Staff Discussion Notes showcase the latest policy-related analysis and research being developed by individual IMF staff and are published to elicit comment and to further debate. These papers are generally brief and written in nontechnical language, and so are aimed at a broad audience interested in economic policy issues. This Web-only series replaced Staff Position Notes in January 2011.

Abstract

Staff Discussion Notes showcase the latest policy-related analysis and research being developed by individual IMF staff and are published to elicit comment and to further debate. These papers are generally brief and written in nontechnical language, and so are aimed at a broad audience interested in economic policy issues. This Web-only series replaced Staff Position Notes in January 2011.

I. Motivation and Context2

Fostering growth is always important; in the euro area it has become urgent. During the last three decades, euro area growth has fallen behind peers, although it has had impressive achievements in terms of inclusiveness. More recently, renewed weakness after a sluggish recovery from the Great Recession has pressured already deteriorated fiscal positions and public debt dynamics, and increased unemployment, particularly in the Southern euro area countries. These unwelcome developments have increased financial system fragility and exacerbated economic divergence within the euro area, threatening the stability of the monetary union. Unprecedented policies from both European institutions and country authorities have avoided catastrophe. But attaining higher and more sustainable growth, while containing risks along the path to recovery, is central for a durable solution to the stress observed in the last few years.

From a long-term perspective, euro area growth has fallen behind its best performing peers (Figure 1). From 1960, euro area GDP per person of working age increased rapidly toward the United States’ level and overtook the United Kingdom. However, starting in the early 1980s, this and other GDP measures have lost ground relative to both the United States and the United Kingdom. Within the euro area, there has been substantial heterogeneity as the convergence of Southern euro area countries (Greece, Italy, Portugal, and Spain) to the richer Northern euro area countries has stagnated. While Eastern Europe grew relatively fast, almost all Southern euro area countries have expanded in the last decade much less than what expected convergence—convergence explained by initial income differences—would predict.

Figure 1.
Figure 1.

Growth Divergences

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Sources: April 2012 WEO; October 2011 Europe REO; and OECD.1/The adjusted growth measures the difference between each country’s actual growth rate and the growth rate that could be expected given initial income levels.

Slower productivity growth explains the decline in euro area potential GDP growth, while lower labor utilization is behind the lower GDP level with respect to peers. The sharp decline in total factor productivity growth in the euro area (Figure 2) had the largest contribution to the trend growth decline observed in the last three decades. While potential growth rates have come down significantly, the slowdown is more pronounced in the Southern euro area countries. But productivity is not the entire story: Mourre (2009) shows that lower labor utilization explains two-thirds of the differential in the GDP per capita level between the euro area and the United States in 2006.

Figure 2.
Figure 2.

Total Factor Productivity and Potential Growth

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: April 2012 WEO, European Commission.

During the last decade, dissimilar patterns of growth across countries and increasing competitiveness differentials exacerbated each other. Exports drove growth in Northern euro area countries, while Southern countries relied on domestic demand with a large share of the employment created in the cyclical and credit-dependent non-tradable sectors, e.g. real estate. Much of the foreign capital that flew into the Southern euro area during the last decade was in the form of debt while the tradable sector limped, creating brittle fundamentals for growth and resource generation for servicing this debt. Relative prices, including nominal unit labor costs, diverged rendering Southern euro area countries uncompetitive (Figure 3).

Figure 3.
Figure 3.

Euro Area Countries: Real Effective Exchange Rate and External Imbalances

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Sources: April 2012 WEO, IFS, and staff estimates.

Cyclical developments since the Great Recession also suggest that Europe has a disadvantage with respect to peers and suffers considerable heterogeneity (Figure 4). Output recovery has been much slower in the euro area than in the United States. Also, euro area countries are experiencing persistent and higher unemployment than the United States and the United Kingdom. The Southern euro area is expected to contract further and recover modestly next year, implying weak prospects for reversing the sharp increase in unemployment, particularly youth unemployment. The region has to go through considerable balance sheet repair, with its negative short-run implications on activity. Bank deleveraging, which is a necessary unwinding of the pre-crisis credit boom, higher private sector savings, and unavoidable fiscal consolidation will remain powerful headwinds, particularly for the South (Figure 5). Euro area countries are projected to improve their cyclically-adjusted fiscal balance by 1½ percent in 2012 (excluding Southern Europe, ¾ percent). Recent estimates also show that fiscal multipliers are higher during times of downturn than in normal times, implying a higher negative impact from the planned consolidation on output, domestic absorption, and employment in the North (IMF, 2012b).

Figure 4.
Figure 4.

Real GDP and Unemployment Rates

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: April 2012 WEO.
Figure 5.
Figure 5.

Headwinds from Fiscal Consolidation and Unwinding the Credit Boom

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Sources: April 2012 WEO, and ECB.

Growth is crucial for stability. Persistent stagnation in the periphery can lead to private sector bankruptcies and even higher unemployment, which would compound the difficulty of fostering confidence in governments as well as the private sector. Consolidation could become ever more elusive, with mounting social unrest, growth spiraling downward, and ever higher debt ratios.

II. Lifting Growth – A 20,000-Foot View

Against a background of low trend growth, relative price misalignment in several countries, and cyclical headwinds, the euro area needs a multipronged approach. Any sensible strategy has to acknowledge that part of the current subpar performance is unavoidable as it represents the needed correction of past excess in some countries. It also needs to recognize that increasing growth is a daunting task, with payoff that sometimes accrues only slowly. But the region should be able to soften the cycle and improve prospects considerably if a comprehensive approach is taken.

