Euro Area Policies: Selected Issues

Abstract

Euro Area Policies: Selected Issues

Risks from Low Growth and Inflation in the Euro Area1

This paper discusses the risks of low growth and inflation over the medium term for the euro area. It examines the consequences of longer-term trends that predate the crisis and the progress made in addressing the crisis legacies of high unemployment and debt. The paper illustrates, in a downside scenario, how low potential growth and crisis legacies leave the euro area vulnerable to the risks of stagnation.

A. Motivation

1. Since the global financial crisis, growth in output per capita in the euro area has stalled and the gap with the United States has widened. For the major advanced economies, per-capita growth rates have fallen well below their pre-crisis levels (Figure 1). The decline has been particularly severe for the euro area where output per capita in 2014 was at the same level as in the early 2000s. In PPP terms, nominal GDP per capita in the euro area is now about $16,000 below that in the United States, the highest gap since the start of EMU (see text charts).

Figure 1.
Figure 1.

Actual and Pre-crisis Trend Output

(1991=100)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: WEO; and IMF staff calculations.
A01ufig1
Sources: World Economic Outlook; and IMF staff calculations.

2. Euro area growth started to decline in the early 2000s. Recent IMF research (IMF, 2015a) points to potential growth having already slowed in the advanced economies well before the global financial crisis, due mainly to declining total factor productivity (TFP) growth. Studies also suggest that potential growth is likely to increase only slightly and remain below pre-crisis levels in the medium term, due to aging and slow progress in addressing crisis legacies. Indeed, potential output estimates for the major advanced economies have been revised down dramatically since the onset of the crisis (Figure 2, text chart).

Figure 2.
Figure 2.

Actual and Potential Output

(2007=100)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: WEO; and IMF staff calculations.

3. Low potential growth raises the risks of stagnation. This is of particular concern given the high levels of unemployment and public and private indebtedness, as well as limited policy space in many countries. A prolonged period of low growth and inflation could exacerbate these weaknesses, leaving the euro area vulnerable to shocks. This paper examines the risks of stagnation for the euro area. Specifically, it asks the following questions: (i) what have been the main drivers of the slowdown in output per capita? (ii) how much progress has been made in addressing the crisis legacies of high unemployment and debt? and (iii) how vulnerable is the euro area to a prolonged slowdown?

A01ufig2

Euro Area: Potential GDP Growth

(percent change)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: World Economic Outlook; and IMF staff estimates.

B. Output per Capita: Diagnosis and Prospects

4. Output per capita can be decomposed into: (i) labor input per capita; (ii) capital per capita; and (iii) total factor productivity.2

Labor

5. The contribution of labor to per-capita growth turned negative during the crisis. Before the crisis, the euro area benefited from increasing labor force participation and declining unemployment, which more than offset the shrinking working age population (as a share of total population) (see charts). During the crisis, labor force participation continued to increase but at a slower pace, while the working age population grew more slowly than total population. All of these factors, combined with higher unemployment, led to a decline in total labor inputs for the euro area (Figure 3). Similarly, in the United States and Japan labor inputs also fell during the crisis, but for different reasons. In the United States, the decline in labor force participation was a major driver, while in Japan labor inputs declined due mainly to the shrinking working age population (as a share of total population).

Figure 3.
Figure 3.

Contribution to Growth in Hours Worked per Capita

(annualized average, percentage point)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: European Commission AMECO; and IMF staff calculations.
A01ufig4

Working Age Population

(percent of total population)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: AMECO; and IMF staff calculations.
A01ufig5

Labor Force Participation

(percent of working age population)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

6. Aging is expected to hold employment growth below pre-crisis levels. Working age population growth is likely to decline significantly in most advanced economies, particularly in Germany and Japan, where it will fall to -0.2 percent annually by 2020 (see chart).3 Aging will also reduce labor participation rates, offsetting the positive contribution of population growth to overall labor supply. The net effect is little expansion in the labor force over the medium term, compared to growth of about ¼ percent during crisis and ¾ percent during 2002–07 (IMF, 2015a). Raising employment growth above the pre-crisis levels can then be achieved only through a significant reduction in structural unemployment (see Section C).

