Euro Area Policies: Selected Issues

Abstract

Euro Area Policies: Selected Issues

Comprehensive, More Balanced Policies to Strengthen the Euro Area1

A. Context and Motivation

1. Despite the strengthening recovery, the medium-term outlook for the euro area remains subdued. Growth is forecast at only a little over 1½ percent for the next five years and inflation at just 1.7 percent in 2021, with public debt and unemployment remaining at high levels for some time. Current accounts have improved for many countries, but external imbalances within the euro area remain sizeable and the growing surpluses of the large creditor countries are contributing to global imbalances. Slow progress in addressing crisis legacies combined with low inflation and growth leave the euro area vulnerable to shocks and risk of stagnation. The policy mix so far has relied heavily on monetary easing while policy buffers at the country level are limited, reflecting the large buildup of public debt in some countries.

2. A more balanced and comprehensive approach to strengthen growth can capitalize on important synergies. Combining continued ECB support, use of available fiscal space, centralized investment, balance sheet cleanup, and vigorous implementation of product and labor market reforms would have several benefits:

  • Faster closing of the output gap. Greater demand support to close the output gap more quickly would raise overall euro area inflation and reduce real interest rates across the zone. Lower real interest rates would give a boost to investment and facilitate deleveraging. Faster cleanup of banks’ balance sheets would enhance the effectiveness of monetary policy by lowering borrowing costs and encouraging investment.

  • Higher multipliers near the zero lower bound. Fiscal support that boosts private investment can be especially effective at or near the zero lower bound where crowding out effects are smaller (Blanchard, Erceg, and Lindé 2016 and others).2 Lower real interest rates from greater demand support can also lead to a temporary boost in competitiveness, although real exchange rate effects should unwind over time as inflation and real interest rates pick up.

  • Better targeting of fiscal support. Fiscal space within the euro area is limited and unevenly distributed such that countries most in need are generally constrained by high levels of debt. Countries with fiscal space could use it, but benefits for the broader euro area will depend mainly on spillovers. Compared to national fiscal policy, centralized investment schemes can help overcome fiscal space constraints and also provide more targeted demand support to countries with large output gaps while mitigating the impact on country debt burdens. This would also help reduce debt burdens and rebuild fiscal buffers.

  • Higher potential growth. Structural reforms would boost longer-term potential growth and reduce unemployment. They also can have near-term demand benefits as higher productivity and expectations of stronger future growth bring forward investment. This would also support monetary policy in closing the output gap more quickly.

  • Positive external spillovers. Stronger domestic demand in the euro area would generate positive spillovers globally both for growth and inflation.

3. Objective. This paper uses model-based analysis to examine the potential benefits of a more balanced, comprehensive policy strategy. The paper also considers how such a comprehensive approach could be effective in countering a prolonged stagnation scenario of low growth and inflation.

B. Simulation of More Balanced, Comprehensive Policies

4. EUROMOD simulations. To examine the possible impact of a more balanced and comprehensive approach, the EUROMOD component of the IMF’s Flexible System of Global Models (FSGM) to illustrate several policy scenarios is used.3 The simulations use the April 2016 World Economic Outlook (WEO) projections through 2021 as a baseline. The analysis focuses on the euro area and the largest euro area members states (Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Spain, the Netherlands, and Portugal), as well as the impact on the rest of the world.4

5. A more balanced and comprehensive strategy would include:

  • a) Monetary policy is assumed to reflect current ECB policy measures. The policy rate is maintained at the current low level through 2021 and asset purchases under quantitative easing (QE) continue through March 2017.5

  • b) Use of available fiscal space and flexibility under the SGP framework. This assumes a fiscal expansion of about 0.2 percent of euro area GDP annually in 2017–2018 with slightly more of the stimulus in the second year, for a total of 0.4 percent relative to the April 2016 WEO.

    • Fiscal space. Germany uses its fiscal space to increase spending on public investment, transfers, and to a lesser extent, government consumption by 0.6 percent of national GDP during 2017–18 (equivalent to 0.2 percent of euro area GDP).

    • Use of SGP flexibility. A fiscal relaxation of 0.5 percent of national GDP to cover the cost of structural reforms or investment is assumed over 2017–18 (0.25 percent of national GDP each year) except for countries under the Excessive Deficit Procedure (EDP) and Italy which has already utilized fully such flexibility.6 This would amount to 0.2 percent of euro area GDP.