The region needs to boost potential output, which would also deliver short-run benefits. Structural reforms are critical to improve the capacity of the economy to grow over time through both a more intensive use of resources and higher productivity. Moreover, they should be implemented without delay because they take time to deliver their full potential, and a simultaneous push should be encouraged to benefit from potentially large positive cross-country spillovers. In addition, through confidence and wealth effects and by facilitating relative price adjustments, structural reforms can also promote aggregate demand in the short run, particularly investment, if they are perceived as part of a coherent policy strategy.

However, structural reforms alone may not deliver a sufficient boost to short-run activity in the current environment of high unemployment, large output gaps, and cyclical headwinds. While there is substantial evidence of their long-run benefits, the immediate gains from reforms, discussed in the next section, are not fully understood and are unlikely to be very large. A distinct threat is that, in an environment of weak aggregate demand, supply-side measures and restructuring fail to boost output, leaving part of Europe in a period of protracted stagnation. Because insufficient demand in the periphery has the potential of being overly disinflationary, this could complicate monetary policy management. Moreover, low growth and high unemployment may hamper the credibility of fiscal consolidation, which needs to be sustained during several years requiring political support.

Therefore, it is also critical to foster aggregate demand, taking into account country-specific needs and constraints. As in other cases where a domestic demand-driven growth cycle came to an end, net exports will be critical for lifting lagging countries (Southern Europe), but this depends on a significant improvement in competitiveness, including changes in relative prices, and reallocation of resources to emerging industries in tradable good sectors. In parallel, Northern countries need to strengthen their domestic demand, ideally with the private sector taking the lead. Macroeconomic policies to soften headwinds from the needed fiscal consolidation and ongoing balance sheet repair are critical. The financial system should be put in shape to support growth of emerging sectors.

Policies should leverage Europe’s many strengths and build on recent progress at the euro area level. The European Union is the largest common market, the euro is a strong reserve currency, the euro area does not have imbalances vis-à-vis the rest of the world, and while, some countries are facing acute fiscal challenges, the aggregate fiscal situation, in terms of both deficits and debt, is stronger than in many other economies. Recent actions to tackle risks at the euro area level—through the fiscal compact, a strengthened euro area firewall, comprehensive ECB liquidity support, and strong policy actions in individual countries— have helped reduce risks and move toward a more supportive pan-European policies and institutions. However, more is needed to get firmly ahead of the crisis and lift confidence.

A comprehensive approach should also include policies to address vulnerabilities and be consistent with a clearer path to the shared-view of the euro area’s long run architecture. Tail-risks that dent confidence and thereby jeopardize growth should be promptly addressed, ideally at the central level. This includes, but is not restricted to addressing financial sector weaknesses. Similarly, strengthening common resource pools, in parallel with implementation of the fiscal compact, would signal progress toward more fiscal integration.

III. What Can Be Realistically Expected from Structural Reforms?

Recent studies

Structural reforms can lift growth considerably, particularly in the medium and long run. Most empirical studies find a positive long-term effect of labor and product market reforms on total factor productivity, growth, and employment (Table 1). In some analyses, comprehensive and ambitious reforms in product and labor markets would boost GDP levels by more than 10 percent in most euro area countries over a decade (OECD, 2012; Goldman Sachs, 2012).

Table 1:

Selected Recent Studies on Labor and Product Market Reforms

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Improving institutions can yield positive results in the labor market. Empirical studies find that collective bargaining, unemployment benefits, and employment protection explain a large part of the cross-country differences in labor market performance, particularly when interacted with macroeconomic shocks (Blanchard and Wolfers, 2000; Fitoussi et al, 2000; and Mourre, 2006). However, studies do not agree on the role of specific institutions, and the evidence is sometimes contradictory for some indicators. This is largely because labor market institutions interact with one another, and with the macroeconomic environment, making a one-size-fits-all reform recipe unsuitable. Studies on Europe find that high employment protection, longer and more generous unemployment benefits, high tax wedges, and collective bargaining systems that are more favorable to wages than employment affect employment and productivity negatively (Nickel et al., 2005; Bassanini and Duval, 2006; Annett, 2007; Fialová and Schneider, 2008; and Jaumotte, 2011).

Product market reforms can boost growth, but country-specific factors matter. There is considerable evidence that excessive product market regulation contributes to higher markups and lower output, investment, and employment (Table 1). In particular, the effect of product market deregulation on productivity growth is larger in more advanced countries, especially in those with better governance. The issue of complementarity between labor and product market reforms is still debated. Some studies find that product market deregulation is more effective when labor market regulation is high (Fiori et al., 2012), others find it more effective when labor market regulation is low (Berger and Danniger, 2007). However, many studies find important synergies in implementation of product and labor market reforms.

Less-burdensome regulations are associated with not only more use of labor and capital but also greater economic efficiency. Recent empirical work by IMF staff (Tiffin, 2012) shows that a high degree of liberalization in product, labor, and credit markets boosts a country’s efficiency—the difference between the total factor productivity and a time-varying frontier for all countries (Figure 6). This effect is particularly pronounced for low- and middle-income countries, where catch-up gains are more readily available, but are significant for high-income countries as well. For example, a one standard-deviation improvement in the reform index is associated with a 9½ percentage point increase in efficiency in a middle-income country and a 5 percentage point increase in a high-income country. The Swedish experience stands out as an illuminating example in this regard (Box 1).

Figure 6.
Figure 6.

Impact of Regulatory Reform on Efficiency, 2000-07

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: Tiffin (2012).