A01ufig6

Working Age Population

(1950=100)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: United Nations; and IMF staff estimates.

Capital

7. The slowdown in capital accumulation accelerated during the crisis. While the United States saw a larger decline in capital accumulation during the global financial crisis, investment has since picked up while in the euro area it continues to decline. The decline was particularly sharp in countries such as Greece and Italy (see charts).

A01ufig7

Capital per Capita

(log change, percent)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: AMECO; WEO; and IMF staff calculations.
A01ufig8

Private Non-Residential Investment Recovery to Date: 2015Q1

(2007 quarterly average=100)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: Eurostat; and IMF staff calculations.

8. Capital accumulation is likely to remain below pre-crisis levels over the medium term. The ratio of investment-to-capital (I/K) has fallen significantly since the onset of the crisis, reflecting the weak economic recovery (see chart). This decline is broadly in line with experience from past financial crises, which suggests the I/K and hence capital stock growth will remain below pre-crisis levels for some time (IMF, 2015a). Country circumstances vary, but even for the United States where capital per capita growth has recovered partially, a complete recovery is likely to take a decade or more (Hall, 2014).

A01ufig9

Investment-to-Capital Ratio

(percentage points; years on x-axis)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: IMF (2015a) based on Laeven and Valencia (2014); euro area data from AMECO; and IMF staff calculations.

Total factor productivity

9. Labor productivity began to slow before the crisis, due to declining TFP growth. Labor productivity in the euro area (measured as output per hour worked) had grown steadily faster than in the United States until the mid-1990s, which helped narrow the productivity gap. Since the mid-1990s, the patterns of productivity growth between these two blocks changed dramatically as euro area productivity growth fell consistently below that of the United States until the onset of the crisis. As a result, the labor productivity gap between the euro area and the United States started widening again in the early 2000s. Empirical studies suggest that the widening gap between the euro area and the United States is driven mainly by slower TFP growth (see, e.g., van Ark and others, 2008). Indeed, within the euro area, TFP growth has slowed across most economies, and has been negative for Italy since the early 2000s and for Greece and a few other countries during the crisis (see charts).

A01ufig9a
Sources: The Conference Board Total Economy Database, January 2014; and IMF staff calculations.1 Based on 14 countries in the euro area, due to data availability.
A01ufig10
Sources: European Commission AMECO; and IMF staff calculations.

10. Service sector productivity has led the decline. Lower productivity growth in service sectors, especially due to slower adoption and diffusion of information and communications technology (ICT), is found to be an important factor in explaining the slowdown in TFP growth in Europe since the mid-1990s (van Ark and others, 2008; Dabla-Norris and others, 2015). Reversing the productivity slowdown in service sectors is therefore essential to raising TFP growth. However, unlike the United States where service sector productivity has picked up and surpassed its pre-crisis peak, it is growing only very gradually in the euro area and remains well below its pre-crisis peak in countries such as Germany and Italy (see chart).

11. Looking forward, overall productivity growth in the euro area is likely to remain weak. First, TFP growth in the United States is likely to slow as growth in ICT-producing sectors already started to decline prior to the crisis (Fernald, 2014), leading some to conclude that the productivity frontier is likely to expand less quickly (Gordon, 2012). This slowdown in expansion of the productivity frontier in the United States is likely to spill over to the rest of the world (IMF, 2015a). Second, although convergence is still possible, adopting and promoting innovations requires flexibility and adaptability, and the slow progress in addressing structural gaps in the euro area may delay the diffusion of technology.

12. To sum up, potential growth in the euro area is expected to be subdued, rising only slightly from 0.7 percent during 2008–14 to about 1.1 percent during 2015–20, significantly lower than the 1999–2007 average of 1.9 percent. In addition to low potential growth; the slow progress in addressing crisis legacies is also likely to weigh on aggregate demand.

A01ufig11

Service Sector Productivity

(2008 = 100)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: Eurostat; national statistics offices; Bureau of Labor Statistics; and IMF staff calculations.Note: Euro area service sector covers travel, trade, accommodation & food, information & communication, finance and insurance, real estate, professional, science & technology; and for the United States trade, transportation & warehousing, information, finance, insurance, real estate, rental and leasing.

