The Euro Zone: What’s Next

IMF News, September 28, 2017

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The Euro Zone: What’s Next

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Bibliographic details

• Authors: Poul Thomsen
• Published: September 28, 2017

Economic outlook and recent performance

• Quarterly growth has been positive for the last 17 quarters.
• IMF June projection for 2017: 1.9 percent; ECB recently raised its projection for 2017 to 2.2 percent; IMF expects its own estimate to be close to that.
• Real investment, excluding construction, has surpassed its pre-crisis level.
• Recovery is broad-based: all euro area countries are growing above trend and unemployment is declining.
• IMF measure of dispersion of growth rates across member states: the most evenly distributed recovery for more than two decades.
• Cautionary point: “there are seven countries in the Euro Zone, among them several large ones, with public debt near or above hundred percent of GDP,” limiting policy buffers for future shocks.

Monetary policy

• IMF estimates the output gap for the euro area as a whole is closing fast.
• Unemployment is down to 9 percent, of which IMF estimates only one percentage point to be cyclical.
• Wage pressures are weak and core inflation is inching up only very slowly.
• IMF projection: inflation in the euro area would reach 1.9% only by 2021.
• Policy guidance and observations:
  • The ECB needs to maintain an accommodative policy stance for the foreseeable future.
  • Unconventional ECB measures have been critical to averting deflation risks and supporting recovery.
  • Unwinding unconventional measures will be gradual and does not imply an immediate end to accommodation.
  • Countries with the strongest cyclical positions will at times need inflation above the medium-term objective to achieve Euro Zone aggregate targets.
  • The ECB’s clear communication about maintaining accommodation as long as necessary should comfort investors.

Fiscal policy

• Historical context: fiscal policies have had to restore confidence and reduce public debt while avoiding choking the recovery.
• Europe’s fiscal governance framework has acted as an important anchor; budget deficits have come down significantly since the crisis.
• Concern: progress on fiscal consolidation has slowed in several countries where debt remains very high despite accelerating growth.
• Key fiscal recommendations:
  • With growth recovering and output gaps narrowing fast, now is the time to rebuild fiscal space and place public debt on a firm downward trajectory.
  • Pursue gradual fiscal consolidation to ensure stronger buffers when the next adverse shock hits.
  • Rebalance fiscal policy to be more growth friendly by:
  • Making public spending more efficient and growth-oriented.
  • Making the tax system more supportive of job creation and productivity growth.
  • Countries with the least fiscal space should use the current window of opportunity to rebuild fiscal buffers to avoid difficult adjustments later.

Structural reforms and productivity

• Commission metrics show almost universally very limited progress on structural reforms in recent years.
• The lack of productivity improvement is the central weakness: divergence in GDP per capita since euro adoption and divergence since the crisis (countries with lower per capita GDP have fallen further behind).
• Persistent productivity gaps are the root cause of high structural unemployment and especially high youth unemployment in several countries.
• IMF observations and guidance:
  • Structural reforms to boost productivity remain the overarching challenge for Euro Zone policymakers.
  • Specific reform measures differ across member states and are generally well understood by national policymakers.
  • IMF welcomes proposals to improve fiscal governance to incentivize productivity-boosting reforms at the national level.
  • Main obstacle: entrenched resistance from vested interests at the national level.

Euro Zone architecture and risk-sharing mechanisms

• Public sentiment: polls show support for the Euro at the highest level in more than a decade; renewed political support for further integration in some national policymakers.
• Areas for further architectural work:
  • Complete the banking union: Single Supervisory Mechanism and Single Resolution Mechanism need to be accompanied by a common deposit insurance and a common fiscal backstop.
  • Advance capital markets union to enhance integration and risk sharing.
  • Consider a Central Fiscal Capacity to improve the euro area’s ability to offset shocks by alleviating fiscal space constraints in downturns and building buffers in good times; could be an element of an eventual common euro area budget.
  • Consideration of a “European Monetary Fund” to strengthen crisis prevention and crisis management, with critical issues including its role relative to existing European institutions and robustness to undue political interference.
• Caveats and political constraints:
  • Any increased risk sharing must go hand-in-hand with risk reduction and solutions to legacy problems, including resolute resolution of problem banks.
  • Concerns about moral hazard and political resistance will temper the boldness and ambition of architectural reforms.
  • The Euro Zone is not a political union; progress will be gradual and evolutionary, requiring difficult political compromises.
  • IMF perspective: success of new institutions depends on overcoming problems that have marred the fiscal governance framework in the past.

Central message and policy priorities

• Central message: the current recovery is an important opportunity to strengthen resilience and growth potential of the currency union.
• Immediate priorities for national policymakers:
  • Gradually rebuild fiscal buffers through fiscal consolidation.
  • Rebalance fiscal policy toward growth-enhancing spending and tax structures.
  • Push ahead with national structural reforms to boost productivity and raise potential output.
  • Avoid complacency and do not defer critical national measures expecting architectural changes to fully mitigate future shocks.
• For countries with limited fiscal space and modest potential growth, the ability to avoid major pro-cyclical tightening when shocks occur depends on buffers built during the current recovery through fiscal adjustment and structural reforms.

Conclusion

• The outlook for the Euro Zone has improved significantly.
• The recovery provides an opportunity to lay foundations at both national and central levels for a more resilient Euro Zone.
• Challenges remain formidable, but there are good reasons for greater optimism about the future.

Speech at the Financial Times Investment Management Summit, London — Poul M. Thomsen, Director of the European Department, International Monetary Fund, September 28, 2017

References

• Poul M. Thomsen
• France and the IMF
• Germany and the IMF
• Speeches
• PRESS CENTER
• https://www.imf.org/en/home