"Reviving Growth in Europe" — By Nemat Shafik, Deputy Managing Director, International Monetary Fund
IMF News, May 31, 2012
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Bibliographic details
- Authors: Deputy Managing Director Nemat Shafik
- Published: May 31, 2012
Context and overview
- Speech delivered at the Brussels Economic Forum, Brussels, May 31, 2012; "As prepared for delivery."
- Framing: Europe at the epicenter of a crisis that threatens achievements of European integration; objective is to identify near-term policies to support demand and longer-term structural and regional reforms to restore growth.
Current situation and costs
- Progress already made:
- Hardest hit countries (Greece, Portugal, Ireland) have undertaken unprecedented fiscal consolidation and ambitious structural reforms with EU and IMF financial assistance.
- EU leaders improved fiscal governance and strengthened the firewall; the European Central Bank provided liquidity support on an unprecedented scale.
- Remaining risks:
- Financial and sovereign stresses remain elevated; negative sovereign–bank feedback loops persist.
- Markets worry about ability and commitment of some governments to rein in fiscal deficits and revive growth.
- Human and social costs:
- Greece overall unemployment: more than 20 percent.
- Greece youth unemployment: above 50 percent.
- Spain youth unemployment: above 50 percent.
- Portugal youth unemployment: more than 35 percent.
- Risk of a "lost generation" and rising social and political tensions that may undermine reform support.
Short-term growth challenges and trade-offs
- Growth and competitiveness:
- Growth and productivity trends in Europe have fallen behind peers over the past decade; divergent performance within the euro area (Portugal contracted by 2.2 percent in the first quarter of 2012; Germany grew by 1.2 percent).
- Competitiveness gaps, reflected in unit labor costs, contributed to severe imbalances within the monetary union.
- Unit labor costs in manufacturing: increased by about 30 percent from 2000 to 2008 in Greece; declined by 8 percent in Germany.
- Constraints of the eurozone:
- Absence of exchange rate adjustment means competitiveness improvements often require reductions in costs, including labor costs — a painful process for crisis-hit periphery countries.
- Adjustment to date has been largely via lower imports; relative prices are beginning to adjust too (core inflation slowed faster in the euro periphery than in the core).
Policy front 1 — Supporting demand in the short run
- Fiscal policy:
- Fiscal consolidation through credible medium-term plans must happen; front-loaded consolidation necessary for the most heavily indebted states.
- Overall, fiscal adjustment plans for this year are broadly appropriate in Europe.
- Some nominal fiscal targets for 2013 may prove too pro-cyclical and may need adjustment or expression in structural terms.
- The Stability and Growth Pact’s excessive deficit procedure allows flexibility in deciding how fast to bring deficits below 3 percent of GDP; flexibility should be used if conditions worsen.
- Consider specifying targets in cyclically-adjusted rather than nominal terms to allow automatic stabilizers to work.
- Monetary policy:
- With price pressures expected to decline, the European Central Bank could consider further expansionary measures to prevent aggregate inflation from slipping far below the target of keeping inflation at or below 2 percent.
Policy front 2 — Restoring the health of the financial sector
- Importance:
- Well-functioning credit markets are essential for sectors with growth potential, especially small and medium-sized enterprises.
- A healthy and well-regulated financial system restores investor confidence and prevents future boom–bust cycles.
- Progress and country examples:
- Ireland: banking system restructured, domestic banks recapitalized on the basis of stringent stress tests and independent loan loss forecasts; priority now is restoring long-term viability and restarting lending.
- Spain: restructuring to address overlending into real estate; recent measures demonstrate resolve but require decisive follow-through to boost confidence and support growth.
Policy front 3 — Structural reforms to boost long-term growth
- Goals:
- Implement comprehensive structural reforms to raise growth potential and facilitate rebalancing.
- Complete the architecture of the monetary union at the regional level.
- IMF simulations and potential gains:
- Eliminating 50 percent of euro area countries’ gap with OECD best practices in labor and product market policies could boost GDP growth by up to 4½ percent over five years.
- About a quarter of additional growth is expected from positive cross-country and cross-reform spillover effects.
- Historical examples:
- Netherlands: employment rate increased from 53 percent in the 1980s to close to 67 percent in 2011.
- Sweden: annual labor productivity growth increased from 1 percent in 1977-92 to 2.5 percent in 1992-2007.
- Country-specific diagnosis:
- Competitiveness problems vary: lack of competitiveness more acute in Greece and Portugal than in Spain; Italy remains relatively competitive but needs reform.
- Common needs: improve competitiveness and invest more in human and physical capital.
- Key reform areas and options:
- Reforming labor markets:
- Make labor markets more inclusive and enable needed price realignments.
- Reduce duality of the labor market, reform wage bargaining, promote higher labor mobility.
- Active labor market programs, possibly financed by EU funds, to bolster employment in the short term.
- Lowering regulatory barriers:
- Ease business start-ups and closures, simplify tax systems, support small- and medium-sized enterprises in international markets.
- Increasing investment:
- Facilitate growth-enhancing public investment by increasing common resources through the EU budget and the European Investment Bank.
- Prioritize project bonds for infrastructure investment and redirect EU funds toward high-impact projects.
- Fiscal devaluation and nominal wage and price restraints:
- Can foster internal devaluation in the short run while minimizing household purchasing power losses.
- Rebalancing within the currency union:
- Northern surplus countries: domestic demand must outpace output somewhat (higher inflation in the north).
- Southern deficit countries: aim for higher net exports (lower inflation in the south).
- Illustrative price movements (tourism example):
- Spain: a hotel room costs 50 percent more than in 2000; vacation packages cost 22 percent more.
- Germany: hotels are only 15 percent more expensive today; the cost of vacation packages has barely changed in 12 years.
Regional integration and financial union
- Need for deeper integration:
- Single market for products exists, but single market for financial services is lagging.
- Decisive steps toward more complete financial integration would complement national reforms and weaken adverse bank–sovereign feedback loops.
- Possible institutional steps:
- Provide banking support from a common resource pool independent from national sources.
- Subject banks receiving pan-European support to centralized regulation and supervision over time.
- Create a joint bank resolution authority with a common backstop and a single deposit insurance fund.
- Trade-offs and benefits:
- A common backstop entails some fiscal risk-sharing and additional pooling of sovereignty.
- Greater fiscal integration would likely lower sovereign yields, improve market access, decouple banks from sovereigns, reduce deleveraging pressures, and facilitate credit and investment availability.
Implementation challenges and public support
- Reform fatigue and social cohesion:
- Adjustment is extremely difficult; the IMF emphasizes protecting social cohesion in crisis-hit economies within tight fiscal constraints.
- IMF programs have worked closely with governments to protect social spending and jobs where possible, even when overall spending had to be cut.
- Political economy:
- Explaining the rationale for reforms to the public is crucial; losing public support now risks negating progress and setting Europe back.
- Closing note:
- Quoting Jean Monnet: “People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them.” It is time to accept necessity and complete the reform agenda to restore Europe’s growth.
Speech: "Reviving Growth in Europe" by Nemat Shafik, Deputy Managing Director, International Monetary Fund — Brussels Economic Forum, Brussels, May 31, 2012.