Tales from Successful Structural Reforms in Europe

The Netherlands in the 1980s and Sweden in the 1990s are examples of how reforms can turn poor economic performance around. Before the reforms, both countries had experienced a prolonged period of subpar performance. When the malaise was further exacerbated by a deep recession (Netherlands, 1980–82) or a banking crisis (Sweden, 1990–92), policies shifted course, and over a decade, extensive macro-economic policy and supply side reforms were implemented. The public expenditure-to-GDP ratio was lowered significantly, allowing a reduction of both the high fiscal deficit and high tax levels; labor markets were made more flexible with increased incentives to work; and product markets were reformed to boost competition. Sweden has experienced two decades of rapid growth; and the Netherlands, which previously was associated with the “Dutch disease,” became known for its employment miracle.

A01ufig01

Sweden, 1991-2007

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

What then are the lessons of these experiences for other countries? First, what needs to be reformed is country-specific. In the Netherlands, reforms focused on increasing the very low employment rate (the result of too rapid wage increases); in Sweden, reforms focused on boosting dismal productivity growth (which was held back by outdated industries and excessive regulation). In Sweden, large downward adjustment in the real effective exchange rate resulting from currency depreciation also helped jump-start the economy. Reforms in both countries, however, had common elements—reducing the role of the government in the economy, increasing competition, and changing incentives.

Second, reforms need to adapt over time, as bottlenecks change. In the Netherlands, the problem initially was the lack of labor demand, and policies focused on reducing wage costs. As employment expanded, reforms shifted to boosting labor supply.

Third, the full impact of reforms builds up over time. In the Netherlands, the employment rate increased from 53 percent in the 1980s to close to 67 percent in 2011. In Sweden, annual labor productivity growth increased from 1 percent in 1977–92 to 2.5 percent in 1992–2007. Cross-country research suggests that the Swedish reforms facilitated a 5½ percentage points increase in efficiency over 10 years relative to the global best-practice frontier (an increase in real output per worker of almost 15 percent).

A01ufig02

Netherlands: Employment rate

(in percent of population aged 15–74)

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

A01ufig03

Sweden: Labor productivity per hour

(Annual growth, in percent)

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

A third, more recent example, of successful labor market reform is Germany. Faced with high structural unemployment, low growth, and an urgent need to reform its social security system in the early 2000s, Germany embarked on a broad reform program (Agenda 2010) that included a set of labor market (Hartz) reforms. The reforms were carefully timed and aimed at (a) introducing flexibility to the labor market by creating temporary employment agencies and setting up the legal framework for the creation of small jobs; (b) increasing the effectiveness of labor market agencies by restructuring them and redesigning active labor market policies; and (c) raising incentives to work by, among others, reducing the duration of unemployment benefits and reducing restrictions on re-assignment. Faced with a shifting environment, core labor market institutions also changed. The wage bargaining process became increasingly decentralized and firm-level agreements traded job security for flexibility, including by reducing paid overtime through work time accounts and linking compensation to firm profitability. The impact of the reforms and the broader change in Germany’s labor market institutions on unemployment were not immediately visible. The matching efficiency of the labor market improved, and unemployment dropped from above 11 percent in 2005 to below 9 percent by 2007, and currently stands at around 6 percent.

A01ufig04

Beveridge Curve for Germany

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Sources: Haver Analytics; and IMF staff estimates.

Short- and long-run impacts of reforms

The full effects of structural reforms may only materialize over time. Several studies find that reforms have a small, and in some cases even negative, short-term effect on output and employment because of costly and timely reallocation of resources and restructuring, with a temporary rise in unemployment and potentially high social costs (Table 1, Box 2). To the extent reforms enhance credibility and confidence, some of the short-run negative effects may be countered. In any case, the full impact on growth and employment are likely to materialize only over a medium- to long-term horizon.

Short- and Long-Run Effects of Structural Reforms

Structural reforms have different effects on output and employment in the short and long run for several reasons:

  1. Some reforms are implemented gradually and thus their effects mature over time.

  2. There are (non-convex) costs of adjustment that make a gradual response optimal. For example, moving resources from one sector to another, or accumulating capital does not happen instantaneously. Similarly, imperfections in the financial market may delay investment.

  3. Losers from reforms—agents who enjoyed rents created by protection—will reduce consumption immediately. In contrast, agents who benefit from the new opportunities are not identified and take time to increase consumption.

  4. Investment may take time to increase and even decline for some time. Potential investors may wait and see before making big investment decisions. Similarly, confidence that changes are permanent takes time to be established.

  5. An increase in productivity implies a decrease in employment in the short run when demand for the final product is inelastic.

  6. Labor reforms that lower dismissal costs increase aggregate employment because firms hire more freely. However, in the short run companies may shed labor and increase productivity.

  7. If there is substantial economic slack and unemployment, some reforms may in the beginning reduce disposable income as unemployment increases.

At the same time, the announcement of comprehensive structural reforms can have a larger short-term effect if investor and consumer confidence reacts immediately in response to the anticipated effects. Both expectations of higher future income and profitability and the perception of a lower risk of tail events can foster consumption and investment today. This speaks to the necessity of an effective communication strategy, possibly coordinated at the European level. This boost in confidence is particularly relevant in the present circumstances of weak aggregate demand.

To compare short-and long-term impact, IMF staff simulated the effects of different reforms on output. The analysis is based on a calibration of the IMF’s Global Monetary and Fiscal (GIMF) model that uses as input OECD empirical estimates of the dynamic effects of structural reforms on labor participation, unemployment, and productivity.3 GIMF is a structural model that brings together both economic agents that optimize freely (firms maximize profits, and households maximize utility from consumption and leisure) and liquidity-constrained agents that consume their income fully—foundations that can be used to compare the impact of individual reforms and macroeconomic policies. Still, for this analysis, the model is not able to capture all potential effects. In particular, the model does not allow for involuntary unemployment and the analysis is conducted around an initial steady state that does not account for different cyclical or competitiveness positions across countries which could affect the extent of reforms that can be implemented or their full effects (e.g., of solving a relative price misalignment). The estimates are therefore illustrative examples of what can be achieved in the short and long run, rather than the precise pay-off from specific reforms.

