## _sdn1407

## Source details

**Canonical URL:** [_sdn1407](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2014/_sdn1407.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2014/_sdn1407.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2014/_sdn1407.pdf.json)

---

### Executive summary and key findings
- Imbalances within the euro area were a defining feature of the crisis: several “deficit” economies accumulated large net foreign liabilities (NFLs) — notably Greece, Ireland, Portugal, and Spain.
- When capital inflows stopped, deficit economies suffered deep recessions and very large increases in unemployment.
- Primitive forces that caused external imbalances were partly reined in, including:
  - scaled-back expectations about future productivity growth and related capital flows; and
  - reduced implicit guarantees owing to financial sector reforms and policy actions, including debt restructuring.
- Two objectives remain:
  - restoring external balance — a NFL position deemed sustainable by market participants; and
  - restoring internal balance — sufficiently high and sustainable growth to reduce unemployment to acceptable levels.
- Relative price adjustment must occur via internal devaluations because nominal exchange rates are absent; if devaluations occur mainly through falling prices in deficit economies rather than rising prices in surplus economies, domestic demand can be reduced and debt overhang problems exacerbated.
- Relative price adjustments observed:
  - Real effective exchange rates of the deficit countries have depreciated by 10–25 percent.
  - Depreciations were driven largely by reductions in unit labor costs (ULCs) due to shedding of labor.
  - Exports rebounded in some deficit economies, but slumping internal demand (and imports) accounted for much of current account deficit reductions.
  - Surplus economies did not show commensurate demand increases; the euro area current account shifted from deficit into surplus.
  - Under current projections, NFLs of deficit countries will remain very large for a long time.
- Short-run hindrances to internal rebalancing:
  - weak demand for exports from euro-area partner economies; and
  - very low inflation in the euro area.
- Policy implications highlighted:
  - Macroeconomic policies to support demand and bring inflation in line with the “below but close to 2 percent” objective.
  - Further bank balance sheet repair to improve prospects for credit and investment.
  - Structural reforms in labor and product markets to improve productivity and support reallocation to tradable sectors.
  - Continued institutional reforms at EU/euro area levels, particularly completing the Banking Union and developing capital markets.
  - Elements of a Fiscal Union to create fiscal integration among Member States to facilitate risk sharing and adjustments.

### EMU origins, causes of imbalances, and crisis chronology
- Origins and concerns:
  - Delors Report expectation: EMU with perfect capital mobility would strengthen the single market, eliminate exchange rate volatility, and foster integration.
  - EMU did not meet several optimal currency area criteria (similar business cycles, high labor mobility, fiscal risk sharing).
  - Nominal interest rate convergence, uneven financial integration, and macroeconomic heterogeneity contributed to risks.
  - Little attention was paid to ballooning NFLs as external adjustment was expected through monetary aggregates.
- Capital inflows and domestic demand booms:
  - Capital flowed from core countries (especially Germany and France; and the United Kingdom in Ireland’s case) to deficit countries, financing property booms (notably Ireland and Spain, also Greece) and fueling wage growth in excess of elsewhere.
  - Interest rates ceased signaling macroeconomic pressure points; sovereign ratings converged and markets behaved procyclically.
- Asymmetric trade shocks and other drivers:
  - Rise of China, higher oil prices, and German outward integration contributed to divergence in export performance; deficit economies attracted little FDI.
  - Declines in transfers and rising net income payments worsened current accounts in some deficit economies.
  - Overvaluations and rising ULCs (mainly in non-tradable sectors) contributed to deteriorating competitiveness.
  - Weak banking supervision, weak demand management, and implicit guarantees under EU prudential rules reinforced imbalances.
- Crisis chronology and events:
  - Trigger: Greece’s understated fiscal data in fall 2009; Greece lost market access; Troika program of May 2010 provided official funding.
  - Crisis spread: Ireland’s banking system and sovereign destabilized in September 2010; Portugal in spring 2011; intensified summer 2011 with concerns about Italy and Spain.
  - A generalized freeze of wholesale funding hit euro area banks in fall 2011; first half of 2012 saw intensified adverse sovereign-bank loops in Spain and Italy.

### Fragmentation, official support, and financing magnitudes
- Fragmentation and cross-border exposures:
  - Reassessment of macro-financial risks led to drastic reduction of cross-border exposures and a sudden stop of capital flows.
  - Emergence of adverse sovereign-bank links, divergence in retail deposit and lending markets, and severe tightening of external budget constraints in deficit countries.
- Role of official support and Eurosystem operations (quantified figures cited):
  - Total official lending disbursed support reached about €400 billion at the end of the first quarter of 2013.
  - The Securities Markets Programme was valued at approximately €200 billion in January 2013.
  - Total value of Target 2 liabilities of deficit countries reached a maximum of €794 billion at the end of the second quarter of 2012.
  - Combined figure noted as about 45 percent of 2012 GDP of the five deficit countries.
  - By comparison, U.S. support to the private sector from the Treasury, FDIC, and the Federal Reserve reached a maximum of 32 percent of GDP during 2008–2010.
  - Some support mechanisms (e.g., Outright Monetary Transactions) provided credible backstops without requiring actual use of financial resources.

### Adjustment mechanisms in a monetary union: internal devaluation, REERs, and ULCs
- Short-run needs:
  - Deficit countries require official financing and bank liquidity support to fill balance of payments financing gaps.
- Medium-term strategy with no nominal exchange rate adjustment:
  - Achieve internal devaluation to close output gaps and lower unemployment via expansion of tradable sectors (more exports, fewer imports).
  - Internal devaluation entails a decline in domestic ULCs relative to trading partners — via lower relative wages and/or increased labor productivity and non-price adjustments.
- Real effective exchange rates and ULC dynamics:
  - Economy-wide ULC-based REERs have depreciated by about 10–25 percent since their peaks in Greece, Ireland, Portugal and Spain.
  - GDP deflator-based REERs also depreciated, though somewhat less than ULC-based REERs — implying increased profit margins.
  - Ireland’s adjustment started fairly early; Greece’s adjustment began later.
  - Main drivers of REER depreciations were large declines in ULCs; nominal exchange rate depreciation played only a small role.
  - ULC developments:
    - Ireland: 15–20 percent reductions in ULCs due to wage cuts and labor shedding; wages now recovering, but output remains below peak.
    - Portugal and Spain: 5–10 percent ULC reductions primarily from labor shedding; real output remains below pre-crisis levels.
    - Greece: ULC reductions mainly from wage cuts; productivity broadly stagnated despite major job losses.
    - Italy: ULCs have risen while productivity remained broadly stable; France and Germany fared similarly.

### Exports, sectoral reallocation, and competitiveness
- Export performance determinants:
  - Export demand growth was more sluggish in deficit countries due to specialization in slower growing markets outside the euro area (Greece and Italy) or lower share of exports to non-euro area countries (Portugal, Spain).
  - Decomposition of exports indicates strongest contributions from export demand from the rest of the world and changes in nominal effective exchange rates; weak demand from within the euro area was a drag.
  - Nominal exchange rate contributed about 1 percentage point to export growth of France, Germany, and Ireland; smaller contributions in Greece, Italy, Portugal, and Spain.
- Empirical observations on competitiveness and margins:
  - Export growth picked up after the crisis mainly from rebound in external demand; Ireland and Spain experienced relatively solid export recoveries.
  - Substantial ULC adjustments have not uniformly translated into export price competitiveness gains:
    - Average profit margins of exporters have risen since the crisis in Greece, Ireland, Portugal, and to some extent Spain.
    - Average margins fell in Italy and France since the crisis; in Germany margins declined somewhat after rising before the crisis.
  - Price competitiveness indicator improved in Ireland and Spain, declined in Greece and Portugal, improved modestly in Germany, and remained stable in France and Italy.
  - Market shares: most euro area countries, including surplus countries, continued to lose world market share; within the euro area, market shares of Greece, Portugal, and Spain barely improved; Ireland modestly declined.
- Sectoral resource reallocation:
  - Before the crisis, employment in non-tradable sectors expanded significantly in Greece, Ireland, and Spain; employment in tradable sectors declined or remained flat.
  - Since the crisis, limited evidence of resource reallocation from non-tradable to tradable sectors despite relative price adjustments.
  - Sectoral ULC patterns:
    - Since crisis, ULC declines were driven by labor shedding; Greece, Ireland, Portugal, and Spain experienced larger reductions of ULCs in tradable than non-tradable sectors — conducive to reallocation.
    - France and Italy’s tradable-sector ULCs have risen faster than non-tradable-sector ULCs since the crisis (deteriorating competitiveness); in Germany tradable-sector ULCs rose somewhat more than non-tradable ULCs.
    - No evidence that non-tradable prices are falling relative to tradable prices.

