Unwinding Crisis Policies in Europe: Are We There Yet?

IMF Blog, January 17, 2010

Source details

Context and assessment:
- "We are no longer at the edge of the abyss that loomed in early 2009, with all but a handful of Europe’s economies now pulling out of recession."
- Recovery remains fragile, uneven across the continent, and subject to important downside risks.
- Extraordinary policy support globally and in Europe "impairs our ability to read the underlying economic fundamentals."
- Crisis requires economic restructuring and widespread balance sheet repair—processes that "necessarily take time."
Observed ambivalence in indicators:
- "Equity valuations anticipate a solid and durable recovery, yet investors are willing to meet governments’ extraordinary financing needs at very low interest rates as if growth prospects were poor."
- "Bank lending... remains tight" for smaller and medium sized enterprises, while "capital markets are very active in funding larger corporations."
- "Unemployment is still rising but consumers appear to be 'believing in inflation again', which is helping dispel lingering worries over deflation."
- "The euro is close to a historic high in real effective terms, and tensions in the euro area from divergences in economic performance and policy implementation have risen."
Recommendation:
- Fiscal and monetary policies should "continue to support the recovery" given fragility and downside risks.
- IMF plans to publish revised growth forecasts "at the end of January in the next quarterly update of the World Economic Outlook."

Appraisal of financial system stability:
- "Confidence and resilience in financial markets has improved and remaining problems appear to be no longer systemic," citing ECB Vice-President Lucas Papademos.
- Vulnerabilities "are still high"—key questions include:
- "Will banks be able to sustain the recent increase in profitability?"
- "Will they succumb to concentrations in lending to commercial property or emerging markets?"
- "How would they handle a sharp increase in sovereign yields if fears about fiscal sustainability became widespread?"
Rationale for progressive unwinding:
- Concern that supportive policies could become "an addiction."
- Most supportive measures have:
- "built in sunset clauses (most enhanced credit support measures),"
- "provisions linked to market conditions (for instance, debt guarantees),"
- or "costs that become more onerous as time progresses (for instance, recapitalization schemes)."
Recommended approach:
- "Encourage policymakers to remove financial system supports in line with their built-in expiration dates."
- Note: "the ECB has started doing this by ending its one year liquidity support measures and some countries have allowed debt guarantee schemes to lapse."
- Policy priority should be to "tackle remaining weaknesses with specific interventions."

Financial sector reform:
- Europe has used the crisis "as an opportunity to put in place new pan-European financial stability arrangements."
- Europe "needs to play its part in implementing global regulatory reform."
- Rapid clarification of "what the new rules will be" would allow financial institutions to "focus on their core business: provide credit where credit is due."
Fiscal consolidation concerns:
- Crisis exposed "the weak underlying state of public finances in Europe."
- Worry about "the surge in government indebtedness and the potential for an adverse shift in sentiment about fiscal sustainability."
- Countries need to "demonstrate credible plans for fiscal consolidation."
- Although Europe's finance ministers "tabled ambitious intentions, guided by the Stability and Growth Pact," translating promises into credible plans "has become more urgent than is generally perceived."
- Some issues are "particularly pertinent for the euro area" and will be addressed in subsequent analysis.

Marek Belka, January 17, 2010