The gains from reforms are large and materialize predominantly in the medium term. GIMF results suggest that eliminating 50 percent of euro area countries’ gap with OECD best practice in labor market and pension policies could boost their GDP on average by almost 1½ percent after 5 years, and by another 2¼ percent through product market reforms (Figure 7). While these potential gains are substantial, the efforts required to implement reforms of this scale are also large. The results show a positive impact in the short run for all reforms. Combined reforms in the labor and product market could yield additional output of up to 0.6 percentage point in the euro area in the first year. Active labor market policies could have an immediate positive impact, larger than its long-term effect, mainly because they entail fiscal spending. The benefits from product market reforms are mostly achieved in the long run, and given the greater distance from “best practice,” the gains appear considerably higher than the labor market reforms.

Figure 7:
Figure 7:

Short-and Long-Run Impact of Reforms in Euro Area Countries on the Level of GDP

(in percent)

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: GIMF estimates.

The simulations suggest reforms can produce sizeable spillovers, counting for one quarter of the total gains in growth. Trade and technology spillovers imply that structural reforms in one country increase growth in other countries (Figure 8). The GIMF analysis shows that the Southern euro area countries would gain more from reforms in the Northern countries than vice versa, for three reasons: (i) the larger size of Northern countries implies a more important trade impact; (ii) productivity improvements would spill over from the more advanced Northern countries (effectively the frontier to which Southern euro area countries would gradually converge to); and (iii) in an environment where the zero interest rate floor is binding, higher aggregate demand from activation policies would lead to higher inflation, thereby reducing real interest rates and boosting output. Within a country, the effect of specific reforms also depends on whether other reforms are implemented (e.g., a labor market reform would have a higher payoff if product markets are also reformed).4 All these underscore the importance of coordinated efforts.

Figure 8:
Figure 8:

Impact of Reforms and Automatic Stabilizers on the Level of GDP (in percent) in Euro Area Countries

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: GIMF estimates.

However, spillover gains in reality could be smaller if relative price adjustments do not take place quickly enough. To the degree euro area countries compete with each other and countries in the South are at a competitiveness disadvantage, gaining further competitiveness in the North could create negative spillovers on the South. Likewise, if progress in the North generates further disinflation need in the South in order to reestablish competitiveness, the zero lower bound would take effect, causing real interest rates to increase, and domestic demand to weaken. Targeted and short-term interventions, particularly fiscal devaluation, could be useful in this regard, but success would depend on country-specific circumstances, with coordination among countries playing an important role (Box 3).

The simulations also suggest that the positive impact of reforms on activity is modest in the very short run, even under the benign conditions assumed here. Concretely, the impact is equivalent to a temporary fiscal expansion of close to 1 percent of GDP. Incidentally, this is comparable to the effects of all euro area countries letting automatic stabilizers work after experiencing a negative output growth shock of around 2 percent. This lower output growth would imply an increase in the budget deficit in the order of 0.9 percent of GDP; suppressing automatic stabilizers is equivalent to offsetting the deficit with additional fiscal consolidation measures. Instead, letting automatic stabilizers operate would avoid a GDP contraction in the short run between 0.3 and 1 percent depending on the fiscal measure chosen, with additional impact through spillovers (Figure 8).

IV. Why Do Structural Reforms Need Other Supportive Policies?

Weak demand and excess capacity conditions risk limiting the short-term output response to reforms and, if they persist, may also damage the long-run potential. In particular, balance sheet concerns and low confidence encumber private sector decisions, thereby weakening demand and possibly hindering the effectiveness of supply side reforms. For example, relaxing employment protection may not stimulate hiring in the short term, but increase unemployment. Similarly, reducing unemployment insurance or increasing the retirement age would lower disposable income if those induced to seek work do not find jobs. IMF staff simulated a case where unemployment insurance is reduced assuming that the cuts in transfers to the unemployed, who are assumed to be liquidity-constrained, take effect immediately, while the increase in employment from higher labor supply is assumed to take place with a lag. The result is a slight output contraction in the short run, even though output expands in the long run. Overall, there are considerable uncertainties about the immediate effects of implementing structural reforms during a recession. Furthermore, because persistent weak demand can negatively impact long-run prospects through hysteresis effects in unemployment, it is imperative to increase growth soon.

Moreover, bringing unemployment down in the short run largely depends on the strength of economic activity. Recent estimates by Ball et al. (2012) show that the relationship between growth and unemployment (generally referred to as Okun’s law) has been very stable for advanced countries since the 1980s, including for euro area countries. This suggests that boosting output growth, through both aggregate supply and—wherever possible—aggregate demand channels, is critical to reducing unemployment. Moreover, based on an empirical study, Bernal-Verdugo et al. (2012) find that unemployment could increase temporarily after labor market reforms are implemented (Figure 9). They also show that after a financial crisis, unemployment tends to increase more in the short term in countries with a more flexible labor market, but the medium-term increase in unemployment tends to be higher for countries characterized by a more rigid labor market.

Figure 9:
Figure 9:

Change in Unemployment (in percentage points) and Labor Market Flexibility

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: Bernal-Verdugo et al. (2012)and staff estimates.1/Estimates the impact of a comprehensive package of labor market reforms, defined as producing an annual change in a labor market flexibilty indicator which exceeds by two standard deviations the average annual change over all observations in a sample of 98 countries over 1980-2008.