  • c) Implementation of centralized investment through the European Fund for Strategic Investment (EFSI) would result in additional private investment of 0.2 percent of euro area GDP each year for 2017-2021. The total amount is assumed to be distributed across member countries proportional to the size of their economies and is assumed not to affect national public debt, consistent with the design of the EFSI, which would use public guarantees to catalyze private investment.

  • d) Strengthening bank and corporate balance sheets. Reducing the stock of non-performing loans would gradually lower corporate borrowing costs, by 4 to 6 basis points in different member states in 2017 with declines becoming larger over time and eventually reaching 22-30 basis points in 2021.7

  • e) Structural reforms. Product and labor market reforms outlined in the 2014 G20 Comprehensive Growth Strategy would be implemented gradually. These would raise the level of total factor productivity (TFP) for the euro area relative to the baseline by about 0.1 percent in 2018 and by 0.8 percent in 2021. TFP increases would vary across countries, with France, Italy, and Spain enjoying the largest gains.

6. The growth and inflation benefits of a more balanced policy strategy are substantial. Real growth for the euro area would increase by an average of more than 0.4 percentage point per year to average 2.0 percent over 2017-21, compared to only a little above 1½ percent in the baseline. Headline inflation would pick up over time and, on average, would be about 0.5 percentage point higher over 2017–21. In 2019 inflation would be slightly below 2 percent—consistent with the ECB’s objective of close to but below 2 percent—compared to a baseline forecast of only 1.7 percent by 2021 (chart).

A05ufig1

Real GDP Growth in Euro Area

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig2

Headline Inflation in Euro Area

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

7. Stronger growth would help output reach potential earlier. While the output gap would turn positive in the baseline only in 2021, implementation of comprehensive policies would more than close the output gap by 2019, when it would reach 0.3 percent (chart). All countries see upward movements, but this means some countries that were near or above zero are pushed farther away from balance, especially Ireland, Germany, and Austria (chart), reflecting in part the distribution of stimulus.

8. Higher growth and inflation would lower debt levels and help rebuild key fiscal buffers. Aggregate euro area public debt in the baseline is forecast to fall from 92½ percent of euro area GDP in 2016 to 83 percent by 2021. With comprehensive policy support, euro area public debt would be 3 percentage points lower by 2021 relative to the baseline, with high debt countries experiencing average declines more than one percentage point larger (charts). Deficits in high debt countries would also be, on average, about 0.4 percent of GDP lower, which would help rebuild policy buffers against future shocks. While this scenario analysis considers only expansionary policies (i.e., largely the use of fiscal space, SGP flexibility, and centralized investment) and finds substantial benefits, further work could examine the tradeoffs involved in combining these stimulus measures with the further fiscal adjustment recommended for high debt countries and whether this policy mix could achieve even faster debt reduction in these cases.

A05ufig3

Output Gap Simulations, 2019

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig4

Euro Area Government Debt

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig5

Change in Public Debt, 2016-21

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook and IMF staff calculations.
A05ufig6

Average fiscal balance, 2017-21

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

9. More balanced policies would also generate positive external spillovers. Stronger domestic demand would accelerate the fall in the current account already projected in the baseline. The euro area current account surplus would be a little more than 0.3 percent of GDP lower than the baseline by 2021 (chart), bringing the surplus to 2.2 percent. This would have spillover benefits for the rest of the world as seen in higher real exports (0.4 percent) and real output (0.1 percent) in 2021. The spillovers to other EU countries would be especially large due to close trade links.

A05ufig7

Euro Area Current Account

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

10. More spending in surplus countries can narrow external imbalances within the euro area. Fiscal stimulus in Germany during 2017–18 contributes to reducing its current account relative to the baseline by much more than in other euro area countries (e.g., 0.5 percent of GDP versus 0.2 percent of GDP for France and 0.1 percent of GDP for Italy as shown in the chart), which would help narrow external imbalances within the euro area. After 2018, however, changes in current account balances relative to the baseline are more similar across countries (chart).

A05ufig8

Change in Currrent Account Balance, 2016-18

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig9

Change in Currrent Account Balance, 2016-21

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook and IMF staff calculations.