C. Crisis Legacies: Progress and Prospects

High unemployment

13. The euro area unemployment rate remains high, especially for youth and the long-term jobless, raising the risks of hysteresis. Despite recent improvements, the unemployment rate remains above 11 percent in the euro area, and near 25 percent in Greece and Spain (see charts). The share of long-term unemployed continues to increase, raising the risks of skill erosion and entrenched high unemployment. High youth unemployment could also damage potential human capital, and give rise to a “lost generation.” While weak demand plays a major role, more spending on active labor market policies would help increase employment opportunities, especially for the young (Banerji and others, 2014).

A01ufig12
Sources: Eurostat; and IMF staff calculations.

14. High unemployment is likely to persist for some time. Looking at some key euro area countries, the natural rate of unemployment (non-accelerating inflation rate of unemployment or NAIRU) is projected to remain higher than during the crisis in Italy, and at the crisis level in France over the medium term (WEO database, April 2015). While the NAIRU is expected to decline significantly from unprecedented levels in Spain, it would still remain above 15 percent over the medium term. Based on historical Okun’s law relationships, staff estimates suggest that, without a significant pick-up in growth, it would take Spain nearly 10 years, and Portugal and Italy nearly 20 years, to reduce the unemployment rate to pre-crisis levels (see chart).

A01ufig13

Reducing Unemployment

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: WEO; and IMF staff calculations.Note: Okun’s coefficient based on Ball and others (2014) is 0.9, 0.4, 0.3, and 0.3 for Spain, France, Italy, and Portugal, respectively. Total cumulative growth needed is calculated as the total reduction in the unemployment rate needed to reach the 2001–07 average rate divided by the country-specific Okun’s coefficient. The number of years needed is then calculated as the total cumulative growth needed divided by the average growth rate over 2015–19 in the WEO baseline.

High debt

15. Deleveraging is holding back spending. Private sector deleveraging is underway, with corporate debt-to-equity ratios falling in most euro area countries, supported by a continuous build-up in financial surpluses to pay down debt (see charts). Spain and Ireland stand out among the countries that have gone through a relatively strong reduction in non-financial corporate (NFC) debt-to-GDP ratios. In the case of Spain, the NFCs’ debt reduction of nearly 20 percentage points from the peak has been driven mainly by declining corporate borrowing and debt repayment through asset sales (IMF, 2015b). The adjustment in net lending flows was accompanied by a fall in investment, a sharp increase in savings, and a significant reduction in employment (see chart; Murphy, 2014).4 A recent study by the European Commission (Pontuch, 2014) also finds that the fall in corporate and household debt-to-GDP ratios has been increasingly driven by negative credit flows with adverse knock-on effects on economic activity.

A01ufig14

NFC Debt/Equity Ratio

(percent)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: Haver Analytics; and IMF staff calculations.Note: Non-consolidated; debt defined as loans and debt securities excluding financial derivatives.
A01ufig15

Non-Financial Corporate and Househod Financial Surplus

(percent of GDP)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: ECB; Eurostat; and IMF staff calculations.
A01ufig16

Spain: Gross Operating Surplus of NFCs

(percent of GVA)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: Haver Analytics; and IMF staff calculations.Note: Non-consolidated; debt defined as loans and debt securities excluding financial derivatives.
A01ufig17

Non-Financial Corporate Deleveraging Episodes

(Corporate debt1/, percent of GDP)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: updated from Bornhorst and Ruiz-Arranz (2013).1 Non-consolidated; ESA2010 for euro area countries.2 Historic episodes: JP 89–97, UK 90–96, AU 88–96, FI 93–96, NO 00–05, SE 01–04.

16. The pressures for further corporate deleveraging will likely remain high in a number of countries. IMF research (Bornhorst and Ruiz-Arranz, 2013) finds that, based on past episodes of significant corporate deleveraging, on average two-thirds of the increase in debt is subsequently reduced. If current deleveraging in the euro area follows a similar path, it would imply still sizable deleveraging needs for firms in a number of countries, and a significant headwind for investment recovery (see chart).5 Barkbu and others (2015) find that in addition to weak demand, expectations of low future growth and continued deleveraging also contributed to the investment decline during the crisis. On the other hand, in countries where the recovery has been relatively firm (such as Spain), more deleveraging will be facilitated by increases in nominal output, reducing the burden on spending.

