either way, the reform of the fiscal framework will need to entail a shift of policy authority to the center. A stronger center would make surveillance more effective, which could help to detect problems early and align policies in a key area of common concern. The planned introduction of a “European semester” in 2011 is a useful step in that direction. This proposal includes intensified monitoring of medium-term budgetary strategies and policy advice from the Council and European Council (anchored by a Commission report) to national governments timed to influence the budgets for the following year. A stronger center could also help the enforcement of EDP and SGP rules. Here the Commission, as guardian of Europe’s treaties, could play a larger role in guiding the process, to provide a better balance with individual national interests, toward the more effective implementation of common fiscal rules. A larger role for the center could be supported by a larger central budget which would aim to provide, among other things, insurance against asymmetric country shocks through larger transfers and additional incentives for favorable economic and structural policies by giving strong performers enhanced access to EU funds. The resources for a larger central budget could come from higher VAT taxes, with the proceeds going to the center, or possibly from a tax on carbon emissions.
A Framework and Policies for Sustained and Balanced Growth
Accelerating structural reform policies and effectively coordinating them is clearly the greatest governance challenge facing EU and euro area policymakers. Some countries have moved ahead in the wake of the crisis. For example, Greece has recently passed substantive labor market reforms and is set to liberalize professional services and to lift regulatory barriers in tourism and retail, and Spain has taken important steps to improve the flexibility of its labor market.3 However, the overall track record is meager at best.4 The euro area’s collective commitment to structural reforms under the Lisbon agenda, relying on soft coordination and peer review, has produced disappointing results, in particular in the labor markets. As a result, potential growth remains too low in most countries and large differences in structural competitiveness persist, leading to differences in growth and unbalanced trade. Any strategy devised to finally overcome these problems will not only have to identify the most promising areas for reform, it will also have to address the governance problems that so far have stood in the way of implementing them.
Most EU and euro area countries could improve their structural characteristics along a number of dimensions compared with the U.S. benchmark (Figure 13), but comprehensive measures to improve market flexibility promise the most significant gains. For example, abolishing the privileges of protected professions in the services sector or remaining rigidities in product markets will have a stronger impact on employment when they are met by a flexible labor supply supported by adequate but not excessive employment protection (Figure 14).5 Portugal and (pre-reform) Greece and Spain remain among those with the highest potential to grow employment in this regard, reflecting their still fairly segmented and inflexible labor markets and limitations in the business environment (Box 3). But similar reforms could also profit a country such as Germany, where the service sector remains relatively small, being stifled by restrictions, high wage costs, and labor taxes.
Figure 13.Selected Countries: Structural Indicators
Source: Organization for Economic Co-operation and Development (OECD).
Note: Indicators are latest available.
1 Airlines, telecoms, electricity, gas, post, rail, and road freight.
Figure 14.Selected Countries: Product and Labor Regulation and Employment Growth Simulations
Sources: OECD; Berger and Danninger (2007); and IMF staff calculations.
Note: Lines connect different combinations of product and labor market regulation that generate the same level of employment growth based on an empirical model that also controls for various other factors, including fixed effects. The implied employment growth differences between countries are based on differences in product and labor market regulation alone. Country observation notes current regulatory levels.
1 Index ranges from 0 (lowest) to 6 (highest level of regulation).
The rewards of comprehensive reforms can be large: IMF (2010c) simulations suggest that the growth impact could be as high as ½ percentage point per year for the euro area over the 2011–15 period—no small number.
In addition to bolstering growth, more flexible markets could also help to reduce intra-euro area trade imbalances. The introduction of the common currency has shifted much of the burden of adjustment to trade shocks from the exchange rate to product and labor markets. Although market prices do react to changes in nonprice competitiveness, these adjustments can take a very long time. And indeed, there is evidence that bilateral trade imbalances (that is, the absolute size of deficits or surpluses) within the euro area have increased and become more persistent since the late 1990s, reaching levels last seen during the Bretton Woods period (Figure 15).