### Nature, sustainability, and decomposition of current account reversals
- Nature of adjustment:
  - All deficit economies saw very large contractions in current account deficits.
  - Much adjustment occurred through imports compression and output slumps rather than symmetric demand shifts; this produced disappointing growth and persistent high unemployment.
- Decomposition and contributions:
  - From a saving-investment perspective, decline in residential investment contributed significantly to external balancing.
  - Higher private saving was more or less offset by lower public saving, except in Greece and Ireland where public savings increased sharply while private saving declined.
  - Observed cyclical factors accounted for substantial shares of current account reversals between 2007 and 2012:
    - cyclical factors account for 50 percent, 32 percent and 27 percent of the actual current account reversals in Greece, Ireland, and Spain, respectively, or respectively 5.3 percent of GDP, 2.5 percent of GDP and 2.2 percent of GDP.
  - Structural factors (including lower potential output and medium-term expected growth) were generally smaller contributors but significant for Germany, Italy, Portugal, and Spain.
  - A “stress factor” (common component for program countries and Spain) accounted for a significant part of reversals; could reflect lasting structural change in investor attitudes or cyclical depressed demand.
  - Unexplained residuals are sizeable and could reflect structural or cyclical factors.
- Outlook for NFL/NFA positions (baseline projections, assuming no valuation effects):
  - NFL positions of Greece, Ireland, Portugal, and Spain will remain above 80 percent of GDP in 2018.
  - Most of the worsening of NFL positions experienced during 2000–2012 will not be undone by 2018 under the baseline.
  - Reaching the EU Commission scoreboard threshold (of 35 percent of GDP) will take even longer for some countries.
  - NFA position of Germany is forecast to continue to grow under the current baseline.

### Labor mobility, risk sharing, and financial mechanisms
- Labor mobility:
  - Labor mobility is significantly weaker in Europe than in the United States; it can cushion demand compression but outflows may aggravate debt overhang problems and slow adjustment.
- Fiscal and private risk sharing:
  - In the United States, fiscal transfers typically smooth about 15 to 30 percent of an initial shock in unions; long-term federal transfers exceed flows within the euro area.
  - Private credit and capital markets in the U.S. smooth about 40 percent (capital markets), 23 percent (credit markets), and 13 percent (federal government) of shocks (Asdrubali, Sorensen, and Yosha, 1996).
  - In the euro area, about 60 percent of income shocks were not smoothed by fiscal or private mechanisms over 1979–2010 (Furceri and Zdzienicha, 2013).
  - Overall risk sharing collapsed in 2010 driven by fiscal consolidations (Kalemli-Ozcan, Luttini, and Sorensen, 2013).
- Financial fragmentation:
  - Fragmentation of the banking system has drastically constrained private risk sharing since the crisis.

### Risks from internal devaluations and debt overhangs
- Internal devaluations accomplished via low or falling inflation can aggravate debt overhang problems among deficit firms, households, and public sectors, undermining domestic demand recovery and slowing closing of output gaps.
- Evidence suggests inflation has become less responsive to slack; large output gaps and unemployment may elicit a slow price response (World Economic Outlook, April 2013).
- Historical example: France in the 1980s — internal devaluation lowered inflation differentials but adjustment was protracted and had limited impact on unemployment and competitiveness (Blanchard and Muet, 1993).

### Policy priorities and recommendations
- Short run:
  - Supportive macroeconomic policies to support domestic demand and facilitate relative price adjustments; further monetary easing can support demand especially if inflation is close to 2 percent.
  - Official financing and liquidity support to fill balance of payments gaps.
- Medium run:
  - Bank balance sheet repair and financial sector reforms to restart credit to creditworthy borrowers and support investment in tradable sectors.
  - Structural reforms in labor and product markets to raise productivity and reallocate resources toward tradable sectors:
    - Active labor market policies and tax reforms have potentially high short-term GDP impact.
    - Deregulating product markets and reducing entry barriers in services and network industries can lift productivity and downstream TFP, lowering non-tradable costs and supporting tradables without nominal wage cuts.
    - Lowering the tax wedge and fiscal devaluation (lower labor taxes, higher consumption taxes) can assist internal devaluation.
    - Reforms to reduce labor market duality, improve employment protection linked to tenure, and strengthen unemployment insurance and active labor market policies.
- Area-wide/architectural reforms:
  - Completing the Banking Union (Single Supervisory Mechanism, Single Resolution Mechanism, common fiscal backstop) to reverse financial fragmentation, speed bank repair, improve monetary transmission, and weaken sovereign-bank feedback loops.
  - Deepening capital markets and integrating them to increase private risk sharing and mobilize financing for recovery; SME financing initiatives and securitization schemes can support SME lending.
  - Strengthening governance and coordination via MIP and European Semester to motivate structural reforms.
  - Elements of fiscal integration for shock smoothing and countercyclical capacity are desirable though politically challenging.
- Cautions:
  - Internal devaluations can be long and painful; productivity-enhancing reforms are preferred as they boost demand and are less likely to exacerbate debt overhangs.
  - Reforms that lower wages rapidly can worsen demand and require complementary macro support and social policies.

### Illustrative numeric facts (selected)
- €400 billion — total official lending disbursed support, end of Q1 2013.
- €200 billion — Securities Markets Programme, January 2013.
- €794 billion — maximum Target 2 liabilities of deficit countries, end of Q2 2012.
- 45 percent — combined support figures as share of 2012 GDP of the five deficit countries.
- 32 percent — maximum U.S. private sector support as percent of GDP during 2008–2010.
- ULC-based REER depreciations of about 10–25 percent in Greece, Ireland, Portugal, Spain since peaks.
- Ireland: 15–20 percent ULC reduction.
- Portugal and Spain: 5–10 percent ULC reduction.
- Cyclical factors account for 50 percent, 32 percent and 27 percent of the actual current account reversals in Greece, Ireland, and Spain respectively (or 5.3 percent of GDP, 2.5 percent of GDP and 2.2 percent of GDP).
- 15 to 30 percent — typical smoothing of an initial shock by fiscal transfers in unions like the United States.
- 40 percent / 23 percent / 13 percent — smoothing by capital markets / credit markets / federal government (Asdrubali, Sorensen, and Yosha, 1996).
- 60 percent — share of income shocks not smoothed in the euro area over 1979–2010 (Furceri and Zdzienicha, 2013).
- NFL positions of Greece, Ireland, Portugal, and Spain projected to remain above 80 percent of GDP in 2018 under baseline (assuming no valuation effects).

*Source: IMF — ADJUSTMENT IN EURO AREA DEFICIT COUNTRIES (excerpts from _sdn1407).*

### INTRODUCTION ...........................................................................................................

### _sdn1407 - INTRODUCTION

### Executive Summary
- Imbalances within the euro area have been a defining feature of the crisis. Since the start of Economic and Monetary Union (EMU), several euro area “deficit” economies accumulated large net foreign liabilities (NFLs) on the back of domestic demand booms and large capital inflows. These included Greece, Ireland, Portugal, and Spain.
- When the crisis hit, capital inflows stopped, and liquidity dried up. The deficit economies suffered deep recessions and very large increases in unemployment rates.
- Primitive forces that caused external imbalances have partly been reined in, including:
  - scaled-back expectations about future productivity growth and related capital flows; and
  - reduced implicit guarantees owing to financial sector reforms and policy actions, including debt restructuring.
- Additional adjustments are needed to achieve two objectives:
  - restoring external balance — a NFL position deemed sustainable by market participants; and
  - restoring internal balance — sufficiently high and sustainable growth to reduce unemployment to acceptable levels.
- Relative price adjustment must occur via relative changes in prices and costs (internal devaluations) because nominal exchange rates are absent. If devaluations occur mainly through falling prices in deficit economies rather than rising prices in surplus economies, these can reduce domestic demand and exacerbate debt overhang problems.
- Relative price adjustments have proceeded gradually:
  - Real effective exchange rates of the deficit countries have depreciated by 10–25 percent.
  - Depreciations have been driven largely by reductions in unit labor costs (ULCs) due to shedding of labor.
  - Exports have typically rebounded, but slumping internal demand (and imports) account for much of the reduction in current account deficits.
  - Surplus economies have not shown commensurate demand increases or narrower current account surpluses, so the euro area current account shifted from deficit into surplus.
  - Internal rebalancing has come with subdued activity and very high unemployment in deficit economies.
  - Under current projections, it will take a long time before the NFLs of the deficit countries decline to levels common elsewhere; net foreign assets of surplus economies (e.g., Germany and the Netherlands) have continued to expand.
- Short-run hindrances to internal rebalancing:
  - weak demand for exports from euro-area partner economies; and
  - very low inflation in the euro area.
- Policy implications highlighted:
  - Macroeconomic policies to support demand and bring inflation in line with the “below but close to 2 percent” medium-term price stability objective.
  - Further bank balance sheet repair to improve prospects for credit and investment.
  - Structural reforms in labor and product markets to improve productivity and support reallocation to tradable sectors in the medium run.
  - Continued institutional reforms at EU/euro area levels, particularly completing the Banking Union and developing capital markets, to ensure proper financial intermediation.
  - Elements of a Fiscal Union to create some fiscal integration among Member States to facilitate risk sharing and adjustments in the euro area.