17. Following a large housing boom-bust cycle, households in some countries also suffer from high debt. After five to seven years of adjustment, housing prices seem to be nearing a trough, similar to past episodes of house price declines (IMF, 2015c). However, domestic demand has been much weaker in the current episode than in the past. This is possibly due to higher household debt both at the peak and a large increase in debt during the boom (IMF, 2015b). Although household debt-to-GDP ratios have come down by 10–20 percentage points in countries with high household debt, they remain significantly above their pre-boom levels, raising the risks that the debt overhang will continue to weign on spending for some time (see charts).

A01ufig18

Real Interest Rate and Total Net Debt, Dec. 2014

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: Eurostat; and IMF staff calculations.

D. An Illustrative Downside Scenario6

18. Notwithstanding the cyclical upturn and positive impact of past structural reforms, staff projects subdued growth and inflation over the medium term. This baseline reflects the impact of long-standing structural weaknesses that lower potential growth, as well as high unemployment, heavy real debt burdens, and weak balance sheets that continue to suppress demand. These factors are also intertwined: lower potential growth makes it harder to reduce debt, while high unemployment and low investment due to the debt overhang delay capital accumulation, lowering potential growth.

19. This leaves the euro area susceptible to negative shocks, which combined with limited policy space, could push the economy into stagnation. In particular, shocks that dampen confidence about future prospects for a solid recovery could push the economy into a bad equilibrium of prolonged low growth and inflation. In such a situation, policy space in the euro area is limited, apart from unconventional monetary policy. The policy rate cannot be lowered further below zero (Bullard, 2013). And fiscal policy is constrained to provide stimulus to raise inflation rate. Without these tools, a negative shock could push the euro area into a self-reinforcing low growth-low inflation equilibrium similar to Japan’s situation (see chart).

20. Unaddressed crisis legacies could amplify shocks through various channels. For instance, markets could take a disproportionately negative view of countries with higher debt, leading to greater increases in borrowing costs and raising the chance of a debt-deflation spiral. Low inflation could also hinder the unwinding of external imbalances in countries with a large output gap by making it harder for real prices and wages to fall or by forcing countries to adjust through painful cuts in nominal wages, prices and/or employment.

A01ufig20

Inflation and Interest Rates

(2002–2014)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: Bloomberg; and Haver Analytics.Note: Nominal interest rates are overnight EONIA for the euro area; the overnight call rate for Japan; federal funds rate for the United States; and SONIA for the United Kingdom.

21. To highlight some of these channels, two illustrative simulations are considered. In these scenarios, unconventional monetary policy is assumed to have reached its limit. Instead, the policy responses rely only on conventional monetary policy and fiscal policy. However, due to the zero lower bound and limited fiscal space, in response to shocks monetary policy cannot be eased further and fiscal policy cannot provide stimulus beyond the operation of automatic stabilizers. The simulations were conducted using the Flexible System of Global Models (FSGM) in coordination with the IMF’s Research Department.7 Simulation outcomes are measured against the April 2015 WEO baseline. In this baseline, growth is projected to rise from 1.5 percent this year to 1.6 percent next year, and stay at this level throughout the medium term. Given the still large output gap (-2.3 percent of potential GDP), inflation is expected to remain low, close to zero this year, before rising to one percent next year and to 1.7 percent over the medium term. The output gap is expected to close around 2020.

A01ufig21

Euro Area Investment Growth

(percent change)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: WEO; and IMF staff estimates.

22. Model simulations first consider a shock to real private sector investment. Such a shock could be triggered by a sudden drop in investor confidence (for instance, due to the intensification of geopolitical tensions, or lower expected future output) that reduces equity prices and private investment demand so that the euro area countries’ investment growth is cut by one-fourth relative to baseline projections—equivalent to a half-percentage-point reduction per year or three percent cumulatively over the medium term (about half of the decline in euro area business investment during 2007–14.)