This reflects the winding down of stimulus in Germany and the strengthening of demand in countries with weaker external positions. Structural reforms that raise private spending in surplus countries and improve productivity and the relative competitiveness of net external debtor countries could help narrow external imbalances within the euro area, but these competitiveness gains may take longer to realize, beyond the forecast horizon.

A05ufig10

Impact of Fiscal Stimulus on Real GDP, 2017

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

11. Fiscal expansion, although unevenly distributed, has important spillover benefits. Given high debt levels in many euro area economies, only a handful of countries are assumed to use fiscal space (including via SGP flexibility), with the bulk of the stimulus coming from Germany. Although other countries do not undertake direct stimulus, these countries do benefit from positive growth spillovers (chart). A fiscal expansion of 0.2 percent of euro area GDP in 2017 by countries undertaking supportive fiscal policies raises their average GDP level by a little more than 0.1 percent that year, and also raises the GDP level of other countries by an average of 0.04 percent.

12. To sum up, centralized investment plays an important role throughout, fiscal stimulus is fairly powerful when used, and structural reforms are critical to longer-term growth prospects (charts).

  • Centralized investment in the scenario accounts for the largest growth impact in the first two years, with an estimated multiplier of around one, consistent with estimates of multipliers at or near the zero lower bound. Centralized investment particularly benefits countries with larger output gaps and no fiscal space, and contributes importantly to the closing of the output gap for the euro area as whole, serving as the main driver for higher inflation.

  • Fiscal policy support is strongest in 2017–2018 when stimulus is implemented. The smaller multiplier for fiscal policy compared to centralized investment reflects some fiscal spending on lower multiplier transfers rather than investment.

  • Structural reforms kick in over time, lifting economic activity by more than 0.3 percentage point on average over 2019–21, and are crucial to sustaining higher growth and debt sustainability in the longer term. Without action on the structural front, growth would fall to a level only slightly higher than in the baseline. The 1 percent improvement in potential output in 2021 is almost entirely due to the impact of increases in productivity and labor market participation with 90 percent of the gain from structural reforms, with the remainder coming mainly from higher investment).8

  • Cleanup of bank and corporate balance sheets has a moderate positive impact on growth, but plays a larger role in raising inflation via the decline in corporate borrowing rates, which encourages borrowing and investment.

A05ufig11

Policy Scenario Decomposition Real GDP Growth in Euro Area

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig12

Policy Scenario Decomposition Inflation in Euro Area

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

13. Comprehensive policies are more effective due to the synergies in a low-inflation, low-interest rate environment (Figure 1). Centralized investment and fiscal stimulus raise domestic demand, particularly investment, which narrows the output gap and raises inflation. With monetary policy remaining accommodative at or near the zero lower bound, higher inflation translates into lower real interest rates, helping to “crowd in” investment. Lower real interest rates also temporarily weaken the nominal exchange rate, providing a temporary boost to competitiveness and investment, but over time, the real exchange rate should appreciate as prices and the real interest rate recover. Balance sheet cleanup reduces real interest rates via lower credit risk premia. Structural reforms further spur growth in the near term by improving confidence and bringing forward investment, especially in some weaker economies, and lift potential growth and support fiscal sustainability over the long run.

Figure 1.
Figure 1.

Policy Synergies in a Low-inflation/Low-interest Rate Environment

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

C. Stagnation and a Policy Response Scenario

14. More balanced, comprehensive policies could also be effective in countering stagnation risks. For a stagnation scenario, it is assumed that private investment shocks (possibly triggered by weaker external demand, lower expected future output, or heightened uncertainty) combined with higher risk premia (reflecting, for example, renewed financial fragmentation and balance sheet concerns), and weaker productivity push the euro area into a low-growth, low-inflation equilibrium.63 Hysteresis would set in, reducing potential output, and with the output gap remaining open, inflation would remain positive but well below the price stability objective.64

15. Under the stagnation scenario, the euro area would experience prolonged low growth and inflation. Compared to investment growth of 2½–3 percent in the baseline, the rate of capital expansion would fall to only ½ percent by 2021, and the level of investment then would be about 6 percent lower than in the baseline. Led by weaker investment, GDP growth would be about 1.1 percent in the medium term, or about 0.4 percentage point lower than the baseline, while inflation would average just 1 percent for 2017–21 (charts). The output gap would widen initially by 0.2 percentage point and be negative 0.7 percent in 2021. Moreover, slower productivity growth and reduced investment over the medium-term would lower potential growth and push up unemployment by 0.4 percentage point in 2021.