Figure 15.Trade Imbalance as Fraction of Total Bilateral Trade, 1948–2008
Sources: Berger and Nitsch (forthcoming); and IMF staff calculations.
But policymakers are not without choices. Imbalances tend to be smaller and less permanent among euro area countries characterized by more flexible labor and product markets, and countries with higher relative market flexibility often have lower trade deficits (Berger and Nitsch, forthcoming) (Figures 16A and 16B). Making labor markets more flexible, supported by complementary reforms such as improved portability of pensions and active labor market policies, could also serve to enhance labor mobility between countries, which will further ease the adjustment to shocks (Wasmer and Janiak, 2008).
Figure 16A.Euro Area: Bilateral Trade Deficits and Regulatory Differences in Employment Protection, 2003 Figure 16B.Euro Area: Bilateral Trade Deficits and Regulatory Differences in Product Market Regulation, 2005
Sources: OECD; and Berger and Nitsch (forthcoming).
1 Difference between OECD indices of trading partners. Indices range from 0 (lowest) to 6 (highest level of regulation).
Reforms will be most effective when coordinated across countries. Labor market reforms currently remain the prerogative of national governments. By contrast, many facets of product and service markets regulation are determined jointly at the EU level. Regional coordination could help the implementation of comprehensive reforms across markets.
Coordination is also key when it comes to ensuring the proper mix of structural and macroeconomic policies in the euro area. Structural policies that succeed in reducing differences in economic and—in particular—inflationary developments within the euro area will make the ECB’s monetary policy a better fit for all member countries (Figure 17). And the ECB will be more inclined to keep interest rates low and accommodate investment if comprehensive structural reforms take place everywhere in the euro area, promising higher aggregate productivity and lower inflation overall.6 And higher growth resulting from a well-coordinated reform effort will facilitate fiscal consolidation across the region. This strengthens the case for integrating fiscal and structural policy making at the EU level.
Figure 17.Selected Euro Area Countries: Taylor Rule Implied Rates and Actual Policy Rate, 1999:Q1–2009:Q4
Sources: IMF, World Economic Outlook database; and IMF staff calculations.
Note: Taylor rule implied rates use the same rule coefficients but different (weighted) rates of inflation and output gaps.
1 Greece, Ireland, Portugal, and Spain.
2 Other euro area countries except Cyprus, Malta, and the Slovak Republic.
Box 3.Why Is Economic Growth Lagging in Europe and What Can Be Done About It?
Convergence of European GDP per capita toward U.S. levels stopped in the early 1980s, leaving a persistent level gap of close to 30 percent (figure at right). Convergence of output per capita levels was swift during the postwar period, driven by catch-up growth, technology assimilation, product standardization, trade liberalization, and economies of scale. However, the process of convergence slowed markedly and even reversed somewhat after the 1970s.
Lower per capita income in the euro area reflects, to different degrees, lower labor utilization and to a lesser extent lower hourly productivity. The reason for the shortfall in GDP per capita vis-à-vis the United States differs markedly across the euro area (second figure). For Germany and France, and some smaller euro area countries, the shortfall is mostly due to lower labor market utilization. Hourly productivity in these two countries is similar or even slightly higher than in the United States. For southern European countries, however, productivity is relatively worse than in the United States in addition to labor utilization being lower.
Although differences in hours worked could reflect preferences, reducing unemployment and raising labor participation would significantly reduce the income gap with the United States. Lower labor utilization not only reflects that people work fewer hours but also that unemployment is higher and participation weaker (and this is not necessarily by choice). As can be seen from the second figure, improving employment and labor market participation could close the GDP per capita gap with the United States by about 10 percentage points.
Euro Area’s per Capita GDP Level (percent of U.S. level), 1960–2008
Source: AMECO database; European Commission; and IMF staff calculations.
Differential in the GDP Per Capita, 2000–08
Source: European Commission.