23. The investment shock would lower output by around 1¼ percent below the baseline by 2020 (Figure 4). The declines in output are broadly similar across all euro area countries, except for Greece and Ireland where the drop in investment growth is significantly greater compared to the baseline. The impulse from lower investment growth to aggregate demand comes from the traditional knock-on effect to households via labor income and wealth effects. In response, inflation expectations and inflation fall, and financial conditions tighten, with real corporate interest rates higher by 65 basis points in 2020. In addition, weaker domestic demand depresses imports, while higher real interest rates lower competitiveness. On balance, the current account improves by 0.4 percentage points of GDP by 2020. The output gap would widen by nearly one percentage point, as potential growth is reduced slightly due to slower investment growth and capital stock accumulation.

Figure 4.
Figure 4.

Simulation Results: Investment Shock 12

(deviation from baseline3)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: and IMF staff estimates.1 Core countries: Austria, Belgium Finland, Germany, France, and Netherlands; High debt countries: Greece, Ireland, Italy, Portugal, and Spain.2 Investment shock: Private investment is cut by one-fourth of baseline average growth of total investment during 2015–19.3 In percentage points, unless noted otherwise.4 In percent.
A01ufig22

Simulation Results: Public Debt/GDP

(deviation from April 2015 WEO, percentage points)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Source: IMF staff estimates.

24. The public debt-to-GDP ratio would rise (by 4½ percentage points) reflecting larger overall deficits and lower nominal output. The increase varies across countries, with highly indebted countries seeing larger increases: Greece (+12 percentage points), Italy (+5½), Portugal (+5¾) and Spain (+5¼). The more the public debt ratio increases, the greater are market concerns about debt sustainability. The model thus adds a second shock—an increase of 100 basis points in sovereign and corporate risk premia to capture the impact of high levels of debt in Greece, Italy, Ireland, Portugal, and Spain. As a benchmark, this magnitude is similar to the increase in Spanish 10-year sovereign bond yields during late June-July of 2012.

25. With an additional risk premium shock, the output loss would increase to nearly two percent by 2020, compared to the baseline (Figure 5, Table 1, text chart). The output gap would widen by around 1¼ percentage points by 2020 and it would take an additional three to four years to close, compared to the baseline. With no policy response, negative shocks would push the euro area back into recession. The key results are:

Figure 5.
Figure 5.

Simulation Results: Investment and Risk Premium Shock 12

(deviation from baseline3)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Sources: and IMF staff estimates.1 Core countries: Austria, Belgium Finland, Germany, France, and Netherlands; High debt countries: Greece, Ireland, Italy, Portugal, and Spain.2 Investment shock: Private investment is cut by one-fourth of baseline average growth of total investment during 2015–19; Risk premium shock: sovereign and corporate risk premium increases by 100 basis points in Greece, Ireland, Italy, Portugal and Spain.3 In percentage points, unless noted otherwise.4 In percent.
Table 1.

Results From An Illustrative Downside Scenario1

article image
Sources: IMF staff estimates.

Percent deviation from the April 2015 WEO baseline for 2020, unless noted otherwise.

Percentage point deviation from the April 2015 WEO baseline for 2020.

Measured by percent changes in REER relative to the April 2015 WEO baseline for 2020, where negative indicates real depreciation.

Note: This scenario contains two. Investment shock: Private investment is cut by one-fourth of baseline average growth of total investment during 2015–19; Risk premium shock: sovereign and corporate risk premium increases by 100 basis points in Greece, Ireland, Italy, Portugal and Spain.
A01ufig23

Simulation Results: Impact on GDP

(by 2020, deviation from baseline, percent)

Citation: IMF Staff Country Reports 2015, 205; 10.5089/9781513523088.002.A001

Source: IMF staff estimates.
  • Financial fragmentation. While the risk premium in highly indebted countries is raised by 100 basis points by design with this shock, the real corporate interest rate would increase by 200 basis points in these countries, reflecting lower inflation.

  • Unemployment. The unemployment rate would be higher by 0.6–1.2 percentage points. This is likely a lower-bound estimate as the model does not fully incorporate nominal wage rigidities. Nominal wage inflation is expected to decline by around 1.5 percentage points for the euro area with some cross-country variations. If nominal wage rigidities are fully present, employment would have to adjust more in countries with modest baseline wage growth.