### Introduction: EMU origins, concerns, crisis, and scope
- Origins:
  - The Delors Report (1989) argued EMU with perfect capital mobility would strengthen the EU single market, eliminate exchange rate volatility, prevent balance-of-payment crises, and foster trade and financial integration.
  - Expectation: viable private consumption and investment of member countries would always be financed.
- Concerns:
  - EMU did not meet several optimal currency area criteria: similar national business cycles, high labor mobility, and significant cross-country fiscal risk sharing.
  - Creation of the euro triggered a substantial convergence of nominal interest rates, uneven financial market integration, and wide divergences in national economic developments (Laeven and Tressel, 2013).
  - Little attention was paid to ballooning NFLs as external adjustment was expected through monetary aggregates (Wyplosz, 2006); macroeconomic heterogeneity across member states was noted as a potential source of concern.
- The crisis:
  - Market perceptions of risk became less tied to nationality after euro creation; capital flowed into deficit economies (particularly Greece, Ireland, Portugal, Spain), fueling domestic demand and housing booms.
  - Current account balances declined and NFLs accumulated to very high levels.
  - Progressive external adjustment through monetary aggregates did not occur; market perceptions became country-specific again, leading to sudden reversals of capital inflows in 2010–2012.
  - Private capital withdrawal precipitated adverse sovereign-bank-real economy feedback loops; safety nets and backstops remained national, fostering fears of exits from the monetary union.
  - Stabilization required interventions from the ECB, member states, and multilateral organizations, including official financing and debt restructuring.
- Adjustment:
  - External imbalances narrowed asymmetrically: deficits narrowed appreciably, surpluses did not decline commensurately.
  - Much of the deficit reduction related to slumping activity rather than symmetric demand shifts, producing large internal imbalances (notably high unemployment).
  - Large NFLs have declined only moderately despite reduced current account deficits.
- Scope of the paper:
  - Focuses on “deficit economies” that accumulated very large current account deficits and net external liability positions and suffered severe market pressure: Greece, Ireland, Portugal, Spain.
  - Italy is discussed for comparison but had smaller current account deficits and net external liability positions in percent of GDP.
  - The paper covers causes of imbalances and a narrative of the crisis (section II), adjustment mechanisms within a monetary union (section III), stylized facts on rebalancing and remaining adjustments (section IV), and policies to facilitate rebalancing (section V).

### Background — What caused euro area imbalances?
- Expectations of convergence:
  - Common view at EMU start: removal of exchange rate risk would trigger “downhill” capital flows, converging income levels within the euro area (Balassa-Samuelson effect cited).
- Capital inflows and domestic demand booms:
  - Exuberant investors sought higher yields; capital flowed from core countries (especially Germany and France; and the United Kingdom in Ireland’s case) toward sovereigns and banks in deficit countries.
  - Capital financed property booms (notably Ireland and Spain, also Greece) at the expense of tradable sectors, undermining debt repayment prospects.
  - Higher growth and domestic demand fueled wage growth in excess of elsewhere, with ULC increases primarily in non-traded sectors.
  - Interest rates ceased signaling macroeconomic pressure points as market discipline weakened; sovereign ratings converged and markets behaved procyclically.
- Asymmetric trade shocks:
  - Rise of China displaced some countries’ exports; higher oil prices increased trade deficits for some.
  - Higher income in oil-producing countries and China boosted demand for machinery and equipment exported by Germany.
  - German outward integration and production platforms in emerging Europe boosted Germany’s competitiveness and exports to deficit economies; deficit economies attracted little FDI.
- Decline in transfers and rising income payments:
  - In many deficit economies, current account balance worsened more than the trade balance due to declining private and official transfers and rising net income payments.
  - Falling transfers typically reduce consumption and improve trade balance, but this did not occur—possibly because private agents anticipated rising incomes and used capital inflows to sustain consumption/investment.
- Sizeable overvaluations and deteriorating competitiveness:
  - Signs of overvaluation appeared in several deficit countries.
  - The lion’s share of real exchange rate appreciations between 2000 and 2009 resulted from the nominal appreciation of the euro vis-à-vis other currencies, even for countries that entered EMU at potentially overvalued real exchange rates.
  - Contribution of relative prices and ULCs was smaller; most ULC increases occurred in non-tradable sectors, which may explain why exports did not substantially weaken (except in Ireland, where merchandise trade share fell while services share rose).
  - Boom in domestic demand and rising ULCs, along with labor market rigidities, exacerbated external imbalances.
- Low productivity and structural rigidities:
  - Initial expectations about productivity growth in deficit economies were overly optimistic; real labor productivity growth declined relative to the euro area average.
  - Labor market rigidities meant unemployment remained relatively high at the boom peak (except Ireland), and ULCs rose.
- EMU institutional setup reinforced imbalances through:
  - Weak banking supervision:
    - Large current account deficits, rising external indebtedness, and bank asset-liability maturity mismatches did not prompt effective risk-reining policies.
    - Banks expanded across borders; national supervisors lacked a full picture of cross-border risks.
    - Supervisory bias toward “national champions” reinforced incentives to ignore financial excesses.
  - Weak demand management:
    - Single monetary policy targeting an average inflation rate may have exacerbated divergence of domestic demand (the “Walters critique”).
    - In deficit economies with higher inflation, low real interest rates contributed to booming domestic demand and widening current account deficits.
    - Fiscal policies did not mitigate demand expansions—output gains were mistaken for permanent improvements and political limits hindered large fiscal surpluses; the Stability and Growth Pact was not enforced (including by France and Germany).
    - Lack of fiscal discipline was a major factor behind external imbalances mainly in Greece and, to a lesser extent, Portugal.
  - Implicit guarantees:
    - Under EU prudential rules, sovereign exposures carried a zero risk weight in all euro area countries.
    - ECB collateral policy treated all euro area sovereign bonds as safe assets and accepted a broad set of financial assets as collateral.
    - These factors reduced credit risk, enhanced refinancing and funding capacities of euro area banks, contributed to cross-border expansions, and helped misprice risks—creating perceptions of implicit guarantees despite the “no bail-out” clause.

### Imbalances and the Euro Area Crisis (overview)
- After euro creation, market perception shifts and large capital inflows to deficit countries created domestic demand and asset-price booms; NFLs rose to very high levels.
- The anticipated progressive external adjustment through monetary aggregates did not occur; instead, sudden capital-flow reversals in 2010–2012 precipitated crises in stressed economies.
- National safety nets and backstops increased vulnerability and fears of exits, making balance-of-payments positions of individual countries a critical source of risk despite the monetary union.
- Crisis stabilization required multi-level interventions, including official financing and debt restructuring.

*Source: IMF — ADJUSTMENT IN EURO AREA DEFICIT COUNTRIES (INTRODUCTION and EXECUTIVE SUMMARY sections).*

### 13.      Events. All euro area countries that had large external imbalances experienced severe

### _sdn1407 - 13.      Events. All euro area countries that had large external imbalances experienced severe

### Events and crisis chronology
- Trigger and early transmission:
  - Trigger: Greece’s fiscal data in the fall of 2009, which had vastly understated the true fiscal deficit of the country.
  - Greece lost access to capital markets; the Troika program of May 2010 provided official funding.
  - Crisis spread: destabilized Ireland’s banking system and its sovereign in September of 2010; spread to Portugal in spring of 2011; intensified in summer of 2011 with market concerns spreading to Italy and Spain.
  - A generalized freeze of wholesale funding hit euro area banks, including those from core countries, in fall of 2011.
  - First half of 2012: adverse sovereign-bank loops intensified financial stress in Spain and Italy; market concerns about euro area exit (IMF, 2012 and IMF, 2012b).