Structural reforms, therefore, need to be complemented by policies that boost aggregate demand. This is not a recommendation of simple fiscal stimulus—fiscal consolidation is inevitable—but of a combination of efforts to alleviate headwinds which, importantly, includes demand rebalancing within Europe and reallocation within countries. Monetary policy and banking sector repair and reform have an important role to play. Short-run growth needs more robust (ideally private) domestic demand in the North and firmer external demand in the South. Domestic absorption would need to outpace output in the North for some time, while a more competitive tradable sector in the South should cushion its unavoidable domestic demand adjustment. Labor markets in the South are at the center of this rebalancing as wage adjustments play a crucial role in undoing the relative price misalignment in the absence of exchange rate policy. Because filling the gap in relative price is not immediate, it is important to avoid an overshooting of the domestic demand adjustment.

Internal and Fiscal Devaluation

International experience suggests that restoring competiveness through internal devaluation is painful. As shown in IMF (2012), there are only a few cases in which a revival of competitiveness and growth through a reduction in labor costs and domestic prices outweigh the negative effects from lower income. Country experience shows that internal devaluations almost always come with drawn-out recessions, where the duration of the initial adjustment could range from 5 to 15 quarters (Figure).

A01ufig05

Cumulative output loss from pre-recession peak

(quarterly, in percent)

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: IMF International Financial Statistics Database and staff calculations.

Several factors are needed for internal devaluation to close a competitiveness gap, most of which do not seem to be present in the Southern euro area countries. Relative price changes have larger effects with more openness and higher factor mobility. Relative prices can change more easily if there is more price and wage flexibility. Also, a low initial public debt and the ability to use fiscal policy/transfers to attenuate the impact on the real economy are useful. Most recent experience from the Baltic countries show that even when public debt is small and flexibility exists in factor markets, the adjustment can be wrenching in terms of output and employment.

Tax reform is a useful complement to correct the price misalignment and boost the tradable sector. Shifting from employer social contributions to the VAT can—even if revenue-neutral—improve competitiveness and promote exports, growth, and employment. Indeed, with nominal wages fixed in the short run, lower labor costs on account of the reduction in social contribution rates can reduce export prices; the increased VAT, in contrast, will not bear on exports and will thus not dampen the effect on competitiveness. Only when wages adjust in response to the higher VAT might the effect eventually disappear.

The short-run effects of a fiscal devaluation can be significant. Macroeconomic models report that effects are quite marked, but not spectacular: for instance, simulations of a fiscal devaluation in Portugal suggest that a shift equal to 1 percent of GDP generates a short-term rise in net exports of somewhere between 0.2 and 0.6 percent of GDP (IMF, 2011). GIMF simulations show considerable effects. Recent econometric estimates for the euro area show large short-term effects: an average reduction in the social contribution rate of 2.6 percentage points and a standard VAT rate increase of 2.7 percentage points could have an impact on net exports somewhere between 0.9 and 4 percent of GDP (De Mooij and Keen, 2012). In reality, the improvement in net exports would also depend on the terms of trade, relative price adjustment in the non-tradable sector, and the composition of the tradable sector. While these estimated positive effects become insignificant in the long run, they last for some time, implying that a fiscal devaluation can accelerate adjustment if economies are in disequilibrium and correct distortions.

The economic effects of a tax shift are however subject to country specific conditions. For instance, if lower social contribution rates are targeted to low-skilled workers, it would likely reinforce the positive impact on jobs. The ability to increase the VAT rate may be limited in countries where rates are already high; broadening the VAT base is a better alternative in these cases. This, however, may come with adverse effects on equity so that alternative measures would need to be contemplated or other tax measures considered, or higher inflation tolerated if the VAT increases are passed through. Fiscal devaluations would best be limited to euro area countries with competitiveness problems. If all countries pursue the same tax shift, none would obtain a gain in competitiveness.

V. What Should Be Done Concretely?

Structural reforms need to tackle many of the pre-crisis or “older” challenges. While some policies are applicable at the euro area level, granularity is necessary, as there is no one-size-fits-all strategy, nor silver bullets.5 Annex II gives a detailed assessment of country-specific progress and priorities. In the Southern euro area, structural policies need to target the efficiency of tradable goods production and help to regain competitiveness. Elsewhere, they need to open business opportunities in the services sector to boost potential growth. Labor market reforms would need to be country specific, targeted to facilitate relative price adjustment in the South and increase participation in the North. Facilitating mobility across countries would ease rebalancing and ultimately make the euro area more resilient to shocks.

But weak demand conditions pose “new” policy challenges. Policies should aim at softening demand headwinds as well as facilitating resource reallocation across firms and sectors, and rebalancing across countries. There is no silver bullet here either. Appropriate macroeconomic policies, targeted actions in credit markets, fostering changes in relative prices, and stronger policies at the central level are all needed to reinvigorate private sector demand.

Older challenges

Structural reforms need to be sustained in several areas. Some countries, particularly in the South, have made significant progress in the last couple of years, with increased impetus in the last few months, but more needs to be done (Table 2). Significant gaps still exist between actual and potentially growth maximizing benchmarks (Annex I). In Southern euro area countries, the major gaps are in the areas of administrative and regulatory environment conducive to set up or expand businesses, and in employment legislation and the wage bargaining system, which hinder wage sensitivity to economic conditions. For the North, priority policy actions are needed to reduce barriers to competition in the services sector, increase labor participation, and scale back tax wedges. Overall, current structural priorities are not very different from what Allard et al. (2010) proposed. Country-specific recommendations are concentrated in labor and product markets (Annex II, Figure 10), but a broader inventory is as follows.