A05ufig13

Euro Area: GDP Growth Simulations

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig14

Euro Area: Inflation Simulations

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

16. The downturn would erode already limited fiscal buffers. Government deficits would be ¼ percentage point higher on average during 2017–21, and public debt-to-GDP for the euro area would rise by 3 percentage points to 86 percent of GDP. The increase would be noticeably larger for high-debt countries (+7 percentage points for Portugal, +5 percentage points for Italy).

A05ufig15

Stagnation Impact on Government Debt, 2021

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

17. Lower growth in the euro area would generate negative spillovers for the global economy. By 2021, global output would be 0.4 percentage point lower than under the baseline, and the euro area current account surplus would be 0.5 percent of GDP higher with real imports almost 3 percent lower (chart). Other EU countries’ exports would be particularly affected, while real exports for the rest of the world would be 0.4 percent lower (chart). In addition to reduced trade, lower growth and inflation in the euro area could also have confidence and financial spillover effects for the world.

A05ufig16

Stagnation Impact on Current Account Balance, 2021

(Percent of GDP)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig17

Impact on Rest of World Real Export Growth

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

18. Limits to policies would contribute to negative feedback loops that exacerbate the downturn. The positive policy synergies shown earlier in Figure 1 are thrown into reverse in a downturn (Figure 2). Weaker demand, especially investment, causes inflation to fall, which raises real interest rates and contributes to real exchange rate appreciation. The burden on monetary policy to address tightening financial conditions and lower inflation would increase. With higher real borrowing costs and weaker competitiveness, investment would fall further.

Figure 2.
Figure 2.

Negative Feedback Loop in a Downturn

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

19. A similar strategy of more balanced and comprehensive policies can help address this more severe downturn. Here it is assumed the main components of the policy mix remain the same with two additions:

  • a) Additional monetary policy support. This includes a one-year extension of the Expanded Asset Purchase Program (APP) until March 2018 at the same rate of monthly purchases as in the baseline (€80 billion each month).

  • b) Slightly larger and more targeted centralized investment. In addition to the EFSI-induced centralized investment of 0.2 percent of euro area GDP each year for 2017–21 included in the scenario above, additional centralized investment of 0.1 percent of euro area GDP each year for 2017 and 2018 is assumed. Moreover, only member states projected to have negative output gaps greater than one percent in 2017 in the baseline will receive additional centralized investment spending, with the amount proportional to the countries’ share in the aggregate negative output gap in the euro area.

20. The analysis suggests a more comprehensive and balanced policy mix would offset the downturn (charts and table). Overall, the policy package would restore most variables to the level in the WEO baseline, and for some indicators, it would go further. Given some frontloading and an increase in policy measures, growth would exceed that under the WEO baseline in 2017 and 2018, reaching 2.0 and 1.8 percent for those years, before returning to a path a little over 1½ percent, which is similar to the WEO baseline. The output gap would be closed by 2018, which is much earlier than the WEO baseline (2021). Closing the output gap raises inflation, which would exceed that under the WEO baseline. Inflation would reach 1.5 percent in 2017, 1.8 percent in 2018, and 2 percent in 2019. Relative to the WEO baseline, in 2021 euro area public debt would be 2 percent of GDP lower at 81 percent of GDP, thus slightly enhancing fiscal policy buffers. The current account surplus would be the same (2.6 percent of GDP).

A05ufig18

Euro Area: GDP Growth Simulations

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig19

Euro Area: Inflation Simulations

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
Table.

Euro Area Scenarios

article image
Source: Fund staff calculations.

21. The synergies from combined policies would play an important role in restoring growth and inflation. Similar to the earlier scenario, centralized investment and fiscal policy are key to addressing the immediate aftermath of the shock. As before, without action on structural measures, longer-term growth would suffer, falling back to only a little above that in the stagnation scenario. What stands out in this simulation is the effect of additional monetary policy support. The one-year extension of asset purchases has a large effect on growth in 2018 as well as a sizeable and persistent impact on inflation alongside centralized investment as the other key factor. This is not entirely consistent with recent experience, though substantial monetary easing may have prevented even lower inflation outcomes in recent years.