### Fragmentation and cross-border exposures
- Reassessment of macro-financial risks led to:
  - Drastic reduction of cross-border exposures within the euro area and a sudden stop of capital flows.
  - Emergence of adverse sovereign-bank links in deficit countries (Merler and Pisani-Ferry, 2012; Tressel, 2012; Laeven and Tressel, 2013b).
  - Divergence in retail deposit and lending markets and severe tightening of external budget constraints in deficit countries.
  - Disruption of monetary policy transmission and creation of procyclical macroeconomic conditions (Goyal and others, 2013; Al-Eyed and Berkmen, 2013).

### Adjustment mechanisms in a monetary union
- Short-run needs:
  - Deficit countries require official financing and bank liquidity support to fill balance of payments financing gaps.
- Medium-term strategy with no nominal exchange rate adjustment:
  - Achieve an internal devaluation to close output gaps and lower unemployment via expansion of tradable sectors (more exports, fewer imports).
  - Internal devaluation entails a decline in domestic ULCs relative to those of trading partners—through a decline in relative wages and/or increases in labor productivity and other non-price adjustments (e.g., related to product quality).

### Role of the central bank and official support
- Official support and Eurosystem operations:
  - Adjustment supported by official financing to Greece, Ireland, and Portugal.
  - Target 2 balances reflect Eurosystem interventions that filled private financing gaps in national balance of payments.
- Quantified support (as presented):
  - Total official lending disbursed support reached about €400 billion at the end of the first quarter of 2013.
  - The Securities Markets Programme was valued at approximately €200 billion in January 2013.
  - Total value of Target 2 liabilities of deficit countries reached a maximum of €794 billion at the end of the second quarter of 2012.
  - Combined figure noted as about 45 percent of 2012 GDP of the five deficit countries.
  - By comparison, in the United States support to the private sector from the Treasury, FDIC, and the Federal Reserve reached a maximum of 32 percent of GDP during 2008–2010.
  - Some support mechanisms (e.g., Outright Monetary Transactions) provided credible backstops without requiring actual use of financial resources.

### Real exchange rate adjustments and relative prices
- Two interrelated relative price adjustments required for internal devaluation:
  - Domestic prices versus foreign prices:
    - Decline in price of domestic tradable goods relative to foreign tradable goods to boost exports; involves production cost adjustments including wages and induces expenditure switching.
  - Tradable versus non-tradable:
    - Increase profitability of tradable goods relative to non-tradable to reallocate resources toward tradables; achievable via falling ULCs in tradable sectors relative to non-tradable sectors, or via falling non-tradable prices.

### Export competitiveness and productivity
- Paths to competitiveness gains:
  - Higher productivity in tradable production or moving up product quality ladders sustain price competitiveness gains.
- Empirical observations:
  - Export growth picked up after the crisis mainly from rebound in external demand; Ireland and Spain experienced relatively solid export recoveries.
  - Export growth forecasts remain modest, particularly in Greece, Italy, and Portugal.
  - Substantial ULC adjustments have not uniformly translated into export price competitiveness gains:
    - In Greece, Ireland, Portugal, and to some extent Spain: average profit margins of exporters have risen since the crisis (gap between tradable costs and export prices).
    - In Italy and France: average margins of exporters have continued to fall since the crisis.
    - In Germany: average margins declined somewhat in recent years after rising before the crisis.
  - Price competitiveness indicator (export prices relative to goods produced in export markets) improved in Ireland and Spain, declined in Greece and Portugal, improved modestly in Germany, and remained stable in France and Italy.
  - Market shares: most euro area countries (including surplus countries) have continued to lose world market share; within the euro area, market shares of Greece, Portugal, and Spain have barely improved; Ireland modestly declined.

### Real effective exchange rates and unit labor costs (ULCs)
- REER and ULC dynamics:
  - Economy-wide ULC-based REERs have depreciated by about 10–25 percent since their peaks in Greece, Ireland, Portugal and Spain.
  - GDP deflator-based REERs also depreciated, though somewhat less than ULC-based REERs—implying increased profit margins.
  - Ireland’s adjustment started fairly early; Greece’s adjustment began later.
  - Main drivers of REER depreciations: large declines in ULCs; nominal exchange rate depreciation played only a small role.
  - In Italy, GDP deflator and ULC-based REER changed only to a limited extent; Italy’s current account and net external liability positions were less deep in deficit than deficit economies.
  - France and Germany: both REER indicators changed by small amounts.

- ULC developments across countries:
  - ULCs have fallen across all deficit countries; in all but Greece, productivity gains contributed significantly to lowering ULCs.
  - Ireland: 15–20 percent reductions in ULCs due to wage cuts and labor shedding; wages are now recovering, but output remains below peak.
  - Portugal and Spain: ULC reductions of 5–10 percent came primarily from labor shedding; real output remains below pre-crisis levels.
  - Greece: ULC reductions came mainly from wage cuts; slump in output large enough that productivity broadly stagnated despite major job losses.
  - Italy: ULCs have risen while productivity remained broadly stable; France and Germany fared similarly.

### Sectoral evidence of production-cost adjustment
- Pre-crisis vs. since-crisis patterns:
  - Pre-crisis: non-tradable ULCs grew faster than tradable ULCs in Italy, Portugal, and Spain; in Germany, tradable ULCs declined faster than non-tradable ULCs.
  - Since crisis: ULC declines driven by labor shedding. Greece, Ireland, Portugal, and Spain experienced larger reductions of ULCs in tradable than non-tradable sectors—conducive to reallocation of production.
  - Divergence for large economies: France and Italy’s tradable-sector ULCs have risen faster than non-tradable-sector ULCs since the crisis (deteriorating competitiveness); in Germany, tradable-sector ULCs rose somewhat more than non-tradable ULCs.
  - No evidence that non-tradable prices are falling relative to tradable prices.

### Internal rebalancing, labor mobility, and fiscal/financial risk sharing
- Internal rebalancing:
  - External adjustment has mostly occurred through demand compression rather than expenditure switching, yielding disappointing growth and persistent high unemployment (Lane and Milesi-Ferreti, 2011).
- Labor mobility:
  - Can cushion need for demand compression by allowing outflows to more productive member states (Blanchard and Katz, 1992).
  - Labor mobility is significantly weaker in Europe than in the United States (Decressin and Fatás, 1995; Dao, Furceri and Loungani, 2014; Obstfeld and Peri, 1998).
  - Labor outflows can aggravate debt overhang problems and slow adjustment (Shambaugh, 2012).
- Financial support from the center in a full union:
  - Fiscal transfers from the center smooth shocks; studies find about 15 to 30 percent of the initial shock is typically smoothed in unions like the United States.
  - Long-term federal transfers in the United States far exceed flows within the euro area and can be large cumulatively for net receiver states.
  - Central safety nets and common banking backstops (centralized bank resolution, central deposit insurance, central fiscal backstops) help avoid contagion from local bank failures to state balance sheets and stem retail depositor panics.
- Role of the financial system in risk sharing:
  - In the United States, private credit and capital markets smooth consumption: Asdrubali, Sorensen, and Yosha (1996) found about 40 percent of shocks to gross state products are smoothed by capital markets, 23 percent by credit markets, and 13 percent by the federal government.
  - In the euro area, risk sharing through the financial system has been more limited; fragmentation of the banking system has drastically constrained private risk sharing since the crisis.
  - Furceri and Zdzienicha (2013): over 1979–2010, about 60 percent of income shocks in the euro area are not smoothed out by fiscal or private risk sharing mechanisms. Kalemli-Ozcan, Luttini, and Sorensen (2013) show overall risk sharing collapsed in 2010 driven by fiscal consolidations.

### Illustrative figures and examples
- Official support and program amounts:
  - €400 billion (total official lending disbursed support, end of Q1 2013)
  - €200 billion (Securities Markets Programme, January 2013)
  - €794 billion (maximum Target 2 liabilities of deficit countries, end of Q2 2012)
  - 45 percent (approximate share of 2012 GDP of the five deficit countries represented by the combined support figures)
  - 32 percent (maximum U.S. private sector support as percent of GDP during 2008–2010)
- Country-specific ULC and competitiveness snapshots:
  - ULC-based REER depreciations of about 10–25 percent since peaks in Greece, Ireland, Portugal, Spain.
  - Ireland: 15–20 percent ULC reduction.
  - Portugal and Spain: 5–10 percent ULC reduction.
- Risk-sharing and smoothing statistics:
  - 15 to 30 percent (typical smoothing of an initial shock by fiscal transfers in unions like the United States).
  - 40 percent / 23 percent / 13 percent (Asdrubali, Sorensen, and Yosha (1996) estimates of smoothing by capital markets / credit markets / federal government).
  - 60 percent (share of income shocks not smoothed in the euro area over 1979–2010, Furceri and Zdzienicha (2013)).

