Traffic jam in Germany. Countries with room for manoeuver could invest in public infrastructure to boost potential growth and domestic demand (photo: Kai Pfaffenbach/Reuters/Newscom)

Euro Area: There Is Recovery, But Reforms Are Needed

July 25, 2017

Euro area recovery has strengthened over the last year, bringing with it more jobs and opportunities. All euro area members are sharing in the recovery now, with the differences in growth rates across countries at their lowest level since the launch of the euro in 1999. But even as the euro area economy gathers momentum, it still faces the hurdles of high public debt in some states, a lack of convergence in income levels among countries, and the need to reduce imbalances that built up before the crisis. Overcoming these requires further reforms, says the latest economic health check of the euro area.

High public debt

Despite the recovery, a number of euro area countries—not least, Greece, Italy, and Portugal—are still saddled with high public debt. These countries have limited buffers to cushion against economic shocks, and could face higher borrowing costs when the current monetary stimulus is gradually reduced, through lower bond purchases by the European Central Bank, for example. These countries need to rebuild buffers now and put their public debt-to-GDP ratios solidly on a downward path.

Income promise unfulfilled

The euro area also suffers from a deeper-rooted challenge: a lack of convergence between countries in income levels per person. In the 12 original euro area members, the catch-up in income levels across countries has stalled since the adoption of the euro. Contrary to expectations, the lower-income countries have not grown faster than the higher-income countries in the group. It calls into question the promise of higher incomes through deeper economic integration, which was one of the original motivations for the monetary union. This lack of convergence is closely linked to slower productivity growth in countries with lower initial income levels.

At the same time, the gaps in underlying competitiveness between some of these countries widened in the years after the euro was adopted. In some countries, wages grew faster than productivity, and this was typically associated with trade deficits and rising levels of external debt. Some countries—such as Greece, Portugal, and Spain—then made painful post-crisis lay-offs, which had the effect of raising output per worker and helped improve their competitiveness.

But these countries need to do more to fully repair the pre-crisis erosion of competitiveness. Efforts now should not focus on job cuts, but rather on improving productivity through investment and more efficient working practices, for example, and reforming their wage bargaining mechanisms. In addition to the restoration of competitiveness, such steps would raise employment and, ultimately, improve living standards.

Good time to reform

The strengthening recovery makes this a good time to press forward with reforms.

The findings of recent IMF research lend hope, showing that reforms tend to have a bigger bang for the buck in countries with lower initial levels of productivity. Hence, reforms boost productivity more in the countries that need it most, helping to restore lost competitiveness and supporting faster income growth.

In Italy, for example, modernizing the wage bargaining framework to better align wages with productivity would improve competitiveness and bolster employment.

Make it budget neutral

Reforms in countries with high public debt levels and no room for maneuver in their budgets should aim to be budget neutral—for example, by using savings from stricter time limits on unemployment benefits to fund job retraining programs for the long-term unemployed. They should also prioritize reforms with few costs, such as product market reforms like eliminating restrictions on shop opening hours.

Aging and investment

Countries with ample room for maneuver in their budgets, such as Germany and the Netherlands, should prepare for the impact their aging populations will have in coming years. These countries will have to raise their productivity to help their economies grow fast enough to be able to support the increasing share of retirees. Reforms could start by focusing on sectors with weaker productivity, such as the professional services sector in Germany.

These countries should also use their budget surpluses for public investment in infrastructure, education, and innovation. This would boost growth over the medium term and would also help bring down their large trade surpluses.

They can also mitigate the short-term negative impact of reforms on certain sections of society. A good recent example is Finland, where workers got an income tax cut in exchange for labor unions’ agreeing to a package of reforms that reduces employers’ labor costs.

Build common institutions

The European Union could do more to convince countries to put EU reform recommendations into practice. For example, targeted support from the EU budget could be provided to incentivize reforms.

The EU should also continue pushing for greater integration of the energy, transport, and digital markets.

The strengthening recovery and recent pro-EU political developments make this an excellent time to push ahead with the euro area institutional architecture as well. Completing the banking union, including with a common deposit insurance scheme, is essential to weaken the link between banks and sovereigns, reducing the risk of failing banks blowing up the public finances.

Creating a more unified European financial market, instead of the current plethora of smaller national ones, would help increase investment by diversifying financing sources.

Finally, developing a central fiscal capacity for the euro area would help struggling economies cope with shocks when their own budgets are stretched. This could also go hand-in-hand with a reform of the fiscal framework to simplify the rules and make enforcement more automatic.