A05ufig20

Decomposition of Real GDP Growth in Euro Area from Stagnation Policy Response

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.
A05ufig21

Decomposition of Headline Inflation in Euro Area from Stagnation Policy Response

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Sources: IMF, World Economic Outlook; and IMF staff calculations.

22. Targeting centralized investment toward countries with larger output gaps enhances the effectiveness of stimulus. Even though the size of the additional centralized investment assumed in the policies to counter stagnation is small (a total of 0.2 percent of euro area GDP over 2017–18), targeting the stimulus toward countries with larger output gaps has a significant impact, raising the cumulative output level by another 0.22 percentage point in 2018 (chart). This implies a multiplier around 16 percent higher than for untargeted centralized investment, underscoring the efficiency of targeted demand support from the center.

A05ufig22

Cumulative Effect of Centralized Investment on GDP level

(Percent)

Citation: IMF Staff Country Reports 2016, 220; 10.5089/9781498353694.002.A005

Source:IMF staff calculations.

D. Conclusions

23. A more balanced, comprehensive policy strategy can raise growth and inflation significantly in the euro area, with positive spillovers globally. Model simulations show that a strategy encompassing continued monetary accommodation, use of fiscal space and SGP flexibility, centralized investment, cleanup of bank and corporate balance sheets, and structural reforms can significantly raise growth and inflation relative to the baseline, and could effectively counter a prolonged downturn. The strong positive impact reflects important synergies in the current low-inflation, low-interest rate environment. Pursuing a comprehensive strategy would help reduce public debt levels and rebuild fiscal buffers. It would also have positive spillovers for the rest of the world through stronger import demand and inflation in the euro area. Targeting support to weaker countries would enhance the impact, but use of fiscal space by stronger countries still has positive growth spillovers, and could also help narrow internal imbalances within the euro area.

References

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1

Prepared by James John and Tao Wu with assistance from Jesse Siminitz (all EUR), and in collaboration with Benjamin Hunt and Susanna Mursula (both RES). We appreciate helpful comments from euro area country teams in EUR, and counterparts at the European Commission and ECB.

2

There is a large literature suggesting that fiscal multiplier tends to be considerably higher in or near a liquidity trap than in normal times, for instance, Eggertsson (2008); Christiano, Eichenbaum, and Rebelo (2011); Woodford (2011), and Belinga and Ngouana (2015).

3

For more detail, see Andrle, Michal et al, “The Flexible System of Global Models,” IMF Working Paper (WP/15/64), March 2015.

4

For Spain, the April 2016 WEO baseline projections do not include the higher-than-expected fiscal deficit in 2015 of 5.1 percent of GDP, implying upward revisions to the path of the fiscal deficit and public debt under current policies.

5

The interest rate assumptions are in line with market expectations as reflected in the EONIA forward curve while the asset purchase assumption is consistent the ECB Governing Council’s forward guidance, whereby asset purchases of €80 billion per month are expected to continue through the end of March 2017 or until there is a sustained adjustment in the path of inflation consistent with the Governing Council’s price stability objective.

6

For illustrative purposes, apart from Italy, use of SGP flexibility is assumed for all five of the non-EDP countries covered in EUROMOD, although in practice some of these countries might not meet all of the criteria specified by the European Commission.

7

The corporate borrowing cost reduction figures are calibrated based on the elasticity of changes in credit risk premiums in each euro area country between August 2014 and June 2015 to the observed write-off rates during the same time period (coinciding with the sample cut-off date of data obtained from the 2015 EBA Transparency Exercise).

8

The analysis assumes two years before structural reforms are implemented. If, due to political or other factors, it took longer to implement reforms or if they were not fully implemented, the impact would be smaller.

63

Specifically, for 2017–21, investment would be ¼ percentage point lower each year, sovereign and corporate risk premia in high-debt countries (Greece, Ireland, Italy, Portugal, and Spain) would be 75 basis points higher, and the total factor productivity growth rate would be 0.1 percentage point lower each year.

64

For further discussion of a stagnation scenario, please see: Lin, Huidan, “Risks of Stagnation in the Euro Area,” January 2016, IMF Working Paper WP/16/9.

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