*Source: IMF staff discussion in _sdn1407, “Adjustment in Euro Area Deficit Countries” (excerpts provided).*

### 28.      Resource reallocation from non-tradable to tradable sectors. Before the crisis,

### _sdn1407 - 28.      Resource reallocation from non-tradable to tradable sectors. Before the crisis,

### Resource reallocation and sectoral employment and output
- Before the crisis, employment in non-tradable sectors expanded significantly in Greece, Ireland, and Spain and, to a lesser extent, Portugal. Employment in tradable sectors of deficit countries declined or remained broadly flat (Greece).
- Despite adjustment in relative prices, there is limited evidence of resource reallocation from non-tradable to tradable sectors since the crisis.
- Sources used: Eurostat, Haver, and IMF staff calculations.

### Determinants of export performance since the crisis
- Export demand growth has been more sluggish in deficit countries because of either:
  - specialization in slower growing markets outside the euro area (Greece and Italy), or
  - lower share of exports to non-euro area countries (Portugal, Spain).
- Demand from other euro area countries has been declining during the period, contributing to slower export growth.
- Decomposition results from country-level export regressions indicate:
  - Export demand from the rest of the world and changes in nominal effective exchange rates provided the strongest contributions to export performance.
  - Weak demand from within the euro area was a drag on exports.
- Specific findings:
  - Initial trade specialization mattered: Germany’s relatively large share of exports outside the euro area and in fast-growing markets contributed to stronger export rebound and made its export performance less dependent on intra-euro area demand than that of deficit countries.
  - Relative price adjustments mattered, though magnitude is difficult to pin down:
    - When measured by CPI deflators, relative price adjustments were relatively small and had a minor effect on exports of the deficit countries.
    - Relative price adjustments measured by GDP deflators were more substantial; the contribution of GDP deflator adjustments to export performance was large for Greece, Ireland, and Spain.
    - The nominal exchange rate contributed about 1 percentage point to the export growth of France, Germany, and Ireland; contributions were smaller in Greece, Italy, Portugal, and Spain.
  - Weak euro area demand was a drag, particularly for Italy and Portugal as demand from euro area trading partners declined in 2008–2009 and 2011–2012.
  - Unexplained residuals:
    - Greece’s export performance was significantly weaker than predicted by external demand and relative price adjustments—possible causes include lower-than-average demand or relative price elasticities, structural and non-price impediments, substantial loss in non-price competitiveness, or vanishing working capital in the tradable sector.
    - In Germany, Portugal, and Spain, the unexplained residual is relatively large and positive, suggesting non-price factors may have supported export performance.

### Nature and sustainability of current account reversals
- Nature of the adjustment:
  - All deficit economies saw very large contractions in current account deficits.
  - If adjustments are structural, internal devaluations and structural changes may allow a return to low unemployment without creating new external imbalances. If not, current accounts may deteriorate when output gaps close or external funding recovers, or unemployment may remain high due to tight external budget constraints.
  - Much of the adjustment in relative ULCs has reflected productivity increases driven by labor shedding, which does not bode well for a quick return to low unemployment without falling current account balances.
- Current account developments since the crisis:
  - Large current account adjustments reflect a combination of imports compression (particularly in Greece and Portugal) and higher exports in Ireland, Spain, and Portugal.
  - In Greece, the decline in imports was the main contributor to the current account improvement; in Spain, exports contributed less than the decline in imports.
  - From a saving-investment perspective:
    - Decline in residential investment contributed significantly to external balancing.
    - Higher private saving was more or less offset by lower public saving, except in Greece and Ireland where public savings increased sharply while private saving declined.
- Determinants of current account adjustments (reduced-form model based on inter-temporal approach and EBA framework):
  - Fundamental determinants include:
    1. demographics (population growth, old-age dependency ratio, and aging speed);
    2. initial wealth (lagged NFA);
    3. long-term growth and neoclassical catch-up (five-year ahead real GDP growth and gap to U.S. GDP per capita), and potential output (relative to trading partners);
    4. other structural factors (cyclically adjusted fiscal balance, public health spending) and cyclical factors (output gap, global capital market conditions, commodity terms of trade);
    - specification also includes domestic credit to the private sector and a fixed effect common to all stressed countries.
- Output gaps:
  - Cyclical reversals have been very significant in deficit countries between precrisis peaks and 2012.
  - WEO estimates point to substantial changes in output gaps for Greece, Ireland, and Spain; Okun’s law–based methods deliver even larger negative output gaps.
  - Output gap indicators point to large remaining internal imbalances, though size is uncertain.
- Cyclical vs structural contributions (baseline projections):
  - Observed cyclical factors made a large contribution to current account reversals of Greece, Ireland, and Spain between 2007 and 2012:
    - cyclical factors account for 50 percent, 32 percent and 27 percent of the actual current account reversals in Greece, Ireland, and Spain, respectively, or respectively 5.3 percent of GDP, 2.5 percent of GDP and 2.2 percent of GDP.
  - Observed structural factors (including lower potential output and medium-term expected growth) were generally smaller contributors but significant for Germany, Italy, Portugal, and Spain; most structural factors represent lower potential output over the medium run (rebalancing of the bad variety).
  - The “stress factor” (common component in evolution of external balances in program countries and Spain) accounted for a significant part of current account reversals; it could reflect structural factors (lasting change in attitude of foreign investors, financial fragmentation) or cyclical factors (depressed animal spirits and demand).
  - Unexplained residuals are sizeable and could reflect structural or cyclical factors; they imply similar policy needs in deficit economies as the stress factor.
- Remaining structural adjustment and relative price shifts:
  - Large output gaps and falling imports played a major role in reducing current account deficits.
  - If the model is correct, closing output gaps would re-emerge external imbalances unless production is progressively reallocated from non-tradable to tradable sectors to allow growth within external budget constraints.
  - If the model or output gaps are mis-specified, current account improvements could persist but domestic demand would remain subdued and unemployment very high for a long time unless further structural adjustment occurs.

### Internal and external rebalancing: outlook and targets
- Restoring internal balance:
  - Strong growth is needed to bring economies to acceptable unemployment levels, and growth must come to a much larger extent from the tradable sector than before the crisis.
  - Current forecasts show potential output growth expected to remain low, implying a protracted reduction in unemployment.
  - Potential output:
    - At the end of 2012, potential output remained below its precrisis level in Greece, Italy, and Portugal, and is marginally above its precrisis level in Spain.
    - WEO projections show potential output growth expected to remain weak in all deficit countries except Ireland, where potential output in 2018 would be 14 percent above its precrisis peak.
    - Germany and France are expected to have 2018 potential output levels about 7 percent higher than in 2013.
  - Unemployment rates:
    - Before the crisis, unemployment rates reached very similar levels (between 7 and 8 percent) in the deficit countries and in France, Germany, and Italy.
    - From those levels to end-2012, unemployment increased most in Spain and Greece.
    - Unemployment rates are projected to decline but are not expected to improve by much in Spain and Portugal over the medium run.
  - Sustaining growth:
    - Growth is likely to remain low; reduction of unemployment to acceptable levels is likely to be protracted.
    - Closing output gaps requires a rebound in demand, followed by reforms to increase potential output, especially in the tradable sector.
- Restoring external balance and NFL targets:
  - Objective: achieve net foreign liability (NFL) positions that can be deemed sustainable; no definitive answers on appropriate NFL in a monetary union.
  - In an “incomplete” monetary union (without full Banking Union and Fiscal Union, incomplete financial integration, lower labor mobility), country-specific macro-financial risk, including NFL position, will continue to determine foreign capital inflows.
  - Outlook under latest projections (assuming no valuation effects):
    - NFL positions of Greece, Ireland, Portugal, and Spain will remain above 80 percent of GDP in 2018.
    - Most of the worsening of NFL positions experienced during 2000–2012 will not be undone by 2018 under the baseline.
    - Reaching the EU Commission scoreboard threshold (of 35 percent of GDP) will take even longer and would be a long-term objective in some cases.
    - High NFL could deter capital inflows and weigh on prospects for investment and growth by requiring large net income payments to the rest of the world.
    - The net foreign asset (NFA) position of Germany is forecast to continue to grow under the current baseline.