Table 2:

Main Progress in Structural Reforms in Southern European Countries since 2010

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Figure 10.
Figure 10.

Priorities for Structural Reforms in Country-Specific Recommendations

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: IMF European Department country teams.

Labor markets

While the degree of difficulty of reforms will vary considerably country by country, based on long tradition, reforms should generally aim at:

  • More inclusive labor markets. This entails lowering duality by reducing excessive protection for insiders, and dismissal costs, and creating better incentives for remaining in or re-entering the workforce (e.g., more flexible part-time arrangements).

  • More responsive wages. Intermediate level coordination in collective bargaining in Southern euro area countries prevents wages from being more responsive to macroeconomic shocks and productivity developments. Bargaining systems that are more favorable to employment than wage increases should be encouraged and automatic indexation minimized. Minimum wages need careful calibration to productivity realities.

  • Higher labor force participation. This is a key to raising potential output in the context of adverse demographics. The pension system should provide incentives to increase the working age. At the other end of the spectrum, the transition between school and labor force should be facilitated.

  • Higher labor mobility. This would help countries deal with specific shocks and cycles. While culture and languages remain a deterrent, portability of social benefits (pensions and unemployment insurance) and some degree of harmonization in labor market conditions across countries would help.

Product markets

Reforms should include:

  • Full implementation of the EU service directives. Several countries, especially within the euro area, have been slow in adopting the necessary internal reforms, as the principle of “necessity, proportionality, and public interest” has opened the door for half-hearted implementation. Relevant areas include wholesale and retail trade and community and personal services.

  • The specific area of professions remains critical. Professions are still highly (self-) regulated and professional orders often stand in the way of effective competition. Coordination at the EU level could also foster effective competition across countries.

  • Modified land/zoning regulation. Land regulation is ultimately in the hands of local authorities, which often do not internalize all economic effects and may face biased incentives. This often results in ineffective use of land and/or real estate cycles.

Public sector reform

To improve the business environment, the following reforms are recommended to remove unnecessary procedures and costs that weigh on entrepreneurship, and harmonize bankruptcy proceedings to facilitate exit of inefficient firms.

  • Justice system reforms. A properly functioning justice system is key for all sectors but, in particular, for the labor market, FDI, and innovation. Good labor market reform may not deliver any result if not supported by a proper judicial system. Foreign investors are deterred from uncertainty related to jurisprudence. Innovation will not take off if property rights are not properly defended. Judicial systems are by definition a national institution, but the EU should exert pressure on countries which do not guarantee a minimum acceptable standard.

  • Education. Education policy is key to upgrading the labor force, especially in countries where production relies mostly on unskilled labor. Countries in the South have been lagging on this.

  • Regulation. The thrust toward federalism has left many countries in Europe with a plethora of regulating authorities at the EU, national, regional, and municipal levels. This excess is a deterrent to entrepreneurship and some simplification is in order.

  • Privatization. Countries should renounce the policy of keeping significant participation in some key companies. Privatization at the local level should also be encouraged.

  • Growth-friendly budgets. Tax and expenditure compositions are not neutral for growth. Pro-growth programs, such as expenditure on education, R&D, and infrastructure, should be preserved under expenditure cuts, while tax increases should rely on least growth-distorting instruments (Sutherland et al., 2012).

Newer challenges

Delivering on the older policy challenges remains critical, and additional actions are needed. Closing structural reform gaps might not provide enough growth lift in the current environment. Even well-designed structural reforms that minimize eventual short-run contractionary effects might not translate fast enough into rising income and employment. It is therefore crucial to accompany the older agenda with impetus in other policy interventions.

Macroeconomic policies

While the space for standard macroeconomic policies is limited, it should be used fully. The average euro area output gap is 2½ percent in 2012 and unemployment is elevated, partly due to cyclical reasons. Policy support is a must.

  • Supportive monetary policy. Steadfast monetary policy support remains essential as long as the inflation forecast points to falling and very low rates of inflation on the policy horizon. Should inflation surprise on the downside, further monetary easing might be necessary. This should also contribute to correcting the current modest over-appreciation of the euro’s real effective exchange rate, thereby further supporting growth.

  • Smart fiscal consolidation. Consolidation will have to proceed rapidly where market pressure remains high. Where financing allows, adjustment should be conducted at a steady underlying pace that balances the need to bring down deficits against that of not undermining the recovery. If recovery falters in the North, the pace of consolidation should slow if fiscal space permits. While implementation is not straightforward, consideration should be given to modifying the current pro-cyclical nominal targets for structural deficit objectives. Priority should be given to reforming future entitlements.

Credit markets

Well-functioning credit markets are key to growth. A legacy of the debt crisis is that, absent policy intervention, credit markets, especially in the Southern euro area, will not work normally and funds will not flow to new investment opportunities, which is critical for structural reforms to pay off. The cost of funding for banks incorporated in countries with high public debt will possibly remain high with an impact on lending rates. Moreover, lingering tail-risks that jeopardize growth and dampen confidence need to be addressed.

  • Steer bank deleveraging. Financial supervisors will have to carefully calibrate bank deleveraging, following European Banking Authority guidelines. Consideration should be given to facilitating access to credit by new emerging sectors, e.g., through partially underwriting credit risk.

  • Bank restructuring. Bank consolidation should be encouraged, possibly through an EU-level policy. Countries in the South in particular should be ready to see foreign banks take a significant domestic credit share. FDI should be actively encouraged through a euro area policy to avoid distortionary competition.