Differential in Labor Utilization, 2000–08
Addressing the euro area’s reform gaps would help to close the GDP gap (table). All but a few euro area countries exhibit severe labor market rigidities compared with their advanced economy peers, including the United States. Binding regulations for businesses and in the services sectors are also prevalent across the euro area while southern countries are lagging in terms of human capital, institutions and contracts, a result that is consistent with the productivity gap in the subregion underscored earlier. Moreover, once the core euro area countries achieve higher labor utilization and solve productivity issues, they will also need to deal with impediments to long-term growth and promote innovation.
|Core Euro Area||Southern Euro Area||Other Euro Area||Selected Comparators|
|Germany||France||Netherlands||Belgium||Italy||Spain||Portugal||Greece||Austria||Finland||Ireland||Denmark||Sweden||United Kingdom||United Stats||Japan|
|Labor market inefficiency|
|Retail sector regulation|
|Professional services regulation|
|Institutions and contracts|
To live up to its growth potential and ensure viability of its social model, the euro area must provide more jobs, with higher productivity. Complementary labor and services sector reforms will boost investment and growth. Initially, demand-friendly measures should include increasing the incentives to hire by lowering the tax burden on labor, stimulating employment of vulnerable categories, and freeing up retail trade, network industries, and the professional services sector. A successful reform package would combine (i) a shift from labor to VAT taxes, (ii) a reduction in the level and duration of unemployment benefits and in early and old-age retirement schemes, and (iii) a reduction in entry barriers in network services (gas, electricity, telecoms), retail distribution, and professional services. In addition, fixing the financial system will be essential to avoid a credit crunch that would stifle economic recovery. For the longer term, focus should be on innovation and education, as well as on continuing financial sector reforms.Note: The main author of this box is Boriana Yontcheva. See IMF (forthcoming) for details.
Realizing these gains will require a well-functioning structural governance framework. Taking a cue from the failure of the Lisbon agenda, any such framework should give a larger role to central EU institutions, provide for more effective surveillance, and include stronger reform incentives for national governments than in the past. Among the approaches floated by the European Commission, Council, and ECB, which all broadly follow these guidelines, is the proposal for an alarm system based on the timely surveillance of macroeconomic and competitiveness indicators. This alarm system would trigger the issuance of country-specific policy recommendations by the Commission and be backed by the EU budget. Under such a system, EU funds could perhaps be withheld from offenders or redirected to support structural reform efforts. Moreover, more explicitly integrating structural with fiscal surveillance in terms of timing (both should take place during the “European semester”) and calibration (SGP and EDP already allow taking into account the costs of structural reforms) would boost visibility and generate better outcomes overall.
Finally, similar to the area of fiscal policy, closing the structural governance gap will require governments to internalize the structural reform agenda at the national level. This should include the development of sufficiently ambitious and country-specific reform agendas. There should also be a public commitment to see them through, perhaps underlined by the establishment of independent commissions to monitor progress.
Completing the European House may not be easy, but it must and can be done. The two years that have elapsed since the collapse of Lehman Brothers have not only shown just how essential the improvement of governance will be for the long-term success of European economic and monetary integration, but have also demonstrated that policymakers can act boldly when necessary. And now is the time to apply the same energy and determination to complete the EU’s and the euro area’s governance system. This will take a very determined effort. The political economy of the necessary reforms is complicated, with privileged households and firms pondering the consequences of coordinated structural reforms, national parliaments ambivalent about more intrusive fiscal surveillance at the EU level, and governments wary of a more assertive role for the European Commission. But closing the remaining governance gaps promises large benefits for the EU and beyond. With the memory of the crisis still fresh, policymakers should seize the moment and act boldly.
IMF, 2010b (Chapter 2) provides further details.
The European Council comprises the heads of government and state, along with its President and the President of the European Commission.
Among other things, Greece has reduced severance costs for white-collar workers and increased considerably the threshold for activating rules for collective dismissals. See Jaumotte (forthcoming) for a discussion of Spain.
This is easily illustrated in Figure 14: for any country or starting combination of labor and product market flexibility, a simultaneous reform (moving straight north-east) will increase employment growth faster—that is, reach the next higher level of employment growth faster—than a partial reform (moving either east or north). Note that the indicators shown in the figure are the latest available and do not incorporate the most recent or planned regulatory reforms.