### Policies to rebalance the euro area
- Policy mix to lift potential output and foster internal and external rebalancing:
  - Supportive macroeconomic policies.
  - Structural reforms.
  - Financial sector repair and reform.
  - Strengthening the EMU architecture.
- Key policy considerations and roles:
  - Structural labor or product market rigidities may have amplified external imbalances and slowed correction.
  - Fiscal policy has typically not been a major cause of external indebtedness, with the notable exception of Greece. Reducing large deficits and debt can lower external funding costs for enterprises and banks, but consolidation should be paced to avoid excessive drag on growth.
  - Further monetary easing can support demand and facilitate internal rebalancing, especially by boosting demand in surplus economies and supporting relative price adjustments—easier when inflation is close to 2 percent than at lower forecasted levels.
  - Distorted financial sector incentives have been important; correcting them involves clarifying banks’ roles in sharing future losses and improving bank resolution regimes.
  - Much balance sheet repair remains essential to restart strong investment in tradable sectors.
  - Continued steps toward a true banking union will facilitate rebalancing and bank repair, and reduce the probability of similarly severe crises in the future.

### How structural reforms can help deficit countries
- Supporting internal devaluation:
  - Achieving internal devaluations requires depreciating the REER through lower nominal wage growth and/or improved productivity relative to trading partners.
  - Evidence shows internal devaluations can be long and painful in environments with wage rigidities.
  - Internal devaluations can be difficult when trading partners’ inflation is low and may exacerbate debt overhang problems.

*International Monetary Fund — Adjustment in Euro Area Deficit Countries (excerpts from chapter content provided).*

### 40.      Internal devaluations can worsen debt overhangs. High debt levels among deficit

### Internal devaluations can worsen debt overhangs

### Risks from internal devaluations and high debt
- High debt levels among deficit firms, households, and public sectors create risks that an internal devaluation accomplished by low or falling inflation in deficit countries could aggravate debt overhang problems (Shambaugh, 2012; Bornhorst and Arranz, 2013).  
- Such aggravation could undermine the recovery of domestic demand, especially if sovereign-bank-real economy adverse links remain active, thereby slowing the closing of output gaps and the internal rebalancing of deficit countries (Tressel, 2012).  
- The experience of France in the 1980s: internal devaluation lowered inflation differentials but adjustment was protracted and had limited impact on unemployment and competitiveness (Blanchard and Muet, 1993).  
- Recent evidence shows that over the past decade, inflation has become less responsive to economic slack (World Economic Outlook, April 2013), suggesting large output gaps and unemployment in stressed countries may elicit a slow price response.

### Structural reforms to raise productivity
- Structural reforms that raise productivity over time can facilitate adjustments; productivity improvements have similar effects on inflation as nominal wage cuts but are more desirable in the medium term because they boost demand.  
- Since the crisis, deficit countries have made major efforts to improve labor or product markets (OECD, 2013; IMF, 2013; Barkbu and others, 2012), but many reforms are still needed relative to OECD or euro area averages.  
- In below-full-employment contexts, productivity gains would improve future prospects and raise current income, which would be partly saved, helping the saving-investment balance.

Key findings on reform impact:
- Active labor market policies and tax reforms would have the highest impact on GDP in the short-term (Barkbu and others, 2012).
- Deregulating product markets can lift productivity, foster sustainable growth under tighter external funding constraints, reduce entry barriers for tradable industries, and lower costs in services and network industries—thereby depreciating the real exchange rate and improving demand for labor in tradable industries without nominal wage cuts (Blanchard and Giavazzi, 2003).
- The indirect impact of liberalizing services and network industries on TFP of downstream tradable industries could be large (Conway and others, 2006; Bourles and others, 2010).

### Adjustment of relative wages and tax structure
- Reforms removing downward wage rigidities would increase the speed of adjustment and contain unemployment costs by making wages more responsive to employment changes, but could adversely affect demand and slow return to internal balance.  
- Lowering the tax wedge would facilitate internal devaluation. Lowering labor taxes and raising consumption taxes (fiscal devaluation) could help as well. Farhi, Gopinath, and Itskhoki (2011) show such tax changes can act as a devaluation.  
- Wage bargaining institutions may need enough flexibility and adequate coordination to help adjust to macroeconomic shocks; trust and dialogue between social partners are important (Blanchard, Jaumotte and Loungani, 2013).  
- Reductions in public wages could improve fiscal positions and, in theory, contribute to adjustment if they affect private wage negotiations, but Latvia’s experience suggests short-run benefits are mainly fiscal with limited impact on private wages (Blanchard and others, 2013).

### Labor market functioning and resource reallocation
- Reducing labor market duality can improve labor flows in and out of unemployment and worker training, aiding reallocation from non-tradable to tradable sectors.  
- Linking employment protection more systematically to tenure may help avoid threshold effects of dual systems (Blanchard, Jaumotte and Loungani, 2013).  
- Unemployment insurance would help mitigate short-term adverse employment impacts of reforms, and supportive macroeconomic policy is key to supporting job creation in response to lower fixed and variable labor costs.  
- Because such reforms can have adverse short-run employment effects, they may need to be complemented by active labor market and social policies (OECD, 2013).

### Product market reform priorities
- Deregulation and reduced entry barriers in services and network industries can:
  - Stimulate competition and innovation in tradable sectors (Aghion and others, 2013).
  - Raise the quality and availability of intermediate inputs for tradable industries (Arnold et al, 2011).
  - Deliver large downstream productivity gains, notably in Greece, Italy, and Spain (Bourles and others, 2010).

### Fostering integration and coordination in the euro area
- Deepening capital markets and further integrating them can increase risk sharing and mobilize financing for recovery; SME financing initiatives (e.g., securitization schemes proposed by the EC and the EIB) could support SME lending and capital market development over the medium term.  
- Completing the Banking Union—comprising the Single Supervisory Mechanism (SSM), the Single Resolution Mechanism, and a common fiscal backstop—can:
  - Reverse fragmentation of the euro area financial system and support return of foreign capital.
  - Speed bank repair and improve transmission of accommodative monetary policy, lowering credit costs for creditworthy borrowers and facilitating firm entry in tradable sectors.
  - Weaken adverse sovereign-bank feedback loops, lower sovereign financing costs, and enhance risk sharing through financial markets. Confidence effects matter as progress assures a more resilient EMU architecture (Goyal and others, 2013).

### Bank repair, governance, and mobility of services and labor
- The ECB’s comprehensive assessment of euro area banks should help resolve uncertainty about bank balance sheets and ensure proper intermediation to support recovery and expansion of tradable sectors.  
- European initiatives like the Macroeconomic Imbalances Procedure (MIP) and the European Semester can reinforce coordination and governance, motivating structural reforms targeted at correcting imbalances.  
- Enhancing cross-country provision of services and implementation of the Services Directive would reduce barriers to entry in protected professions, improving productivity and the depreciation of non-tradable prices in deficit countries.  
- Further integrating factor markets by fostering labor mobility (e.g., improved portability of pension, insurance, and unemployment benefits; job and language training) could contribute to rebalancing, but care is needed to avoid accelerating structural decline and debt overhangs. Fostering capital mobility may be a preferable adjustment channel.

### Fiscal integration
- Greater fiscal integration would facilitate adjustment and provide fiscal risk sharing (temporary transfers or joint provision of public goods), but political hurdles are considerable in the short-term. Conditional on better governance and stronger national incentives, some system of transfers or joint provision could make automatic stabilizers less constrained by external balances and facilitate countercyclical fiscal policy (Allard and others, 2013).

### Conclusion: policy mix to advance adjustment
- The crisis showed external balances remain a critical macroeconomic constraint due to interlinked government, bank, and private sector balance sheets and tail risks of exit from monetary union.  
- Deficit countries pursued internal devaluations combining relative price adjustments (mainly via internal demand compression and labor shedding) and structural changes to raise productivity and reallocate resources to tradable sectors; progress on the structural side has been limited.  
- Exports have rebounded but manufacturing sectors typically remain smaller than before the crisis; large current account deficits in Greece, Ireland, Portugal, and Spain have shrunk or turned into surpluses mainly because imports and potential growth slowed drastically relative to precrisis trends, with high net foreign liabilities (NFLs) and sharply higher unemployment. Weak demand from euro area partner countries slows adjustment.  
- Short run: supportive macroeconomic policies to support domestic demand and facilitate relative price adjustments.  
- Medium run: further structural reforms in product and labor markets to raise productivity and potential output.  
- Area-wide initiatives (Banking Union, financial market development) are critical to loosen tight external financing constraints and support tradable sector growth; return of foreign investors is welcome but should not weaken efforts to complete the Banking Union.  
- In the future, elements of a Fiscal Union would help facilitate adjustment across member states.