  • Bank recapitalization. Domestic backstops should be enhanced if market pressures intensify and the private sector cannot cope with capital needs. Consideration should be given to using centralized resource pools to provide direct capital support to banks (against acquisition of due control), limiting the adverse feedback loop between banking and sovereign risks. Over time, banks receiving pan-European support could be subjected to centralized regulation and supervision, a joint bank resolution authority with a common backstop, and a single deposit insurance fund. This would be the first step toward a unified financial stability framework operating in the single financial market, a crucial pillar of an ideal architecture for the euro area.

Rebalancing within countries and within Europe

Reversing the cross-country divergence in the external current account can be done with less disruption on activity if relative prices adjust. Southern euro area countries need to lower their current account deficits due to sustainability considerations, and the surplus countries can help such adjustments. This can happen with smaller effects in activity if Southern countries regain competiveness not only through increased productivity, but also through lower relative prices and wages.6 From a multilaterally consistent perspective, it is not possible for the euro area as a whole to have a large current account surplus.

  • Tolerate inflation differentials. Given the euro area at-large inflation target, the relative price adjustment needs higher (lower) than usual inflation in the North (South) (Figure 11). This should ideally be the result of domestic demand outpacing output in the current account surplus countries and continued adjustment toward higher net exports in the deficit economies, developments that should be carefully steered.

  • Restrain nominal wage growth in the South. Nominal wage restraint (e.g., in the form of freezes or cuts, initiated by public sector wage discipline) in Southern euro area countries would accelerate the process of regaining competitiveness. Wages in the surplus countries should be allowed to keep pace with market developments, safeguarding their flexibility.

  • Fiscal devaluation. Deficit-neutral tax reforms that shift revenue from labor or social security taxation to VAT in the periphery would be helpful, mostly in the short run. Moreover, this policy would need to be well-coordinated across countries as a simultaneous implementation of such a policy would not yield the intended gains.

Figure 11.
Figure 11.

Inflation Differentials and Possible Output Gain

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

1/ Combinations of inflation rates (respecting 2 percent euro area average) and number of years to close the gap accumulated in real effective exchange rates. The solid lines refer to closing the North-South gap that has been accumulated since 1998 and the dotted lines refer to closing the South’s gap versus its trading partners, comparing current real effective exchange rates with the 1980-98 average.2/ Range of possible gains in GDP levels from closing competitiveness gap based on staff estimates of the range of real exchange rate misalignement.

More active policies at the central level

There is also potential for common resource pools to be increased and better targeted. Past evidence shows that structural funds are allocated to projects with limited spillovers and low impact on EU-wide growth (Santos, 2008). In particular, transnational projects represent only around 2.5 percent of total funds. A strategy to connect the Southern euro area to those countries and regions that lead world growth promises potentially large returns. Here — although of course opportunities will differ across countries—the successful cluster around Germany could potentially serve as a connecting link to the dynamic growth markets in Asia and elsewhere (Figure 12).

Figure 12.
Figure 12.

Links to Global Supply Chain

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Sources: OECD Input-Output Database, OECD Bilateral Trade Database, WEO, IMF staff estimates.
  • Targeted investment. In addition to providing stronger incentives for reforms, the structural funds need to be better targeted towards investment in infrastructure and human capital to connect to export chains and facilitate private sector FDI from the surplus countries, particularly in countries where sovereigns face market stress. Funding policy interventions that improve the functioning of problematic markets and have a large positive short-run payoff. For example, labor and financial market policies should have priority.

  • Leveraging common pools. Currently, common pools represent a small fraction of total fiscal resources. A larger common pool—with a corresponding reduction in domestic budgets—as well as project bonds, would allow more flexible allocation and facilitate public investments where they are most productive. Further steps towards fiscal integration should be considered.

VI. Final Remarks

To meet Europe’s growth challenge, structural reforms need to be implemented now, and complemented by other policies. The long-run gains from product and labor market reforms are found to be substantial, offering a much-needed opportunity to increase Europe’s growth potential. Moreover, a simultaneous push for reform could generate positive cross-country spillovers. However, gains from structural reforms accrue gradually, and the immediate gains are unlikely to be large. With the current weak economic outlook, combined with fiscal and financial stability woes, supportive macroeconomic policies need to accompany the structural reforms, even if the policy space is limited. Hence, accommodative monetary policy should continue, and, while fiscal consolidation should proceed, it should be structured to avoid excessive procyclicality. Bank and corporate sector restructuring, including through FDI, should be actively encouraged, and bank recapitalization promoted, possibly with support from centralized resource pools and moving propped-up banks to a new pan-European regulation and supervision system.

A consistent policy package at the euro area level that takes into account country-specific reform priorities would yield large gains and facilitate rebalancing within the euro area. Despite important ongoing efforts, the scope for structural reforms remains considerable in many euro area countries, and recommendations tailored to country-specific needs along the lines in Annex II can help focus attention where potential gains are larger. For many countries, priorities include reducing barriers to competition and improving the business environment. Empirical evidence shows that such product market reforms can provide a substantial lift to growth in these cases. Labor market reforms, in addition to raising growth and employment in the long term, can help achieve the price re-alignment that is needed to regain lost competitiveness for some countries. Fiscal devaluation and nominal wage restraint would help accelerate this rebalancing process. Reallocation across sectors could be supported by more active policies at the central EU level, including by targeting investment and leveraging the common resource pools.

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Annex I. Key Gaps in Structural Policies—Cross-Country Comparisons

Identifying country-specific gaps can help focus on reforms that yield larger gains. The European social model has delivered strong outcomes combining periods of sustained growth with relatively low income inequality. But weak growth prospects imply a need to adjust institutions, focusing on areas with more scope for reform and hence larger potential gains. A cross-country comparison of structural characteristics can help identify those areas, though such an approach also has shortcomings. Institutional features are complex and difficult to measure, and defining the frontier or best practice will involve a judgment of which institutional characteristics yield favorable economic outcomes (specifically, the indicators are generally geared toward growth, not other considerations such as equity), to which the empirical evidence does not often provide a clear-cut answer. These short-comings need to be overcome by an in-depth country-specific analysis.