  • Public debt dynamics. The public debt-to-GDP ratio would also rise more in these countries (Greece: +17 percentage points; Italy and Portugal: +9; Spain: +8), due to larger declines in the fiscal balance and nominal GDP, compared to an average increase of 5¼ percentage points in the core countries.

  • Bad rebalancing. Current account balances would improve in both surplus and deficit countries, with increases of around 0.7 percentage points in Germany and the Netherlands, and 2 and 0.7 percentage points in Greece and Portugal, respectively.

26. Both scenarios highlight the potential for moderate shocks to push the euro area into a bad low growth-inflation equilibrium. In addition to lower output, inflation would also fall close to zero through the medium term, as a result of the wider output gap. Low inflation could lead to debt-deflation dynamics. While not fully captured by the scenarios in this paper, debt-deflation-like dynamics could occur in countries with high public or private debt levels. This would further depress demand because low inflation or deflation redistributes wealth from debtors to creditors, pushing down the economy-wide propensity to consume. It would also delay the much-needed recovery in business investment and capital stock accumulation which in turn lowers potential growth, and generate a feedback loop that lowers expected future growth (see, e.g., Barkbu and others, 2015; Kalemli-Ozcan and others, 2015).

27. Low inflation would reverse rebalancing within the euro area. Model results suggest that current account balances would improve in response to these shocks, but the improvement would reflect mainly import compression. Moreover, low inflation for the euro area as a whole would require deflation for the countries that need to achieve relative price adjustment and redress their loss of competiveness against the surplus countries. Combined with downward nominal wage rigidities, this would imply more labor shedding, adding to an already severe high unemployment problem. Downward nominal wage rigidities and the feedback loop of low inflation are not directly built in the scenarios, suggesting the impact on output would likely be worse.

E. Concluding Remarks

28. The weak medium-term prospect and limited policy space leave the euro area vulnerable to shocks that could lead to a prolonged period of low growth and inflation. Model simulations suggest that a modest shock to investor confidence could push up risk premia and real interest rates, as policy space is constrained at the zero lower bound and fiscal policy space to provide stimulus is limited. Moreover, the lingering crisis legacies of high debt and unemployment could amplify the original shocks, creating a bad feedback loop and keeping the economy stuck in an equilibrium of stagnation.

29. Insuring against the risks of stagnation would require addressing both longer-term structural issues and crisis legacies. This suggests continued monetary accommodation to lift demand and inflation expectations, while strengthening bank and corporate balance sheets to enhance the effectiveness of monetary transmission. To permanently raise productivity, reforms should aim to address structural gaps in labor, product, and capital markets. To mitigate the impact of aging, policies should look to raise labor participation.

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1

Prepared by Huidan Lin (EUR), with contributions from Benjamin Hunt, Susanna Mursula (both RES) and research support from Jesse Siminitz (EUR).

2

A decomposition along a Cobb-Douglas specification of the output per capita would be Y/N = A(K/N)α(L/N)1–α, where Y, N, A, K, L, α are output, population, TFP, capital stock, labor input (in hours), and labor share, respectively.

3

In the case of Germany, this decline could be partly offset by continued net immigration (IMF, 2015a).

4

The deleveraging process of NFCs has been uneven within the economy. Debt reductions have been more intense in the construction/real estate sector than in other sectors, and by SMEs rather than by large firms. More generally, the decline in debt, investment, and employment has been (appropriately) more acute in those sectors that were more leveraged before the crisis (Mendez and Menendez, 2013).

5

For instance, if two-thirds of the accumulated debt were to be reduced, it would imply a further reduction of nine percentage points of GDP for the euro area as a whole.

6

Simulations are provided by B. Hunt and S. Mursula (both RES).

7

FSGM comprises three core models (G20MOD, EUROMOD, and EMERGMOD), each of which captures the global economy. FSGM is semi-structural with a single good, but private consumption and investment are structural (micro-founded); trade, labor supply and inflation are reduced form representations; supply is determined by an aggregate Cobb-Douglas production function; and monetary and fiscal policies are endogenously set with simple rules (Andrle and others, 2015).

Euro Area Policies: Selected Issues
Author: International Monetary Fund. European Dept.