*Source: ADJUSTMENT IN EURO AREA DEFICIT COUNTRIES, INTERNATIONAL MONETARY FUND (excerpts paragraphs 40–53).*

### References

### References

### Cited works

- Aghion, Philippe, Ufuk Akcigit, and Peter Howitt, 2013, “What Do We Learn From Schumpeterian Growth Theory?” NBER Working Paper No. 18824 (Cambridge, Massachusetts: National Bureau of Economic Research).  
- Al-Eyd, Ali J. and Pelin Berkmen, 2013, “Fragmentation and Monetary Policy in the Euro Area,” IMF Working Paper No. 13/208 (Washington: International Monetary Fund).  
- Allard, Céline, Petya Koeva Brooks, John Bluedorn, Fabian Bornhorst, Franziska Ohnsorge, and Katharine Christopherson Puh, 2013, “Toward a Fiscal Union for the Euro Area,” IMF Staff Discussion Note 13/9 (Washington: International Monetary Fund).  
- Arnold, Jens, Giuseppe Nicoletti, and Stefano Scarpetta, 2011, ”Regulation, Resource Reallocation and Productivity Growth,” European Investment Bank Papers, Vol. 16, No 1, pp. 90–115.  
- Asdrubali, Pierfederico, Bent E. Sorensen, and Oved Yosha, 1996, “Channels of Interstate Risk Sharing: United States 1963–1990,” Quarterly Journal of Economics, Vol. 111, No. 4, pp. 1081–1110.  
- Ball, Laurence, Daniel Leigh, and Prakash Loungani, 2013, “Okun’s Law: Fit at 50?” IMF Working Paper No. 13/10 (Washington: International Monetary Fund).  
- Barkbu, Bergljot, Jesmin Rahman, Rodrigo Valdés, and a staff team, 2012, “Fostering Growth in Europe Now,” IMF Staff Discussion Note 12/07 (Washington: International Monetary Fund).  
- Bayoumi, Tamim, Richard T. Harmsen and Jarkko Turunen, 2011, “Euro Area Export Performance and Competitiveness,” IMF Working Paper No. 11/140 (Washington: International Monetary Fund).  
- Bennett, Herman, Julio Escolano, Stefania Fabrizio, Eva Gutiérrez, Iryna Ivaschenko, Bogdan Lissovolik, Marialuz Moreno-Badia, Werner Schule, Stephen Tokarick, Yuan Xiao, and Ziga Zarnic, 2008, “Competitiveness in the Southern Euro Area: France, Greece, Italy, Portugal, and Spain,” IMF Working Paper No. 08/112 (Washington: International Monetary Fund).  
- Blanchard, Olivier, 2007, “Current Account Deficits in Rich Economies,” IMF Staff Papers 54 (Washington: International Monetary Fund) 191–219.  
- Blanchard, Olivier, 2007, “Adjustment Within the Euro: The Difficult Case of Portugal,” Portuguese Economic Journal, Vol. 6 (April) pp.1–21.  
- Blanchard, Olivier and Lawrence H. Summers, 1986, “Hysteresis and the European Unemployment Problem,” in NBER Macroeconomic Annual, ed. by Stanley Fischer (Cambridge, Massachusetts: MIT Press) pp. 15–74.  
- Blanchard, Olivier and Lawrence Katz, 1992, “Regional Evolutions,” Brookings Papers on Economic Activity, No. 1, pp. 1–75.  
- Blanchard, Olivier, Pierre Alain Muet, Vittorio Grilli and Patrice Vial, 1993, “Competitiveness through Disinflation: An Assessment of the French Macroeconomic Strategy,” Economic Policy, Vol. 8, No. 16, pp. 11–56.  
- Blanchard, Olivier and Justin Wolfers, 1999, “The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence,” NBER Working Paper 7282 (Cambridge, Massachusetts: National Bureau of Economic Research).  
- Blanchard, Olivier and Francesco Giavazzi, 2002, “Current Account Deficits in the Euro Area: The End of the Feldstein-Horioka Puzzle,” Brookings Papers on Economic Activity, No. 2, pp.148–186.  
- Blanchard, Olivier and Francesco Giavazzi, 2003, “Macroeconomic Effects of Regulation and Deregulation in Goods and Labor Markets,” The Quarterly Journal of Economics, Vol. 118, No. 3 (August), pp. 879–907.  
- Blanchard, Olivier and Gian Maria Milesi-Ferretti, 2009, “Global Imbalances: In Midstream?” IMF Staff Position Note No. 2009/29 (Washington: International Monetary Fund).  
- Blanchard, Olivier, Florence Jaumotte, and Prakash Loungani, 2013, “Labor Market Policies and IMF Advice in Advanced Economies During the Great Recession,” Staff Discussion Note 13/02 (Washington: International Monetary Fund).  
- Blanchard, Olivier, Mark Griffiths, and Bertrand Gruss, 2013,”Boom, Bust, Recovery: Forensics of the Latvia Crisis,” Economic Studies at Brookings, Fall 2013 Brookings Panel on Economic Activity, September 19–20, 2013.  
- Bornhorst, Fabian and Marta Ruiz Arranz, 2013, “Indebtedness and Deleveraging in the Euro Area,” Euro Area Policies – Article IV Consultation, IMF Country Report No. 13/232 (Washington: International Monetary Fund).  
- Bouis, Romain, Orsetta Causa, Lilas Demmou, Romain Duval, and Aleksandra Zdzienicka, 2012, “The Short-Term Effects of Structural Reforms, An Empirical Analysis, Economics,” OECD Department Working Paper No. 949 (Paris: Organization for Economic Cooperation and Development).  
- Renaud Bourlès, Gilbert Cette, Jimmy Lopez, Jacques Mairesse, and Giuseppe Nicoletti, 2010, “Do Product Market Regulations in Upstream Sectors Curb Productivity Growth? Panel Data Evidence for OECD Countries,” NBER Working Paper 16520 (Cambridge, Massachusetts: National Bureau of Economic Research).  
- Buiter, Willem and Anne Sibert, 2005, “How the Eurosystem’s Treatment of Collateral in its Open Market Operations Weakens Fiscal Discipline in the Eurozone (and what to do about it),” CEPR Discussion Paper No. 5387 (London: Centre for Economic Policy Research).  
- Cahuc, Pierre and Fabien Postel-Vinay, 2002, Temporary Jobs, Employment Protection and Labor Market Performance,” Labour Economics, Vol. 9, No. 1, pp. 63–91.  
- Chen, Ruo, Gian Maria Milesi-Ferretti, and Thierry Tressel, 2013, “External Imbalances in the Euro Area,” Economic Policy, Vol. 28, No.73, pp. 101–142.  
- Cheun, Samuel, Isabel von Köppen-Mertes, and Benedict Weller, 2009, “The Collateral Frameworks of the Eurosystem, the Federal Reserve System and the Bank of England and the Financial Market Turmoil,” ECB Occasional Paper Series No. 107 (Frankfurt: European Central Bank).  
- Committee for the Study of Economic and Monetary Union, 1989, Report on Economic and Monetary Union in the European Community, report to the European Council by Committee chaired by Jacques Delors (Brussels: European Commission).  
- Dao, Mai, Furceri, Davide, and Prakash Loungani, 2014, “Regional Labor Market Adjustments in the United States and Europe,” IMF Working Paper No. 14/26 (Washington: International Monetary Fund).  
- Decressin, Jorg and Antonio Fatas, 1995, "Regional Labor Market Dynamics in Europe,” European Economic Review, Vol. 39 No. 9, pp. 1627–655.  
- Di Mauro, Filippo and Katrin Forster, 2008, “Globalisation and the Competitiveness of the Euro Area,” ECB Occasional Paper No. 97 (Frankfurt: European Central Bank).  
- Di Mauro, Filippo, Katrin Forster, and Ana Lima, 2010, “The Global Downturn and Its Impact on Euro Area Exports and Competitiveness,” ECB Occasional Paper No. 119 (Frankfurt: European Central Bank).  
- Elmeskov, Jorge, John Martin, and Stefano Scarpetta, 1998, “Key Lessons for Labour Market Reforms: Evidence from OECD Countries' Experiences,” Swedish Economic Policy Review, Vol. 5, pp. 205–252.  
- European Central Bank, 2012, “Competitiveness and External Imbalances in the Euro Area,” ECB Occasional Paper No. 139 (Frankfurt: European Central Bank).  
- European Commission, 1990, “One Market, One Money, an Evaluation of the Potential Benefits and Costs of Forming an Economic and Monetary Union,” Directorate-General for Economic and Financial Affairs, European Economy, No. 44.  
- European Commission, Directorate-General for Economic and Financial Affairs, 2008, EMU@10: Successes and Challenges After 10 Years of Economic and Monetary Union, European Economy–The EU Economy Review, Issue 2 (Brussels: European Commission).  