What do surveys and ratings show?

Regulations and administrative burdens are higher in Europe relative to its OECD peers (Annex Figure 1). Europe’s work model features stronger security for those with jobs, more generous benefits for those without work, and easier pension eligibility. European enterprises also face more administrative burdens, less competition and higher employment tax burden than its OECD peers. These features limit labor participation, incentivize fewer working hours, and smaller enterprises, making Europe less productive and less prepared to face the aging challenge. The Southern euro area is more encumbered with administrative and regulatory burdens than the rest of the euro area. While several countries in the Northern euro area pursued strong labor market reforms in the 1990s and 2000s that allowed businesses to take advantage of a more integrated Europe and the pan-European value chain, the Southern euro area remained more regulated and protected, missing out on the trade and investment train.

Annex Figure 1.
Annex Figure 1.

Labor and Product Market Constraints

(Relative to OECD average)

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Southern Europe consists of Greece, Italy, Portugal and Spain.1/ Average tax wedge on labor; average of two income situations (67% and 100% of average earnings). Source: OECD and Staff calcualtions.

Specific structural gaps vary considerably across euro area countries, and are reflected in different reform priorities. All euro area countries have structural gaps with respect to the OECD benchmark, as shown by the orange flags (a rating below average) and the red flags (a rating more than one standard deviation below average) in Annex Table 1. The South stands out as a region with larger structural reforms gaps across the board, including with regards to institutions and contract enforcement, education, business regulation, and innovation capacity. To respond to the most urgent priorities, most euro area countries, in particular in the South, have put in place comprehensive reforms in the past years, which are not captured in these backward-looking indicators, and more are in the pipeline (Annex II). Nevertheless, IMF recommendations on reform priorities for each country indicate that further measures are needed, in particular to improve the functioning of labor markets, increase labor force participation, and reduce barriers to competition, which should help enhance competitiveness and dampen the negative impact of aging.

Annex Table 1.

Structural Reform Gaps in Selected Euro Area Economies: A Heatmap 1/

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Sources: OECD Going for Growth 2012; Fraser Institute Index of Economic Freedom 2011; WEF Global Competitiveness Report 2011-12; WB Doing Business 2012.

See IMF (2010) for a description of the methodology. The indicators reflect the most recent data available from the sources, and do not always capture the most recent reforms implemented.

Labor market institutions represent a key reform priority, but reform should take into account different work models. It is notable that the German labor market, which is found to have significant gaps compared to their OECD benchmarks (Annex Figure 2), produced favorable employment outcomes during the crisis. Episodes of successful labor market reforms in various European countries during the last three decades show that wage moderation is a basic ingredient in ensuring large shifts in labor and output growth. This was achieved through agreements between social partners in exchange for higher job security (Ireland and Netherlands, see Box 1), and with cuts in labor tax (Denmark and Ireland). Collective bargaining systems that are more favorable to employment than wage increases, which typically requires strong coordination or strong decentralization as opposed to intermediate coordination (a feature in several Southern countries), seemed to have worked better. Most reform episodes also took place in conjunction with reduction in government wages and transfers highlighting the complementarity of institutional reform and fiscal policy elements (Annett, 2007).

Annex Figure 2.
Annex Figure 2.

Cross-Country Differences in Labor Market Institutions: Euro Area 1/

Citation: Staff Discussion Notes 2012, 007; 10.5089/9781475504644.006.A001

Source: Organization for Economic Cooperation and Development.1/ 2008 for EPL and minimum wage; 2009 for unemployment benefit; and 2011 for tax wedge.2/ Average tax wedge on labor; average of two income situations (67 percent and 100 percent of average worker earnings). Data for Greece are from 2010.3/ Average of net replace rates for six family types and two earning levels (67 percent and 100 percent of average worker earnings).

Annex II. Euro area: Country-Specific Structural Reform Recommendations

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1

The staff team consisted of Derek Anderson, Bas Bakker, Helge Berger, Davide Furceri, Benjamin Hunt, Florence Jaumotte, Prakash Loungani, Ruud de Mooij, Esther Pérez Ruiz, Mika Saito, Antonio Spilimbergo, Yan Sun, Andrew Tiffin, Edouard Vidon, and desk economists for euro area countries in the European Department.

2

The theme of growth in Europe is by no means new. See for example, Allard et al., 2010, the World Bank, 2012 and OECD, 2012, for a discussion of policy priorities in Europe.

3

GIMF is a general equilibrium model where all markets clear, though it features nominal and real rigidities and incomplete asset markets. The gradual implementation of reforms, combined with the gradual adjustment of labor supply and capital in response, drive the difference between short and long-run effects. The simulations are conducted with monetary policy constrained at the zero lower bound in the short run, but this only exacerbates the magnitude of effects, it does not change the sign.

4

This also raises the issue of sequencing. Blanchard and Giavazzi (2003) argue that, by reducing rents, greater competition in product markets facilitate labor market reforms.

5

This note does not delve into important longer-term labor market issues, such as adverse demographics and immigration, the size of the government, and the role of innovation and non-bank financial institutions.

6

The south needs to regain competiveness with respect to all its trading partners, not only northern Europe. Convergence of the north to the competiveness levels of the south is not a solution.

Fostering Growth in Europe Now
Author: Ms. Bergljot B Barkbu, Jesmin Rahman, and Mr. Rodrigo O. Valdes