- Farhi, Emmanuel, Gita Gopinath, and Oleg Itskhoki, 2011, “Fiscal Devaluations,” NBER Working Paper No. 17662 (Cambridge, Massachusetts: National Bureau of Economic Research).  
- Furceri, Davide and Aleksandra Zdzienicka, “The Euro Area Crisis: Need for a Supranational Fiscal Risk Sharing Mechanism?” IMF Working Paper No. 13/198 (Washington: International Monetary Fund).  
- Giavazzi, Francesco and Luigi Spaventa, 2010, “Why the Current Account May Matter in a Monetary Union, Lessons from the Financial Crisis in the Euro Area,” CEPR Discussion Paper No. 8008 (London: Centre for Economic Policy Research).  
- Goyal, Rishi, Koeva Brooks, Petya, Pradhan, Mahmood, Tressel, Thierry, Dell'Ariccia, Giovanni, and Ceyla Pazarbasioglu, and an IMF Staff Team, 2013, “A Banking Union for the Euro Area,” IMF Staff Discussion Note SDN 13/1 (Washington: International Monetary Fund).  
- Honohan, Patrick, 2009, “What Went Wrong in Ireland?” Trinity College Dublin.  
- International Monetary Fund, 2010, United States: Publication of Financial Sector Assessment Program Documentation—Technical Note on Crisis Management Arrangements, IMF Country Report No. 10/120 (Washington: International Monetary Fund).  
- International Monetary Fund, 2011, Regional Economic Outlook, Strengthening the Recovery, World Economic and Financial Surveys.  
- International Monetary Fund, 2011b, Germany Sustainability Report, G-20 Mutual Assessment Process.  
- International Monetary Fund, 2012, Euro Area Policies – 2012 Article IV Consultation.  
- International Monetary Fund, 2012b, World Economic Outlook – Growth Resuming, Dangers Remain, (Spring).  
- International Monetary Fund, 2013, Euro Area Policies – 2013 Article IV Consultation.  
- International Monetary Fund, 2013b, 2013 Spillover Report – Analytical Underpinnings and Other Background, IMF Multilateral Issues Report (August 1).  
- International Monetary Fund, 2013c, “The Dog that Didn’t Bark: Has Inflation Been Muzzled or Was it Just Sleeping?” in World Economic Outlook, Chapter 3, (April).  
- International Monetary Fund, 2013d, Greece: Ex Post Evaluation of Exceptional Access under the 2010 Stand-By Arrangement, IMF Country Report No. 13/156.  
- International Monetary Fund, 2013e, IMF Multi-Country Report, German-Central European Supply Chain – Cluster Report, IMF Country Report No. 13/263.  
- International Monetary Fund, 2013f, External Sector Report, (August).  
- Jaumotte, Florence and Piyaporn Sodsriwiboon, 2010, “Current Account Imbalances in the Southern Euro Area,” IMF Working Paper No. 10/139 (Washington: International Monetary Fund).  
- Florence Jaumotte, 2011, “The Spanish Labor Market in a Cross-Country Perspective,” IMF Working Paper No. 11/11 (Washington: International Monetary Fund).  
- Jaumotte, Florence and Hanan Morsy, 2012, “Determinants of Inflation in the Euro Area: The Role of Labor and Product Market Institutions,” IMF Working Paper No. 12/37 (Washington: International Monetary Fund).  
- Sebnem Kalemli-Ozcan, Emiliano Luttini, and Bent Sorensen, 2013, “Debt Crises and Risk Sharing: The Role of Markets versus Sovereigns,” CEPR Discussion Paper No. DP9541 (London: Centre for Economic Policy Research).  
- Kang, Joong Shik and Jay Shambaugh, 2013, “The Evolution of Current Account Deficits in the Euro Area Periphery and the Baltics: Many Paths to the Same Endpoint,” IMF Working Paper No. 13/169 (Washington: International Monetary Fund).  
- Kang, Joong Shik and Jay Shambaugh, 2014, “Progress Towards External Adjustment in the Euro Area Periphery and the Baltics,” IMF Working Paper, forthcoming.  
- Laeven, Luc and Thierry Tressel, 2013a, “European Financial Integration before the Crisis,” in From Fragmentation to Financial Integration in Europe (Washington, DC: International Monetary Fund).  
- Laeven, Luc and Thierry Tressel, 2013b, “Fragmentation of the Financial System,” in From Fragmentation to Financial Integration in Europe, (Washington, DC: International Monetary Fund).  
- Lane, Philip R., 2006, “The Real Effects of European Monetary Union,” Journal of Economic Perspectives, Vol. 20, No. 4, pp. 47–66.  
- Merler, Silvia and Jean Pisani-Ferry, 2012, “Sudden Stops in the Euro Area,” Bruegel Policy Contribution, Issue 6 (March).  
- Martin, John and Stefano Scarpetta, 2012, “Setting It Right: Employment Protection, Labour Reallocation and Productivity,” De Economist, Volume 160, pp. 89–116.  
- Mongelli Francesco Paolo and Charles Wyplosz, 2008, “The Euro at Ten: Unfulfilled Threat and Unexpected Challenges,” presented at the Fifth ECB Central Banking Conference The Euro at Ten: Lessons and Challenges, November 13–14, Frankfurt am Main.  
- Nkusu, Mwanza, 2013, “Boosting Competitiveness to Grow Out of Debt—Can Ireland Find a Way Back to Its Future?” IMF Working Paper No. 13/35 (Washington: International Monetary Fund).  
- Obstfeld, Maurice and Giovanni Peri, 1999, “Regional Non-Adjustment and Fiscal Policy: Lessons for EMU,” NBER Working Paper 6431 (Cambridge, Massachusetts: National Bureau of Economic Research).  
- Organization for Economic Cooperation and Development, Economic Policy Reforms, Going for Growth 2013 (Paris: Organization for Economic Cooperation and Development).  
- Cour-Thimann, Philippine, 2013, “Target Balances and the Crisis in the Euro Area,” CESifo Forum, Vol. 14 (April).  
- Scarpetta, Stefano, 1996, “Assessing the Role of Labour Market Policies and Institutional Settings on Unemployment: A Cross-country Study,” OECD Economic Studies, No. 26, pp. 43–98.  
- Scarpetta, Stefano and Thierry Tressel, 2002, “Productivity and Convergence in a Panel of OECD Industries, Do Regulations and Institutions Matter?” OECD Economics Department Working Paper 342 (Paris: Organization for Economic Cooperation and Development).  
- Scarpetta, Stefano and Thierry Tressel, 2004. “Boosting Productivity via Innovation and Adoption of New Technologies: Any Role for Labor Market Institutions?” World Bank Policy Research Working Paper Series 3273, (Washington, DC: World Bank).  
- Schmitz, Birgit and Jürgen von Hagen, 2011, “Current Account Imbalances and Financial Integration in the Euro Area,” Journal of International Money and Finance, Vol. 30, No. 8, (December) pp. 1676–95.  
- Shambaugh, Jay, 2012, “The Euro’s Three Crises,” Brookings Papers on Economic Activity, Vol. 44, No. 1 (Spring) pp.157–231.  
- Suarez, Javier, 2010, “The Spanish Crisis: Background and Policy Challenges”, CEPR Discussion Paper 7909 (London: Centre for Economic Policy Research).  
- Tressel, Thierry, 2012, “The Eurozone Crisis and the Sovereign-Bank Nexus: The Case for a Eurozone Banking Union,” Selected Issues Paper Euro Area Policies – 2012 IMF Article IV Consultation. (Washington, DC: International Monetary Fund).  
- Thierry, Tressel and Shengzu Wang, 2013, “Rebalancing in the Euro Area: Where do We Stand and Where to Go?” Selected Issues Paper, Euro Area Staff Report (Washington, DC: International Monetary Fund).  
- Tressel Thierry and Shengzu Wang, 2014, “Rebalancing in the Euro Area and Cyclicality of Current Account Adjustments?” IMF Working Paper, forthcoming.  
- Veron, Nicolas, 2013, “Banking Nationalism and the European Crisis,” (Washington, DC: Peterson Institute for International Economics).  
- Wyplosz, Charles, 2006, “European Monetary Union: The Dark Sides of a Major Success,” Economic Policy (April) pp. 207–61.

*International Monetary Fund — _sdn1407 - References*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/sdn/2014/_sdn1407.pdf_